The Risk of Less Risk

As Ben Bernanke, the Federal Reserve Chairman testifies before Congress, we will come to the conclusion that there is risk, we should do something about it and we still have no idea exactly what. Referring to the problem as systemic risk, both in the creation of firms seeking to reach, through acquisition, the "to-big-to-fail" status and the inability of one agency to oversee every player in this complicated, global game of finance, Bernanke admits that we are far from where we need to be but much closer than we think.

There is absolutely no doubt in anyone's mind, this is bigger than one agency. Even the ability to provide oversight to this sort of mechanism creates a risk in itself. The Fed will admit it has learned a great deal.

Top of those now known facts is that numerous other participants in the financial world, those whose regulation falls under the purview of other agencies/regulators who, because it was not previously needed, failed to look at the leverage and risk some of their charges were assuming. Insurance firms and lending institutions that fell outside of what the Fed was trying to watch, slipped through the regulatory cracks. It is now known that these firms provided just as much in terms of financial disruptions as did the banking system.

President Obama has suggested that the central bank be the primary torch bearer in this effort to provide stability. The ability to understand the complexities of this type of problem should fall to those who can make the best decision. But the question of how quickly the Fed can react, outside of increased regulation and policing of the regulatory follow-through, has never been an attribute of this agency.

While the world has never experienced this kind of downturn, one where risk was sold as predictable and eventually collapsed under its own promises, the aftermath of such activity does justify the need for some reaction.

So how does Mr. Bernanke describe the harness he has determined is needed: consolidated supervision. This allows the Fed to take the lead and offer some much needed protections.

Many of the decisions the Fed makes are reactive. The Fed has proven in numerous circumstances that its decisions take weeks, often months to find their way into the system. This time-lag can be costly in a marketplace that responds to news now. It also relies on the predictive powers of the central bank, the ability of these bankers to spot the problem long before it becomes a problem and to move without causing a panic. Not exactly in the Fed's wheelhouse.

I'm not seeing how this could be done to the benefit of everyone concerned. Mr. Bernanke shows his concern as well: "Unfortunately, the current regulatory and supervisory framework for systemically important payment, clearing, and settlement arrangements is fragmented, creating the potential for inconsistent standards to be adopted or applied." Consumers will ultimately find this sort adoption of rules to be expensive.

As banks begin to anticipate the future of what these agencies adopt, pass down costs will further restrict any recovery in the short-term. The stock market, suffering from "yeah, but" syndrome, an affliction that allows you to second guess every piece of good news and discount every piece of bad, will not be phased. The markets will instead see this much the way they see the continued unemployment, limited growth because of it, and tighter lending requirements: a bump in the road.

But will any of these proposals eliminate systemic risks? Risk comes from uncertainty and the Fed is too smart to try and wipe away this sort of activity. Investors have to believe, if wrongly so, that the markets offer enough risk to warrant their participation. "Yeah, but" not too much that they get blindsided by something they could not possibly have anticipated.

We tend to think of investors on a personal level, believing that our participation in these risky endeavors is acceptable, even encouraged. Even after all we have been through, we still want to believe that somewhere, someone is watching over us. It is the comfort of this regulation, humming in the background that let us down and now, retooled, it is supposed to revitalize that trust.

So how does this play out in the long-term? Probably better than we might anticipate. Most businesses have become as lean as they possibly can. Their ability to borrow still remains more costly than it should and new leverage and capitalization requirements by both borrowers and lenders will make the process of regrowing the economy slower. Which is probably a good thing.

We have gotten swept up in the speed of business without allowing us the opportunity to examine motives and risks. The slightly slower pace that another regulatory door will provide should make the long-term health of the marketplace more welcoming. Money is returning to markets because it has no place else to go. To create a healthy investment environment, this has to stop. Money has to want to be invested, not forced.

The risk of less risk is threefold: a slower moving system, a more expensive system, and lesser short-term rewards for participation. The glory days are behind us and had anyone been able to see the future, they most assuredly would have suggested "yeah, but". But in the long-term, we could experience less severe downturns, more or better prolonged gains and a healthier retiree (at least from a financial standpoint).

The "yeah, but" syndrome will carry us forward for quite some time. But as all long-term investors know, we will soon forget. Let's hope those in the position to be the regulators don't.

Retirement Planning and Your Personal Finance Skills, Part Three

Personal Financial Literacy Quiz:

(Answers and explanations by me are at the bottom of the page)

21. Matt has a good job on the production line of a factory in his home town. During the past year or two, the state in which Matt lives has been raising taxes on its businesses to the point where they are much higher than in neighboring states. What effect is this likely to have on Matt's job?

a.) Higher business taxes will cause more businesses to move into Matt's state, raising wages.

b.) Higher business taxes can't have any effect on Matt's job.

c.) Matt's company may consider moving to a lower-tax state, threatening Matt's job.

d.) He is likely to get a large raise to offset the effect of higher taxes.

22. If you have caused an accident, which type of automobile insurance would cover damage to your own car?

a.) Comprehensive.

b.) Liability.

c.) Term.

d.) Collision.

23. Scott and Eric are young men. Each has a good credit history. They work at the same company and make approximately the same salary. Scott has borrowed $6,000 to take a foreign vacation. Eric has borrowed $6,000 to buy a car. Who is likely to pay the lowest finance charge?

a.) Eric will pay less because the car is collateral for the loan.

b.) They will both pay the same because the rate is set by law.

c.) Scott will pay less because people who travel overseas are better risks.

d.) They will both pay the same because they have almost identical financial backgrounds.

24. If you went to college and earned a four-year degree, how much more money could you expect to earn than if you only had a high school diploma?

a.) About 10 times as much.

b.) No more; I would make about the same either way.


c.) A little more; about 20% more.

d.) A lot more; about 70% more.

25. Many savings programs are protected by the Federal government against loss. Which of the following is not?

a.) A U.S. Savings Bond.

b.) A certificate of deposit at the bank.

c.) A bond issued by one of the 50 States.

d.) A U. S. Treasury Bond.

26. If each of the following persons had the same amount of take home pay, who would need the greatest amount of life insurance?

a.) An elderly retired man, with a wife who is also retired.

b.) A young married man without children.

c.) A young single woman with two young children.

d.) A young single woman without children.

27. Which of the following instruments is NOT typically associated with spending?

a.) Debit card.

b.) Certificate of deposit.

c.) Cash.

d.) Credit card.

28. Which of the following credit card users is likely to pay the GREATEST dollar amount in finance charges per year, if they all charge the same amount per year on their cards?

a.) Jessica, who pays at least the minimum amount each month and more, when she has the money.

b.) Vera, who generally pays off her credit card in full but, occasionally, will pay the minimum when she is short of cash

c.) Megan, who always pays off her credit card bill in full shortly after she receives it

d.) Erin, who only pays the minimum amount each month.

29. Which of the following statements is true?

a.) Banks and other lenders share the credit history of their borrowers with each other and are likely to know of any loan payments that you have missed.

b.) People have so many loans it is very unlikely that one bank will know your history with another bank

c.) Your bad loan payment record with one bank will not be considered if you apply to another bank for a loan.

d.) If you missed a payment more than 2 years ago, it cannot be considered in a loan decision.

30. Dan must borrow $12,000 to complete his college education. Which of the following would NOT be likely to reduce the finance charge rate?

a.) If he went to a state college rather than a private college.

b.) If his parents cosigned the loan.

c.) If his parents took out an additional mortgage on their house for the loan.

d.) If the loan was insured by the Federal Government.

31. If you had a savings account at a bank, which of the following would be correct concerning the interest that you would earn on this account?

a.) Earnings from savings account interest may not be taxed.

b.) Income tax may be charged on the interest if your income is high enough.


c.) Sales tax may be charged on the interest that you earn.

d.) You cannot earn interest until you pass your 18th birthday.

ANSWERS: 21) c; 22) d; 23)a; 24)d; 25)c 26) c; 27) b; 28) d; 29) a; 30) a; 31) b

Part One

Part Two

Retirement Planning and Debt: Liquidity

Retirement Planning and Debt: Liquidity

No one can downplay the importance of debt in your financial plan. While I am guilty for frequently mentioning the concept as a negative influence on your plan, we are besieged with information offering us a contrary view.

We are encouraged to keep the economy going by spending. Savings on the other hand, is actually portrayed as a negative influence. An economy can slow the flow of goods if consumers keep their cash close.

While this may be true, it is overspending or buying on credit that has propelled these markets on a global scale. And that movement is based on the availability of money.

What motivates equity markets is liquidity. This is a financial terms that in its simplest form refers to the availability of cash to borrow. Let me explain how liquidity works, often differently depending on where and who you are.

On a corporate level, liquidity can be incredibly deceiving. It acts as a reward for savvy business acumen. And because of so many people are using their skills to find this excess capital where little to none exists, we have these stock market levels (over the month of July, the DJIA hit 14,000, then gyrated wildly downward in fits and starts losing five percent of its value).

Liquidity in its purest form comes from the banking system. The Federal Reserve Board fixes the overnight short-term interest rates for the best borrowers. When it does this, it is suggesting a rate at which it believes the marketplace has just enough cash at the right price to keep the corporate engines fueled. That rate is then passed on to each subsequent lender, who increases the rate in small increments right on down the line.

This gives the average borrower like you and I the impression that the Fed controls the economy with each pull of its purse strings. And you would be right, to a degree. The flip side of making money inexpensive to borrow is having enough available in adequate quantities to those willing to pay the price. But liquidity offers business and consumers different opportunities but similar punishments.

In order for the borrower to qualify for a sizable loan, whether it be business or consumer related they often need to have some sort of underlying asset that they are willing to “put on the line” for the amount of money they seek. With business, it is often money borrowed for reinvestment in production or to expand a product line. With the consumer, it is often their largest asset: their home.

Most of the time this borrowing is at the heart of how a business grows, tapping inexpensive money that gives them additional competitive opportunities.

Each asset the company owns acts as collateral. But what happens when the borrower wants money not for the usual and traditional purpose of expanding the business but to reinvest it? On the surface, it creates an illusion of economic health.

A business can borrow cash to buy back its own stock. The net effect of such a maneuver suggests two things: the company thinks its stock is fairly valued and is taking some of it off the table, making it unavailable for buyers and secondly, it believes that the markets will reward just such an action by increasing the share price. But what happens when the interest rates (called debt service) rise faster that the return on the stock? Nothing until someone begins to realize that this whole debt structure might be nothing more than a house of cards.

The housing analogy is not accidental. For well over three years, I have wondered how consumers would react if their ability to extract money from their homes dried up. For over two years I have been wondering what would happen if all of those creative mortgages, the ones done with adjustable rates and fancy, no-documentation paperwork, became too burdensome for the borrower.

As money becomes too expensive to borrow, opportunities to make money in market places like stocks begin to seem risky and after they calculate the debt service, not too affordable. Businesses, instead of growing and creating new markets find themselves facing the possibility that they may just have painted themselves into a corner.

Consumers, no longer feeling as though the cost of borrowing is worth it, will spend less. This of course has a domino effect disrupting economic growth.

That is the simple explanation. There are global forces at work as well but these will only have an effect on you if your liquidity has dried up. With debt, liquidity is based on your ability to borrow and pay the cost of that transaction and, most importantly, you feel as though the risk and the cost are worthwhile.

If you have no debt, your liquidity is based on your ability to tap cash when you need it. In the book, I fall back on the old stand-by, the emergency account as the base for a good retirement plan. Creating just such an account allows you to have more than just enough money to get you by during times of income disruptions, it gives you peace of mind knowing that the money comes without a cost if you need it and you were able to save it.

It also has the effect of immunizing you from any economic fallout as a result of nefarious corporate and marketplace shenanigans or because other consumers over-extended themselves in unwieldy loans.