Credit Card Debt

It seems every week or so, just as we get going on a certain topic for Ways of the World, a new event occurs that upstages our current discussion. This time, of course, it's the General Motors bankruptcy. We had seen this coming, as we wrote here some time ago, and we do want to talk about it with you. But for today, we'll stick to our current program: some commentary on consumer borrowing and a little on the new law.

Americans had a total of $945 billion in credit card debt at the end of March, according to Federal Reserve data. Other government information tells that there were about 130 million households in the country at that time. These figures divide out to an average credit card debt per household of just over $7,200. A different Fed survey of consumer finances that covers 2007 indicates that half of the households who have a credit card had at least $3,000 in balances then. The constant publicity and recent legislation regarding credit cards suggests that this debt must still be growing, evidently without bound.

But this is not so. In the last six months, the total amount of credit card debt has started to go down. That is, people really are paying off more than they're adding in new charges. The graph below shows clearly that an unprecedented contraction in credit card debt is occurring.

In fact people are apparently constraining quite considerably their use of credit cards for new purchases. The Fed data also show that the rate of finance charges added to balances increased markedly in the first quarter this year to 13% from 12% in the prior quarter. So people's debt paydowns are large enough and their new charges small enough that their total balances are falling despite the higher interest costs.

Indeed, total consumer spending has been falling, an unusual development in and of itself. People have historically tended to keep expanding their outlays, even during recessions. They just increase spending more slowly then. But this second graph shows the striking difference now – and one big reason for it: the lower outlays for gasoline in recent months. Gasoline is one item we think people tend to charge heavily to credit cards, so this could be a factor in the reduced debt. But as we are all painfully aware, gasoline prices have tilted back up once again in the last couple of months, subsequent to the periods covered by our data here. So we will have to see what happens to the spending and borrowing figures yet to be published.

About those higher interest costs. There are probably several reasons they have gone up. This specific measure is the actual finance charges as a percent of the outstanding balances. One factor we can cite is higher delinquencies, eliciting more late fees on top of the interest. The delinquency rate for the first quarter (Q1) is 6.50%, up from 5.66% in Q4 and the highest ever in the 18-year history of this information; this means that people are more than 30 days behind making even a minimum payment on 6.5% of their outstandings. A second issue is probably higher interest rates; banks may be thought to profiteer in setting their rates, and indeed the new federal legislation addresses such a perceived strategy. On the banks' behalf, though, we would point out that risk is much higher now, so higher rates are not surprising and can even be seen prudent. And third, from a political viewpoint, the banks may well have wanted to raise their rates in anticipation of just such restrictions on them as were enacted last month. More rate hikes and other actions may come in the months ahead, before the various features of the law become effective.

The new law, the Credit CARD Act of 2009*, signed by President Obama on May 22, will help make the setting of credit card lending terms a less abrupt and more orderly process, requiring 45 days' notice for a change in terms, for instance. At the same time, we think a couple of the features are actually too hard on the banks. The banks probably set themselves up for the stricture against raising rates on outstanding balances. This is a popular item among consumers and likely reflects the often substantial hikes the banks forced on them; one example we saw was an increase from 12% to 24%. In contrast, floating interest rates on mortgages don't get doubled; many have a ceiling of 2% on each increase. Banks might well have followed such a more measured strategy with credit cards too. But we believe the banks deserve to be able to do something about the rates. In a mortgage or a car loan, there's a maturity date. The bank knows when to expect its money back – and it is the bank's money that we have spent up front – but in a credit card situation, the bank doesn't really know how long the customer will take to repay. So there's an added element of risk here that's not present with other kinds of loans.

And we're therefore even more concerned about the new rule prohibiting the banks from raising rates when the customer defaults on some other debt. This "no cross default" provision hardly seems reasonable to us, even if the customer is current on the credit card bill. Clearly, the customer carries more risk if they're missing other payments. But, yes, raising this rate would make the customer's life harder.

So none of this is as simple as it looks. These parts of the law would look to make high credit limits less profitable for banks, so they might well cut limits more. And we'd surmise that they will exercise greater scrutiny before granting credit to someone with spotty records elsewhere. Maybe they should have done that to begin with, but a good number of people are likely to be unhappy at getting rejected for a card in the first place or for an application for a higher limit. Maybe in the end, that would actually be to people's benefit.

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*Credit Card Accountability, Responsibility, and Disclosure Act" – Credit CARD. Here's the White House Fact Sheet on the law: http://www.whitehouse.gov/the_press_office/Fact-Sheet-Reforms-to-Protect-American-Credit-Card-Holders/

And we also call your attention to an informative consumer website: http://www.creditcards.com/, which has rate quotes and other helps. It's the kind of catalog of credit card information that http://www.bankrate.com/ is for savings.

By coincidence, Debbie Loeb posted another helpful credit card site on Hodgepodge the same day as our original post here. See http://www.cardratings.com/. Thanks, Debbie!

Personal Finances, the Great Recession and the Sluggish Recovery

We all keep wishing the economy would "feel better", don't we? that there could be a sense of greater confidence in jobs, in opportunities, in everyone's financial situations.  We wonder why the recovery from the recent Great Recession could be taking so very long.

Our last look at the economy, posted in late June, focused on the job market, and we promised then to talk again about possible reasons the current malaise has resulted in people dropping out of the labor force.   Very soon, the Census Bureau and the Labor Department will publish some detailed data for 2013 that hopefully will help us tackle that question.

Meantime, there is one area we can speak to, the condition of personal finances, a topic for which we already have a quantity of recent information.  One of the main causes of the Great Recession was that people borrowed lots and lots of money.  Much of the public commentary about that recession asserts that financial speculation and bankers brought on the crisis.  Clearly they were important, but it's also true that people took on more and more debt.  Bankers and traders did speculative things with that debt, but it all did start with the consumers who borrowed the money.  A key, then, to the resumption of stronger growth is likely related to the progress people are making in correcting this over-reaching.

Mortgages & Homeowners' Negative Equity

Mortgage debt expanded sharply from the middle of 2001 through 2006, over 13% a year.  The payments on that debt, so-called "debt service", surged from 5.9% of people's disposable income in 2004 to 7.2% at the end of 2007.  People who refinanced mortgages borrowed more than their existing liability during those years, decreasing the equity they had in their homes.  Overall, this home equity withdrawal amounted to almost $500 billion a year from 2003 to 2006.[1]

As people were stretching their personal financial conditions, interest rates began to rise in 2004 and people with adjustable rate mortgages or initially low "teaser" rates saw their mortgage payments go up sharply.  By late 2006, unusual numbers of borrowers started having trouble keeping current on their payments on those and regular mortgages as well.  The greater delinquencies hurt the lenders and the owners of bonds backed by the mortgages.  The climb in home sales peaked in 2005, and they began to decline.  Home prices started to fall in 2006; although those have finally begun to climb again, they remain well below their 2005/06 highs.  The result, even now, is that 17% of homeowners have a mortgage that is larger than the value of their home.[2]  Called "negative equity", that's actually an improvement from over 25% in early 2013 and almost 31% in mid-2012, but remains a heavy weight on people's approach to spending and their outlook on the economy in general.

Even now, after some recovery, housing and mortgage activity remain in the doldrums.  New home construction this year is running no more than half the pace of 2005, and sales of existing homes are still down some 30% from that year's pace.  The latest weekly report from the Mortgage Bankers Association shows a new recovery low last week in the volume of mortgage applications.  People are still staying back from mortgage debt.

Credit Card Debt Got Big Too

Another consumer debt issue is credit cards.  From the spring of 2006 through early 2008, credit card balances accelerated; from very modest growth of about 2% year-over-year in early 2006, they were expanding at a 10% rate by late 2007.

Average credit card balances reached what are, to us, astounding levels:  in 2007, households in the middle 20% income bracket owed $6,300 and those in the next rung down, $4,900.  Balances were higher, of course, in higher brackets, so the average over the entire income span was $8,200.[3]  If these were charged interest at a common credit card rate of 1-1/2% a month, the interest add-on each month would have been $120!  Delinquency rates on credit cards in those years hovered around 9% and rose rapidly during the recession; they reached 13.74% by the spring of 2010.[4]

Credit card usage did slow.  By last year, the middle income bracket's average had fallen to just $4,900 and the overall average to $5,700, this latter a reduction of 35% from its peak.  People are paying larger portions of their bills each month too; from 19% of their balance each month in 2006, people in recent months have been paying almost 25%.[5]  The lower balances have obviously accompanied more sluggish spending growth.  In the 2004-2007 period of big increases in credit card balances, spending was expanding at rates of 6 and 7% a year.  It declined outright in 2009 and has had a modest, uneven pattern since then.  In 2013, people increased their outlays on categories of items that might be charged to a card by just 3% and this year's second quarter was up 3.6% from a year earlier, half the pace during the "spree".[6]

There are numerous reasons for the currently mediocre performance of the U.S. economy, and one of them is surely this restraint on credit use.  Some of this might be banks turning down applications, but as we note with the mortgage information, people are not even applying in much volume in the first place.  In view of the excess of the 2004-2007 period, this caution is quite appropriate.   Importantly, it is helping to improve credit quality; credit card delinquencies in the second quarter were back down to 2.25%, and those on mortgages are down from a peak of 8.9% in early 2010 to 3.4% in the latest period.

The better delinquency situation is laying the groundwork for renewed spending growth on a much sounder basis.  Recent retail sales reports suggest this might be happening.  Also, we do note that people are buying cars these days and obviously borrowing to do that.  After a long hiatus, many people's cars and SUVs have simply grown old and need replacing, so it is not surprising to see this.  It is the only category of ordinary consumer borrowing with much vigor.

People May Still Not Be Saving Enough.  Are You?

At the same time, there are two issues still to grapple with: student loans and saving.  Student loans are a whole topic on their own and we will return to talk about them and the "worth" of incurring big, long-term debt to pay for college.  Saving has improved since the Crash and recession, but continues as a matter of concern.

The saving rate, that is, the amount of personal income not spent, got as low as 2% during the debt-spree years, reached a band of 6-7% in 2011 and 2012 and recently was 5.3% in the second quarter.[7]  So it's clearly up off the lows, but not "high".  Also what isn't "high" is the number of people who actually have a cautionary stash of emergency cash under their mattress (or in a safe bank account somewhere) .  A special Federal Reserve survey of people's economic well-being taken during 2013 asked them about this:  "Have you set aside emergency or rainy day funds that would cover your expenses for 3 months?"  Only 39% of participants said yes.   Further, younger people have a lower positive response: only 33% of households headed by 18-44 year-old people said yes.  There is no history of this for comparison, so we don't know how low that number would have been during the spending-spree era.[8]

So we are not surprised that the economy remains relatively sluggish; we believe some of this reflects the extension of a rebuilding effort for people's own financial standing.  There are lots of other issues, but that is certainly one that had not impacted previous business cycles so deeply or pervasively.  We've illustrated some progress, though, and look forward to further improvement.  Meantime, stick a little cash under your mattress every paycheck until you think you can cover three months' worth of expenses!

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A new book, published just in May, encouraged us to give these ideas some extra emphasis.  House of Debt, by Atif Mian and Amir Sufi, explores mortgage borrowing by zip code around the country, highlighting the role of the debt itself in generating the severe recessionary conditions throughout the economy, not just in the housing sector.  The book's subtitle is "How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again."  Hmmm. 

We also consulted Stephan Whitaker's "The Evolution of Household Leverage during the Recovery", an Economic Commentary of the Federal Reserve Bank of Cleveland, dated September 2, 2014.  Whitaker has calculated household debt/income ratios for census tracts around the country.  http://www.clevelandfed.org/research/commentary/2014/2014-17.cfm

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Footnotes cover specific data sources.  Most of our actual data references come from these sources as presented in the databases of Haver Analytics.

[1] Federal Reserve Board, Financial Accounts of the U.S.  Equity withdrawal amounts are taken from calculations made by Haver using those Federal Reserve data.

[2] Zillow, Inc. "U.S. Negative Equity Falls to 17 Percent", Press Release, August 26, 2014.  http://zillow.mediaroom.com/2014-08-26-U-S-Negative-Equity-Falls-to-17-Percent.

[3] Federal Reserve Board.  2013 Survey of Consumer Finances.  Issued September 4, 2014.  http://www.federalreserve.gov/econresdata/scf/scfindex.htm

[4] Federal Reserve Bank of New York.  Household Debt and Credit Report.  2^nd Quarter 2014, August 14, 2014.  http://www.newyorkfed.org/microeconomics/hhdc.html#/2014/q2

[5] Payment rates on credit cards from the Standard & Poor's Ratings Services' U.S. Credit Card Quality Index (CCQI).

[6] Data on consumer spending from the Department of Commerce, Bureau of Economic Analysis (BEA), in the "national income accounts", that is, the same dataset as GDP and its other components.  We calculated a "credit card spending subtotal" by taking total consumer spending and subtracting off housing services, education, health care, vehicle purchases and other broad spending categories that aren't likely to be paid for by charging to a credit card.

[7] The saving rate is also taken from the BEA's national income accounts.

[8] Federal Reserve Board.  Report on the Economic Well-Being of U.S. Households in 2013.  "Savings Behavior", pp. 17-18.  July 2014.  http://www.federalreserve.gov/econresdata/2014-economic-well-being-of-us-households-in-2013-household-economic-wellbeing.htm

New Credit Card Rules: an Update

New Federal rules on credit card rates and fees take effect Monday, February 22. You've surely been hearing about these in the press or perhaps from your own credit card companies. We last talked about credit cards here in early June 2009, right after the law was enacted which mandates these rules. It's obviously time for an update.

To review briefly, the rate the bank charges on your outstanding balance can't be hiked on you overnight. Indeed, if you're current in your payments, the rate on your existing balance can't be raised at all, just the rate they charge on your new purchases. Your rate can't be hiked if you're current on this card's payments, but you default on some other credit card or loan. If you get a new card, the bank can't raise the rate at all for a year. The bank must tell you how long it will take to pay off your current balance if you make just the minimum payment each month; they must also calculate for you how much you need to pay each month to pay off your balance in three years. In other words, the law, the Credit CARD Act of 2009, seeks to protect you from seemingly capricious changes in the terms of your borrowing arrangement.

There's more to this law and certainly more we all need to know about consumer credit and credit cards. The Federal Reserve has just inaugurated a new website to help ordinary people with those issues. Find it here: http://www.federalreserve.gov/creditcard/. Check it out. Among other things, it has links to a credit report service and to the Federal Trade Commission's credit repair site. The latter includes a list of legitimate sources for low- or no-cost help in rebuilding creditworthiness.

Today's Wall Street Journal does note some cautions.* The new rules will not be a panacea; especially, they will not protect you from all interest rate increases or other charges. And like the airlines with their new baggage fees and other extra charges, there are clearly ways banks can still extract additional income: suppose, for instance, that you order online from a company in England. The Journal tells us that there can be fees not only for changing the foreign currency but for the non-U.S. payment processing. Balance transfers, often done free as a promotion to get you to change cards, may incur charges, as well. More broadly, some cards that presently have no annual fee may find that one is imposed. Finally, rates themselves may be higher across the board. Still, the new law should limit some of the more egregious, burdensome practices that have seemed to hit some borrowers' statements right out of the blue.

How are consumers doing with credit card debt? Well, they're continuing to pay it down. Really. The latest data from the Federal Reserve show that through December, "revolving consumer credit" was down $91.3 billion from December 2008; this is equivalent to just about $76 a month for every household in the country. The last monthly increase occurred in August 2008.

In the current economic environment, delinquency rates don't look very good, but through the third quarter of 2009, they've at least stopped getting worse. From an average of 4% or so during the mid-2000s, the Federal Financial Institutions Examination Council (FFIEC) reports that the amount of delinquent loans past due 30 days or more surged to 6.7% of outstanding balances in the second quarter of last year, then edged down to 6.6% in the third quarter. Clearly, at present, there's more risk in these loans than there had been, and if banks have tightened lending terms, we can hardly blame them.

What about the terms that are actually in place? The Fed gives us data on average rates, and they are higher. Finance charges ran about 12% of outstanding balances in 2008, but by late 2009, they were 13.6%. Some people, of course, pay off their balance every month and do not incur charges. If these are excluded, finance charges on accounts that do pay them amounted to 13.5% in mid-2008 and rose about a percentage point in late 2009 to 14.6%. Banks might also have been raising rates to get in front of the impending new regulations. It remains to be seen if rates might go still higher now.

How do we face these higher charges? That new Fed website has some advice for us in managing our credit, one piece of which we quote here: "pay your bills on time". This is the best way to keep our costs to a minimum, both in the short run and later on when we might want or need to borrow for some major project or event. For those of us in the Church, it might be a very significant Lenten discipline to work on our own personal finances in this way. As indicated here, we now have some new regulatory tools to support us in that work. And for everyone, this is a major way we can help the whole economy recover and move forward on a firmer foundation.

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*Robin Sidel, "Credit Card Fees: The New Traps", The Wall Street Journal, February 20-21, 2010, Page B7. http://online.wsj.com/article/SB10001424052748704804204575069374130248754.html.

The data we cite all come from USECON, an online subscription database compiled and maintained by Haver Analytics, Inc., New York. If readers would like to see the Federal Reserve's source data, email carol@geraniumfarm.org and we can direct you to the Fed's various statistical releases.

Convention Resolution A-102: "Culture of Debt"

A financial services company that advertised on the TV coverage of the US Open golf tournament concluded one commercial, "You plan your life. We'll plan your money around your life." A thought-provoking slogan, isn't it? Another expression of the same sentiment comes from Fr. John Haughey, a Jesuit priest: "You control your money. Don't let your money control you."

"That's easy for them to say," you argue, "they don't have my bills! With my salary, I just don't have the flexibility to get on top of my money."

If this sounds like you, you've got lots of company and more every day. The Episcopal Church's Standing Commission on Stewardship and Development has taken note of these circumstances and proposed a statement about them for the General Convention, Resolution A-102. It was enacted in Columbus on June 15. Through this, the Convention "urge[s] each diocese to offer training, education, and resources that promote the healthy role of money in our lives . . . . " The background statement expresses the goal "to help people address the serious issues of debt, greed, hyper-consumerism, and cultural pressures that encourage people to spend beyond their means." The Commission highlights special concern for young people.

We can work on this issue here. In fact, we absolutely agree with the Commission's concern and we want to work on it. Following the Resolution's rough priorities, we'll begin with some measures of the debt situation and try to see why this is so important.

How Much Debt?
The average family carries a $95,000 mortgage on their home, $11,500 in installment loans, and $2,200 in credit card balances. These figures come from the Federal Reserve's (the "Fed") 2004 Survey of Consumer Finances*; the averages are the median values, that is, half of mortgages are bigger and half smaller, half of individual families' credit card debt is larger and half smaller and so on. Just under 50% of all families have each of these types of borrowing. All told, 76.4% of families have any kind of debt.

These debts represent car loans, student loans, purchases of clothes for the family, remodeling the second bathroom, taking the kids to Disney World over spring break and on and on; you know: what families just do. Is this "hyper-consumerism"? Why is it such a problem?

Heavier Burden on Income
First, debt has gotten large relative to income. According to the Fed's calculations, debt payments absorb 18% of a typical family's income. That is, just to stay current on these obligations takes almost two full days' pay each pay period. For some 12% of families with debt, this ratio of current payments to income is 40%: four days' pay out of each check. As we said at the outset, if monthly bills are making you feel strapped, many others are in the same boat.

More Paying Late
An increasing number of families are falling behind. Almost 9% of debtors were more than 60 days late with any of their payments in 2004, up from just 7.1% in 1995. By age group, as the Church Commission emphasizes, young people are in the biggest trouble. Of families headed by 35-year-olds and under, 8.7% had any delinquent payment in 1995. By 2004, this percentage had risen an alarming 5 points to 13.7%, the highest of any age group. The next group, ages 35 to 44, had the next highest incidence of late pays, 11.7%.

Among income rankings, the lowest 20% had the highest delinquency, 15.9%, as might be expected. But the most deterioration – from 4% in 2001 to 7.1% in 2004 – came in what to us is a surprising income range, the fourth rank of five, that is, the 60-79% tier, a group that averages $70,000 in annual income.

So perhaps when we redid the bathroom, we didn't just replace the basin and the faucets; maybe we added a Jacuzzi and tiled some walls. Or maybe we went to Disney and then bought a new LCD TV just a couple of months later, without paying down some of the trip's bills first. It's so easy for this debt load to get out of hand. Even before we face paying today's gasoline prices.

Here we examined some Federal Reserve data on debt. The same survey also shows what we have in our savings; it's worth looking at that too to see how far they can go in helping us out. An increasing number of folks have been borrowing against their home equity and we want to see what role that plays – both helpful and not-so-helpful. But first, it might clarify matters to talk a little about what we actually spend our money on. The US Commerce Department tallies that up in amazing detail every single month. More to come. Remember, to quote the title of a book we'll also refer to: it's "Your Money or Your Life"!

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*A comprehensive, triennial interview survey of 4,522 families around the country, conducted for the Fed by the National Opinion Research Center. See the Fed's website for all of the information: http://www.federalreserve.gov/pubs/oss/oss2/scfindex.html. The items we discuss here are available in the accompanying article from the Federal Reserve Bulletin.

Links to More of the Debt Turmoil of the Day

We're working on an article about credit card debt and the new law, and we hope to finish it "soon". In the meantime:

Last week, we told you about Edmund Andrews, a New York Times economics reporter who has managed to get himself in substantial financial woe with a too-big mortgage and unmanageable credit card debt. His Times article that we directed you to is an excerpt from a whole book, which has just been published. Reviews of it say the same thing we did about the article: it's really tough to read about this mess, but you should. The book, Busted: Life Inside the Great Mortgage Meltdown, is available from Amazon and other booksellers. Besides Andrews' personal story, chapters tell about the less-than-honorable lenders he borrowed through, so there's a broader and deeper picture of the whole sordid affair. And royalties from the book can help pay Andrews' bills.

A blogger on AOL's WalletPop has interviewed Andrews, and that is worth your time too. Tom Barlow asks hard questions, which Andrews doesn't try to sidestep. http://www.walletpop.com/blog/2009/05/26/busted-how-a-new-york-times-reporter-fell-into-the-subprime-tra/

Finally, lest you think we have no sense of humor at all, we call your attention to Debbie Loeb's Hodgepodge item from Friday, the video of "Worst $lide $tory". From Newsday's Walt Handelsman, it is a great take-off on the currently hot Broadway ticket, recast for today's economy. Do enjoy it! Animation: Recession Sing-A-Long

Uncharted Waters

Several months ago, midst great fanfare, a local developer announced plans for a massive, mixed-use building diagonally across the street from where I live in Brooklyn. Sixty-five stories, with retail stores on the street, then classrooms for the local college, then umpteen floors of condo apartments. Ten days ago, as reported well inside the New York Daily News, the deal between the college and the developer came unraveled due to "cost overruns". The big talk has disappeared, along with 55 stories of the envisioned Tower, and the college will proceed to build the utilitarian, ten-story classroom building it really needs.

Thank goodness.

It's "deals" just like this that have the U.S. economy in considerable trouble and canceling them beforehand will prevent some more trouble down the road. The housing and development bubble has burst, and contrary to one media assessment the other day that its effects are merely "lingering" and a credit-rating firm's comment just today that much of the bad news is already out, it seems to us that those effects have just begun. We don't really know how this will play out.

The Financial Waters Are Always "Uncharted"
"This time is different", economists are fond of saying when they can't explain or predict. Yes, this time is different, and we can describe that, but every recession is different from every other, so that's no excuse for expressing bewilderment at the unexpected path this one is taking. The new wrinkle now is the tiered financing schemes that financed the house price surge – and the financing schemes that funded those and other financing schemes, which in turn are funded by still other schemes, and on and on. For example, we are intrigued to learn that the "buyout firms" which issue debt to buy up the equity in various companies are not the ones liable for the interest and principal payments on that debt; those companies are. So if the management policy changes imposed by the buyout firm don't generate enough extra profit to cover the debt cost, the bought-out company will be in trouble. If interest rates go up, the situation is worse. Several well-known firms face just such consequences today.

Fed Tries To Shore Up Monetary Policy
In the risky financing markets, investors are shying away from many forms of private debt. This means that even though the Federal Reserve has cut base interest rates substantially in the last few months, rates on much debt have not seen much relief, as risk premiums have widened considerably. The Fed is seeking different ways to help in this increasingly tenuous situation where its standard policy tools have less impact than their historical norms. In December, it altered the way it supplies new money to the banking system, increasing the size of individual injections and lengthening their maturity. This is good if you're a bank. But another distinctive feature of the current experience is the greater roles being taken by firms and funds that are outside the banking system and have no account at the Fed that can be credited with new reserve money. So doing that has more limited impact than would have been the case historically. Tuesday the Fed announced a new system, where it will lend some of its holdings of US Government securities to stock and bond dealers, and they, in turn, can put up mortgage securities as collateral. This plan can help support the market for mortgage securities and reduce the greater risk now prevalent there, letting the lower base interest rates do more of the work they're supposed to.

Historically, financing of day-to-day economic activity was centered in commercial banks, and thrift institutions handled most mortgage financing. These two institutions were heavily regulated. Before you say that we should revert to this seemingly simpler financial organization, we'll point out that recessions, when they came in those days, could prove deep and prolonged, due at least in part to a lack of flexibility among lenders and also businesses. In contrast, the last two recessions, in 1990-91 and 2001, followed considerable deregulation of financial institutions along with the computerization of business, and these down-cycles traced a more saucer-like path, with the economy sliding gradually and climbing out slowly. And other recent scary episodes, such as the stock market crash in 1987 and the Russian debt default in 1998, did not produce generalized recessionary conditions at all. Now, though, the involvement is much broader, with U.S. consumers (that's us!) and businesses feeling restraint from crimped credit conditions as well as surging energy costs.

Which Way Is the Shore? Can We Get Back There?
Last Friday's February employment report from the Labor Department showed jobs contracting for a second consecutive month. Other basic indicators of activity, such as industrial production and retail sales, have been flat to down for the last three or four months. So the overall economy appears to be "dead-in-the-water", but hardly in a steep decline. Surely, home-building has pulled way back, but sustained growth in exports has basically offset that downward pull. So in all, evidence is presently inconclusive on how hard or long the economy's fall will be. Surely we have said enough here to imply that we're pretty concerned because it's not clear how much negative force might come as a financial house-of-cards continues folding in on itself even as rising food and energy costs eat into consumers' discretionary income. Still, growth persists in some sectors and also in other countries, and with active, creative monetary policy, that may stave off further worsening.

Meantime, what can you do? There's our usual mantra: pay down your credit card debt. In fact, that's exactly what you can do with the extra tax rebate you'll soon receive from the IRS. And there's another avenue of caution. With the plethora of complex financial instruments floating around, make sure you understand the terms of loans and other credit agreements you have and that you understand all the features of the financial assets you own. One of the sorry stories of these times was the loss by two brothers of the better part of an inheritance. As explained in the Wall Street Journal about a month ago, their funds were invested in supposedly safe "short-term" securities. But those bonds had their own wrinkle, and they not only turned out to have an actual maturity several years out, but in nervous markets to face lack of any trading outlet. No one would cash the brothers out of their bonds, which dropped half their value almost overnight. This week, too, with one of the country's major hedge funds having its assets seized by lenders, note that "hedge fund" is a complete misnomer: they aren't hedged at all, they're full of debt-laden risk. Things aren't what they seem: the sea's waves break where and when you're not looking.

The Sluggish Economic Recovery

Assessing the economy is always tricky business, but these days it seems all the more so. Every new indicator seems to portray a different vision of current conditions. For instance, week before last, the Federal Reserve's Open Market Committee issued a policy statement in which members complained that the economy's output was sluggish and that household spending was increasing only gradually. The Committee was so concerned that it enacted a policy shift intended to give the economy more support. But reports just a few days later showed upturns for July in both industrial output and in retail sales. At the same time, housing remains stubbornly constrained; construction starts of new houses looked better in July, increasing by 1.7% from June, but May and June numbers were revised lower as more complete information was reported to the Census Bureau, so the new figure for July, 546,000, is actually lower than the original report for June, 549,000.

The stock market mirrors this uncertainty; during trading today, August 23, the Dow Jones Industrial Average (DJIA) surged as much as 101 points from Friday evening's close, then dropped abruptly to a loss of 22 points. Now, at this hour, 3:08PM, it is up 23 points. Several recent days have seen wider swings, and over the last three months, the index has oscillated in a band of nearly 1,500 points. Clearly, investors continue to be unable to sense a trend toward momentum in either direction.

Recessions Correct Excesses
What can we make of this muddled situation? Usually, a recession corrects excesses in business inventories and homebuilding. Stores and manufacturers have generally accumulated too much merchandise and contractors have gotten ahead of demand in homebuilding. The processes of recession curtail manufacturing and construction activity, and after a time, they become better aligned with consumers' ability to buy goods and new homes. In this current case, inventories have gone through that correction. The drop in industrial production (and also in imports of goods) acted to slash inventories back to levels more appropriate for the pace of spending. Then—usually – inventories stop falling and business activity stabilizes and starts to grow again. Some of the subsequent restocking of store shelves and warehouses has indeed begun.

Also, usually, the fall in interest rates that accompanies the recession sets the stage for renewed gains in home construction. This renewal helps push consumer buying of furniture and appliances back up as well. This entire sector is experiencing it differently this time. Interest rates certainly fell, and remain very low. But a burst of renewed lending and buying is not happening – and may not happen for some time ahead.

Consumer Borrowing Excesses Were Really Great
We talked back in the spring about sustainable government budgets, and in some sense, we need to have the same kind of discussion about consumer budgets. Look at these two graphs. The first one shows consumer debt as a percent of consumers' liquid assets. Here we include credit card debt, installment loans, mortgages and some other smaller items. We see that prior to 2000, people's debt never approached their holdings of bank deposits, bonds and other safe financial assets. In general, then, people had ready cash to more than cover their obligations. That changed dramatically during the 1990s and especially the first part of the 2000s. See that at the peak in 2005, people's debt exceeded 125% of their quick, ready cash; for some, this would have been a far higher number.

As if that weren't enough, many people were borrowing on their home equity. The low interest rates made it easy to tap that otherwise inaccessible source of funds; people refinanced their mortgages and borrowed more than their current mortgage amount. With the low interest rates, their payments may easily have been no larger than before and that unlocked money was available for them to spend. In the second graph, we see that from 2003 through 2006 this "home equity withdrawal" supported more than 6% of consumers total spending. Back in the 1990s, by contrast, such liquidation of home equity was never more than an occasional funding source for spending.

Protracted Correction Not Helped by High-Priced Gas
In the subsequent recession, the tables have turned, of course, and part of what the economy is going through at present is the reformation of consumer finances. This process of debt reduction and liquidity rebuilding is holding the economy back right now, but we have to believe that it's a good thing. We're getting liabilities back in line with assets and we're returning equity to our homes. We learned, much to our shock over the last three years, that home prices can fall, bringing us up short when we least expect. We're correcting our behavior, some of the correction forced through foreclosure and other unpleasant disciplines.

We're also experiencing one other burden, the price of gasoline. Energy continues to absorb more than 10% of the measure we have compiled that we call consumer "take-home pay". This share is lower than in 2008, when gas hit $4/gallon, but, at almost $3/gallon, it's well above the 7-8%that prevailed prior to 2005. As we've noted here separately, people are working at cutting energy use, but these costs are still a constraint on our ability to buy other things.

But We're Building a Firmer Foundation for Later Growth
Our graphs here do show that the necessary financial adjustments are occurring, but this is an unusual phenomenon, so it's hard to know how long it will last. Also note that these processes don't lend themselves to formula antidotes, such as "shovel-ready" government stimulus programs. We can guess that more vigorous growth will return to the economy "next year", but that's only a guess. Fortunately for the world's economy, there is growth elsewhere; the so-called "emerging markets" are indeed emerging and demand from them will help everyone recover. And again, what the U.S. is experiencing now is a good thing for the long term; consumers and the economy as a whole will be operating on a much healthier base going forward.

Baby Boomer Retirement

"Have you thought about retirement?" We've asked this question before, and we'll no doubt ask it again. Retirement is an important matter in general and in particular because it makes us look beyond today. Debbie from Hodgepodge writes to ask us for ideas about what to do if our own time "beyond today" is approaching rapidly. What if we're in that great Baby Boom generation now nearing retirement and we haven't really begun to save for it? What can we do?

Since a good number of folk are in that circumstance, we don't have to go far to find advice. Two quick, current sources: Kiplinger's Personal Finance Retirement Planning 2007, a brand new magazine, dated Fall 2007, for $5.95 at good-sized newsstands and supermarket magazine racks. And the March 2007 issue of Money Magazine, which by now is probably available at your local public library. The Kiplinger's has an article titled "Late Bloomer" that addresses these questions, while the cover story of Money promises "Everything You've Always Needed To Know About Money…But Now You're Too Old To Ask". Some of their notions are a little too cheery and facile, as if you could change your attitude and behavior, if not overnight, then in just a couple of days. That's easier said than done, of course, but at least our thinking will get started in the right direction.

Spending and Debting – Again!
Two places that both of these popular magazines urge us retirement planners to start have, interestingly, no direct link to saving and investment. Those will come, to be sure, in just a couple of paragraphs, but the initial steps consider the other side of our financial statements, spending and debt. Ah, we've heard this before too! Make a budget, say Kiplinger's and Money, and Kiplinger's contains a nice worksheet to help you do this. You need to know how much money you need to live on. You will be more conscious, then, of how much you spend and what you're buying. You can see more easily where you might cut back. Money lists several websites that help you do this on-line, if you prefer.*

Pay down your debt. How many times in its young life has Ways of the World said this to you? When you're looking at retirement, paying off debt now will help then in two major ways: It reduces the cash drain of big payments. And it lowers your own personal risk at a time when other life factors may make you more vulnerable: your own health, your family's health and your income. One tactic you can use if you carry significant credit card debt is to pay it off using a home equity loan. Paying that off, in turn, costs you far less interest and may have some tax benefit.

401(k) Plans and IRAs
Now to saving and investment. One thing Ways of the World does not do is give investment advice. But we can make some broad statements about ways of saving and investing. We mentioned, for instance, in our November article on retirement that a surprisingly large number of people don't know anything about their employer's 401(k) or other pension plan. Now's the time to find out.

New federal legislation passed last year gives more employers the opportunity to enroll employees automatically in 401(k) programs unless the employee chooses to opt out. This is the reverse of the prior arrangement that called for the employee to make the enrollment decision. With the new law, employers will set initial investment amounts and asset allocations, and employees can choose to alter these. A kind of forced saving. Further, the new law also forces the employer to let employees diversify; many of these plans' investments have been restricted to the employer's own stock, but this can be phased down, if the employee chooses.

Note that you can contribute to both an IRA and a 401(k) in the same year. Within certain income limits (in 2007, $99,000 for singles, $156,000 for married couples) you can choose a Roth IRA. You make deposits into this account from after-tax income, but its income and capital gains will always be tax-free. Regular IRAs, which come from pre-tax income, are tax-deferred; they impose the tax on your withdrawals of the initial amount and its growth, and you must begin withdrawals by age 70-1/2. Roth IRAs have no such withdrawal requirement, and your money can continue to grow tax-free. This year, people under 50 can contribute $4,000 to a Roth IRA and those 50 and over can contribute $5,000. Last year's law also established a "Roth 401(k)". Whatever instrument you choose, take as much advantage as you can of tax-advantaged savings vehicles to enhance your return.

Asset Recipe: Mix Thoroughly
Both the Kiplinger and Money publications drew my attention to a new kind of mutual fund, called the "target date fund". As life circumstances change, so should our investment profile: when we are young, we want our investments to emphasize growth, but as we get older, it's more current income we need. The growth portfolio has a large proportion of stocks, while the income portfolio needs bonds and stocks that pay large dividends. These "target date" funds shift your money more-or-less automatically at preset "target dates" to achieve this remix. To learn more, including mutual fund companies that offer these, check out our source publications or their respective websites.

These comments about shifting around asset types highlight another general feature of our retirement plans: they should be diversified. No single asset type, much less a single asset, can be counted on to provide the cash we need at the time we need it. So combinations are best – some of this and some of that – some home equity, some stocks, some bonds, some simple bank account. And increasingly, as markets become more global, some of the stocks and bonds should represent companies and governments outside the United States.

Watch Those Fees
A couple of investment "don'ts". Don't invest in an asset you don't understand. "Variable universal life annuity". Excuse me? BDCs? REITs? Gas royalty pass-throughs? These may all be fine. But make sure you know how they work. And how their fees are structured.

Then the other "don't": stay away from high-fee instruments. There are hundreds of no-load mutual funds and funds with low expense ratios. Look at prospectuses and other information to find out about these costs. If someone is trying to sell you a high-fee product, make sure there's such a good reason for the fee that the investment still pays for you. [Someone we know really well has a particular asset for which something called "insurance charges" eats up almost all of the capital gain every quarter. Hmmm. Wouldn't her money be better off somewhere else?]

Think Twice About Early Retirement
One more pre-retirement concern, especially for us older Boomers. In reading up for this article, we were shocked – shocked!! – to learn that half of workers start to draw Social Security at age 62. This permanently reduces your benefit by about 25%, and until your "normal" retirement age there are earnings caps that are really restrictive. If you work and your income this year is more than just $12,960, earnings above that amount reduce your benefit check further until your regular retirement age (presently 65 years and 10 months). So unless there's a health or a family reason to stop working early, keep going, distasteful as this may seem in the moment. Depending on your profession, you might be able to work out a less-demanding job situation, so you can at least slow down. But please reconsider plans for "early retirement".

We still need to talk in more detail about Social Security and Medicare, and we will do that. The demographics are already in place: 3.3 workers per beneficiary in 2006 will become 2.3 in 2025 and headed still lower. The programs are likely to experience further benefit cuts and tax increases. Further, despite many politicians' disdain for private accounts, we're probably going to need them too – and don't look now but that automatic 401(k) enrollment scheme is a step in that direction. More to come.

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*Here are some helpful websites. Google can bring you many more.

Social Security Administration: www.ssa.gov
Kiplinger's: www.kiplinger.com
Money Magazine: www.cnnmoney.com
Retirement planning worksheets: www.ifigure.com (select the "Money" item in the left margin menu. Further links to numerous resources) and www.360financialliteracy.org

And Ms. Debbie's own personal choice: http://finance.yahoo.com/expert/article/yourlife/27943 and associated pages

Happy New Year from Ways of the World!

We hope your 12 Days of Christmas were fun, warm, caring and spiritual times. The Geranium Farm had such a "fun, warm, caring and spiritual" occasion Saturday night, "Twelfth Night", at the Farm, where almost all of us gathered for dinner and great conversation around the Crafton/Quaintance fireplace. Then yesterday, we celebrated by email the word from Matt the Web Dude that www.geraniumfarm.org was being honored with a World Wide Web Awards Humanitarian Award.

This last is a special thing. A group of web designers evaluate websites on criteria of design, content and ease of navigation. There are separate categories for Patriotic and Humanitarian sites, but to receive the award, even these must meet a minimum quality point requirement judged on the same basis as high-budget commercial sites. So it's a tribute to Matt and to the others for all the work each must do every single day to cultivate the Farm's Geraniums. However, if Barbara and Debbie and DJ and Buddy and Fr. Matthew feel as I do, this isn't really "work".

So let us proceed to the non-work at hand.

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Coming back down to earth, it is January, and that means we're all sitting around with a boat-load of credit card bills and, this year, enormous heating expenses. How can we manage?

We're AOL users and some of their editorial content can be very helpful. Today, they feature material from SmartMoney.com on formulating a household budget we "can live with". Just reading through the topic headings is useful:

1. Make a list of regular expenses, such as mortgage payment, car payment and the like
2. Prepare for those high energy costs
3. Eliminate credit-card debt
4. Build an emergency fund
5. Estimate your total tax bill

I know, you're saying, "what did you mean, Carol, about 'non-work'? This is big work!" But it will save you work – and lots of money – later if you can take time to do these things now. [Ask me in two weeks if I've started on these myself!!]

See the AOL site, http://money.aol.com/top5/general/set-a-budget-you-can-live-with, for more color on exactly why these tasks are important and how to get going.

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Meantime, it's the Epiphany Season, when Jesus as the Christ was made manifest to the world at large. On Ways of the World, we'll be commemorating this by writing more on the church and young people. You might recall from our "Advent Reading List" (December 2) that startling revelation from some Evangelical churches that young people seem not to be as church-going as before. We think our role as a social scientist is to talk about this and make sure you know about it, so we've been doing some reading on survey work among kids to see what they think. That and other information on factors in church growth are upcoming here during January.

Lent, as you're aware, follows quickly this year with Ash Wednesday on February 6; we plan some commentary then on stewardship. Yes, fund-raising, but really stewardship in the broader sense: how we take care of our resources and how we can translate that into ministry to business and business leaders. If that's an intriguing idea to you, stay tuned!

Best wishes to you all for a healthy and prosperous 2008! Don't forget to pray for the folks in Kenya and Pakistan . . . .

What's Happening in the Stock Market?

We have been working on nice posts for this blog on the latest list from Forbes Magazine of the world's richest people and on the impact of taxes in our lives. But in the meantime, daily developments in financial markets are getting way ahead of us, and the business economist in our blood says, "Carol, you have to say something to them about these stock prices."

The Dow Jones Industrial Average dropped 242.66 points today, March 13, a one-day decline of 2% to close at 12075.96. In the recent decline, the worst single day was February 27, when this widely watched 30-stock bellwether fell 416.02 points or 3.3%. The recent peak was 12,786.64 on February 20. As of this afternoon's close, the index is off 5.6% from that February 20 peak.

Numerous factors have played a role in the downturn, some of which we have talked about here as long ago as last summer. We talked about how little consumers (that's us!) are saving and how big some people's debt loads are. Some of that is coming home to roost. The Mortgage Bankers Association, a national industry group, reported today that almost 5% of home mortgages were delinquent at the end of 2006, meaning the homeowner was at least 30 days behind in making payments. A record 0.54% of mortgages entered foreclosure during the fourth quarter. The payment performance on loans of all quality types worsened, but was especially bad for FHA mortgages, up from 12.8% delinquent on September 30 to 13.46% on December 31. Delinquencies on so-called "sub-prime" mortgages, which are loans to people whose credit is substandard to begin with, came to 13.33% in December, up from 12.56% just three months before. People who have adjustable rate mortgages, regardless of their credit quality, are having a harder time as interest rates moved up in general last year, raising their mortgage payments significantly. This is tough for them to manage in the face of high fuel costs too.

In that regard, the US Commerce Department reported today that consumers' purchases at retail stores moderated in February, just barely inching ahead from January, and they declined outright when gas stations' sales are excluded.

Some international markets have also been shaky, as that first big down day for the Dow Jones February 27 came on the heels of a shake-out the night before in the Chinese market. China's economy continues to expand rapidly, but its government is known to want to restrain its growth and potential inflation, making investors nervous.

We're not political scientists, but we'd surmise that uncertainty in the US government is making US investors nervous too. The resignation of a top aide in the Justice Department adds to a list of other political concerns.

Fortunately, our job here at Ways of the World is not to tell you how or when these market conditions will all be straightened out. What we do know is that aside from the housing and mortgage situation, the underlying economy has been holding in fairly well in recent months. Jobs have continued to increase, albeit modestly, and unemployment has remained low. Inflation in the US has stayed remarkably steady, so that those high energy costs don't seem to have worked their way into prices of other goods and services. Growth is continuing in Europe and among our other major trading partners. Today's Wall Street Journal calls our attention to the boom in Russia, which, as an oil producer, is benefiting from high oil prices, and their consumers are spending. Still, there's plenty of risk, economic and political, in many parts of the world, and risk makes us all nervous. Stay tuned, then, and perhaps the best response you can make to nervous markets is to put your tax refund in your savings account or use it to pay down some credit card debt.

Cost of "Risk" Soars; Economy Threatened

The last few weeks have been eventful ones in financial markets and for economic news. We've started to write to you several times about it and were afraid we were getting bogged down in the technicalities. We'll try again here; some of the "technicalities" are important for everyone, not just financial market specialists.

Investors Suddenly Realize Their Assets Are Risky!
We talked to you in early August about how subprime mortgage lenders got "carried away" with their lending. Other investors were also quite exuberant. The spreads between the interest rates on risky assets, for instance, low-grade ["high yield"] corporate bonds, and US Treasury securities were at all-time lows from 2004 through the middle of this year. Similarly, securities backed by credit-card debt also had narrow spreads to Treasuries until very recently. As the severity of the mortgage crisis came to light, investors dumped their risky holdings and switched to more of the safest asset, the Treasury notes and bonds. This demand drove down Treasury interest rates and pushed up rates on other debt. The suddenness of this move – within just a couple of weeks – caught many investors and bond issuers off guard.

Some issuers of debt occasionally utilize bridge loans while they are preparing a more permanent bond issue. These bridge loans are not usually bank loans, but short-term market instruments called commercial paper. This paper has had shorter and shorter maturities over the years, so now more than half comes due in 4 days or less. During early and mid-August, as markets were in turmoil, some funders of commercial paper withdrew this financing, leaving would-be issuers in the lurch. Their plans were incomplete, but they couldn't proceed without the interim funding. Some "deals" were cancelled, postponed or had their prices reduced.

The Fed Helps Out
The Federal Reserve provided some limited help to prevent these disruptions from spreading through the banking system. It added billions of dollars in short-term funds to the money markets and it reduced the discount rate, the rate it charges for loans it makes to banks. The infusions of cash were the largest since the aftermath of 9/11, when Wall Street shut down briefly. The Fed further encouraged banks to borrow from it, an action banks are loath to take, because they believe it shows they cannot manage their business properly. Not many are borrowing even now, although the quantities they are borrowing are the largest in years. The Fed is anxious not to be seen "rescuing" or "bailing out" bankers and investors who made poor decisions, but the Fed needs to try to protect the underlying health of the financial system.

But Jobs Post a Surprising Decline in August
Until this past Friday, we thought most of the damage from these dislocations was going to be confined to housing markets and to financial institutions. But then the Labor Department reported that the number of jobs in the US decreased in August by 4,000. This is a tiny number when there are 138 million total jobs, but an outright decline has historically been a signal of genuine weakness, at least bordering on recession. Some of the decline was related to varying dates of school openings across the country, which cut government jobs reported in education. This should reverse shortly. But employment in construction fell 22,000, accounted for mainly in residential contractors, and there were small declines in manufacturing of wood products, furniture and electrical machinery and appliances, all products related to home-building. In contrast, a number of service industries, especially retailing and hotels and restaurants, had nearly offsetting gains. But the handwriting is on the wall: the disruption in housing finance is great enough that it could impair the actual performance of the economy. Those laid-off construction workers can't spend as much on themselves, so strength in retailing and restaurants might not last for long . . . .

The Federal Reserve will hold one of its regular policy-setting meetings next Tuesday, September 18. They are likely to do what they had hoped to avoid, cut their key short-term interest rate, the "federal funds rate". This has the effect of lowering costs throughout the financial markets. While some had argued for this move earlier, it may have been seen as the bail-out no one really wanted. To a degree, the markets themselves have already effected some easing through the lower rates they have engineered on Treasury securities. But the Fed's action would affirm their judgment and hopefully relieve some tension and nervousness.

Can Fed Action Limit the Fall-Out Enough?
Notice here that we have not once mentioned the stock market. As we explained in an earlier article on this situation, the rest of the economy has so far held firm and the vast majority of businesses are maintaining their profitability. So while the stock market has been highly volatile in the midst of the uncertainty, it has not broken down. The companies who make it up are not the source of the problem. They and their stocks may suffer, but other sectors of the financial system are where it started. Possibly – possibly – if the financial turmoil can be contained with the corrective actions already being taken, that spillover won't result in a self-reinforcing economic contraction. Stay tuned and hang on: it may not be a roller-coaster, but it's certainly a very rough ride.

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Clearly there are lots more features to this story. We will follow soon with further comments about housing and homeownership in particular. Also, our entire explication above centers on "risk". We need to talk about that, why it's important and how people are compensated for bearing it. And who is the amorphous group we keep referring to, "investors"? What do they do and does it matter to me?

Entirely separately, in a preview of a different coming attraction, we got asked a pointed question by Matt the Web-Dude about the propriety of Mrs. Astor using her money to fund art projects. Wasn't there some higher use for the funds, he argued. This will bring us to the value of art. It indeed has value and even economists can talk about it in their own language. Stay tuned, as well, for this divertissement!

Moral Hazard

In last week's article, "Fannie & Freddie and the Banks", we began our story with the present [dismal] state of their affairs. That is, we didn't really talk about how or why they reached that state. That entire topic will fill numerous books and PhD dissertations in months and years to come. Today, we want to highlight one aspect here, the so-called "moral hazard" endemic to their structure and position in financial markets. Apparently, "moral hazard" is a term unfamiliar to many of you. But these words used by economists describe an ethical dilemma you have surely faced and probably given counsel about any number of times.

Fannie & Freddie's Risky Business
As we did say last week, Fannie Mae and Freddie Mac are privately owned, but they were founded by the federal government to foster the development of national mortgage markets, helping to maintain the availability of reasonably priced loans for middle-income Americans. The firms conduct their business in three ways. First, they buy mortgages from local lenders or brokers, combine groups of these mortgages together in "pools" and issue bonds transferring ownership of the pools to private investors; through elaborate computerized systems, the investors receive the principal and interest payments on the specific loans in the pools. These investors, not Fannie & Freddie or the original lenders, bear the ultimate risk of loss should the borrower default. The bonds are called "mortgage-backed securities" (MBS). Second, Fannie & Freddie buy mortgage loans and hold them in their own portfolios. Third, they buy MBS securities for their own portfolios; these may have been issued by themselves, by their counterpart institutions, and by non-government-connected institutions. These last are "private label" MBS, sold by Merrill Lynch and other similar investment banks. While the mortgages comprising their own MBS have specified minimum credit quality and maximum size, the loans they choose to keep in their own portfolios and the other MBS securities they buy can include lower quality items, especially subprime mortgages.

Their Government "Connection"
While, as we also emphasized before, Fannie and Freddie have no direct, concrete government guarantee, everyone has always assumed that the federal government would back them up somehow. This "connection" [our phrase] means they can borrow in money and capital markets at low cost, markedly lower than purely private debt would cost.

Further, we said last week that, despite their recent multi-billion-dollar losses, their capital position remains well above legally mandated minimums. However, it is also the case that those minimums are considerably more liberal than general accounting standards would permit for a similar business without a government connection. This means they can borrow more and do more business with a given size capital base than ordinary firms can.

At the same time, these firms believe they must have skilled managers, people who might just as well choose to work in the private financial sector. So the scales and provisions of their compensation plans are at least as generous as those available for similar positions at private institutions: the packages include stock options and bonuses in addition to base salary.

A Recipe for Moral Hazard
So here's the picture: we have highly paid executives, whose pay increases with the size and volume of the firm's business, operating with low borrowing cost, liberal capital constraints and pass-through of much of the risk to downstream investors, along with a fuzzy, but apparent government "guarantee". Your low cost structure means more business opportunities are profitable, and risky business – assuming it pays off – is more profitable still. The government connection means that you can reach for that risk because someone else will suffer the loss if the risk winds up going against you. Fannie and Freddie have behaved in response to these incentives.

Reaching for more risk than you would otherwise incur because someone else will bear the cost of failure is moral hazard. Critics of the government's efforts to prop up Fannie and Freddie argue that the support validates the threat of moral hazard. Moreover, since it's the government, other institutions might see this rescue as a precedent and behave more recklessly as well, thinking they can make a plea for a similar rescue. Moral hazard begets more moral hazard.

Finance is hardly the only field that faces it. A classic example is seat belts. Accident rates have increased since imposition of mandatory seat belt laws. The injuries in car accidents are perceived to be less severe, so people drive less carefully, which is hardly the desired outcome. Damage per accident may be less, but total aggregate damage may remain the same or even increase. Insurance is another area of widespread moral hazard: the availability of health insurance has led to increased usage rates for various optional medical services. People "have it done" just because "the insurance pays". Teenage behavior is subject to moral hazard: if Dad is likely to pay off the arrears on the credit card bill or talk the English teacher into a better grade on the term paper, then the initial effort could well be less prudent. And your siblings think if he's done it for you, he'll do it for them too. Moral hazard.

No Simple Remedy
Now that your mind is on these issues, you've probably already come up with three or four other examples. And you know this is tricky. Clearly the dental insurance company means for you to get that new crown. And clearly seat belts prevent much serious injury. So too, the availability of government loans to Fannie and Freddie – as formalized over the last few days in new Congressional legislation – should prevent the spread of chaotic conditions that might otherwise paralyze mortgage and other financial markets. So we shouldn't withhold protection altogether.

We can put conditions on the protection, though. Dad can set inviolate limits on his bailout of Suzie's credit card bill and a new regulator can put more concrete determinants on the scope of Freddie's and Fannie's operations. The new law, passed this past Saturday (yes, Saturday) forms the Federal Housing Finance Agency to conduct their regulation; it is empowered to oversee their investment and loan practices as well as to lend them money, a specific quid pro quo arrangement. These things never turn out exactly as they are intended, but this approach looks to have good potential to effect reform. We hope so!

The Economy Springs Ahead -- But then Falls Back

We haven't talked to you for a long while about the state of the economy, and as spring arrives, we see some signs of life that finally might be suggesting a break out to more vigorous times.  But, similar to this spring's weather thus far in the New York region, the gains are hesitant and a bit erratic, but they still point to the development of more economic strength.

A Better Stock Market Helped by Low Interest Rates

First, while very erratic itself, the stock market is hovering around new highs.  The last couple of days, the Dow Jones and the S&P 500 have both been down, but just on Monday, they closed at new record levels.  The S&P finally beat its October 2007 peak on March 28 and advanced more on Monday, April 1; the Dow pierced its 2007 peak just on March 5.  This week's subsequent declines were fairly sharp, but even so, the Dow is up almost 9% over the last three months and the S&P more than 6%.

These moves in stocks seem to us mainly generated by low interest rates, rather than genuine optimism.  People with cash to invest in financial instruments can choose stocks or bonds.  If an investor is cautious, bonds might be the choice, but the Federal Reserve has conducted monetary policy with a goal of keeping long-term interest rates low, and they are.  A 10-year Treasury note pays a mere 1.7% in today's market and high quality corporate bonds with roughly that maturity pay just over 3%.  As we'll see, such low rates are helping spur growth in interest-sensitive parts of the economy, but they don't provide investors much return.  So by comparison, if there is much reason at all to believe the economy could grow, stocks, which should rise with it, may be the better choice.

Home Sales and Prices Helped by Low Interest Rates

Second, the low interest rates are helping the housing market.  Mortgage rates are at 50-year lows – really.  Home sales and house prices are rising.  These moves have not been strongly resurgent, but they mark upturns from the protracted declines during and after the financial crisis.  Sales of existing home were 7.1 million in 2005 and they dropped to a low of 3.5 million in the fall of 2010; last year, they averaged 4.66 million, and they advanced through this February to a 4.98 million annualized rate.  Home values dropped from April 2006 through February of last year by a total of 26% and they have since recovered by 10%.  While those values are still well below their 2006 highs, at least the decline in that wealth cushion for homeowners seems to be over.

These improvements, more home sales and firmer home values for homeowners are helping support consumer spending, giving further lift to the overall economy.  People are also borrowing somewhat more.  This is a relative shift as well; we paid off debt from 2008 through much of last year, and home mortgage obligations were actually still edging lower through the end of 2012.  But credit card and other consumer borrowing has picked up.

Aging Cars Lift Sales of New Cars

One area of greater demand is cars.  As with homes, vehicle buying dipped very low for a long time during and after the recession; the average age of vehicles on the road reached 11.2 years in 2012, up from 9.4 years in 2007.  Cars, SUVs and small trucks can go this long because they're made better now than, say 10 years ago, but clearly, car owners have also been getting their old rattle-traps repaired more before they decide to trade them in.  Improving economic conditions and greater credit availability are helping them make that trade-in decision, and since November, car and light truck sales have been noticeably stronger, above 15 million (annual rates).  For those concerned that this only benefits auto plants overseas, these recent gains have come almost entirely in domestically produced vehicles.

Purchases of home furnishings have also increased noticeably just the last few months, logically, with increased home sales and new home construction.  People are also eating out more and spending more on cell-phone, cable TV and internet service and air travel, just to name some scattered items where expenditures have risen over the last few months.

Business Finally Put Their Cash to Work

Business spending is also a source of growth at present.  Expenditures on structures, particularly power and communications installations and even manufacturing facilities, contributed marked growth in the fourth quarter of 2012.  Installations of information and communications equipment added as well.  During and after the recession, businesses pulled in their expenditures on such assets greatly.  This occurred in particular despite a substantial improvement in their internal cash flow and they finally began during 2012 to move their investment outlays closer in line with the profits and other funds generated by their operations.  Until early last year, the post-recession period had seen companies stash away their cash flows in financial assets – and quite properly – paying off or restraining their use of bank debt.  The move away from short-term debt was also accompanied by a shift to corporate bonds; this is a healthy development and also more sensible with the current 50-year-plus lows in those borrowing rates.

But Major Uncertainties Get Hinder Momentum

These consumer and business spending and borrowing patterns are constructive for growth, but several forces stop us from getting too excited about economic prospects.  You've probably seen the headlines today about March's jobs report, with businesses adding just 88,000 new jobs and still more people withdrawing from the job market altogether.  Prior months' new hiring was actually revised higher from previous reports, so the trend over the last six months is no weaker, but job growth is still unacceptably low and uninspiring.  Surveys of consumer confidence bear this out; those surveys and the job counts are both above recession lows, but well below levels 10-15 years ago.

We also continue to worry about gasoline prices.  At $3.50 to $4.00 a gallon for regular at the moment, these amounts mean consumers have to spend noticeable portions of their incomes just to fill up their cars.  This doesn't bode well for spending on other things, especially as the summer driving season gets going soon.  At the same time, these stubbornly high prices are evoking more structural responses – more hybrids, more Fiat 500's, other energy-saving efforts.  The recognition that cheap energy will not return can spark efforts at more innovation.

Finally, continuing heckling and haggling in Washington mean no one knows what to expect about taxes and government regulations.  Delays in formulating the structure of ObamaCare arrangements adds to these woes.  Recent surveys of small business owners by the National Federation of Independent Business highlight their concerns; the largest share of that group in 20 years reports that government requirements are their biggest business problem.  Their plans for expanding their businesses and for hiring are also restrained well below amounts that prevailed for decades before the recession.

So we see fundamentals reasserting themselves in ordinary demand for cars and houses.  Innovations in energy and business investment can also support further growth.  But uncertainty remains intense, holding back the outburst of self-reinforcing growth we're all looking for.  More, we didn't even mention continuing financial stress in Europe, and who knows what's going on with North Korea . . . .

Up next for Ways of the World:  Earth Day in just over two weeks brings attention to another force that interacts with all of this: sustainability and business efforts to practice it.  Those two words, "sustainability" and "business", can appear in the same sentence, as we'll see.

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Our comments about spending are based on Commerce Department data associated with the GDP accounts.  Housing data come from the National Association of Realtors, and home prices from First American Core Logic.  The Federal Reserve uses the latter source to value all homes for the balance sheets it compiles for the total economy.  Our comments about borrowing are based on accompanying tables from the Fed's Flow-of-Funds Accounts.

'Twas The Week Before Christmas

'Twas the week before Christmas and all through Wall Street
Many creatures were stirring – they had deadlines to meet . . . .

Poor Clement Moore. We won't mangle his fine text anymore. But in fact, for the week before Christmas, there's lots going on – on Wall Street and especially in Washington. Nobody has "settled [their] brains for a long winter's nap". Normally by this time, Congress is long gone, the rest of the federal government is pretty still, and Wall Street is busy, but with Christmas partying more than trading. Not so this year.

That Tax Bill
Let us hit a couple of the high spots. Congress finally passed a tax bill last Thursday evening. The basic feature of this bill – extension of the current income tax rate structure for two more years – is easy to misinterpret, so we will try to describe it in a gingerly fashion. Notice that we didn't use the term "tax cuts". After as many as nine years, these tax rates hardly seem like a tax "cut" any longer and certainly allowing the rates to go up would hit just like a tax "increase", even if it isn't formally called by that name.

Extending the current rates for middle income taxpayers was never much disputed. Contention focused on those in upper income brackets. Many of us perhaps thought that these well-to-do people are quite comfortable and wouldn't miss the 5% or so more of their income that they'd be paying to Uncle Sam. Maybe. But some research we did several months ago for a different need taught us something about who those upper-income people are. According to the Federal Reserve's Survey of Consumer Finances, the largest asset of the top 10% of wealth-holders is equity in a business. Not a portfolio of shares of stock, but ownership interest in their own company. So this group encompasses proprietors of the country's small businesses. It's not as if they were settled back in their palatial mansions, collecting their dividends and interest; for the most part, they're out there in the mix, working hard – and employing well more than half the country's workforce. We'll talk about this issue and these people more in a subsequent article, probably during the upcoming tax season. For now, it's clearly advantageous to the economy and to the rest of us that we didn't hike their taxes in the face of the fragile recovery we're experiencing.

An addition to the bill will actually put cash in everyone's hands beginning in January: a one-year reduction of two percentage points in the social security payroll tax. As you may recall from our article on social security in late summer, this action of reducing social security funds' receipts is not particularly good for the financial condition of that system. But it will lift everyone's take-home pay in the short run, providing cash for stepped-up spending or for paying down on credit-card and other debt. For a year, that may well be a beneficial trade-off. We will need the discipline this time next year to let it expire, however.

Latest Wrinkles in Federal Reserve Policy
What is the Federal Reserve up to these days? Why was the Fed Chairman Ben Bernanke on the 60 Minutes CBS-TV program a couple of weeks ago?

The Fed has two main functions, banking regulation and lending, and economic stabilization through monetary policy. The monetary policy role has a two-pronged goal mandated by federal law: maintaining stable inflation and minimizing unemployment. At present, inflation is low and unemployment is high. The economic recovery doesn't seem strong enough on its own to improve the unemployment situation, as Mr. Bernanke explained on 60 Minutes, so the Fed is more or less required to at least try some action toward that end. This is not straightforward, though, since the Fed's key policy interest rate, the so-called federal funds rate, is virtually at 0 percent; so they can't pursue the usual course of lowering that short-term interest rate. The Fed is taking a different tack, which Mr. Bernanke also tried to help us understand through his TV appearance. Business investment and home mortgage lending really involve longer-term financial commitments. The Fed is trying to facilitate a decline in longer-term interest rates by buying Treasury bonds, $600 billion worth by next May, about $75 billion a month.

So far, long-term rates have risen, which is not exactly the desired result. Ten-year Treasury yields traded at 2.57% in the early November week when the Fed announced its bond-buying approach, and last week, they averaged 3.41%, an increase of 0.84%. We can guess that the bond markets are concerned about the Government's budget, and that overshadowed the Federal Reserve's added demand for the government bonds. Still, these interest rates may have increased more without the Fed's buying.

Separately, the Federal Reserve is also supplying funds to central banks in Europe. As government debt strains hurt financial conditions in various countries – Ireland's credit rating was slashed five notches on the widely followed Moody's scale last Friday – the Fed has been lending in currency markets through a "swap" arrangement. Today, in an indication that those policymakers haven't gone on Christmas break yet either, they announced the extension of these arrangements until next August. The central banks borrowing dollars in these transactions lend them on to banks in their own countries, suggesting that the Federal Reserve is serving as an indirect lender to financial institutions in a number of other countries as well as the United States.

Private Economy Might Be Picking Up
At the same time, in the private sector, some economic indicators are showing signs of improvement. U.S. consumers appear to be doing what they usually do just before Christmas: shop. Weekly chain store reports issued today for last week show some encouraging vigor on top of a sizable increase in overall retail sales for the month of November. Industrial production also increased last month. And perhaps most notable, the latest available figures show a decline in the number of people filing claims for unemployment insurance benefits. A four-week average of these initial claims was 423,000 in the week ended December 11, the smallest number since August of 2008, just as the financial panic was really setting in.

So, as the year closes out, in the midst of our caution, we're seeing some better signs: perhaps consumer spending is picking up and both fiscal and monetary policies in the U.S. are supportive of growth. There's even an early hint in that unemployment insurance data that labor market conditions might be getting more heartening.

Maybe Congress can get out of Washington soon, now, and leave the skies to Santa Claus!

Merry Christmas!