Handling Finances

I have a friend who was recently caught by a rather questionable policy in the credit card industry of changing billing due dates.  By moving the due date around by just a week or so, they hope to catch people who try to pay at the last minute each month and simply assume that the due date will be the same from month to month.

It’s easy to solve this problem — pay bills when you get them and not when they’re due!  I totally understand if you run out of money to do this once or twice, but if you’re waiting for your paycheck to clear before you pay your bills, you need to change your habits.  Always keep one paycheck of funds in your checking account and live off your previous paycheck, not your next paycheck! This might be hard at first if you’re used to spending every penny that goes into your checking account, but it’s certainly not impossible!  Unless you’re reading this from your local library you might start by canceling your internet account if you can’t think of any other ways to save money to get started on this.

Anyway, my friend was particularly resistant to paying early because he didn’t want to give his credit card company even one day extra interest on the money.  This is silly — the credit card company is already giving you an average of half a month with the cash interest free, and that’s before they even send you the bill.  In essence, you’re getting an interest-free loan for a month and a half, so while you might want to hurt the credit card company by a few pennies of lost interest, it’s not worth the amount of effort it takes to avoid late payments if you’re trying to nail the deadlines.

Don’t just pay your debts on time, pay them ASAP and you’ll reduce your stress, miss fewer deadlines, and even if your checking account pays money-market interest rates, the pennies you might lose just isn’t worth the trouble!

Now that people are starting to get their tax rebates, our economy is in for some serious stimulation!  The idea is that we’re supposed to go out and buy new stuff which will keep businesses rolling along which will keep people employed.  Some might argue that we need a recession to drive inefficient companies out of business (freeing up workers and resources for better-run companies) but it’s a rather unpopular idea — especially now that our retirement savings are almost universally invested in the stock markets after years of our government giving tax breaks for 401(k) contributions.

If we step back for a moment and consider that the economy won’t totally collapse if every penny of the 100 billion is turned into profits and wages (it won’t), it will become clear that paying off debt will actually do as much or more to stimulate the economy than simply spending on consumer products.

Increasing future spending.

First of all, with every penny you pay back on your debt, you free up the monthly interest to be spent on other things.  Putting the $600 individual rebate toward debt could save as much as $150 a year in interest at an all-to-common 25% interest rate!  Today’s politicians are no-doubt counting on the stimulus today so they can take credit for the booming economy, but if we’re willing to think just a couple years out, the sustained effect of $100 billion less debt would be huge (and wouldn’t largely be wasted in profits to foreign countries).

Free up financial markets.

One of the biggest reasons for the current recessionary scare is sub-prime lending.  Sub-prime lending is hugely profitable as long as the economy is booming because lenders can charge exorbitant interest rates that more than cover defaults.  Of course, the banks book their profit each year and don’t generally set aside some of that profit to cover future defaults if the economy goes bad (or it wouldn’t be profit) so they’re stuck with huge numbers of bad loans that are no longer profitable as people become unable to repay them.

Banks don’t really want you to pay back your loan faster since they don’t earn as much interest that way, but in this case, the financial markets are so gummed up that every dollar they get back will be one more dollar they can lend out — further greasing the skids of our economy and getting everything moving again.

Ultimately, do what’s best for you!

Nobody’s trying to tell you what to do with your money, but I hate to hear people say that you should spend it or save it.  Politicians will benefit more if you spend it ASAP and make them look like they lead the economy well.  Companies worldwide will benefit more if you spend it on consumer products and a small fraction of it will go towards jobs.  The economy will benefit if loans are repaid (especially sub-prime loans) and banks will benefit if you continue to make minimum payments no matter what else you do.

In the end, look for where the money will do the most good in your personal financial situation.  While there are no strings attached, with the government running a huge yearly deficit (it doesn’t look so bad until you add in the regular “emergency was spending” to the budget), we’ll get stuck with the tab in the form of increased taxes or decreased services (say a 50% cut in social security payments?) in the long run.  While I’m a big fan of doing what’s best for my country and the world, ultimately, what keeps you self-sufficient will benefit those around you the most in the long-run.

On the radio a few days ago, I heard an interview with New York Times economy columnist David Leonhardt on the state of the economy. The interview centered on his column from March 19, 2008 called “Can’t Grasp Credit Crisis? Join the Club.” The first line of the column grabbed my attention: “Raise your hand if you don’t quite understand this whole financial crisis.”

In short, the stock market is jumping around like a caffeinated jackrabbit on a hotplate because nobody really knows what’s wrong. Subprime mortgages and other subprime loans got sliced up, packaged together and sold in so many different ways that it’s been nearly impossible to figure out which investments are losing how much. And when people don’t know how bad it is, they tend to panic. That’s what happened to Bear Sterns — the major investment banker that is being sold for a small fraction of what it was worth a year ago… or even a month ago! They didn’t just lose all their money investing in risky subprime loans, but when the market panicked, people started pulling millions of dollars out of Bear Sterns (and other investments like mutual funds) to protect their money from further losses. The more people sold, the more Bear Sterns was forced to sell more and more failing investments — right when they were at their lowest. After a few weeks and months of selling more and more of their assets at lower and lower prices (desperate to repay those who asked for their money back) they were finally forced to admit that they didn’t have enough assets left to cover all their obligations. It’s really similar to a run on a bank where too many people ask for their money back, but since the bank has loaned most of it out, they can’t repay it right away and end up in big trouble with it’s patrons (though in the US, there are protections to keep this from happening).

So what caused the credit crisis?

So some of the trouble — and certainly the speed and magnitude of recent market declines has been caused by fear and panic among investors. To understand what set it off requires a bit more understanding of recent economic history.

After the real-estate slump in the early 1990’s, mortgage lenders were becoming increasingly national and international in scale rather than simply local. Instead of developing long-term relationships with their borrowers, they competed for loans nationwide and lowered fees while creating new types of mortgages like ARMs — perfect for people who aren’t planning to stay in their house for more than a couple of years and want to save on interest.

Everybody was sure that home values could never drop nationwide, and with the federal funds rate held very low to ward off a second recession in the early 2000’s, everybody from homeowners who took out mortgages with little or no down payment, to big-time investing firms were increasing their returns by heavily borrowing at a low rate and investing in the high interest-rate subprime loans. When betting with borrowed money, even a relatively small drop in investment value can wipe out the investor which explains why so many groups went bankrupt all of a sudden. To make it worse, since the investing firms don’t always know how much exposure they have to the subprime loans (since they’re all sliced up and packaged in many different ways), they’re now holding onto cash to avoid the same fate as Bear Sterns by running out of money as investors ask for their money back. More cash means less investing which just compounds the problem as those trying to sell have an even harder time finding buyers and are forced to drop prices even further.

It’s a highly complex issue with all sorts of ripples affecting what would normally seem like barely-related investments. My main goal through this whole mess is to follow it closely and learn as much as I can — this kind of perfect storm doesn’t come often, but it’s always a potential danger and understanding how bubbles grow and burst is the first step to recognizing them in the future.