EU predicts European Union and euro-zone to shrink by 4 percent this year
BRUSSELS (AP) -- The European Union said Monday that Europe is suffering "a deep and widespread recession" and that unemployment will rise sharply over the coming two years.
The European Commission said both the 27-nation EU and the 16 countries that use the euro currency will shrink by 4 percent this year, more than double its January estimates, when it forecast a 1.8 percent contraction for the EU and a 1.9 percent decline for the euro area.
Because of the big drop in output, the Commission said some 8.5 million jobs will disappear in EU in 2009 and 2010, more than wiping out the number of new jobs created in the last two years. Euro-zone unemployment will hit a postwar record of 11.5 percent next year, it said.
The EU's executive predicted a "subdued recovery" next year with both the EU and euro-zone economies shrinking by 0.1 percent -- but warned that this would only happen if the banking sector and world trade start to recover. The new forecasts echo those made by other bodies such as the International Monetary Fund.
The EU said manufacturing and exports are suffering, with euro-zone exports "forecast to suffer one of the worst setbacks on record" with a 13-percent slump this year. Europe's manufacturers have been hit badly by the slide in global trade and the strength of the euro against the dollar and other currencies.
Germany, the EU's largest economy, is faring particularly badly in the current economic climate as demand for high-value exports such as cars and machinery dries up. The EU is forecasting that Germany will contract by 5.5 percent this year and only recover moderately when trade picks up next year.
Britain and Italy will shrink by between 4 percent to 4.5 percent, it said, while France, cushioned by heavy government spending that supports growth, will post a smaller 3-percent drop. Spain will also likely shrink by 3 percent.
Both Britain and France will see unemployment climb over 3 million next year -- with France reporting an 11 percent jobless rate. Spain is forecast to fare worse with one in five workers unable to find a job -- an unemployment rate of 20 percent.
The EU warned that even worse may be ahead and banks' efforts to deleverage -- shore up their financial position by putting more money aside to cover bad debt -- "may unravel with greater intensity than currently expected."
It said a bad debt spiral from falling house prices could trigger a wave of business bankruptcies that lift unemployment and lead to more debt defaults.
To avoid this, it called on European governments to shore up confidence in banks by moving swiftly to clean up banks' balance sheets by taking on hard-to-value assets that have racked up huge losses and launching new bank recapitalizations as needed.
EU banks have already written down euro290 billion in losses, it says, calling for close-monitoring of debt defaults, particularly in eastern Europe where many western banks may face bad loan books as housing prices collapse and unemployment rises.
It also warned of "disruptive exchange rate developments" and protectionist measures that could further cut global trade and remove one major crutch to an economic recovery next year.
The EU said Europe faces a limited risk of deflation -- a corrosive spiral of falling prices -- but that several countries will see "disinflation" for several months this year as energy prices plunge from record highs last summer.
The EU now expects euro-zone inflation of 0.4 percent this year -- far below the European Central Bank's guideline of just under 2 percent and said that lower inflation may help support the economy by giving people more money to spend via such things as lower mortgage payments.
The EU made no criticism of European government efforts to stimulate the economy by spending an extra euro135 billion this year-- 1.1 percent of EU GDP -- and more than euro90 billion next year -- 0.7 percent of EU GDP.
But it said government investment and consumption is likely to be the main driver of growth and tax breaks and reductions -- particularly lower company tax rates -- will have little impact on the economy.
Stimulus spending and billions of euros to shore up banks with guarantees and capital injections will massively increase EU governments' debt and deficit, it said.
EU governments will jointly next year run a budget deficit of around euro900 billion -- or 7.25 percent of gross domestic product.
Monday, 4 May 2009
Changing course
Bank of America’s shareholders get tough—sort of 
KEN LEWIS, the boss of Bank of America (BofA), famously said he had had as much fun as he could stand in investment banking in the autumn of 2007. How on earth must he feel now? Mr Lewis’s decision to buy Merrill Lynch in September has cost him his reputation, his independence and, on April 29th, one of his many titles. At the bank’s annual general meeting shareholders re-elected Mr Lewis to the board, but voted to split the role of chairman and chief executive. Walter Massey, a board veteran, replaced him as chairman. Mr Lewis can count himself lucky. True, there was strong logic in buying Merrill Lynch, with its coveted retail brokerage, and Countrywide, a sickly mortgage lender, before that. True too, that the government resisted his belated attempts to get out of the Merrill deal in December, as losses at the bank rapidly worsened.
But these are figleaves. The Merrill deal was stitched together too quickly. Mr Lewis agreed on a price (in shares, to give him some credit) that looked inflated even before Merrill posted losses of more than $15 billion in the fourth quarter. “As a group, they are not disciplined buyers,” says Jonathan Finger, a disgruntled shareholder. Claims that Merrill paid out lavish bonuses to employees without BofA’s say-so, and that Mr Lewis was forbidden by officials to disclose details of Merrill’s losses to shareholders (both disputed), make BofA’s managers look impotent at best and contemptuous of shareholders at worst. Hostile investors argue that Merrill was already burning money when they voted on the deal on December 5th, before Mr Lewis crossed swords with the government.
The bank’s share price has lost more than three-quarters of its value since September. Things could yet get worse. Leaks about the results of the stress tests that have been conducted on America’s largest banks suggest that BofA, which has already received $45 billion from the government, needs yet more capital (it would probably not be the only supplicant). This could well mean that the government’s preferred shares are converted into common equity. If other investors do not want to get rid of Mr Lewis, the government may do it for them.
For bank shareholders in America, the ground is slowly shifting. Managers and boards will find it much harder in future to argue that they know best after the pasting they have given investors. Chuck Schumer, a Democratic senator, is reportedly planning a bill requiring non-binding “say on pay” votes, independent chairmen and annual elections for boards of directors. The Securities and Exchange Commission is also expected to enact two reforms. One would make it easier for shareholders to nominate their own candidates to the board. The other would stop retail brokers from casting votes, almost always in favour of management, on behalf of investors who have not given instructions on how to vote. These broker votes accounted for roughly a quarter of the BofA ballots.
Working out what effect enhanced shareholder rights would have on banks is harder. Governance activists in America typically laud the shareholder regime in Britain, yet the British banks fouled up just as badly as everyone else. Take RBS, where the shareholders merrily voted to buy ABN AMRO—the deal that sank the bank—after the credit crunch had struck.
The sympathetic explanation is that shareholders face a difficult job of holding banks to account. Banks are opaque and complex firms. Working out the risks they were taking on was apparently beyond most managers, let alone shareholders. Banks are heavily regulated, which created an unhealthy reliance on supervisors, who were also incapable of understanding the risks. And banks are fragile, which makes shareholders think twice about flexing their muscles when confidence is shaky. “There isn’t a halfway house to register effective dissent without risk of nuclear war,” says Peter Montagnon of the Association of British Insurers.
That worry still preoccupies some BofA shareholders. The bank argues that Mr Lewis and his team are skilled at integrating acquisitions; now that Merrill and Countrywide have been bought, in other words, shareholders would cut off their own noses by getting rid of them. That is a bit like saying BofA managers are experts in getting out of holes they have dug for themselves. But the judgments are finer for other banks. Take Barclays, which riled shareholders with a dilative capital-raising in October but has avoided taking government cash. On April 23rd an unusual number of shareholders opposed the re-election of Marcus Agius, Barclays’ chairman, but nowhere near enough to threaten his appointment. That seems supine to some, pragmatic to others.
Even when shareholders raise objections, it is apparently too easy for executives to ignore them. The boss of Legal & General, a large institutional shareholder, has described the way British banks ignored its advice during the crisis as “sobering”. Some think the role of lead independent directors needs to be beefed up. Another idea is for a committee of the most powerful shareholders to dig deeper into the composition of the board. Increased public scrutiny will also make it harder for executives to brush off criticism. Daniel Bouton announced his intention to resign as chairman of Société Générale on April 29th, citing personal attacks since a rogue-trading scandal forced him out of the chief executive’s job a year ago.
There is another, more sinister explanation for the failure of shareholders to discipline their managers—they do not want to. Shareholders accrue all the gains from risk-taking, but their losses are capped by the amount of equity they hold. Once capital is wiped out, any further losses are borne by creditors. A forthcoming paper by Shams Pathan of Australia’s Bond University finds that bank boards that are more aligned with shareholders’ interests are more likely to take risk than those that are under the thumb of the chief executive.
When banks have only thin slices of equity, or when share prices have dropped precipitously, shareholders’ propensity to gamble goes up even more. A new paper from Lucian Bebchuk and Holger Spamann of Harvard Law School suggests that bankers’ pay be tied not just to equity but to other bits of the bank’s capital structure, such as preferred shares and bonds. Giving shareholders more control makes sense, but like every other solution to this wretched crisis, it creates problems of its own.
KEN LEWIS, the boss of Bank of America (BofA), famously said he had had as much fun as he could stand in investment banking in the autumn of 2007. How on earth must he feel now? Mr Lewis’s decision to buy Merrill Lynch in September has cost him his reputation, his independence and, on April 29th, one of his many titles. At the bank’s annual general meeting shareholders re-elected Mr Lewis to the board, but voted to split the role of chairman and chief executive. Walter Massey, a board veteran, replaced him as chairman. Mr Lewis can count himself lucky. True, there was strong logic in buying Merrill Lynch, with its coveted retail brokerage, and Countrywide, a sickly mortgage lender, before that. True too, that the government resisted his belated attempts to get out of the Merrill deal in December, as losses at the bank rapidly worsened.
But these are figleaves. The Merrill deal was stitched together too quickly. Mr Lewis agreed on a price (in shares, to give him some credit) that looked inflated even before Merrill posted losses of more than $15 billion in the fourth quarter. “As a group, they are not disciplined buyers,” says Jonathan Finger, a disgruntled shareholder. Claims that Merrill paid out lavish bonuses to employees without BofA’s say-so, and that Mr Lewis was forbidden by officials to disclose details of Merrill’s losses to shareholders (both disputed), make BofA’s managers look impotent at best and contemptuous of shareholders at worst. Hostile investors argue that Merrill was already burning money when they voted on the deal on December 5th, before Mr Lewis crossed swords with the government.
The bank’s share price has lost more than three-quarters of its value since September. Things could yet get worse. Leaks about the results of the stress tests that have been conducted on America’s largest banks suggest that BofA, which has already received $45 billion from the government, needs yet more capital (it would probably not be the only supplicant). This could well mean that the government’s preferred shares are converted into common equity. If other investors do not want to get rid of Mr Lewis, the government may do it for them.
For bank shareholders in America, the ground is slowly shifting. Managers and boards will find it much harder in future to argue that they know best after the pasting they have given investors. Chuck Schumer, a Democratic senator, is reportedly planning a bill requiring non-binding “say on pay” votes, independent chairmen and annual elections for boards of directors. The Securities and Exchange Commission is also expected to enact two reforms. One would make it easier for shareholders to nominate their own candidates to the board. The other would stop retail brokers from casting votes, almost always in favour of management, on behalf of investors who have not given instructions on how to vote. These broker votes accounted for roughly a quarter of the BofA ballots.
Working out what effect enhanced shareholder rights would have on banks is harder. Governance activists in America typically laud the shareholder regime in Britain, yet the British banks fouled up just as badly as everyone else. Take RBS, where the shareholders merrily voted to buy ABN AMRO—the deal that sank the bank—after the credit crunch had struck.
The sympathetic explanation is that shareholders face a difficult job of holding banks to account. Banks are opaque and complex firms. Working out the risks they were taking on was apparently beyond most managers, let alone shareholders. Banks are heavily regulated, which created an unhealthy reliance on supervisors, who were also incapable of understanding the risks. And banks are fragile, which makes shareholders think twice about flexing their muscles when confidence is shaky. “There isn’t a halfway house to register effective dissent without risk of nuclear war,” says Peter Montagnon of the Association of British Insurers.
That worry still preoccupies some BofA shareholders. The bank argues that Mr Lewis and his team are skilled at integrating acquisitions; now that Merrill and Countrywide have been bought, in other words, shareholders would cut off their own noses by getting rid of them. That is a bit like saying BofA managers are experts in getting out of holes they have dug for themselves. But the judgments are finer for other banks. Take Barclays, which riled shareholders with a dilative capital-raising in October but has avoided taking government cash. On April 23rd an unusual number of shareholders opposed the re-election of Marcus Agius, Barclays’ chairman, but nowhere near enough to threaten his appointment. That seems supine to some, pragmatic to others.
Even when shareholders raise objections, it is apparently too easy for executives to ignore them. The boss of Legal & General, a large institutional shareholder, has described the way British banks ignored its advice during the crisis as “sobering”. Some think the role of lead independent directors needs to be beefed up. Another idea is for a committee of the most powerful shareholders to dig deeper into the composition of the board. Increased public scrutiny will also make it harder for executives to brush off criticism. Daniel Bouton announced his intention to resign as chairman of Société Générale on April 29th, citing personal attacks since a rogue-trading scandal forced him out of the chief executive’s job a year ago.
There is another, more sinister explanation for the failure of shareholders to discipline their managers—they do not want to. Shareholders accrue all the gains from risk-taking, but their losses are capped by the amount of equity they hold. Once capital is wiped out, any further losses are borne by creditors. A forthcoming paper by Shams Pathan of Australia’s Bond University finds that bank boards that are more aligned with shareholders’ interests are more likely to take risk than those that are under the thumb of the chief executive.
When banks have only thin slices of equity, or when share prices have dropped precipitously, shareholders’ propensity to gamble goes up even more. A new paper from Lucian Bebchuk and Holger Spamann of Harvard Law School suggests that bankers’ pay be tied not just to equity but to other bits of the bank’s capital structure, such as preferred shares and bonds. Giving shareholders more control makes sense, but like every other solution to this wretched crisis, it creates problems of its own.
New fund, old fundamentals
Has the IMF changed? Or has the world?
BY ANY standards, $500 billion is an impressive birthday present. The IMF’s managing director, Dominique Strauss-Kahn, turned 60 on April 25th, the same day the fund’s steering committee gave its blessing to a proposed tripling of the institution’s resources from $250 billion to $750 billion. As the birthday boy is fond of saying: “The IMF is back.”
But it is back in a new guise. The IMF is notorious for favouring hard money and tight budgets. The new fund (“IMF 2.0” as Time magazine called it) believes in casual Fridays and Keynesian policies. Since January 2008, Mr Strauss-Kahn has urged the world’s biggest economies to loosen their belts. And fiscal stimulus is not just for rich countries, he said at the spring meetings last week. Poor, well-run countries like Tanzania should also try it.
He also referred to a new position note*by Atish Ghosh and four other IMF economists, laying out the options for emerging markets in the global crisis. Those include monetary easing as well as fiscal stimulus and “heterodox” debt workouts. “We really are in new times, no?” the managing director said. “I like this.” His comments raise a further question: do the different prescriptions reflect a new fund or new times?
In the Asian financial crisis, the IMF supported punishingly high interest rates to defend the region’s currencies and combat inflation. Real rates in Indonesia topped 49% in August 1997 (even before the fund arrived). The aim was to bludgeon speculators and impress creditors. The obvious alternative was to abandon the fight and let the currency fall. That would free the central bank to cut rates. Unfortunately, it would also bankrupt any firms or banks that had borrowed heavily in foreign currency in the belief that the traditional parities were sacrosanct.
More than ten years on, the wisdom of the fund’s strategy is still in dispute. (If an economy carries a lot of short-term debt, high interest rates may wreak such havoc that the exchange rate collapses anyway.) But whatever its merits during the Asian financial crisis, the high-rate defence has little appeal today. The benefits of tight monetary policy are more doubtful, and the damaging side-effects of depreciation less severe.
This is because today’s crisis originates with rich-world lenders, not emerging-market borrowers, as Mr Ghosh and his co-authors point out. Gripped by the urgent need to raise cash, foreigners have sold whatever assets they can. Often, they have sold most enthusiastically in emerging markets that are deep, liquid and easily exited. Raising interest rates a few points is unlikely to tempt them back. Besides, the rate gap between emerging markets and America’s Federal Reserve is already wider now than it was a year or two ago.
Most emerging economies now allow their currencies some freedom of movement. In Latin America and Asia, they have also worked hard to contain currency mismatches, borrowing wherever possible in their own currencies, rather than someone else’s. As a result, exchange rates can fall without upending their balance-sheets.
The exception is emerging Europe, which is, in many ways, reliving the Asian financial crisis. Households and companies have borrowed in hard currencies, believing that their exchange rates could only harden against the euro in advance of joining it. For these countries Mr Ghosh and his co-authors advocate debt restructuring in advance of monetary easing. (The IMF has also recommended a swift entry to the euro.) But otherwise, their macroeconomic prescriptions are very IMF 1.0: if a parity is to be defended, high rates will be needed. And even if the parity is abandoned, high rates may still be needed to escape an “inflation-depreciation spiral”.
What about fiscal stimulus? In December 1997 the IMF asked South Korea to tighten its belt a notch (a fiscal improvement of 0.4% of GDP). That is now widely seen as a mistake. However, the fund learnt that lesson within a month, urging the Koreans to ignore the fund’s own fiscal conditions. As Jonathan Ostry, one of the paper’s authors, points out, the fund now appreciates that fiscal retrenchment does little to restore confidence unless there is an underlying fiscal problem.
Where a country has fiscal room for manoeuvre, it should by all means use it, the IMF argues. Mr Strauss-Kahn has welcomed the pronounced fiscal easing undertaken by the world’s biggest emerging markets (see chart).In principle, a dollar of government spending can raise output by more than a dollar if it stimulates resources that might otherwise lie idle. Public investment might also yield rich returns in countries short of infrastructure. But most studies show that fiscal multipliers are small in emerging economies, especially over the medium term. In some cases, they are negative.
As the authors are keen to point out, a fiscal stimulus can do more harm than good if it jeopardises the sustainability of the public finances. Governments need a credible plan to set aside enough resources in the future to repay the additional public debt their stimulus has added. As Willem Buiter of the London School of Economics puts it, only fiscal conservatives can use counter-cyclical fiscal policy well.
A textbook case
So how much has the IMF’s thinking really evolved? Its economics is now overseen by Olivier Blanchard, on leave from the Massachusetts Institute of Technology. In the 1990s the fund’s most prominent economist was Stanley Fischer, now governor of Israel’s central bank. Each has written a seminal graduate textbook. So whose text do fund economists now turn to for guidance? The answer is easy: both. They are one and the same textbook: “Lectures on Macroeconomics” (1989) by O. Blanchard and S. Fischer. Perhaps the IMF will not be so different after all.
Promising to try harder
For once, an international institution half-agrees with its critics
YOU are part of a global conglomerate. Your market share has fallen from 18% to 6% in a decade. Well-financed niche-players are moving in, threatening to appropriate the most exciting areas. And now a report by your auditors has said that, even of your remaining business, a third has failed to come up to scratch. If you were a division of General Electric in Jack Welch’s day (“Be first or second in a field, or get out of it”), you would probably be facing closure. Who, in these circumstances, would want to be in charge of global health at the World Bank?
(Yes, some good things happen )
The report in question*was prepared by the bank’s Independent Evaluation Group, an internal monitoring organisation that reports to the bank’s board. It looked at how effective the loans dished out for health purposes by the bank and its private-sector-promoting associate, the International Finance Corporation, have been at doing what they were meant to do.
The sums involved are not trivial. Between 1997 and 2008 the bank provided $17 billion for government-run projects in the fields of health, nutrition and family planning. Over the same period its associate invested $873m in health-related private-sector activity. And although the bank’s market share has fallen as new sources of money have emerged, such as the Global Fund (which deals with AIDS, malaria and tuberculosis) and PEPFAR (an anti-AIDS plan started by the Bush administration), the actual amount it lends for health each year has remained fairly constant.
The evaluators’ criticism was not just that a third of the 220 projects under scrutiny had failed to achieve their goals, but that those goals were often misconceived. In particular, the bank’s remit is to end poverty, but that was the specific objective of only 6% of the projects and a subsidiary objective of only another 7%. Even where poverty reduction was a stated objective, little had been done to find out whether poverty had, in fact, been reduced. If there had been any investigation, it often failed to find any reduction.
There was criticism, too, of the fact that many projects were of a kind more likely to benefit the middle and upper classes which, in poor countries as in rich ones, are often better able to take advantage of infrastructure, such as new hospitals, which the bank helps to create.
Yet another ground for self-reproach was that the failure was concentrated in Africa, the poorest part of the world. Middle-income countries did not do too badly. But in Africa three-quarters of projects were deemed not to be up to snuff.
That is not to say that things were all bad. It is, of course, good that the bank has an independent evaluation mechanism at all. It also remains to be seen whether other global-health bodies are doing better, though that may become evident soon. A report on the Global Fund’s impact is to be published in May, and GAVI (the Global Alliance for Vaccines and Immunisation) is also undergoing independent scrutiny. It is also fair to say that the bank’s managers have taken most of the criticism on the chin, and promised to do better in future.
What the bank needs, in a crowded market, is a niche of its own, and it is trying to carve one out. Sensibly, it is not competing hard in the fashionable area of infectious disease, which is occupied not only by the Global Fund, PEPFAR and GAVI, but also by the (American) President’s Malaria Initiative, the Gates Foundation and numerous bilateral deals between governments. Instead it has, since 2007, been building up its activities in the less glamorous but equally vital area of “health systems”. This means getting local bureaucracies to recruit the right staff and deliver the right drugs to the right people at the right times, and knocking the heads of aid agencies together to eliminate gaps and overlaps in coverage. That, plus an expansion of its nutritional and reproductive health work, should be enough to protect the agency from a Welch-like fate.
YOU are part of a global conglomerate. Your market share has fallen from 18% to 6% in a decade. Well-financed niche-players are moving in, threatening to appropriate the most exciting areas. And now a report by your auditors has said that, even of your remaining business, a third has failed to come up to scratch. If you were a division of General Electric in Jack Welch’s day (“Be first or second in a field, or get out of it”), you would probably be facing closure. Who, in these circumstances, would want to be in charge of global health at the World Bank?
(Yes, some good things happen )
The report in question*was prepared by the bank’s Independent Evaluation Group, an internal monitoring organisation that reports to the bank’s board. It looked at how effective the loans dished out for health purposes by the bank and its private-sector-promoting associate, the International Finance Corporation, have been at doing what they were meant to do.The sums involved are not trivial. Between 1997 and 2008 the bank provided $17 billion for government-run projects in the fields of health, nutrition and family planning. Over the same period its associate invested $873m in health-related private-sector activity. And although the bank’s market share has fallen as new sources of money have emerged, such as the Global Fund (which deals with AIDS, malaria and tuberculosis) and PEPFAR (an anti-AIDS plan started by the Bush administration), the actual amount it lends for health each year has remained fairly constant.
The evaluators’ criticism was not just that a third of the 220 projects under scrutiny had failed to achieve their goals, but that those goals were often misconceived. In particular, the bank’s remit is to end poverty, but that was the specific objective of only 6% of the projects and a subsidiary objective of only another 7%. Even where poverty reduction was a stated objective, little had been done to find out whether poverty had, in fact, been reduced. If there had been any investigation, it often failed to find any reduction.
There was criticism, too, of the fact that many projects were of a kind more likely to benefit the middle and upper classes which, in poor countries as in rich ones, are often better able to take advantage of infrastructure, such as new hospitals, which the bank helps to create.
Yet another ground for self-reproach was that the failure was concentrated in Africa, the poorest part of the world. Middle-income countries did not do too badly. But in Africa three-quarters of projects were deemed not to be up to snuff.
That is not to say that things were all bad. It is, of course, good that the bank has an independent evaluation mechanism at all. It also remains to be seen whether other global-health bodies are doing better, though that may become evident soon. A report on the Global Fund’s impact is to be published in May, and GAVI (the Global Alliance for Vaccines and Immunisation) is also undergoing independent scrutiny. It is also fair to say that the bank’s managers have taken most of the criticism on the chin, and promised to do better in future.
What the bank needs, in a crowded market, is a niche of its own, and it is trying to carve one out. Sensibly, it is not competing hard in the fashionable area of infectious disease, which is occupied not only by the Global Fund, PEPFAR and GAVI, but also by the (American) President’s Malaria Initiative, the Gates Foundation and numerous bilateral deals between governments. Instead it has, since 2007, been building up its activities in the less glamorous but equally vital area of “health systems”. This means getting local bureaucracies to recruit the right staff and deliver the right drugs to the right people at the right times, and knocking the heads of aid agencies together to eliminate gaps and overlaps in coverage. That, plus an expansion of its nutritional and reproductive health work, should be enough to protect the agency from a Welch-like fate.
Sunday, 26 April 2009
Commercial break
Disaster looms in yet another asset class
GENERAL GROWTH PROPERTIES (GGP) and the Great Basin Bank do not have a lot in common. One is America’s second-largest mall owner, the other a small bank in Elko, Nevada. But both shut their doors within a day of each other this month because of their exposure to commercial property, the most threatening in a line-up of suspect asset classes.GGP filed for Chapter 11 bankruptcy protection on April 16th. Its assets, which include the Fashion Show Mall in Las Vegas (pictured) and South Street Seaport in New York, are high-quality and continue to generate decent income. Its financing structure is what got it into trouble. GGP found that it simply could not roll over its debts because of a lack of liquidity.
GGP’s difficulties were not unexpected. It was carrying lots of debt, principally because of a big acquisition in 2004, and much of it was short-term. But its failure still sends two shock waves. First, by including several properties that back commercial mortgage-backed securities (CMBS) in its Chapter 11 filing, GGP has unnerved investors who expect such assets to be ringfenced in a bankruptcy.
The second shock wave is that GGP’s bankruptcy underlines a pervasive refinancing risk for the industry. Foresight Analytics, a research firm, reckons that $594 billion of commercial mortgages will mature in America alone between 2009 and 2011. Many of these borrowers will have a big problem when their loans mature. Just as in residential property, the financing terms that were available to property and construction firms got ever laxer as the bubble inflated. Loan-to-value ratios of 85-95% were common in 2006 and 2007. These have now tightened to 60-65% and below for new lending.
That would be bad enough if prices were static. They are not. Commercial-property prices have fallen by 35% or so in America. Richard Parkus, of Deutsche Bank, thinks that 70% of all CMBS issued recently in America will not be able to refinance without a big increase in the capital that borrowers stump up.
It is likely to be a similar story with bank lending. Many banks are extending loan terms, hoping that the problem will go away. It will not. A growing overhang of debt will only make it harder for the market to recover. And the full effects of the bust are only just beginning to be felt. Losses on commercial property tend to lag behind rises in the unemployment rate by a year or so, largely because lease terms protect landlords from immediate falls in rental income. (An exception is the hotel industry, where leases are, in effect, renewed daily). The pain is now arriving. Office vacancies in America’s city centres increased to 12.5% in the first quarter, up from 9.9% a year earlier. Delinquencies are spiralling. Write-offs on bank-held commercial-property loans rose sevenfold in 2008.
The potential for further damage to the banks is especially worrying. Morgan Stanley’s first-quarter results on April 22nd included a $1 billion loss on its real-estate investments. But the loan books are where the real concerns lie. Commercial-property loans, including construction and development, account for 22% of American bank loans, up from an average of 14% in the 1980s and 1990s.
Smaller banks are exposed. Matthew Anderson of Foresight Analytics says that banks with assets between $100m and $10 billion hold commercial-property loans worth more than three times their total risk-based capital. Great Basin Bank, the 25th American bank to fail this year, was undone by heavy losses on commercial property. It will not be the last.
That would be bad enough if prices were static. They are not. Commercial-property prices have fallen by 35% or so in America. Richard Parkus, of Deutsche Bank, thinks that 70% of all CMBS issued recently in America will not be able to refinance without a big increase in the capital that borrowers stump up.
It is likely to be a similar story with bank lending. Many banks are extending loan terms, hoping that the problem will go away. It will not. A growing overhang of debt will only make it harder for the market to recover. And the full effects of the bust are only just beginning to be felt. Losses on commercial property tend to lag behind rises in the unemployment rate by a year or so, largely because lease terms protect landlords from immediate falls in rental income. (An exception is the hotel industry, where leases are, in effect, renewed daily). The pain is now arriving. Office vacancies in America’s city centres increased to 12.5% in the first quarter, up from 9.9% a year earlier. Delinquencies are spiralling. Write-offs on bank-held commercial-property loans rose sevenfold in 2008.
The potential for further damage to the banks is especially worrying. Morgan Stanley’s first-quarter results on April 22nd included a $1 billion loss on its real-estate investments. But the loan books are where the real concerns lie. Commercial-property loans, including construction and development, account for 22% of American bank loans, up from an average of 14% in the 1980s and 1990s.
Smaller banks are exposed. Matthew Anderson of Foresight Analytics says that banks with assets between $100m and $10 billion hold commercial-property loans worth more than three times their total risk-based capital. Great Basin Bank, the 25th American bank to fail this year, was undone by heavy losses on commercial property. It will not be the last.
The monetary-policy maze
The simple rules by which central banks lived have crumbled. A messier, more political future awaits.
New combatants in the political arena
IN THE world that existed before the financial crisis, central bankers were triumphant. They had defeated inflation and tamed the business cycle. And they had developed a powerful intellectual consensus on how to do their job, summarised recently by David Blanchflower, a member of the Bank of England’s monetary policy committee, as “one tool, one target”. The tool was the short-term interest rate, the target was price stability. This minimalist formula fitted the laissez-faire temper of the times. A growing array of financial markets could price risk and allocate credit efficiently. Central bankers had merely to calibrate their interest-rate tools and all other markets would automatically adjust. Central banks still cared about financial stability and full employment, but could argue these were best served by stabilising prices—without, if you please, interference from politicians.
The financial crisis has upended all that. The business cycle was supposedly subdued, yet the world is in the deepest recession since the 1930s. Deflation has become a more dangerous enemy than inflation; with interest rates in many countries at or close to zero, central banks have had to reach for other tools.
More fundamentally, the collapse of stable relationships in financial markets has forced central banks to make judgments they once left to the private sector. From lenders of last resort, they became lenders of first resort when banks stopped trusting each other. They are, increasingly, arbiters of which types of borrowers get credit. With the reputation of market discipline in tatters, central bankers will get vast new supervisory powers. All this is dragging central banks back towards political turf from which they had been distancing themselves for years.
Central bankers still believe that once the crisis has passed they will return to their pre-2007 roles as apolitical technocrats pulling a single lever and eyeing a single variable. It may be a vain hope. “When you question the basic premise which you have worked under for the last 15 to 20 years, which is that markets are rational and efficient, there is a case for a different approach to both monetary policy and regulation,” says Thomas Mayer, chief European economist of Deutsche Bank.
Start with the most immediate question: what tools will central banks use to steer the economy in the near future? Before the crisis almost all leading central banks operated through the short-term (usually overnight) money-market rate. By itself, that rate mattered much less to economic activity than, say, those on 12-month corporate loans or 30-year mortgages. But the links between these and official rates were stable enough to allow the central banks to influence overall financial conditions and hence the entire economy.
Those links came under strain before the crisis, as a global saving glut caused a decoupling of long- and short-term rates. During the crisis they disintegrated as lenders worried that loans could not be sold on or would not be repaid. Central banks responded by expanding their lending operations through a mixture of more types of credit and collateral, longer terms and more counterparties (see chart 1). The Federal Reserve began lending to investment banks. The European Central Bank (ECB) guaranteed unlimited funds for up to six months instead of one week. Some have gone much further. The Bank of Japan has bought equities and the Swiss National Bank has intervened in the currency markets.
More fundamentally, the collapse of stable relationships in financial markets has forced central banks to make judgments they once left to the private sector. From lenders of last resort, they became lenders of first resort when banks stopped trusting each other. They are, increasingly, arbiters of which types of borrowers get credit. With the reputation of market discipline in tatters, central bankers will get vast new supervisory powers. All this is dragging central banks back towards political turf from which they had been distancing themselves for years.
Central bankers still believe that once the crisis has passed they will return to their pre-2007 roles as apolitical technocrats pulling a single lever and eyeing a single variable. It may be a vain hope. “When you question the basic premise which you have worked under for the last 15 to 20 years, which is that markets are rational and efficient, there is a case for a different approach to both monetary policy and regulation,” says Thomas Mayer, chief European economist of Deutsche Bank.
Start with the most immediate question: what tools will central banks use to steer the economy in the near future? Before the crisis almost all leading central banks operated through the short-term (usually overnight) money-market rate. By itself, that rate mattered much less to economic activity than, say, those on 12-month corporate loans or 30-year mortgages. But the links between these and official rates were stable enough to allow the central banks to influence overall financial conditions and hence the entire economy.
Those links came under strain before the crisis, as a global saving glut caused a decoupling of long- and short-term rates. During the crisis they disintegrated as lenders worried that loans could not be sold on or would not be repaid. Central banks responded by expanding their lending operations through a mixture of more types of credit and collateral, longer terms and more counterparties (see chart 1). The Federal Reserve began lending to investment banks. The European Central Bank (ECB) guaranteed unlimited funds for up to six months instead of one week. Some have gone much further. The Bank of Japan has bought equities and the Swiss National Bank has intervened in the currency markets.
Even if the crisis is getting no worse, it is not over and most of the world is in recession. No central bank is about to withdraw any emergency measures. Some are contemplating new ones. Both the Bank of Canada and the ECB are considering outright purchases of government or corporate debt to boost the quantity of credit.
Central bankers assume they will wind down these measures when the crisis ends. The Fed, for example, is required by law to end some when the need is no longer urgent. It charges a penalty for some programmes so that borrowers will return to private markets once these have healed. An exit strategy is necessary to “end up with a market-based economy that is more balanced and more resilient,” Donald Kohn, the Fed’s vice-chairman, has said. Mervyn King, governor of the Bank of England, has said the exit strategy will be dictated by the outlook for inflation and that central banks should not support markets that cannot survive on their own.
Central bankers assume they will wind down these measures when the crisis ends. The Fed, for example, is required by law to end some when the need is no longer urgent. It charges a penalty for some programmes so that borrowers will return to private markets once these have healed. An exit strategy is necessary to “end up with a market-based economy that is more balanced and more resilient,” Donald Kohn, the Fed’s vice-chairman, has said. Mervyn King, governor of the Bank of England, has said the exit strategy will be dictated by the outlook for inflation and that central banks should not support markets that cannot survive on their own.
In need of new targets
But withdrawal may be harder than it sounds. A study last year by IMF staff asked, “What will ‘normal’ look like?” It argued: “There is no expectation that markets will return to their pre-crisis mode of operation soon, if ever. Market spreads taking account of credit and liquidity risk had arguably become too compressed pre-August 2007, and are now wider than they should be long-term. But it is not clear what the appropriate level should be.”
After the Bank of Japan became the primary supplier of overnight funds to banks earlier this decade, the interbank market atrophied. It remains a fraction of its former size. European banks today are now heavily dependent on the Fed for dollars (supplied via swap lines with local central banks) and on the ECB for six-month euro funds.
A tepid recovery will make central banks reluctant to withdraw support from critical markets, especially if business or politicians protest. In 1942 the Fed agreed to hold down long-term interest rates to help the Treasury finance the war; it did not extract itself from the commitment until 1951. When the time comes to sell its large holdings of mortgage debt, it may face resistance from America’s housing lobby.
Central banks may not just have to rethink their tools. They may also have to rethink their goals. Governments and central banks had come to agree that they should focus only on achieving low and stable inflation. The Fed by law must emphasise employment and inflation equally, but in practice it, too, targets inflation. This consensus was forged in central banks’ research departments and universities, and its adoption paralleled a rise by academics to the top ranks of central banks: among the leading lights are not only Ben Bernanke, chairman of the Fed, and Mr King but also Lucas Papademos, vice-president of the ECB, and Lars Svensson, a deputy governor of Sweden’s Riksbank.
Macroeconomics in general has come under fire for depending too much on assumptions of efficient markets and its inability to incorporate the spasms of emotion that create economic manias and panics. “As a monetary policymaker I have found the ‘cutting edge’ of current macroeconomic research totally inadequate in helping to resolve the problems we currently face,” said Mr Blanchflower, a labour economist, in a speech he gave on March 24th.
The exclusive focus on low and stable inflation is being questioned for the same reason. The recession began against a backdrop of price stability—as did America’s Depression and Japan’s lost decade. “Inflation targeting alone will not suffice,” Mr Blanchflower said. “This approach failed to prevent the build-up of imbalances that presaged the crisis and was insufficient in dealing with failing banks and financial-market stress as the crisis developed. There is now a consensus that new tools are required to regulate the financial sector and prevent such crises in the future.”
Mr Bernanke and his predecessor, Alan Greenspan, argued before the crisis that bubbles are hard to identify before they burst. Pricking them is even harder without wrecking the economy. Central banks should act only if bubbles threaten price stability; otherwise, they should wait and clean up after they burst. The shallow recession that followed the tech-stock boom of the late 1990s seemed to vindicate them.
Recent experience does not help their argument. William White, who retired last year as chief economist of the Bank for International Settlements, argues that because central banks were focused on price stability in the medium term, they allowed bubbles to form. The bursting of these raises the risk of deflation in the long run.
Inflation in many countries will be negative this year mainly because of cheaper fuel. But even in 2010, when that effect is fading, inflation will stay below the 2% most central banks define as price stability. In its latest forecast, published on April 22nd, the IMF says prices will fall in America, Japan and Switzerland (see chart 2).
To be sure, many central banks are more sanguine, noting that inflation expectations are, in the jargon, well-anchored. Many in the market fear that once the crisis passes central banks will be too slow to raise rates and wind down their credit programmes, unleashing inflation. But persistently falling prices would constrain central banks’ ability to boost growth, because they would be unable to push interest rates below inflation—ie, make them negative in real terms. Using the Taylor rule, a popular rule of thumb, economists at Deutsche Bank suggest that given today’s degree of economic slack and inflation rates, short-term rates should be negative in America, Britain and the euro area. Instead, they are at or near zero (see chart 3). Were deflation to deepen, real interest rates would rise, further hampering economic activity.
Eric Rosengren, president of the Federal Reserve Bank of Boston, noted recently that the Fed has hit, or all but hit, the zero limit twice this decade. That is more often than earlier simulations had indicated—and it suggests higher inflation targets should be considered. Another proposal is that central banks aim at a path for the price level rather than the inflation rate. Suppose that this path rose by 2% each year. Then after deflation of 1% in year one, the central bank would aim for inflation of more than 2% in later years (inflation of 5% in year two, say) to bring prices back up to the target. Greg Mankiw, a Harvard University economist, goes further, suggesting that inflation simply be given lower priority. “There are worse things than inflation,” he says. “We have them today.”
Altering or abandoning inflation targets would make a big dent in the credibility that central banks took decades to establish and is therefore highly unlikely. And although benign neglect of bubbles no longer appears an option, central bankers are not ready to advocate pre-emptive popping, because the problem of identifying them early enough remains unsolved. Better, they argue, to use regulation to identify and defuse dangerous accumulations of risk in the financial system.
The term for this is “macroprudential” supervision. Last year Mr Bernanke laid out how this would differ from the normal supervision of individual banks. He said a single firm may have an acceptable exposure to a particular type of risk that would be unacceptable if replicated across many firms. Similarly, a supervisor might press a particular bank to lend less during a slump whereas a “macroprudential supervisor would recognise that, for the system as a whole,” that could make matters worse.
The embrace of macroprudential supervision represents a reversal of another pre-2007 trend—for central banks to shed supervisory duties and concentrate on monetary policy. Academics argued that supervision was a distraction from the pursuit of price stability and created potential conflicts: a central bank might run an inflationary policy to cushion a failing banking system, or prop up an insolvent bank to cushion the economy. Central banks in Australia and Britain gave up some or all of their supervisory roles. The ECB was created with none.
The run on Northern Rock, a British bank, and problems at state-owned German banks were blamed in part on inadequate involvement by the central bank in supervision. This year the Bank of England received a more formal role in overseeing banks. A commission headed by Jacques de Larosière, a former head of both the Bank of France and the IMF, has recommended that the ECB chair a new European Systemic Risk Council made up of its member central banks and supervisors, but that it remain out of firm-specific supervision. The Fed until recently was the leading candidate to fill the American Treasury’s proposed job of “systemic risk regulator”, empowered to examine any corner of the financial system and act against emerging risks.
Yet macroprudential supervision smacks of a fad that will not live up to its billing. It faces the same difficulty as conventional monetary policy does in spotting and popping bubbles. Moreover, there has been no correlation between a central bank’s supervisory responsibilities and its ability to prevent or deal with the crisis. The Fed is America’s most powerful and best informed financial regulator but the trouble began under its nose. Neither Australia’s central bank nor Canada’s has any supervisory duties, yet the financial systems of both countries have been virtually unscathed. This record has less to do with who supervises the financial system than with local laws and behaviour. Subprime mortgages peaked at about 1% of the total in Australia and 2.5% in Canada, compared with more than 14% in the United States.
Illustration by Derek Bacon
After the Bank of Japan became the primary supplier of overnight funds to banks earlier this decade, the interbank market atrophied. It remains a fraction of its former size. European banks today are now heavily dependent on the Fed for dollars (supplied via swap lines with local central banks) and on the ECB for six-month euro funds.
A tepid recovery will make central banks reluctant to withdraw support from critical markets, especially if business or politicians protest. In 1942 the Fed agreed to hold down long-term interest rates to help the Treasury finance the war; it did not extract itself from the commitment until 1951. When the time comes to sell its large holdings of mortgage debt, it may face resistance from America’s housing lobby.
Central banks may not just have to rethink their tools. They may also have to rethink their goals. Governments and central banks had come to agree that they should focus only on achieving low and stable inflation. The Fed by law must emphasise employment and inflation equally, but in practice it, too, targets inflation. This consensus was forged in central banks’ research departments and universities, and its adoption paralleled a rise by academics to the top ranks of central banks: among the leading lights are not only Ben Bernanke, chairman of the Fed, and Mr King but also Lucas Papademos, vice-president of the ECB, and Lars Svensson, a deputy governor of Sweden’s Riksbank.
Macroeconomics in general has come under fire for depending too much on assumptions of efficient markets and its inability to incorporate the spasms of emotion that create economic manias and panics. “As a monetary policymaker I have found the ‘cutting edge’ of current macroeconomic research totally inadequate in helping to resolve the problems we currently face,” said Mr Blanchflower, a labour economist, in a speech he gave on March 24th.
The exclusive focus on low and stable inflation is being questioned for the same reason. The recession began against a backdrop of price stability—as did America’s Depression and Japan’s lost decade. “Inflation targeting alone will not suffice,” Mr Blanchflower said. “This approach failed to prevent the build-up of imbalances that presaged the crisis and was insufficient in dealing with failing banks and financial-market stress as the crisis developed. There is now a consensus that new tools are required to regulate the financial sector and prevent such crises in the future.”
Mr Bernanke and his predecessor, Alan Greenspan, argued before the crisis that bubbles are hard to identify before they burst. Pricking them is even harder without wrecking the economy. Central banks should act only if bubbles threaten price stability; otherwise, they should wait and clean up after they burst. The shallow recession that followed the tech-stock boom of the late 1990s seemed to vindicate them.
Recent experience does not help their argument. William White, who retired last year as chief economist of the Bank for International Settlements, argues that because central banks were focused on price stability in the medium term, they allowed bubbles to form. The bursting of these raises the risk of deflation in the long run.
Inflation in many countries will be negative this year mainly because of cheaper fuel. But even in 2010, when that effect is fading, inflation will stay below the 2% most central banks define as price stability. In its latest forecast, published on April 22nd, the IMF says prices will fall in America, Japan and Switzerland (see chart 2).
To be sure, many central banks are more sanguine, noting that inflation expectations are, in the jargon, well-anchored. Many in the market fear that once the crisis passes central banks will be too slow to raise rates and wind down their credit programmes, unleashing inflation. But persistently falling prices would constrain central banks’ ability to boost growth, because they would be unable to push interest rates below inflation—ie, make them negative in real terms. Using the Taylor rule, a popular rule of thumb, economists at Deutsche Bank suggest that given today’s degree of economic slack and inflation rates, short-term rates should be negative in America, Britain and the euro area. Instead, they are at or near zero (see chart 3). Were deflation to deepen, real interest rates would rise, further hampering economic activity.
Eric Rosengren, president of the Federal Reserve Bank of Boston, noted recently that the Fed has hit, or all but hit, the zero limit twice this decade. That is more often than earlier simulations had indicated—and it suggests higher inflation targets should be considered. Another proposal is that central banks aim at a path for the price level rather than the inflation rate. Suppose that this path rose by 2% each year. Then after deflation of 1% in year one, the central bank would aim for inflation of more than 2% in later years (inflation of 5% in year two, say) to bring prices back up to the target. Greg Mankiw, a Harvard University economist, goes further, suggesting that inflation simply be given lower priority. “There are worse things than inflation,” he says. “We have them today.”Altering or abandoning inflation targets would make a big dent in the credibility that central banks took decades to establish and is therefore highly unlikely. And although benign neglect of bubbles no longer appears an option, central bankers are not ready to advocate pre-emptive popping, because the problem of identifying them early enough remains unsolved. Better, they argue, to use regulation to identify and defuse dangerous accumulations of risk in the financial system.
The term for this is “macroprudential” supervision. Last year Mr Bernanke laid out how this would differ from the normal supervision of individual banks. He said a single firm may have an acceptable exposure to a particular type of risk that would be unacceptable if replicated across many firms. Similarly, a supervisor might press a particular bank to lend less during a slump whereas a “macroprudential supervisor would recognise that, for the system as a whole,” that could make matters worse.
The embrace of macroprudential supervision represents a reversal of another pre-2007 trend—for central banks to shed supervisory duties and concentrate on monetary policy. Academics argued that supervision was a distraction from the pursuit of price stability and created potential conflicts: a central bank might run an inflationary policy to cushion a failing banking system, or prop up an insolvent bank to cushion the economy. Central banks in Australia and Britain gave up some or all of their supervisory roles. The ECB was created with none.
The run on Northern Rock, a British bank, and problems at state-owned German banks were blamed in part on inadequate involvement by the central bank in supervision. This year the Bank of England received a more formal role in overseeing banks. A commission headed by Jacques de Larosière, a former head of both the Bank of France and the IMF, has recommended that the ECB chair a new European Systemic Risk Council made up of its member central banks and supervisors, but that it remain out of firm-specific supervision. The Fed until recently was the leading candidate to fill the American Treasury’s proposed job of “systemic risk regulator”, empowered to examine any corner of the financial system and act against emerging risks.
Yet macroprudential supervision smacks of a fad that will not live up to its billing. It faces the same difficulty as conventional monetary policy does in spotting and popping bubbles. Moreover, there has been no correlation between a central bank’s supervisory responsibilities and its ability to prevent or deal with the crisis. The Fed is America’s most powerful and best informed financial regulator but the trouble began under its nose. Neither Australia’s central bank nor Canada’s has any supervisory duties, yet the financial systems of both countries have been virtually unscathed. This record has less to do with who supervises the financial system than with local laws and behaviour. Subprime mortgages peaked at about 1% of the total in Australia and 2.5% in Canada, compared with more than 14% in the United States.
Illustration by Derek Bacon
New combatants in the political arenaRightly or wrongly, central banks will emerge from the crisis with a bigger role in the markets and in supervision. This will challenge another element of the pre-2007 consensus: that central banks be as far removed from politics as possible. Formal independence insulated the central bank from politicians’ desire to play fast and loose with inflation. And part of the appeal of “one tool, one target” was that it made monetary policy explicitly a technical rather than political affair.
The divide between central banking and politics looks much less clean today. Unconventional policies often require a central bank to make loans that may not be repaid in full. Because taxpayers will bear any losses, finance ministries need some say. Credit allocation and tighter regulation make some firms winners and others losers, and so require more public accountability. With interest rates at zero, the Fed and the Bank of England are buying government debt to boost the quantity of credit and the money supply. But governments could come to rely on such purchases to finance budget deficits. The potential for political conflict extends abroad too. Having cut its rates to zero, the Swiss National Bank has bought foreign currency to drive down the Swiss franc. Some labelled this competitive devaluation.
Managing such conflicts is a delicate job. The Fed and the Treasury attempted to assuage concerns by releasing a joint statement affirming the Fed’s sole responsibility for price stability. Mr King broke a longstanding silence on fiscal policy to warn the British government against adding to a fast-growing national debt.
Such tensions are unlikely seriously to dent the institutional protections built around central banks in recent decades. Last year Japanese opposition parties blocked the appointments of two candidates to head the Bank of Japan on the ground they were insufficiently independent of the government. There are exceptions: Iceland’s government amended the law so that it could fire David Oddsson, the head of its central bank. But Mr Oddsson had presided, first as prime minister and then as central-bank governor, over the policies that led to the country’s crisis.
Central bankers’ jobs matter even more than they did before 2007. At the same time, they have been drawing more criticism and political scrutiny. Public disapproval ratings have risen notably for Mr Bernanke, the Bank of England and the ECB. They are having to defend their policies to the public as well as to the markets. Mr Bernanke agreed to a profile by “60 Minutes”, a news programme, in which he strolled down the streets of his hometown. Mr King sat for an interview with the BBC to explain quantitative easing. The six members of the ECB’s executive board gave 200 interviews last year.
After the Riksbank slashed its interest-rate target to 0.5% on April 21st, its governor, Stefan Ingves, took questions from the public in an online chat session. Asked what he liked most about his job, the former economics professor said that what he used to study in theory he now gets to put into practice. He added: “It’s fun to go to work every day.” You may wonder how many of his peers would agree with him.
The divide between central banking and politics looks much less clean today. Unconventional policies often require a central bank to make loans that may not be repaid in full. Because taxpayers will bear any losses, finance ministries need some say. Credit allocation and tighter regulation make some firms winners and others losers, and so require more public accountability. With interest rates at zero, the Fed and the Bank of England are buying government debt to boost the quantity of credit and the money supply. But governments could come to rely on such purchases to finance budget deficits. The potential for political conflict extends abroad too. Having cut its rates to zero, the Swiss National Bank has bought foreign currency to drive down the Swiss franc. Some labelled this competitive devaluation.
Managing such conflicts is a delicate job. The Fed and the Treasury attempted to assuage concerns by releasing a joint statement affirming the Fed’s sole responsibility for price stability. Mr King broke a longstanding silence on fiscal policy to warn the British government against adding to a fast-growing national debt.
Such tensions are unlikely seriously to dent the institutional protections built around central banks in recent decades. Last year Japanese opposition parties blocked the appointments of two candidates to head the Bank of Japan on the ground they were insufficiently independent of the government. There are exceptions: Iceland’s government amended the law so that it could fire David Oddsson, the head of its central bank. But Mr Oddsson had presided, first as prime minister and then as central-bank governor, over the policies that led to the country’s crisis.
Central bankers’ jobs matter even more than they did before 2007. At the same time, they have been drawing more criticism and political scrutiny. Public disapproval ratings have risen notably for Mr Bernanke, the Bank of England and the ECB. They are having to defend their policies to the public as well as to the markets. Mr Bernanke agreed to a profile by “60 Minutes”, a news programme, in which he strolled down the streets of his hometown. Mr King sat for an interview with the BBC to explain quantitative easing. The six members of the ECB’s executive board gave 200 interviews last year.
After the Riksbank slashed its interest-rate target to 0.5% on April 21st, its governor, Stefan Ingves, took questions from the public in an online chat session. Asked what he liked most about his job, the former economics professor said that what he used to study in theory he now gets to put into practice. He added: “It’s fun to go to work every day.” You may wonder how many of his peers would agree with him.
Sunday, 19 April 2009
The audacity of hope
Optimism that banks’ fortunes have reached bottom may be premature
LLOYD BLANKFEIN may travel by train rather than private jet these days, but the firm he heads has moved back into the fast lane. On April 13th Goldman Sachs kicked off the banks’ earnings season in impressive fashion: the $1.8 billion of net profit it posted for the first quarter smashed analysts’ forecasts, leaving them wondering, if only for a moment, whether they were back in 2006. At the same time, Goldman cheekily raised more than $5 billion of common equity to help pay back the $10 billion of taxpayer money it was arm-twisted into taking last October.
Goldman is keen to distinguish itself from weaker banks, but optimists see its results as part of a pattern of recovery for the industry. JPMorgan Chase reported stronger-than-expected results on April 16th. Wells Fargo expects to post record quarterly profits, largely thanks to surging mortgage refinancing as interest rates have fallen. Optimism about banks’ performance has given their shares a much-needed lift from their March lows (see chart). Hope is growing that, with markets thawing and the yield curve steeper, allowing banks to lend at higher rates than those at which they borrow, many will be able to earn their way out of trouble. The reality may be less cheering.
It is easy to see why Goldman considers it a “duty” to repay the government (it would be the first big bank to do so). With a business model that relies on rewarding top performers handsomely, it is chafing more than most under the executive-pay restrictions that come with the infusion—though it still managed to pay employees slightly more last quarter, as a proportion of total costs, than it did the year before, a “massive middle finger” to congressional critics, as one rival puts it. Goldman worries about other forms of interference, too: politicians have questioned, for instance, whether it should have so much invested in foreign banks, such as China’s ICBC.
Goldman hopes to be able to settle its debt to the taxpayer once it gets the result of the stress tests being conducted on America’s 19 largest banks, which are due to end at the end of April. A clean bill of health seems all but assured given its high capital ratio, a $164 billion pool of cash and a culture of marking assets to market.
But what is good for one bank may be bad for the system as a whole. Regulators worry that letting one or two strong banks repay risks turning the weak into targets and takes lending capacity out of the system. They also worry about the embarrassing prospect of banks that repay early having to return to the trough if markets deteriorate again, which would create political fireworks. Brad Hintz of Alliance Bernstein expects the government to delay Goldman’s repayment until a larger group of banks is able to repay simultaneously.
Goldman hopes to be able to settle its debt to the taxpayer once it gets the result of the stress tests being conducted on America’s 19 largest banks, which are due to end at the end of April. A clean bill of health seems all but assured given its high capital ratio, a $164 billion pool of cash and a culture of marking assets to market.
But what is good for one bank may be bad for the system as a whole. Regulators worry that letting one or two strong banks repay risks turning the weak into targets and takes lending capacity out of the system. They also worry about the embarrassing prospect of banks that repay early having to return to the trough if markets deteriorate again, which would create political fireworks. Brad Hintz of Alliance Bernstein expects the government to delay Goldman’s repayment until a larger group of banks is able to repay simultaneously.
When that might be is far from clear. Even Goldman is in less stellar shape than its results might suggest. First, they excluded December, a poor month that fell into a convenient gap when Goldman and Morgan Stanley switched to calendar-year reporting on becoming bank-holding firms.
Second, Goldman, like others, benefited from one-off boosts, such as the surge in corporate-bond issuance as seized-up markets began moving again in January, and from managing each other’s government-backed debt issues. They are also enjoying freakishly high bid-ask spreads and margins in “flow” businesses, such as fixed income, currencies and commodities (FICC). These have widened by up to 300% thanks to spiking volatility and the retreat of several big rivals, according to a study by Morgan Stanley and Oliver Wyman, a consultancy. Fully 70% of Goldman’s first-quarter revenue came from FICC.
These spreads are sure to come down as new actors enter the fray and old ones return, albeit gingerly. Other businesses will struggle to take up the slack any time soon. Goldman’s quarter-on-quarter investment-banking revenues were down 20%. Merger-advisory fees are likely to remain depressed for several years.
There is, moreover, still plenty of red ink sloshing around. Citigroup was expected to post its sixth straight quarterly loss on April 17th. It continues to shrink its balance-sheet and to look to sell non-core assets. Morgan Stanley, too, is expected to report a loss on April 22nd, largely thanks to having to mark-to-market its own debt, which has become more expensive. Across the Atlantic UBS, a Swiss bank, warned on April 15th of yet another loss and more job cuts as it tries to stem client defections that, according to its outgoing chairman, have put it in a “precarious” situation.
More blows are coming. Banks worldwide have written down their assets by $1.1 trillion. The final tally is expected to be double that, or more. The pain is only now starting to spread through commercial property and commercial loans. As a result, the first-quarter reprieve will turn out to be a “head fake”, says Chris Whalen of Institutional Risk Analytics.
It does not help that many banks have not set aside enough reserves for credit losses—though the blame lies as much with accounting rules as with their own managers. Analysts at Keefe, Bruyette & Woods argue that Wells Fargo holds an array of assets at rose-tinted values and may need another $25 billion in capital, on top of the $25 billion it has already taken from the Treasury. Few banks hold their commercial-property portfolios anywhere close to the 50-60 cents on the dollar valuation that Goldman does.
The longer-term outlook is equally sobering. In 2006 investment banks made an average return on equity of 17%. Just to get back to double digits, they will have to cut costs by well over $100m for every $100 billion of assets they hold, reckon the authors of a recent report from the Boston Consulting Group. Commercial banks can expect their returns to stay in the 10-12% range of the 1940s-80s for the indefinite future, says Richard Ramsden, a Goldman analyst.
Although the overall pie will be less mouth-watering, some will enjoy a bigger slice. Barclays, which snapped up Lehman Brothers’ American operations for a song, now boasts a 15% share of the Treasuries market, for instance. But even the survivors remain cautious. David Viniar, Goldman’s chief financial officer, this week said market conditions remain “dangerous”. One interpretation of the timing of the bank’s capital-raising is that it wants to grab what it can in case the second quarter is not as hospitable as the first. No wonder American bank shares are still, on average, trading some 70% below their peak.
Shelter, or burden?
The social benefits of home ownership look more modest than they did and the economic costs much higher
IN A scene from the film “It’s a Wonderful Life”, a happy couple is about to enter their new home. Jimmy Stewart, whose firm has sold them the mortgage, reflects that there is “a fundamental urge…for a man to have his own roof, walls and fireplace.” He offers them bread, salt and wine so “joy and prosperity may reign for ever”.
That embodies the Anglo-Saxon world’s attitude to home ownership. Owning your own roof, walls and fireplace, it is thought, is good for householders because it helps them accumulate wealth. It is good for the economy because it encourages people to save. And it is good for society because homeowners invest more in their neighbourhoods, engage more in civic activities and encourage their children to do better at school than do renters. Home ownership, in short, benefits everyone—not just the homeowner—and the more there is of it, the better. Which is why it is usually encouraged by the government. In America, Ireland and Spain, homeowners can deduct mortgage-interest payments from taxable income.
Yet the worldwide crash was bound up in this supposed miracle of social policy. The disaster began with defaults on American subprime mortgages, a financial instrument designed to spread home ownership among the poor. It gathered pace after the failures of Fannie Mae and Freddie Mac, two government-sponsored enterprises that provide cheap home loans. As a result, the home-ownership rate in America has fallen for four years, the first time that has happened in a quarter of a century. In 2008, 2.3m families lost their homes or faced foreclosure—double the average before the crisis—reducing the home-ownership rate from 69% in 2004 to 67.5% at the end of 2008. The number of owner-occupied dwellings also slipped in Britain in 2007-08 for the first time since the 1950s.
Subsidised castles
So attempts to expand home ownership have contributed to the wider economic crisis without succeeding in their own terms. How does that affect the arguments for supporting home ownership? Should it still be deemed a public good?
Yet the worldwide crash was bound up in this supposed miracle of social policy. The disaster began with defaults on American subprime mortgages, a financial instrument designed to spread home ownership among the poor. It gathered pace after the failures of Fannie Mae and Freddie Mac, two government-sponsored enterprises that provide cheap home loans. As a result, the home-ownership rate in America has fallen for four years, the first time that has happened in a quarter of a century. In 2008, 2.3m families lost their homes or faced foreclosure—double the average before the crisis—reducing the home-ownership rate from 69% in 2004 to 67.5% at the end of 2008. The number of owner-occupied dwellings also slipped in Britain in 2007-08 for the first time since the 1950s.
Subsidised castles
So attempts to expand home ownership have contributed to the wider economic crisis without succeeding in their own terms. How does that affect the arguments for supporting home ownership? Should it still be deemed a public good?
No, say several economists and commentators. “Given the way US policy favours owning over renting,” writes Paul Krugman, 2008’s Nobel laureate in economics, “you can make a good case that America already has too many homeowners.” Edward Glaeser, an economist at Harvard University, talks about “the madness of encouraging Americans to bet everything on housing”.
So far, policymakers are unmoved. In mid-February Barack Obama proposed a $275 billion plan to support America’s housing market. Outside the Anglo-Saxon world Nicolas Sarkozy, who campaigned for the presidency to turn France into a property-owning democracy, has expanded zero-interest housing loans for the poor.
The main economic argument for home ownership is that, in the words of Thomas Shapiro of Brandeis University, “it is by far the single most important way families accumulate wealth”. This argument now looks as weak as house prices.
In Britain prices have fallen 21% since their peak in October 2007. Prices in America have fallen more slowly but further, down 30% since their peak in mid-2006 (see chart 1). This has reduced the total value of the country’s housing stock from over $22 trillion in 2007 to $19 trillion at the end of 2008. In the past few weeks, housing markets on both sides of the Atlantic have seen signs of life, but there is every chance that prices have further to fall before they finally reach their low.
The collapse in house prices matters most directly to two overlapping groups: those who bought property at the peak of the market and now face “negative equity”; and those (in America) who took out subprime mortgages. Roughly 10m Americans are in negative equity—ie, the cost of their mortgage exceeds the value of their home. In Britain about 3% of households are in negative equity. For homeowners, negative equity makes houses more like a trap than a piggy bank. Those who cannot meet their payments lose their house, their savings and (in America, usually) their credit rating for seven years.
The other area of concentrated distress is subprime mortgages, which increased their share of the American mortgage market from 7% in 2001 to over 20% in 2006. According to the Mortgage Bankers Association, the delinquency rate was 22% in the fourth quarter of 2008, compared with only 5% for prime loans. Many people have concluded that, in Mr Krugman’s words, “home ownership isn’t for everyone.” However, a study by the Centre for Community Capital, part of the University of North Carolina, Chapel Hill, casts some doubt on that conclusion. It compared a group of people who took out subprime loans with a group of borrowers from the Community Advantage Programme (CAP), a government-backed scheme that lends to the sort of people who might have had a subprime mortgage. The default rate for CAP borrowers was only a quarter what it was for subprime mortgage holders, even though the incomes and backgrounds of borrowers were similar. Since the real problem lay partly in the mortgages, rather than the borrowers, this suggests the subprime crisis was a financial-market mess, as well as a housing one.
Does that also imply that home ownership has the economic benefits that its proponents claim? Two pieces of evidence seem to support such a view. The first is that housing has fared better in the crisis than other assets. Share prices are around 50% below their peaks in many countries, so compared with shareowners, homeowners have not done badly. However, home ownership in a downturn has one big disadvantage: most people buy shares outright but homes on margin (ie, they put down a small stake, if anything). If share prices fall by 10%, you lose 10%; if house prices fall by 10%, you may lose your entire savings. The value of American homeowners’ equity in their own houses has slumped from a peak of $12.5 trillion in 2005 to just $8.5 trillion at the end of 2008. This undermines one claim that homeowning is economically beneficial.
The other piece of evidence for home ownership’s benefits is that the house-price fall has so far spared most existing homeowners from absolute losses. In America, for example, house prices have fallen back only to where they were in 2004. There were roughly 29m house sales in the United States between 2004 and 2007, compared with 115m households, and anyone who bought before then is probably sitting on a nominal profit. However, as Harvard University’s Martin Feldstein points out, if house prices rise, people feel richer and borrow and spend more. If they feel poorer, they may cut back even if the price of their house has not fallen below what they paid for it.
Subsidies to home ownership have thus increased economic volatility. They boosted consumption, as homeowners used their houses as collateral to finance consumption or investment. In America mortgage-equity withdrawals reached $9 trillion between 1997 and 2006—equal to more than 90% of disposable income in 2006. This gave homeowners more to spend in the good times but less in bad ones. In Britain home-equity withdrawals added the equivalent of 3% of post-tax income to households in the fourth quarter of 2007 but subtracted 3% a year later. So changes to house prices aggravate the economic cycle. Recent research by the IMF finds that a quarter of the 100-odd recessions since 1960 have been associated with house-price busts and that these contractions “are deeper and last longer than other recessions do”.
Subsidies to home ownership have also weakened financial services. They encouraged more people to buy houses (which was the point), but, logically enough, also encouraged lenders to take greater risks with housing. This was fine while house prices were rising, but the fall exposed how vulnerable banks’ balance sheets had become.
Moreover, if public policy aims to create wealth, there are other ways of doing it. People could invest their savings in the stockmarket and rent their homes, for example. Had they done so in the past two years, they would have done worse than homeowners. But for three decades before that, equity prices easily outstripped property prices (see chart 2), so in the long run equities have been a better bet than houses. (Admittedly, this strips out the effects of share dividends and imputed rents, which favour property.) Housing suffers from two further weaknesses as an investment. It sucks up disproportionately large amounts of money, falling foul of the idea that investors should diversify: in America the equity tied up in houses accounts for 45% of the net worth of the average householder. And it is illiquid. If you need to raise money, you cannot sell a room or two, whereas you can always sell a few shares. It is hard to argue houses are the best asset for building wealth.
“Perhaps the most compelling argument for housing as a means of wealth accumulation”, argues Richard Green of the University of Southern California, “is that it gives households a default mechanism for savings.” Because people have to pay off a mortgage, they increase their home equity and save more than they otherwise would. This is indeed a strong argument: social-science research finds that people save more if they do so automatically rather than having to choose to set something aside every month.
Yet there are other ways to create “default savings”, such as companies offering automatic deductions to retirement plans. In any case, some of the financial snake oil peddled at the height of the housing bubble was bad for saving. Subprime, interest-only and other kinds of mortgage instruments allowed people to buy their homes without a down-payment and without building up equity. “Negative amortisation” (neg-am) mortgages even let people pay only part of their interest each month and to add the rest to the principal, increasing their debt, not their savings. Home-equity loans had the same effect.
Where the heart is
The main arguments for home ownership, though, are not primarily economic, but social. Home ownership, argue those who want to expand it, benefits society because it encourages stable, more law-abiding communities; it makes people more likely to vote in local elections and join clubs; and it benefits future generations because, it turns out, the children of homeowners do better at school and have fewer behavioural problems than children of renters.
On the face of it, the evidence for these claims is strong. In America homeowners are less likely to move than renters, so areas with a lot of homeowners are more stable. According to the 2007 American Housing Survey, homeowners stay where they are for about nine years whereas renters move every two.
The main arguments for home ownership, though, are not primarily economic, but social. Home ownership, argue those who want to expand it, benefits society because it encourages stable, more law-abiding communities; it makes people more likely to vote in local elections and join clubs; and it benefits future generations because, it turns out, the children of homeowners do better at school and have fewer behavioural problems than children of renters.
On the face of it, the evidence for these claims is strong. In America homeowners are less likely to move than renters, so areas with a lot of homeowners are more stable. According to the 2007 American Housing Survey, homeowners stay where they are for about nine years whereas renters move every two.
More stable neighbourhoods are more law-abiding. According to a study of New York City, the home-ownership rate was second only to income as an explanation for different crime rates.
The link between ownership and political participation is stronger still. In America in the early 1990s, 69% of homeowners voted, compared with only 44% of renters. Homeowners are more likely to know who their representatives are; more likely to support local causes or parent-teacher associations and (this being America) more likely to go to church.
Perhaps the most surprising link is between ownership and children. One study in America found that, in 2000, the mathematics scores of the children of homeowners were 9% higher than those of renters’ children; reading levels were 7% higher. This had nothing to do with income: the research controlled for that. In another study homeowners’ children were 25% more likely to graduate from high school and more than twice as likely to go to university. Their teenage daughters were also less likely to become pregnant.
The link between ownership and political participation is stronger still. In America in the early 1990s, 69% of homeowners voted, compared with only 44% of renters. Homeowners are more likely to know who their representatives are; more likely to support local causes or parent-teacher associations and (this being America) more likely to go to church.
Perhaps the most surprising link is between ownership and children. One study in America found that, in 2000, the mathematics scores of the children of homeowners were 9% higher than those of renters’ children; reading levels were 7% higher. This had nothing to do with income: the research controlled for that. In another study homeowners’ children were 25% more likely to graduate from high school and more than twice as likely to go to university. Their teenage daughters were also less likely to become pregnant.
these studies, though, are not the last word. They find a link between children’s education and homeowning. But is this because, as some suggest, home ownership requires parents to possess managerial or financial skills that they pass on to their children? Or is it because the people with those skills help their children at school and also buy houses? No one knows.
Nor is it certain that owners always take better care of their neighbourhoods than renters do. Some studies claim that the effect in fact depends on a few public-spirited people willing to set an example. Renters can be public-spirited too. In America areas with lots of renters tend to be transient because the typical rental period is short. In Germany, though, people rent for years. Stable neighbourhoods and widespread home ownership can go together but do not need to. As Bill Rohe of the University of North Carolina, Chapel Hill puts it, “evidence regarding the societal benefits of home ownership is highly conjectural.”
Still, on balance, home ownership gives people a stake in the state of their surroundings. Thriving streets increase the value of properties, giving owners incentives to improve them further. Renters get no such benefit; they may even have to pay more if the neighbourhood improves.
Whether stability is such a good thing in a downturn, though, is a different matter. A decade ago Andrew Oswald of Warwick University argued that owning your own home makes you more reluctant to move, so labour markets tend to become more rigid as home ownership increases. He claimed that increases in the level of home ownership (though not necessarily the level itself) are associated with rises in unemployment. Ireland, Greece and Spain all saw large increases in home ownership in the 1980s and 1990s, and had relatively high unemployment. America and Switzerland had stable ownership rates, and escaped the long-term rise in joblessness.
His argument remains controversial. Critics point out that many things other than home ownership might prevent people from moving (children’s schools, friends and so on). Anyway, liquid housing markets should make it possible for people to move, if they want to. It is also possible that, even if people were trapped in distressed areas, jobs should move there to take advantage of the willingness of homeowners to accept lower wages.
All that said, Mr Oswald’s arguments seem especially powerful at the moment. The recession in America is bearing down most heavily on two groups of states: Florida, California and Nevada, which had the largest house-building booms in the 1990s; and Michigan, New Hampshire, Delaware, West Virginia and Mississippi, which have the highest home-ownership rates. People are not, in fact, moving as frequently as they used to: the share of those moving house in 2007-08—11.9% of the population—was the lowest since records began. So labour markets look less flexible than they were. Negative equity exacerbates immobility because people are reluctant to move if it means selling at a loss. Researchers at the Wharton School reckon that people in negative equity are only half as likely to move as those who are not. In all these ways, high home ownership may prolong and deepen a recession.
The problem remains of how to weigh the economic costs against the social benefits of home ownership. There can be no easy judgment about this but the recent rise and fall of house prices suggests both that the costs are greater and the benefits smaller than once thought.
If owning were such a boon, you would expect neighbourhoods with lots of owners to have done better than those with lots of renters during the boom years. That does not seem to have happened.
If owning were such a boon, you would expect neighbourhoods with lots of owners to have done better than those with lots of renters during the boom years. That does not seem to have happened.
What has happened, though, is that above a certain level, foreclosures have done a lot of damage during the bad years. Recent studies of New York and Cleveland find that, if lenders foreclose on 3-4% of properties in an area, local prices fall even faster and further than average. Rows of For Sale signs almost certainly have the same effect in Britain. In other words, ownership can sometimes be worse for a neighbourhood than renting.
A shelter—for your money
Lastly, and perversely, the decade of obsession with expanding home ownership may actually have reduced neighbourhood stability. Nicolas Retsinas, the director of the Joint Centre for Housing Studies at Harvard University, suggests that, until the crash in 2008, Americans were coming to see their homes as financial investments rather than as places to live. That is true in other countries. Neg-am mortgages in America and buy-to-rent arrangements in Britain were based on the assumption that houses were primarily investments.
As a result, people seem to have started to buy and sell homes more frequently. Between the mid-1990s and mid-2000s, the number of new houses sold almost doubled in America, from just over 600,000 to over 1.2m in 2006.
Perhaps that made labour markets more mobile, but it was certainly not what policymakers were aiming for when they set out to increase home ownership. Their efforts in the past few years seem to have weakened, though not destroyed, the best arguments for treating home ownership as something to be encouraged: that it increases people’s savings and creates better neighbourhoods for everyone. But perhaps you should not be surprised by that. As Adam Smith wrote in “The Wealth of Nations” two centuries ago, “a dwelling-house, as such, contributes nothing to the revenue of its inhabitants.”
Thursday, 16 April 2009
Starting Out: Begin Funding for Your Financial Security
An overview of financial planning geared toward young people just entering the workforce. The importance of saving for the future will be stressed, and tips on budgeting, insurance, and paying off student loans will be offered
Topics
--Starting Out: Begin Funding for Your Financial Security
--Get Out From Under
--What You Really Should Buy
--Build a Cash Reserve
--Shopping for the Best Credit Card
--Build Your Financial Future
--Stop Waiting for the Next Paycheck
1.Starting Out
Congratulations! You've graduated from school and landed a job. Your salary, however, is limited, and you don't have much money (if any) left at the end of the month. So where can you find money to save? And, once you find it, where should this cash go?Here are some ways to help free up the money you need for current expenses, financial protection, and future investments -- all without pushing the panic button.
2.Get Out From Under
For most young adults, paying down debt is the first step toward freeing up cash for the financial protection they need. If you're spending more than you make, think about areas where you can cut back. Don't rule out getting a less expensive apartment, roommates, or trading in a more expensive car for a secondhand model. Other expenses that could be trimmed include dining out, entertainment, and vacations.
If you owe balances on high-rate credit cards, look into obtaining a low-interest credit card or bank loan and transferring your existing balances. Then plan to pay as much as you can each month to reduce the total balance, and try to avoid adding new charges.
If you have student loans, there's also help to make paying them back easier. You may be eligible to reduce these payments if you qualify for the Federal Direct Consolidation Loan program. Though the program would lengthen the payment time somewhat, it could also free up extra cash each month to apply to your higher-interest consumer debt. The program can be reached at (800) 557-7392.
3.What You Should Buy
How would you pay the bills if your paychecks suddenly stopped? That's when you turn to insurance and personal savings -- two items you should "buy" before considering future big-ticket purchases.
Health insurance is your first priority, as hospital stays can be extremely costly. If you're not covered under a group plan, see if you can join any trade associations, which often offer group-rate policies. Otherwise, start obtaining quotes on individual policies by calling the major insurers in your state.
Life insurance is the next logical step, but may only be a concern if you have dependents. In fact, at the age of 25 you're statistically more likely to become disabled than to die prematurely, according to a 2004 report funded by the nonprofit Actuarial Foundation. Disability insurance will replace a portion of your income if you can't work for an extended period due to illness or injury. If you can't get this through your employer, call individual insurance companies to compare rates.
4.Build a Cash Reserve
If you should ever become disabled or lose your job, you'll also need savings to fall back on until paychecks start up again. Try to save at least three months' worth of living expenses in an easy-to-access "liquid" account, which includes a checking or savings account. Saving up emergency cash is easier if your financial institution has an automatic payroll savings plan. These plans automatically transfer a designated amount of your salary each pay period -- before you see your paycheck -- directly into your account.
To get the best rate on your liquid savings, look into putting part of this nest egg into money-market funds. Money-market funds invest in Treasury bills, short-term corporate loans, and other low-risk instruments that typically pay higher returns than savings accounts. These funds strive to maintain a stable $1 per share value, but unlike FDIC-insured bank accounts, can't guarantee they won't lose money.
Some money-market funds may require a minimum initial investment of $1,000 or more. If so, you'll need to build some savings first. Once you do, you can get an idea of what the top-earning money market funds are paying by referring to imoneynet.com, which publishes current yields. Many newspapers also publish yields on a regular basis.
5.Shopping for the Best Credit Card
In addition to looking at fees and the interest that you will be charged (also known as the annual percentage rate or APR), consider your lifestyle and past payment history when shopping for a credit card. Factors you may want to consider include:
--A fixed vs. a variable rate of interest. Most cards assess a variable rate, which can be reset monthly. In most cases, the rate of interest will not be less than a floor established by the card issuer.
--Minimum payment you are required to make.
--Maximum you can borrow without incurring an over-the-limit fee.
--Fees such as an annual fee, late payment charges, and interest rates on cash advances.
--Circumstances when the credit provider can change provisions of the agreement.
--How the company calculates the finance charge. Is it based on the average daily balance, the balance at the beginning of the billing cycle, or another amount?
--A low introductory interest rate, if offered (extensive lists of the latest low-interest-rate cards in the United States are available at www.bankrate.com and www.cardtrak.com). When is the rate likely to increase? What is the new rate likely to be?
--Incentives such as cash rebates on purchases, purchase protection, and frequent flyer miles.
--Your prior payment history. If you typically pay off your balance every month, the APR may be less of an issue than getting cash back with a purchase.
6.Build Your Financial Future
Some long-term financial opportunities are too good to put off, even if you are still building a cache for current living expenses.
One of the best deals is an employer-sponsored retirement plan such as a 401(k) plan, if available. These tax-advantaged plans allow you to make pretax contributions, and taxes aren't owed on any earnings until they're withdrawn. What's more, new Roth-style plans allow for after-tax contributions and tax-free withdrawals in retirement, provided certain eligibility requirements are met. Another big plus is direct contributions from each paycheck so you won't miss the money as well as possible employer matches on a portion of your contributions.
Don't underestimate the potential power of tax savings. If you invested $100 per month into one of these accounts and it earned an 8% return compounded annually, you would have $146,815 in 30 years -- nearly $50,000 more than if the money were taxed annually at 25%. Bear in mind, however, that you will have to pay taxes on the retirement plan savings when you take withdrawals. If you took a lump-sum withdrawal and paid a 25% tax rate, you'd have $110,111, which is still more than the balance you'd have in a taxable account.
If you're already participating, think about either increasing contributions now or with each raise and promotion.
If a 401(k) isn't available to you, shop around for individual retirement accounts (IRAs), both traditional and Roth, at banks or mutual fund firms. In 2007, you can contribute up to $4,000 to traditional IRAs or Roth IRAs. Generally, contributions to and income earned on traditional IRAs are tax deferred until retirement; Roth IRA contributions are made after taxes, but earnings thereon can be withdrawn tax-free upon retirement. Note that certain eligibility requirements apply and nonqualified taxable withdrawals made before age 59 1/2 are subject to a 10% penalty.
7.Stop Waiting for the Next Paycheck
Beginning your working life with good financial decisions doesn't call for complex moves. It does require discipline and a long-term outlook. This commitment can help get you out of debt and keep you from a paycheck-to-paycheck lifestyle.
Summary
--Outstanding debt is one of the biggest obstacles to saving.
--Disability insurance is a major safeguard against financial trouble if you're out of work for an extended period.
--Most experts recommend saving at least three months' worth of living expenses in case income stops. An easy and painless way to fund an emergency cash account is through an automatic savings plan.
--Money-market funds are a potentially higher-earning alternative to bank savings accounts. But money-market finds can technically lose money (though they have met their financial obligations), and yields will fluctuate, unlike savings accounts. Also, savings accounts are FDIC-insured.
--Tax-advantaged retirement plans are a terrific way to help build long-term financial security.
Checklist
--Buy additional insurance coverage if necessary.
--Use savings from your newly revised budget to pay off debt ahead of schedule and accumulate enough money for your emergency savings account.
--Consolidate high-interest debt in a single low-rate account.
--Consider scheduling a meeting with a financial professional to review your plans for pursuing your entire range of goals.
Topics
--Starting Out: Begin Funding for Your Financial Security
--Get Out From Under
--What You Really Should Buy
--Build a Cash Reserve
--Shopping for the Best Credit Card
--Build Your Financial Future
--Stop Waiting for the Next Paycheck
1.Starting Out
Congratulations! You've graduated from school and landed a job. Your salary, however, is limited, and you don't have much money (if any) left at the end of the month. So where can you find money to save? And, once you find it, where should this cash go?Here are some ways to help free up the money you need for current expenses, financial protection, and future investments -- all without pushing the panic button.
2.Get Out From Under
For most young adults, paying down debt is the first step toward freeing up cash for the financial protection they need. If you're spending more than you make, think about areas where you can cut back. Don't rule out getting a less expensive apartment, roommates, or trading in a more expensive car for a secondhand model. Other expenses that could be trimmed include dining out, entertainment, and vacations.
If you owe balances on high-rate credit cards, look into obtaining a low-interest credit card or bank loan and transferring your existing balances. Then plan to pay as much as you can each month to reduce the total balance, and try to avoid adding new charges.
If you have student loans, there's also help to make paying them back easier. You may be eligible to reduce these payments if you qualify for the Federal Direct Consolidation Loan program. Though the program would lengthen the payment time somewhat, it could also free up extra cash each month to apply to your higher-interest consumer debt. The program can be reached at (800) 557-7392.
3.What You Should Buy
How would you pay the bills if your paychecks suddenly stopped? That's when you turn to insurance and personal savings -- two items you should "buy" before considering future big-ticket purchases.
Health insurance is your first priority, as hospital stays can be extremely costly. If you're not covered under a group plan, see if you can join any trade associations, which often offer group-rate policies. Otherwise, start obtaining quotes on individual policies by calling the major insurers in your state.
Life insurance is the next logical step, but may only be a concern if you have dependents. In fact, at the age of 25 you're statistically more likely to become disabled than to die prematurely, according to a 2004 report funded by the nonprofit Actuarial Foundation. Disability insurance will replace a portion of your income if you can't work for an extended period due to illness or injury. If you can't get this through your employer, call individual insurance companies to compare rates.
4.Build a Cash Reserve
If you should ever become disabled or lose your job, you'll also need savings to fall back on until paychecks start up again. Try to save at least three months' worth of living expenses in an easy-to-access "liquid" account, which includes a checking or savings account. Saving up emergency cash is easier if your financial institution has an automatic payroll savings plan. These plans automatically transfer a designated amount of your salary each pay period -- before you see your paycheck -- directly into your account.
To get the best rate on your liquid savings, look into putting part of this nest egg into money-market funds. Money-market funds invest in Treasury bills, short-term corporate loans, and other low-risk instruments that typically pay higher returns than savings accounts. These funds strive to maintain a stable $1 per share value, but unlike FDIC-insured bank accounts, can't guarantee they won't lose money.
Some money-market funds may require a minimum initial investment of $1,000 or more. If so, you'll need to build some savings first. Once you do, you can get an idea of what the top-earning money market funds are paying by referring to imoneynet.com, which publishes current yields. Many newspapers also publish yields on a regular basis.
5.Shopping for the Best Credit Card
In addition to looking at fees and the interest that you will be charged (also known as the annual percentage rate or APR), consider your lifestyle and past payment history when shopping for a credit card. Factors you may want to consider include:
--A fixed vs. a variable rate of interest. Most cards assess a variable rate, which can be reset monthly. In most cases, the rate of interest will not be less than a floor established by the card issuer.
--Minimum payment you are required to make.
--Maximum you can borrow without incurring an over-the-limit fee.
--Fees such as an annual fee, late payment charges, and interest rates on cash advances.
--Circumstances when the credit provider can change provisions of the agreement.
--How the company calculates the finance charge. Is it based on the average daily balance, the balance at the beginning of the billing cycle, or another amount?
--A low introductory interest rate, if offered (extensive lists of the latest low-interest-rate cards in the United States are available at www.bankrate.com and www.cardtrak.com). When is the rate likely to increase? What is the new rate likely to be?
--Incentives such as cash rebates on purchases, purchase protection, and frequent flyer miles.
--Your prior payment history. If you typically pay off your balance every month, the APR may be less of an issue than getting cash back with a purchase.
6.Build Your Financial Future
Some long-term financial opportunities are too good to put off, even if you are still building a cache for current living expenses.
One of the best deals is an employer-sponsored retirement plan such as a 401(k) plan, if available. These tax-advantaged plans allow you to make pretax contributions, and taxes aren't owed on any earnings until they're withdrawn. What's more, new Roth-style plans allow for after-tax contributions and tax-free withdrawals in retirement, provided certain eligibility requirements are met. Another big plus is direct contributions from each paycheck so you won't miss the money as well as possible employer matches on a portion of your contributions.
Don't underestimate the potential power of tax savings. If you invested $100 per month into one of these accounts and it earned an 8% return compounded annually, you would have $146,815 in 30 years -- nearly $50,000 more than if the money were taxed annually at 25%. Bear in mind, however, that you will have to pay taxes on the retirement plan savings when you take withdrawals. If you took a lump-sum withdrawal and paid a 25% tax rate, you'd have $110,111, which is still more than the balance you'd have in a taxable account.
If you're already participating, think about either increasing contributions now or with each raise and promotion.
If a 401(k) isn't available to you, shop around for individual retirement accounts (IRAs), both traditional and Roth, at banks or mutual fund firms. In 2007, you can contribute up to $4,000 to traditional IRAs or Roth IRAs. Generally, contributions to and income earned on traditional IRAs are tax deferred until retirement; Roth IRA contributions are made after taxes, but earnings thereon can be withdrawn tax-free upon retirement. Note that certain eligibility requirements apply and nonqualified taxable withdrawals made before age 59 1/2 are subject to a 10% penalty.
7.Stop Waiting for the Next Paycheck
Beginning your working life with good financial decisions doesn't call for complex moves. It does require discipline and a long-term outlook. This commitment can help get you out of debt and keep you from a paycheck-to-paycheck lifestyle.
Summary
--Outstanding debt is one of the biggest obstacles to saving.
--Disability insurance is a major safeguard against financial trouble if you're out of work for an extended period.
--Most experts recommend saving at least three months' worth of living expenses in case income stops. An easy and painless way to fund an emergency cash account is through an automatic savings plan.
--Money-market funds are a potentially higher-earning alternative to bank savings accounts. But money-market finds can technically lose money (though they have met their financial obligations), and yields will fluctuate, unlike savings accounts. Also, savings accounts are FDIC-insured.
--Tax-advantaged retirement plans are a terrific way to help build long-term financial security.
Checklist
--Buy additional insurance coverage if necessary.
--Use savings from your newly revised budget to pay off debt ahead of schedule and accumulate enough money for your emergency savings account.
--Consolidate high-interest debt in a single low-rate account.
--Consider scheduling a meeting with a financial professional to review your plans for pursuing your entire range of goals.
Advice for Young Investors
It's a bewildering time to begin saving and investing. BusinessWeek asked financial advisers for words of wisdom for the young investor.
Two 22-year-olds are just starting their careers and beginning to save and invest. One devotes half his salary to quickly paying off student loans, with the goal of saving money to travel the world. The other dabbles in stocks, while planning to buy a home. Which one is starting out on the right foot? Neither? Both?
Learning to invest is hard enough. Now try doing it during the worst recession in a generation and the biggest financial crisis in a lifetime. If you're a young person with money to invest, however, you can consider yourself lucky. You have income at a time when the jobless rate is rising rapidly. If you're just starting out, you avoided—so far—huge losses of the sort that drastically changed the retirement plans of many baby boomer parents
No Easy Answers
But the current environment naturally leaves a beginner confused about how to invest. The tough housing market means real estate looks cheap, but it's also an unreliable investment. After the financial market's problems of the past year, the same can be said for stocks, bonds, and other investments. Are they a bargain or a dangerous trap? At the same time, the financial crisis and widespread layoffs seem to argue for playing it safe. But how much cash can really fit into your piggybank or under your mattress?
BusinessWeek asked experienced financial advisers for some advice to young investors. Experts don't always agree, but all agreed on one piece of wisdom: There is no easy answer. The right investing plan depends on your personality and your short-term and long-term goals, advisers say. Consider the two young investors mentioned above. On the surface, they're similar, but they're going about saving and investing very differently.
Alex Engelman is 22 and works at a market strategy consulting firm near Burlington, Vt. He distrusts the stock market and he doesn't plan to buy a home anytime soon. "I'm all about mobility in my twenties," he says. Instead, Engelman plows half of his income toward one goal—paying off student loans that once totaled more than $20,000. "I don't want debt hanging over my shoulder," he says. When the loans are paid off—before the end of the year—he'll start saving cash so he can pack up and travel.
Robin Jordan, also 22, works in marketing at a retirement planning firm in Santa Barbara, Calif. He doesn't plan to move away anytime soon, and is seriously considering buying real estate. "The rent I'm paying right now to live in downtown Santa Barbara is more than the monthly payment on my parents' mortgage in northern California," he says. "I look at home ownership more as an investment than as a lifelong commitment," he adds. Meanwhile, Jordan is also starting to dabble in stock investing—setting aside 20% to 30% of his savings to buy individual stocks and another 50% for broad index funds. He's trying to diversify his portfolio, but has noticed that's hard to do because many funds require minimum contributions.
Both young men may be pursuing plans that are perfect for their particular circumstances. There are, however, some general principles of investing and saving that it pays to be aware of.
Advisers offer these tips:
1. Cash, cash, cash. Both Engelman and Jordan said they're not yet saving much cash from month to month. However, nearly every financial planner will tell clients the first priority is an emergency cash fund. Before you can invest for the long term, you need enough to cover your current needs, they say. It's important not just if you lose your job, but for covering any eventuality from a major car repair or moving expenses to a pet's—or your own—surgery. For years, many clients resisted this advice, says Leisa Brown Aiken of Timothy Financial Counsel in Chicago. They preferred to be making money in the stock market or spending more on a future or existing home. Now that stocks and home prices have been pummeled, there's been "a big sea change" in attitudes, Aiken says.
The insecurity of many jobs these days also prompts more saving. "People are getting wise: You've got to have money in the bank," says Robert Timineri of Total Return Advisory in Oroville, Calif. The goal is keeping the cash handy so you can get it in an emergency. Many online banks pay out relatively generous interest rates on savings accounts.
But how much to save? A bare minimum starting point is one month of expenses, but ideally a fund should cover three to six months of expenses. Timineri used to advise each adult should have ready access to $10,000 in cash, but, because of the bad economy, he has boosted that to $15,000 to $20,000.
2. Enough insurance? One other base that needs to be covered before serious investing starts is insurance. Robert Oliver of Oliver Financial Planning in Ann Arbor, Mich., says most young people don't have enough disability insurance, which covers living expenses in case you're injured and can't work. "As younger people, your main asset is yourself, your ability to earn over a lifetime," Oliver says. A disability puts that in jeopardy, but the basic disability insurance offered by employers is rarely adequate, he says.
3. Should you buy a home? This might look like a great time to buy real estate. Home prices are falling, mortgage rates are low, and Congress is debating rich incentives for first-time homebuyers as part of the pending economic stimulus package.
But there are problems: Credit standards are tighter and it's harder to get a mortgage by putting only 5% or 10% down, a practice that was common a couple years ago. Also, if your job situation is tenuous, this might not be a good time to take on a heavy debt load. Using your emergency cash fund for your down payment defeats the purpose of such funds. Plus, you'll probably need that cash once you move in. "Owning a home is expensive," says Paula Hogan of Hogan Financial Management in Milwaukee. Maintenance on average costs 1% of the value of the home each year. "That can take a new homeowner by surprise," she says. The housing bubble misled many Americans about real estate investing. Taking into account maintenance and the long history of home values in the U.S., the annual return on a home might be only 1%, says Kristopher Johnson of Timothy Financial Counsel in Wheaton, Ill. A home purchase might be the right choice, but it's often a decision made for nonfinancial reasons. "I view my home as an expense," Johnson says. "I need a place to live."
4. How secure is your job? The U.S. unemployment rate is inching higher every month, with thousands of layoffs announced each week in a range of industries. "At this point, I don't think anyone's job is secure," says Jorie Johnson of Financial Futures in Manasquan, N.J. Even teachers are facing layoffs. "Anyone who feels too comfortable is doing themselves a disservice."
The security of your job matters because it affects how much risk you should feel free to take in your investing portfolio and how much cash you should hold. One oft-repeated guideline, says Aiken: "Is your earnings stream more like a bond or a stock?" Though the financial crisis put these distinctions to a test, bonds are supposed to be reliable, while stocks can be volatile and unpredictable. A person or couple with jobs that fit in the bond category can afford to take on more risk in their investments.
5. How much risk can you handle? If you're saving for the long term, you probably have time to ride out market turbulence and, in 30 or 40 years, rack up some nice gains even from risky investments. That's how it's supposed to work in the abstract, anyway. In reality, the ups and downs of the market can leave you anxious and cause you to bail out of investments too early. "Some can't take the heat," Kris Johnson says.
Thus, the amount you should invest in, for example, risky stocks is driven partly by your personality, Jorie Johnson says. Lately, investors have gotten a taste of just how bad conditions can get.
"The last six months have been a good test of risk tolerance," Oliver says. If you can't sleep at night when your nest egg loses 40% of its value, a more conservative portfolio—for example, more bonds and less stocks—may help. Engelman, for example, admits equity investing doesn't fit his personality. To him, he says, "There's something intrinsically unreliable about it."
6. Equities are risky. Equities, or stocks, do better than most other investments over the long term. The problem is that equities sometimes go through long periods—the 1930s, the 1970s, the past decade—when values barely budge and even fall substantially. That has sparked debate over how appropriate it is to risk retirement funds in the stock market, and, if so, what portion of a portfolio should consist of these risky assets.
Any amount of money you need soon, i.e., in the next five or ten years, should not be in stocks, advisers say. Even a decade is too short of a period for some conservative investors.
Young people have an advantage here because they have longer until retirement. Jordan says he doesn't mind betting on stocks because "while I'm young, I still have time to recover those losses." For young people in their twenties, 50% or more of a 401(k) or other retirement plan could go into equities. But, says Aiken: "The key is not time period, but the resiliency of their ability to earn income." Young people have decades to earn back money lost in bad years like 2008.
The classic antidote to the riskiness of equities is bonds. However, that didn't work last year. Funds based on U.S. Treasuries—safe government debt—saw outsize gains, while corporate bond funds registered huge losses. "A lot of people got caught by surprise," Jorie Johnson said. Bonds may return to their calmer behavior eventually, but in the meantime bank certificates of deposits and inflation-protected Treasuries, or TIPS, are other safe alternatives.
7. Get started. Retirement can feel like a long time from now, but money invested now can compound year after year. "Compounding is a very powerful thing," Oliver says. "Even if it's just a small amount, time is your biggest ally." Also, young investors can learn and even make mistakes while the stakes are still low, Hogan says. Almost all experts advise clients to take full advantage of an employer that matches retirement contributions. Doing otherwise is leaving money on the table. Jorie Johnson advises saving 10% of your income no matter what. Get started now, because while your income may rise in the future, so will your responsibilities and spending, she says.
8. Do everything. "It's important to do everything," Jorie Johnson says. This means you've got to juggle it all, financially: pay down debt while saving for both short-term and long-term needs. "You have to make sure that every month you're putting money aside for each goal," she adds. Without that balanced approach, you're likely to focus on one goal—like buying a house—and never meet the others—like setting up an emergency fund or saving for retirement.
9. Be flexible. Timineri, who advocates setting aside a larger-than-usual cash reserve, says the financial crisis and stock market collapse have changed the rules for investors. "I don't have the faith that I used to have [in the financial system]," he says. For now, he's allocating a maximum of only 50% of portfolios to stocks, and telling clients to wait before making any major moves. "No one thinks this is going to be over in a couple months," he says. In other words, this may not be the time to set up a financial plan that you stick with for life. A little caution and flexibility may be warranted for the time being.
10. Can you save and invest too much? It's rare that young people can set aside too much money for the future, advisers say. More often, clients need to be reminded of the risks of saving too little. "If you don't save [a certain] amount, you're never going to be able to stop working," Aiken tells clients. "That often motivates them."
But how do you balance your present happiness with future needs? Bob Smrekar of Wade Financial Group in Minneapolis says some clients save very aggressively, living a lean lifestyle because they want to retire by age 55. "If that's what their goals are and that's what they want to do, more power to them," he says. Other of his clients prefer to travel while they're young and healthy, even if they're well aware that expensive trips may delay their retirement.
Obviously, advisers say, it makes sense to spend now on college or graduate school. Even if it delays the start of your retirement investing, another educational degree could add substantially to your income over a lifetime. "Your life today is just as important as your life in retirement," Oliver says. "But the difference is you're not going to have some earned income in retirement. It's all about that trade-off."
With each paycheck, young investors must weigh a variety of goals, for the present and into the future, against each other. It's a balancing act made even more difficult by these unstable times.
Two 22-year-olds are just starting their careers and beginning to save and invest. One devotes half his salary to quickly paying off student loans, with the goal of saving money to travel the world. The other dabbles in stocks, while planning to buy a home. Which one is starting out on the right foot? Neither? Both?
Learning to invest is hard enough. Now try doing it during the worst recession in a generation and the biggest financial crisis in a lifetime. If you're a young person with money to invest, however, you can consider yourself lucky. You have income at a time when the jobless rate is rising rapidly. If you're just starting out, you avoided—so far—huge losses of the sort that drastically changed the retirement plans of many baby boomer parents
No Easy Answers
But the current environment naturally leaves a beginner confused about how to invest. The tough housing market means real estate looks cheap, but it's also an unreliable investment. After the financial market's problems of the past year, the same can be said for stocks, bonds, and other investments. Are they a bargain or a dangerous trap? At the same time, the financial crisis and widespread layoffs seem to argue for playing it safe. But how much cash can really fit into your piggybank or under your mattress?
BusinessWeek asked experienced financial advisers for some advice to young investors. Experts don't always agree, but all agreed on one piece of wisdom: There is no easy answer. The right investing plan depends on your personality and your short-term and long-term goals, advisers say. Consider the two young investors mentioned above. On the surface, they're similar, but they're going about saving and investing very differently.
Alex Engelman is 22 and works at a market strategy consulting firm near Burlington, Vt. He distrusts the stock market and he doesn't plan to buy a home anytime soon. "I'm all about mobility in my twenties," he says. Instead, Engelman plows half of his income toward one goal—paying off student loans that once totaled more than $20,000. "I don't want debt hanging over my shoulder," he says. When the loans are paid off—before the end of the year—he'll start saving cash so he can pack up and travel.
Robin Jordan, also 22, works in marketing at a retirement planning firm in Santa Barbara, Calif. He doesn't plan to move away anytime soon, and is seriously considering buying real estate. "The rent I'm paying right now to live in downtown Santa Barbara is more than the monthly payment on my parents' mortgage in northern California," he says. "I look at home ownership more as an investment than as a lifelong commitment," he adds. Meanwhile, Jordan is also starting to dabble in stock investing—setting aside 20% to 30% of his savings to buy individual stocks and another 50% for broad index funds. He's trying to diversify his portfolio, but has noticed that's hard to do because many funds require minimum contributions.
Both young men may be pursuing plans that are perfect for their particular circumstances. There are, however, some general principles of investing and saving that it pays to be aware of.
Advisers offer these tips:
1. Cash, cash, cash. Both Engelman and Jordan said they're not yet saving much cash from month to month. However, nearly every financial planner will tell clients the first priority is an emergency cash fund. Before you can invest for the long term, you need enough to cover your current needs, they say. It's important not just if you lose your job, but for covering any eventuality from a major car repair or moving expenses to a pet's—or your own—surgery. For years, many clients resisted this advice, says Leisa Brown Aiken of Timothy Financial Counsel in Chicago. They preferred to be making money in the stock market or spending more on a future or existing home. Now that stocks and home prices have been pummeled, there's been "a big sea change" in attitudes, Aiken says.
The insecurity of many jobs these days also prompts more saving. "People are getting wise: You've got to have money in the bank," says Robert Timineri of Total Return Advisory in Oroville, Calif. The goal is keeping the cash handy so you can get it in an emergency. Many online banks pay out relatively generous interest rates on savings accounts.
But how much to save? A bare minimum starting point is one month of expenses, but ideally a fund should cover three to six months of expenses. Timineri used to advise each adult should have ready access to $10,000 in cash, but, because of the bad economy, he has boosted that to $15,000 to $20,000.
2. Enough insurance? One other base that needs to be covered before serious investing starts is insurance. Robert Oliver of Oliver Financial Planning in Ann Arbor, Mich., says most young people don't have enough disability insurance, which covers living expenses in case you're injured and can't work. "As younger people, your main asset is yourself, your ability to earn over a lifetime," Oliver says. A disability puts that in jeopardy, but the basic disability insurance offered by employers is rarely adequate, he says.
3. Should you buy a home? This might look like a great time to buy real estate. Home prices are falling, mortgage rates are low, and Congress is debating rich incentives for first-time homebuyers as part of the pending economic stimulus package.
But there are problems: Credit standards are tighter and it's harder to get a mortgage by putting only 5% or 10% down, a practice that was common a couple years ago. Also, if your job situation is tenuous, this might not be a good time to take on a heavy debt load. Using your emergency cash fund for your down payment defeats the purpose of such funds. Plus, you'll probably need that cash once you move in. "Owning a home is expensive," says Paula Hogan of Hogan Financial Management in Milwaukee. Maintenance on average costs 1% of the value of the home each year. "That can take a new homeowner by surprise," she says. The housing bubble misled many Americans about real estate investing. Taking into account maintenance and the long history of home values in the U.S., the annual return on a home might be only 1%, says Kristopher Johnson of Timothy Financial Counsel in Wheaton, Ill. A home purchase might be the right choice, but it's often a decision made for nonfinancial reasons. "I view my home as an expense," Johnson says. "I need a place to live."
4. How secure is your job? The U.S. unemployment rate is inching higher every month, with thousands of layoffs announced each week in a range of industries. "At this point, I don't think anyone's job is secure," says Jorie Johnson of Financial Futures in Manasquan, N.J. Even teachers are facing layoffs. "Anyone who feels too comfortable is doing themselves a disservice."
The security of your job matters because it affects how much risk you should feel free to take in your investing portfolio and how much cash you should hold. One oft-repeated guideline, says Aiken: "Is your earnings stream more like a bond or a stock?" Though the financial crisis put these distinctions to a test, bonds are supposed to be reliable, while stocks can be volatile and unpredictable. A person or couple with jobs that fit in the bond category can afford to take on more risk in their investments.
5. How much risk can you handle? If you're saving for the long term, you probably have time to ride out market turbulence and, in 30 or 40 years, rack up some nice gains even from risky investments. That's how it's supposed to work in the abstract, anyway. In reality, the ups and downs of the market can leave you anxious and cause you to bail out of investments too early. "Some can't take the heat," Kris Johnson says.
Thus, the amount you should invest in, for example, risky stocks is driven partly by your personality, Jorie Johnson says. Lately, investors have gotten a taste of just how bad conditions can get.
"The last six months have been a good test of risk tolerance," Oliver says. If you can't sleep at night when your nest egg loses 40% of its value, a more conservative portfolio—for example, more bonds and less stocks—may help. Engelman, for example, admits equity investing doesn't fit his personality. To him, he says, "There's something intrinsically unreliable about it."
6. Equities are risky. Equities, or stocks, do better than most other investments over the long term. The problem is that equities sometimes go through long periods—the 1930s, the 1970s, the past decade—when values barely budge and even fall substantially. That has sparked debate over how appropriate it is to risk retirement funds in the stock market, and, if so, what portion of a portfolio should consist of these risky assets.
Any amount of money you need soon, i.e., in the next five or ten years, should not be in stocks, advisers say. Even a decade is too short of a period for some conservative investors.
Young people have an advantage here because they have longer until retirement. Jordan says he doesn't mind betting on stocks because "while I'm young, I still have time to recover those losses." For young people in their twenties, 50% or more of a 401(k) or other retirement plan could go into equities. But, says Aiken: "The key is not time period, but the resiliency of their ability to earn income." Young people have decades to earn back money lost in bad years like 2008.
The classic antidote to the riskiness of equities is bonds. However, that didn't work last year. Funds based on U.S. Treasuries—safe government debt—saw outsize gains, while corporate bond funds registered huge losses. "A lot of people got caught by surprise," Jorie Johnson said. Bonds may return to their calmer behavior eventually, but in the meantime bank certificates of deposits and inflation-protected Treasuries, or TIPS, are other safe alternatives.
7. Get started. Retirement can feel like a long time from now, but money invested now can compound year after year. "Compounding is a very powerful thing," Oliver says. "Even if it's just a small amount, time is your biggest ally." Also, young investors can learn and even make mistakes while the stakes are still low, Hogan says. Almost all experts advise clients to take full advantage of an employer that matches retirement contributions. Doing otherwise is leaving money on the table. Jorie Johnson advises saving 10% of your income no matter what. Get started now, because while your income may rise in the future, so will your responsibilities and spending, she says.
8. Do everything. "It's important to do everything," Jorie Johnson says. This means you've got to juggle it all, financially: pay down debt while saving for both short-term and long-term needs. "You have to make sure that every month you're putting money aside for each goal," she adds. Without that balanced approach, you're likely to focus on one goal—like buying a house—and never meet the others—like setting up an emergency fund or saving for retirement.
9. Be flexible. Timineri, who advocates setting aside a larger-than-usual cash reserve, says the financial crisis and stock market collapse have changed the rules for investors. "I don't have the faith that I used to have [in the financial system]," he says. For now, he's allocating a maximum of only 50% of portfolios to stocks, and telling clients to wait before making any major moves. "No one thinks this is going to be over in a couple months," he says. In other words, this may not be the time to set up a financial plan that you stick with for life. A little caution and flexibility may be warranted for the time being.
10. Can you save and invest too much? It's rare that young people can set aside too much money for the future, advisers say. More often, clients need to be reminded of the risks of saving too little. "If you don't save [a certain] amount, you're never going to be able to stop working," Aiken tells clients. "That often motivates them."
But how do you balance your present happiness with future needs? Bob Smrekar of Wade Financial Group in Minneapolis says some clients save very aggressively, living a lean lifestyle because they want to retire by age 55. "If that's what their goals are and that's what they want to do, more power to them," he says. Other of his clients prefer to travel while they're young and healthy, even if they're well aware that expensive trips may delay their retirement.
Obviously, advisers say, it makes sense to spend now on college or graduate school. Even if it delays the start of your retirement investing, another educational degree could add substantially to your income over a lifetime. "Your life today is just as important as your life in retirement," Oliver says. "But the difference is you're not going to have some earned income in retirement. It's all about that trade-off."
With each paycheck, young investors must weigh a variety of goals, for the present and into the future, against each other. It's a balancing act made even more difficult by these unstable times.
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