How Bad is the Financial Meltdown?

What is going on in the financial markets right now? How bad are things going to get?

Ok, let's talk about what's happening, first.

So, there are a couple of things going on in the economy that could affect you.

The markets are down. This won't affect you directly if you don't have any investments, but if you have 401k's, this could delay or change your retirement plans. If you don't have a retirement plan, now is a great time to get one, partly because a lot of people think we're near the bottom of the market, and even if you don't invest in an Index fund you can still sock away some money in case things get worse.

A credit crunch (this is a long one). This is what happens when no one wants to lend any money because no one trusts anyone else. When you need a taco and your friend won't lend you $2 it's bad, but when one bank won't lend another $1B over night, it's a crisis.

When the credit markets start locking up it causes problems throughout the economy. Businesses often take out short term loans ("commercial paper") to finance paychecks, purchases, etc. and when they can't get these loans it causes big big problems.

Another way this can affect you is if you try and get a loan from a bank. Mortgages right now are extremely hard to get, even for applicants with pristine credit records, and personal loans like hen's teeth. This means it's harder to buy a house, and we're going to see housing prices continue to fall as the pool of available buyers continues to shrink, and the pool of sellers continues to grow. The record number of foreclosures we're seeing makes this even worse, as it increases the number of sellers even more.

This also hits CDOs (Collateralized Debt Obligations). Since CDOs are just bundles of mortgages, if the value of those mortgages drop then the CDO becomes more worthless. It's the CDOs that are causing most of the problems in the banking system right now, so this will weaken banks further and cause more bank failures, necessitating more bailouts.

CDOs are a problem, and are what the Fed was proposing to buy, but the biggest problem with the banks right now is that they've bought a bunch of contracts called Credit Default Swaps.

Let's say you have a billion dollar bond that General Motors sold you. You're happy getting your coupon (monthly interest payment), but you're worried that GM is going to go tits-up and your bond will be worth nothing. So I come along and say "I'll sell you some insurance on that bond. If GM goes under, I'll pay you face-value for the bond, but in the meantime, you pay me some interest (let's say 2% the face value) every year."

This sounds like a great deal for me, since I get 20 million a year, and it also sounds like a great deal for you, since you're protected if GM goes under (which will probably happen every day). This is a Credit Default Swap. We're "swapping" risk. You take one type of risk, and I take the other.

The problem here is that we've entered into a contract. This isn't a security like a share of stock, or a derivative, like an option. This is a contract between two parties. There are a bunch of standard CDS contracts, but since they're contracts, not securities, if you want to get out of the CDS, you have to enter into another CDS with another party. You're not off the hook for the first CDS.

This is what's called "counterparty risk". The risk here is if I go to the big bankruptcy court in the sky, I break the CDS chain, and potentially bring down everyone that's entered into a CDS agreement, with me. This is why AIG got bailed out, Bear got sold with Fed backing on losses to JP Morgan, and is why Lehman didn't. Lehman didn't have much CDS exposure, and so the Fed could let them fail. If AIG went under, they would have brought down banks all over the world.

The problem right now is that no one knows how many CDS agreements there are out there, and no one knows who has exposure. Everyone is convinced everyone else is going to go under, so they're not lending any money.

About the only way out of this mess if for the adults (reserve banks and governments of the G7) to step in and stop the madness. Force CDSes to be securitized, and for the counterparty risk to be removed.

Will this happen? I think it has to, and it needs to happen really soon.

Inflation! When the Fed decides to make money cheaper (reduce the interest rates), they effectively increase the money supply. This drives up prices since the value of each individual dollar goes down.

This means any savings you have is worth less, but it also means any loans you have are easier to pay off, assuming your wage increases at least keep up with inflation.

Jobs! As the economy gets worse it'll be harder to find a job, especially in certain industries.

There are some good things happening right now, though.

Oil is cheaper. This is a short term improvement, but since so much of our economy depends on cheap energy (oil), this means inflation won't be as bad as it could be.

The dollar is strong. The dollar is up to $1.30 to the Euro. This might also be a short term change, but it means travel won't be as expensive, and consumer consumption won't take as large a hit.

There are some massive things I'm glossing over here, but to answer the original questions, yeah, that blog comment you read was basically right, but he's more alarmist than I am. I don't think we're going to go back to a barter economy any time soon.

I don't know if everything is actually going to crumble, though. I'd be willing to bet it's not. If it does, it'll be the Second Great Depression, but if we work our way through it, then it'll just be the worst recession in 25 years.

The main things to do: pay off all your debt, asap.

Save as much as you can in liquid assets. This means savings accounts, not stocks. This could be a great time to buy stocks, but we don't have any idea if we're anywhere near the bottom. We could easily see the DJIA go to 6k, if people start pulling money out of IRAs and 401ks.

I don't think you need to buy gold. It's already pretty expensive, and if we get to the point where you need a piece of physical gold to buy food, then we have bigger problems.