Thursday, October 17, 2013
Wake me when it's over, or....
Why I quit worrying and learned to love coming collapse. We had another artificial deadline and another artificially created crisis. A coworker asked my opinion about what has been going on in Washington, and I told him I stopped paying attention. This wasn't entirely true; if we didn't have a deal in place to increase the debt ceiling as of today, I would have taken $1000 out of the bank and kept it on hand in case of problems with the bank. I would have been able to buy food and gas, as well help my mom with food and rent. It didn't happen this time, but it will happen in the future.
As I'm fond of saying, the reduction in government spending and programs (and the resultant reduction in economic activity and the average American's standard of living) will be either policy driven or market driven. Changing policy is a much better option, but the recent exchanges in Washington have convinced me that America's politicians will not reduce spending in time to avoid a market forced end to the nation's borrowing.
That leaves a market-driven solution. To avoid an accusation of invoking a false dichotomy, I do realize that the two can be intertwined. The bond market my have a rise in interest rates, and that would raise America's borrowing costs, so D.C. could be forced to lower spending. Both factors could be involved in a negative feedback loop, with changes from one forcing changes on the other. So, when I say the market will cause the change, I really mean that the market will drive the change, with the federal government following the market's dictates, with no chance to switch positions.
Now, and I alluded to one above, I feel that the markets themselves will have two different methods of correction, though these are not different paths, but escalations. 1) Interest rates will rise. One of the ironies of our present day is though the debt has risen, our interest payments have fallen. Back in 1998, I was listening to an NPR story on mortgages, and the reporters were remarking that the interest rate in 1982 was around 14%. This meant the payment on a $200,000 mortgage was 2369 a month, not including PMI or property taxes. In Nov. of 1998, the prime rate was 7.78%, cutting your house payment in half; alternately, that meant if you could afford the $2400 payment, you suddenly could borrow $330,000 for your home.
The rates given above are the Prime rates, so the mortgage rates would have been higher, but the math otherwise works. Now imagine you took out a mortgage in 1982 and refinanced in 1998, cashing out 50,000 dollars in equity. You originally paid 2369 an month, and now you're only paying 2100 a month. You blow through the $50,000 borrowed, and cash out more equity again. Now rates are 0.5%, so you borrow the 250,000 to pay off the second mortgage, and take out an additional $100,000. Your payment is a scant 1050.00 a month! Suddenly, the banks, who considered you a risk-free borrower, start getting a little skeptical. When you blow through you additional 100,000 and come back for more money to both pay off the 3rd mortgage and take more equity to finance your lifestyle (say 50,000), the rates suddenly jump up to 3%. The bank lends you the money, but now your payment is 1686 a month. You make $4000 a month after taxes. It was affordable at 1050, much less so now. In a mad scramble, you reduce spending a little bit, but the bank is unimpressed. Now you're in dire straights, and you didn't cut spending enough to live within your means, or at least close to that level. Yes, your salary is going up a little bit, but no where near enough for the bank to be happy.
One more time to head to the bank, and you find the interest rate in 6.5%! Yikes. Now the payment for the $400,000 you owe and the additional $50,000 you need is a whopping 2,844. Your salary went to $4,100, and you have to scramble to afford food, gas, what have you. All your excess spending is gone; you no longer eat out at the best restaurants in town, and the kids no longer have private school, their own cars, 1000 digital channels and on demand movies, and so forth. As a ripple effect, all the local businesses that depended on your stupidity largess have much lower sales, and waitress you were sending through college has to drop out to pick up more shifts, and the town's sales taxes go down because you aren't acting like a rapper in a strip club anymore.
Without beating the metaphor any longer, you the point. As bad a the above scenario sounds, it's the milder of the two option the rest of the world has when making the USA curtail her borrowing. Moreover, the process would be much swifter than as described above. Also, you have the chance to reduce your spending to rectify the situation, but you then have to explain this to the wife, and kids, and those who depended on your support. I'm not saying ALL the spending was a total waste; you were trying to keep grandma in her home (if only to prevent her from moving in with you...), and you were trying to send the kids to the best schools, etc.
The real damage will be caused by the second option: removing the American dollar as the world reserve currency. I've covered this in the past, but for next time, let's look at whether or not this is likely.
As I'm fond of saying, the reduction in government spending and programs (and the resultant reduction in economic activity and the average American's standard of living) will be either policy driven or market driven. Changing policy is a much better option, but the recent exchanges in Washington have convinced me that America's politicians will not reduce spending in time to avoid a market forced end to the nation's borrowing.
That leaves a market-driven solution. To avoid an accusation of invoking a false dichotomy, I do realize that the two can be intertwined. The bond market my have a rise in interest rates, and that would raise America's borrowing costs, so D.C. could be forced to lower spending. Both factors could be involved in a negative feedback loop, with changes from one forcing changes on the other. So, when I say the market will cause the change, I really mean that the market will drive the change, with the federal government following the market's dictates, with no chance to switch positions.
Now, and I alluded to one above, I feel that the markets themselves will have two different methods of correction, though these are not different paths, but escalations. 1) Interest rates will rise. One of the ironies of our present day is though the debt has risen, our interest payments have fallen. Back in 1998, I was listening to an NPR story on mortgages, and the reporters were remarking that the interest rate in 1982 was around 14%. This meant the payment on a $200,000 mortgage was 2369 a month, not including PMI or property taxes. In Nov. of 1998, the prime rate was 7.78%, cutting your house payment in half; alternately, that meant if you could afford the $2400 payment, you suddenly could borrow $330,000 for your home.
The rates given above are the Prime rates, so the mortgage rates would have been higher, but the math otherwise works. Now imagine you took out a mortgage in 1982 and refinanced in 1998, cashing out 50,000 dollars in equity. You originally paid 2369 an month, and now you're only paying 2100 a month. You blow through the $50,000 borrowed, and cash out more equity again. Now rates are 0.5%, so you borrow the 250,000 to pay off the second mortgage, and take out an additional $100,000. Your payment is a scant 1050.00 a month! Suddenly, the banks, who considered you a risk-free borrower, start getting a little skeptical. When you blow through you additional 100,000 and come back for more money to both pay off the 3rd mortgage and take more equity to finance your lifestyle (say 50,000), the rates suddenly jump up to 3%. The bank lends you the money, but now your payment is 1686 a month. You make $4000 a month after taxes. It was affordable at 1050, much less so now. In a mad scramble, you reduce spending a little bit, but the bank is unimpressed. Now you're in dire straights, and you didn't cut spending enough to live within your means, or at least close to that level. Yes, your salary is going up a little bit, but no where near enough for the bank to be happy.
One more time to head to the bank, and you find the interest rate in 6.5%! Yikes. Now the payment for the $400,000 you owe and the additional $50,000 you need is a whopping 2,844. Your salary went to $4,100, and you have to scramble to afford food, gas, what have you. All your excess spending is gone; you no longer eat out at the best restaurants in town, and the kids no longer have private school, their own cars, 1000 digital channels and on demand movies, and so forth. As a ripple effect, all the local businesses that depended on your
Without beating the metaphor any longer, you the point. As bad a the above scenario sounds, it's the milder of the two option the rest of the world has when making the USA curtail her borrowing. Moreover, the process would be much swifter than as described above. Also, you have the chance to reduce your spending to rectify the situation, but you then have to explain this to the wife, and kids, and those who depended on your support. I'm not saying ALL the spending was a total waste; you were trying to keep grandma in her home (if only to prevent her from moving in with you...), and you were trying to send the kids to the best schools, etc.
The real damage will be caused by the second option: removing the American dollar as the world reserve currency. I've covered this in the past, but for next time, let's look at whether or not this is likely.
