Two housing market shifts encourage potential homebuyers to call real estate agents: drops in housing prices and low interest rates. But deciding which factor is more important than the other can make a difference in monthly payments, the ability to move if your home value drops and HOA fees. TUTORIAL: Mortgage Basics
Monthly PaymentLet's say you started the home search process when interest rates were 7%. You saw a one-bedroom condo for sale for $100,000. You calculated your 30-year monthly mortgage payment on $80,000 – the amount you are mortgaging after a 20% down payment and your closing costs. Your monthly payment would be $532. You decide you don't like this payment and rate, so you wait six months and the interest rate drops to 5%. However, a condo in the neighborhood you want now averages $120,000. You put down 20% plus closing costs, and you are left with a mortgage amount of $96,000. Your monthly payment on a 30-year mortgage is $515. Your payment dropped by $17. But does a payment drop financially make up for the higher down payment? Factoring in that your down payment was $4,000 more, you still save about $5 to $6 per month - around $2,100 of savings over the course of 30 years. If real estate prices never rose in your perspective neighborhood from the $100,000 price point you started your search with - and you snagged a 5% interest rate - your mortgage would be $430. However, the volatility of housing prices and interest rates cannot be accurately predicted to move in your favor.
IN PICTURES: Financing For First-Time Homebuyers
Down PaymentRegardless of your interest rate on a lower-priced home, you can get into a home with less money. In the example of the condo that rose from $100,000 to $120,000, your monthly payment dropped. But would the lower payment help you if you didn't have an extra $4,000 for a larger down payment? The down payment amount difference could eliminate the possibility of buying the home you want, or knocking out of the buyer's market altogether if you can't find a cheaper neighborhood.
Plus, the extra $4,000 can impact your ability to pay for unexpected home repairs, your emergency savings and ability to afford to furnish your new home.
Can Low Interest Rates and Low Prices Unite?Yes. In September 2010, interest rates and housing prices were both rather low. But how do you know what a low rate is comparatively? You can find historic mortgage rates on the Freddie Mac website. Look at the last five years for highs and lows.
Although such an opportunity was presented in the past, there is no assurance that history will repeat itself. More importantly, if you need a house soon, the option to wait an extra five years for the ideal housing market circumstances may not be a realistic alternative.
MovabilityInterest rates don't matter as much, as long as you can easily afford your payments, if you live in your home for five years or less. While it's never a guarantee that housing prices won't drop further, you can view estimated housing prices for the last 10 years by selected an address in the neighborhood you are studying online. Always compare neighborhood values instead of national or city-by-city. Home price patterns vary rapidly from neighborhood-to-neighborhood and state-to-state. The likelihood you will end up owing more than the remainder of your mortgage can be lower if you buy a home when your local real estate market is below its peak.
HOA FactorHomeowners Association (HOA) fees are often more expensive for higher-priced homes, plus they can climb higher when more homes are vacant. Why? HOAs cover shared services such as lawn maintenance, condo maintenance, clubhouses, pools, tennis courts and/or private streets. Similar to other historic data, you should contact potential HOAs and ask for historic rates over the last 10 years. You should also ask about maximum fees, or what factors determine rate hikes and decreases. Always ask about HOA fees on all homes you are considering. HOA fees may be lower on a slightly higher priced home, especially if less services are offered.
In low interest rate environments, HOA payments can present an excessive monthly burden, so make sure that these payments are factored into your monthly budget. (For more on Homeowner's Association's see 9 Things You Need To Know About Homeowners' Associations and Buying A Condo.)
RefinancingA big perk to a lower home price versus a lower interest rate is that your home can be refinanced or modified in the future. Basically, the problem with high initial interest rates can be mitigated in the future if rates decrease. If your home's interest rate isn't at a five-year interest rate low, ask potential mortgage bankers about costs to modify your loan. The range can be anywhere from free to thousands. There isn't a guarantee your home loan's interest rate will drop, but you can insure you can afford to refinance when it does.
ConclusionThe decision to buy a home should always be based on your ability to afford your monthly payment, your down payment, emergency savings, home repairs and furnishings. Always consider potential future factors such as HOA fees and the option to pay down your mortgage if you have to move quickly.
There isn't an exact right time to buy a home, but there is a time when you're financially ready and know you're going to stay put for at least five years. Buy a home that you can afford both now and five years in the future.
For further reading, checkout New Home Repair Troubleshooting, Are You Ready To Buy A House?, Buying A Home: Calculate How Much Home You Can Afford, and Will You Break Even On Your Home?.
by Reyna Gobel,MBA
Thursday, November 4, 2010
Top 6 Mortgage Mistakes
During the 2007-2009 financial crisis, the United States economy crumbled because of a problem with mortgage foreclosures. Borrowers all over the nation had trouble paying their mortgages. At the time, eight out of 10 borrowers were trying to refinance their mortgages. Even high end homeowners were having trouble with foreclosures. Why were so many citizens having trouble with their mortgages?
Let's take a look at the biggest mortgage mistakes that homeowners make. 1. Adjustable Rate Mortgages
Adjustable rate mortgages seem like a homeowners dream. An adjustable rate mortgage starts you off with a low interest rate for the first two to five years. They allow you to buy a larger house than you can normally qualify for and have lower payments that you can afford. After two to five years the interest rate resets to a higher market rate. That's no problem because borrowers can just take the equity out of their homes and refinance to a lower rate once it resets.
Well, it doesn't always work out that way. When housing prices drop, borrowers tend to find that they are unable to refinance their existing loans. This leaves many borrowers facing high mortgage payments that are two to three times their original payments. The dream of home ownership quickly becomes a nightmare. (For more on types of mortgages, see Mortgages: Fixed-Rate Versus Adjustable-Rate.)
2. No Down Payment
During the subprime crisis, many companies were offering borrowers no down payment loans to borrowers. The purpose of a down payment is twofold. First, it increases the amount of equity that you have in your home and reduces the amount of money that you owe on a home. Second, a down payment makes sure that you have some skin in the game. Borrowers that place down a large down payment are much more likely to try everything possible to make their mortgage payments since they do not want to lose their investment. Many borrowers who put little to nothing down on their homes find themselves upside down on their mortgage and end up just walking away. They owe more money than the home is worth. The more a borrower owes, the more likely they are to walk away.
3. Liar Loans
The phrase "liar loans" leaves a bad taste in your mouth. Liar loans were incredibly popular during the real estate boom prior to the subprime meltdown that began in 2007. Mortgage lenders were quick to hand them out and borrowers were quick to accept them. A liar loan is a loan that requires little to no documentation. Liar loans do not require verification. The loan is based on the borrower's stated income, stated assets and stated expenses.
They are called liar loans because borrowers have a tendency to lie and inflate their income so that they can buy a larger house. Some individuals that received a liar loan did not even have a job! The trouble starts once the buyer gets in the home. Since the mortgage payments have to be paid with actual income and not stated income, the borrower is unable to consistently make their mortgage payments. They fall behind on the payments and find themselves facing bankruptcy and foreclosure.
4. Reverse Mortgages
If you watch television, you have probably seen a reverse mortgage advertised as the solution to all of your income problems. Are reverse mortgages the godsend that people claim that they are? A reverse mortgage is a loan available to senior citizens age 62 and up that uses the equity out of your home to provide you with an income stream. The available equity is paid out to you in a steady stream of payments or in a lump sum like an annuity.
There are many drawbacks to getting a reverse mortgage. There are high upfront costs. Origination fees, mortgage insurance, title insurance, appraisal fees, attorney fees and miscellaneous fees can quickly eat up your equity. The borrower loses full ownership of their home. Since all of the equity will be gone from your home, the bank now owns the home. The family is only entitled to any equity that is left after all of the cash from the deceased's estate has been used to pay off the mortgage, fees, and interest. The family will have to try to work out an agreement with the bank and make mortgage payments to keep the family home. (For more information, take a look at Is A Reverse Mortgage Right For You?)
5. Longer Amortization
You may have thought that 30 years was the longest time frame that you could get on a mortgage. Are you aware that some mortgage companies are offering loans that run 40 years now? Thirty five and forty year mortgages are slowly rising in popularity. They allow individuals to buy a larger house for much lower payments. A 40-year mortgage may make sense for a young 20-year-old who plans to stay in their home for the next 20 years but it doesn't make sense for a lot of people. The interest rate on a 40-year mortgage will be slightly higher than a 30 year. This amounts to a whole lot more interest over a 40-year time period, because banks aren't going to give borrowers 10 extra years to pay off their mortgage without making it up on the back end.
Borrowers will also have less equity in their homes. The bulk of payments for the first 10 to 20 years will primarily pay down interest making it nearly impossible for the borrower to move. Besides, do you really want to be making mortgage payments in your 70's?
6. Exotic Mortgage Products
Some homeowners simply did not understand what they were getting themselves into. Lenders came up with all sorts of exotic products that made the dream of home ownership a reality. Products like interest only loans which can lower payments 20-30%. These loans let borrowers live in a home for a few years and only make interest payments. Name your payment loans let borrowers decide exactly how much they want to pay on their mortgage each month.
The catch is that a big balloon principal payment would come due after a certain time period. All of these products are known as negative amortization products. Instead of building up equity, borrowers are building negative equity. They are increasing the amount that they owe every month until their debt comes crashing down on them like a pile of bricks. Exotic mortgage products have led to many borrowers being underwater on their loans. (For more on IO loans, read Interest-Only Mortgages: Home Free Or Homeless?)
The Bottom Line
As you can clearly see, the road to home ownership is riddled with many traps. If you can avoid the traps that many borrowers fell into then you can keep yourself from financial ruin. (For related reading, take a look at Mortgages: The ABCs of Refinancing.)
by Mark Riddix
Let's take a look at the biggest mortgage mistakes that homeowners make. 1. Adjustable Rate Mortgages
Adjustable rate mortgages seem like a homeowners dream. An adjustable rate mortgage starts you off with a low interest rate for the first two to five years. They allow you to buy a larger house than you can normally qualify for and have lower payments that you can afford. After two to five years the interest rate resets to a higher market rate. That's no problem because borrowers can just take the equity out of their homes and refinance to a lower rate once it resets.
Well, it doesn't always work out that way. When housing prices drop, borrowers tend to find that they are unable to refinance their existing loans. This leaves many borrowers facing high mortgage payments that are two to three times their original payments. The dream of home ownership quickly becomes a nightmare. (For more on types of mortgages, see Mortgages: Fixed-Rate Versus Adjustable-Rate.)
2. No Down Payment
During the subprime crisis, many companies were offering borrowers no down payment loans to borrowers. The purpose of a down payment is twofold. First, it increases the amount of equity that you have in your home and reduces the amount of money that you owe on a home. Second, a down payment makes sure that you have some skin in the game. Borrowers that place down a large down payment are much more likely to try everything possible to make their mortgage payments since they do not want to lose their investment. Many borrowers who put little to nothing down on their homes find themselves upside down on their mortgage and end up just walking away. They owe more money than the home is worth. The more a borrower owes, the more likely they are to walk away.
3. Liar Loans
The phrase "liar loans" leaves a bad taste in your mouth. Liar loans were incredibly popular during the real estate boom prior to the subprime meltdown that began in 2007. Mortgage lenders were quick to hand them out and borrowers were quick to accept them. A liar loan is a loan that requires little to no documentation. Liar loans do not require verification. The loan is based on the borrower's stated income, stated assets and stated expenses.
They are called liar loans because borrowers have a tendency to lie and inflate their income so that they can buy a larger house. Some individuals that received a liar loan did not even have a job! The trouble starts once the buyer gets in the home. Since the mortgage payments have to be paid with actual income and not stated income, the borrower is unable to consistently make their mortgage payments. They fall behind on the payments and find themselves facing bankruptcy and foreclosure.
4. Reverse Mortgages
If you watch television, you have probably seen a reverse mortgage advertised as the solution to all of your income problems. Are reverse mortgages the godsend that people claim that they are? A reverse mortgage is a loan available to senior citizens age 62 and up that uses the equity out of your home to provide you with an income stream. The available equity is paid out to you in a steady stream of payments or in a lump sum like an annuity.
There are many drawbacks to getting a reverse mortgage. There are high upfront costs. Origination fees, mortgage insurance, title insurance, appraisal fees, attorney fees and miscellaneous fees can quickly eat up your equity. The borrower loses full ownership of their home. Since all of the equity will be gone from your home, the bank now owns the home. The family is only entitled to any equity that is left after all of the cash from the deceased's estate has been used to pay off the mortgage, fees, and interest. The family will have to try to work out an agreement with the bank and make mortgage payments to keep the family home. (For more information, take a look at Is A Reverse Mortgage Right For You?)
5. Longer Amortization
You may have thought that 30 years was the longest time frame that you could get on a mortgage. Are you aware that some mortgage companies are offering loans that run 40 years now? Thirty five and forty year mortgages are slowly rising in popularity. They allow individuals to buy a larger house for much lower payments. A 40-year mortgage may make sense for a young 20-year-old who plans to stay in their home for the next 20 years but it doesn't make sense for a lot of people. The interest rate on a 40-year mortgage will be slightly higher than a 30 year. This amounts to a whole lot more interest over a 40-year time period, because banks aren't going to give borrowers 10 extra years to pay off their mortgage without making it up on the back end.
Borrowers will also have less equity in their homes. The bulk of payments for the first 10 to 20 years will primarily pay down interest making it nearly impossible for the borrower to move. Besides, do you really want to be making mortgage payments in your 70's?
6. Exotic Mortgage Products
Some homeowners simply did not understand what they were getting themselves into. Lenders came up with all sorts of exotic products that made the dream of home ownership a reality. Products like interest only loans which can lower payments 20-30%. These loans let borrowers live in a home for a few years and only make interest payments. Name your payment loans let borrowers decide exactly how much they want to pay on their mortgage each month.
The catch is that a big balloon principal payment would come due after a certain time period. All of these products are known as negative amortization products. Instead of building up equity, borrowers are building negative equity. They are increasing the amount that they owe every month until their debt comes crashing down on them like a pile of bricks. Exotic mortgage products have led to many borrowers being underwater on their loans. (For more on IO loans, read Interest-Only Mortgages: Home Free Or Homeless?)
The Bottom Line
As you can clearly see, the road to home ownership is riddled with many traps. If you can avoid the traps that many borrowers fell into then you can keep yourself from financial ruin. (For related reading, take a look at Mortgages: The ABCs of Refinancing.)
by Mark Riddix
How The Federal Reserve Was Formed
The Federal Reserve is widely considered to be one of the most important financial institutions in the world. The Fed can either be your kindly grandmother or the mother-in-law from hell, and its character is usually a function of the Federal Reserve's board of governors. Its monetary policy decisions can send waves through not only the U.S. markets, but also the world. (To find out what the Fed does for investors, check out our Federal Reserve tutorial.)
In this article we will look at the formation of the Federal Reserve and follows its history as it riles the market and then turns it around and sends it to new highs.
Life Before the Federal ReserveThe United States was considerably more unstable financially before the creation of the Federal Reserve. Panics, seasonal cash crunches and a high rate of bank failures made the U.S. economy a riskier place for international and domestic investors to place their capital. The lack of dependable credit stunted growth in many sectors, including agriculture and industry. (To learn more about the history of banking, see Cold Hard Cash Wars and The Evolution Of Banking.)
J.P. Morgan and the Panic of 1907It was J.P. Morgan who forced the government into acting on the central banking plans it had been considering off and on for almost a century. During the Bank Panic of 1907, Wall Street turned to J.P. Morgan to steer the country through the crisis that was threatening to push the economy over the edge into a full crash and depression. Morgan was able to convene all the principal players at his mansion and command all their capital to flood the system, thus floating the banks that, in turn, helped to float the businesses until the panic passed.
The fact that the government owed its economic survival to a private banker forced the necessary legislation to create a central bank and the Federal Reserve. (Keep reading about this in Get To Know The Major Central Banks.)
Learning from EuropeIn the years between 1907 and 1913, the top bankers and government officials in the U.S. formed the National Monetary Commission and traveled to Europe to see how the central banking was handled there. They came back with favorable impressions of the British and German systems, using them as the base and adding some improvements gleaned from other countries.
The Federal Reserve was given power over the money supply and, by extension, the economy. Although many forces within the public and government were calling for a central bank that printed money on demand, President Wilson was swayed by Wall Street arguments against a system that would cause rampant inflation. So the government created the Federal Reserve, but it was by no means under government control.
The Great Depression The government soon came to regret the freedom it had granted the Federal Reserve as it stood by during the crash of 1929 and refused to prevent the Great Depression that followed.
Even now, it is hotly debated whether the Fed could have stopped the depression, but there is little doubt that it could have done more to soften and shorten it by providing lower interest rates to allow farmers to keep planting and businesses to keep producing. The high interest rates may even have been responsible for the unplanted fields that turned into dust bowls. By restricting the money supply at a bad time, the Fed starved out many individuals and businesses that might otherwise have survived.
The RecoveryIt was World War II, not the Federal Reserve, that lifted the economy out of the depression. The war benefited the Federal Reserve as well by expanding its power and the amount of capital it was called on to control for the Allies. After the war, the Fed was able to erase some of the bad memories from the depression by keeping interest rates low as the U.S. economy went on a bull run that was virtually uninterrupted until the '60s.
Inflation or Unemployment?Stagflation and inflation hit the U.S. in the '70s, slapping the economy across the face, but hurting the public far more than business. The Nixon administration ended the nation's on and off again affair with the gold standard, making the Fed that much more important in controlling the value of the U.S. dollar. The big question for the Fed was whether the nation was better off with inflation or unemployment. (To learn more, read The Gold Standard Revisited.)
By controlling interest rates, the Fed can make corporate credit easy to obtain, thus encouraging business to expand and create jobs. Unfortunately, this increases inflation as well. On the flip side, the fed can slow inflation by raising interest rates and slowing down the economy, causing unemployment. The history of the Fed is simply each chairman's answer to this central question. (For more insight, check out All About Inflation.)
The Greenspan YearsAlan Greenspan took over the Federal Reserve a year before the infamous crash of 1987. When we think of crashes, many people consider the crash of 1987 more of a glitch than a true crash - a non-event nearer to a panic. This is true only because of the actions of Alan Greenspan and the Federal Reserve. Much like J.P. Morgan in 1907, Alan Greenspan collected all the necessary chiefs and kept the economy afloat.
Through the Fed, however, Greenspan used the additional weapon of low interest rates to carry business through the crisis. This marked the first time that the Fed had operated as its creators first envisioned 80 years before. (To read about a more modern-day Fed, check out The Federal Reserve's Fight Against Recession and A Farewell To Alan Greenspan and Ben Bernanke: Background And Philosophy.)
The Bottom Line
Criticisms of the Federal Reserve continue. Boiled down, these arguments center on the image people have of the caretaker of the economy. You can either have a Fed that feeds the economy with ideal interest rates leading to low unemployment - possibly leading to future problems - or you can have a Fed that offers little help, ultimately forcing the economy to learn to help itself. The ideal Fed would be willing to do both. Although there have been calls for the elimination of the Federal Reserve as the U.S. economy matures, it is very likely that the Fed will continue to guide the economy for many years to come.
by Andrew Beattie
Life Before the Federal ReserveThe United States was considerably more unstable financially before the creation of the Federal Reserve. Panics, seasonal cash crunches and a high rate of bank failures made the U.S. economy a riskier place for international and domestic investors to place their capital. The lack of dependable credit stunted growth in many sectors, including agriculture and industry. (To learn more about the history of banking, see Cold Hard Cash Wars and The Evolution Of Banking.)
J.P. Morgan and the Panic of 1907It was J.P. Morgan who forced the government into acting on the central banking plans it had been considering off and on for almost a century. During the Bank Panic of 1907, Wall Street turned to J.P. Morgan to steer the country through the crisis that was threatening to push the economy over the edge into a full crash and depression. Morgan was able to convene all the principal players at his mansion and command all their capital to flood the system, thus floating the banks that, in turn, helped to float the businesses until the panic passed.
The fact that the government owed its economic survival to a private banker forced the necessary legislation to create a central bank and the Federal Reserve. (Keep reading about this in Get To Know The Major Central Banks.)
Learning from EuropeIn the years between 1907 and 1913, the top bankers and government officials in the U.S. formed the National Monetary Commission and traveled to Europe to see how the central banking was handled there. They came back with favorable impressions of the British and German systems, using them as the base and adding some improvements gleaned from other countries.
The Federal Reserve was given power over the money supply and, by extension, the economy. Although many forces within the public and government were calling for a central bank that printed money on demand, President Wilson was swayed by Wall Street arguments against a system that would cause rampant inflation. So the government created the Federal Reserve, but it was by no means under government control.
The Great Depression The government soon came to regret the freedom it had granted the Federal Reserve as it stood by during the crash of 1929 and refused to prevent the Great Depression that followed.
Even now, it is hotly debated whether the Fed could have stopped the depression, but there is little doubt that it could have done more to soften and shorten it by providing lower interest rates to allow farmers to keep planting and businesses to keep producing. The high interest rates may even have been responsible for the unplanted fields that turned into dust bowls. By restricting the money supply at a bad time, the Fed starved out many individuals and businesses that might otherwise have survived.
The RecoveryIt was World War II, not the Federal Reserve, that lifted the economy out of the depression. The war benefited the Federal Reserve as well by expanding its power and the amount of capital it was called on to control for the Allies. After the war, the Fed was able to erase some of the bad memories from the depression by keeping interest rates low as the U.S. economy went on a bull run that was virtually uninterrupted until the '60s.
Inflation or Unemployment?Stagflation and inflation hit the U.S. in the '70s, slapping the economy across the face, but hurting the public far more than business. The Nixon administration ended the nation's on and off again affair with the gold standard, making the Fed that much more important in controlling the value of the U.S. dollar. The big question for the Fed was whether the nation was better off with inflation or unemployment. (To learn more, read The Gold Standard Revisited.)
By controlling interest rates, the Fed can make corporate credit easy to obtain, thus encouraging business to expand and create jobs. Unfortunately, this increases inflation as well. On the flip side, the fed can slow inflation by raising interest rates and slowing down the economy, causing unemployment. The history of the Fed is simply each chairman's answer to this central question. (For more insight, check out All About Inflation.)
The Greenspan YearsAlan Greenspan took over the Federal Reserve a year before the infamous crash of 1987. When we think of crashes, many people consider the crash of 1987 more of a glitch than a true crash - a non-event nearer to a panic. This is true only because of the actions of Alan Greenspan and the Federal Reserve. Much like J.P. Morgan in 1907, Alan Greenspan collected all the necessary chiefs and kept the economy afloat.
Through the Fed, however, Greenspan used the additional weapon of low interest rates to carry business through the crisis. This marked the first time that the Fed had operated as its creators first envisioned 80 years before. (To read about a more modern-day Fed, check out The Federal Reserve's Fight Against Recession and A Farewell To Alan Greenspan and Ben Bernanke: Background And Philosophy.)
The Bottom Line
Criticisms of the Federal Reserve continue. Boiled down, these arguments center on the image people have of the caretaker of the economy. You can either have a Fed that feeds the economy with ideal interest rates leading to low unemployment - possibly leading to future problems - or you can have a Fed that offers little help, ultimately forcing the economy to learn to help itself. The ideal Fed would be willing to do both. Although there have been calls for the elimination of the Federal Reserve as the U.S. economy matures, it is very likely that the Fed will continue to guide the economy for many years to come.
by Andrew Beattie
The Rise And Fall Of The Shadow Banking System
Before getting into an analysis of how the shadow banking system played a role in the 2008 economic downturn, we must first understand what this system is in the most basic sense. Although the term "shadow" may conjure up all sorts of nefarious and unpleasant images in one's mind, it would simply be unfair to characterize this aspect of our financial system in such an emotional or negative context. (Four major players slice and dice your mortgage in the secondary market. To learn more, check out Behind The Scenes Of Your Mortgage.) Tutorial: Banking
We all know the traditional banking system provides checking and savings accounts, auto and home loans, and various other financial services. But most people fail to understand that these institutions do not possess infinite capital, and are therefore limited in the amount of loans they can provide to consumers or small businesses. This limitation is where the shadow banking system came into play.
The Rise of Shadow Banking
Prior to the Great Recession, banks realized their ability to profit from lending was limited by access to capital and the size of their balance sheet. So instead of lending and holding loans like banks did in the "good old days" (limiting profit potential), they began specializing in originating loans, packaging them and selling them to other investors through securitization processes via investment banks; hence the inception of the unregulated "shadow banking system" which provided a conduit capital seeking to purchase these securities.
How this worked is rather simple. A financial institution would lend as much money as possible for home, general consumer and auto loans, and would then work with investment bankers to securitize these pools of assets. These securities would then be sold to a variety of investors such as pension funds, endowments, mutual funds, hedge funds and other financial institutions; these were the funders of the shadow system. These instruments could take a great many forms such as asset-backed securities (ABS), collateralized debt obligations (CDO), mortgage-backed securities (MBS) and collateralized loan obligations (CLO). (Learn more in CDOs And The Mortgage Market.)
It was through these instruments that more and more people were easily able to access credit as financial institutions could profit from making ever increasing amounts of risky loans. This led to the lending institutions selling these loans to other investors in the form of innovative fixed-income securities. So it seemed a win-win situation for everyone involved. Consumers got the cheap credit they desired and investors found a way to earn higher returns over Treasuries with minimal perceived risk in the face of robust and stable economic growth.
The Problem
So if this was such a good thing, how did it turn so ugly? Well the answer to this question centers on one very persistent aspect of investor behavior in that people tend to extrapolate current events too far into the future. In this particular instance, investors implicitly believed through their pricing of risks (or required credit spread over Treasuries) that the economic stability we enjoyed during the mid 2000s would persist. Premiums investors required for bearing the credit risks associated with MBSs, CDOs, ABSs etc., were not priced accordingly for the level of underlying risk. This relationship can be dimensioned by using the proxy of falling credit spreads between the U.S. 10-Year Treasury and Moody's AAA rated corporate bonds as demonstrated in Figure 1. (Despite investor distrust, rating agencies can be helpful. Just be sure you use these ratings as a starting point. For further, see Bond Rating Agencies: Can You Trust Them?)
One of the many problems in hindsight is that the Federal Reserve failed to take into consideration not only the incredible leverage inherent in our economy, but the reliance on low interest rates. Corporations were not the only parties dependent on low interest rates, home owners could only pay off their mortgage if rates remained low. Thus, they could not pay interest payments on their mortgages that exceeded the initial teaser rate. The shadow banking system enabled such a system to flourish because many of these economic anomalies remained hidden in the unregulated market.
So with the dual effect of high 2008 energy costs (recall gasoline at around $4 per gallon) alongside the higher interest rates that followed the mortgage teaser rates, the economy began to sputter. But more importantly, investors began to discount a recession into their pricing of securities and willingness to bear risk. This in turn created a positive feedback loop that hit the economy with higher credit costs as investors now required greater compensation for bearing risk given the fragility of the U.S. economy and peoples' ability to service their interest payments. See Figure 3.
So the end of result of this confluence of events was exactly what the economy did not need. Investors were far less likely to lend money over fears over economic weakness and the shadow banking system essentially collapsed. So any lending that did take place was done at far higher interest rates than people were accustomed to. On top of this, the highly levered U.S. economy was not only unable to bear these precipitous increases in interest rates, but the lack of availability of credit in general. This is what led to the precipitous decline in U.S. economic activity, or the "Great Recession." See Figure 4.
The Bottom Line
The point of this article is two-fold. The first is to serve a big picture history lesson for what the shadow banking system was, what caused its failure, how that failure contributed to the 2008 economic woes, and also to provide a demonstration of how important this system is to our economy given societal leverage. Albeit people always seek to demonize someone or something when things go wrong, it's important to remember that the shadow banking system could never have existed if there had been no demand for its services - the demand created the supply.
Like it or not, this aspect of our economy is essential given our country's penchant for borrowing to support consumer spending. Can we regulate it for the betterment of society and preclude such future meltdowns? Well, that remains to be seen. (Find out how this economic cycle affects both small and big business. Read The Impact Of Recession On Businesses.)
by Eric Petroff
We all know the traditional banking system provides checking and savings accounts, auto and home loans, and various other financial services. But most people fail to understand that these institutions do not possess infinite capital, and are therefore limited in the amount of loans they can provide to consumers or small businesses. This limitation is where the shadow banking system came into play.
The Rise of Shadow Banking
Prior to the Great Recession, banks realized their ability to profit from lending was limited by access to capital and the size of their balance sheet. So instead of lending and holding loans like banks did in the "good old days" (limiting profit potential), they began specializing in originating loans, packaging them and selling them to other investors through securitization processes via investment banks; hence the inception of the unregulated "shadow banking system" which provided a conduit capital seeking to purchase these securities.
How this worked is rather simple. A financial institution would lend as much money as possible for home, general consumer and auto loans, and would then work with investment bankers to securitize these pools of assets. These securities would then be sold to a variety of investors such as pension funds, endowments, mutual funds, hedge funds and other financial institutions; these were the funders of the shadow system. These instruments could take a great many forms such as asset-backed securities (ABS), collateralized debt obligations (CDO), mortgage-backed securities (MBS) and collateralized loan obligations (CLO). (Learn more in CDOs And The Mortgage Market.)
It was through these instruments that more and more people were easily able to access credit as financial institutions could profit from making ever increasing amounts of risky loans. This led to the lending institutions selling these loans to other investors in the form of innovative fixed-income securities. So it seemed a win-win situation for everyone involved. Consumers got the cheap credit they desired and investors found a way to earn higher returns over Treasuries with minimal perceived risk in the face of robust and stable economic growth.
The Problem
So if this was such a good thing, how did it turn so ugly? Well the answer to this question centers on one very persistent aspect of investor behavior in that people tend to extrapolate current events too far into the future. In this particular instance, investors implicitly believed through their pricing of risks (or required credit spread over Treasuries) that the economic stability we enjoyed during the mid 2000s would persist. Premiums investors required for bearing the credit risks associated with MBSs, CDOs, ABSs etc., were not priced accordingly for the level of underlying risk. This relationship can be dimensioned by using the proxy of falling credit spreads between the U.S. 10-Year Treasury and Moody's AAA rated corporate bonds as demonstrated in Figure 1. (Despite investor distrust, rating agencies can be helpful. Just be sure you use these ratings as a starting point. For further, see Bond Rating Agencies: Can You Trust Them?)
 |
| Figure 1: Spread Between Moody's AAA and U.S. 10-Year Treasury |
| Source: Federal Reserve |
What Went Wrong?
The question then turns to what went wrong and why did investors sour so precipitously on what had become an apparently successful means to provide easy access to credit for the average American and bolster investor returns? The answer to this question is rather simple in that it involves the relationship between leverage and the cost thereof.
Although Americans were more than happy to have easy access to credit cards, cars and home loans, it is unlikely they were aware this practice was placing the U.S.'s societal balance sheet in the most precarious position in its entire history. As you can see from Figure 2, total leverage in American society had not only reached its highest levels in history, but had done so at an accelerating pace in recent years. The result was our economy had become extremely addicted to leverage and overburdening unrealistic budget practices.The question then turns to what went wrong and why did investors sour so precipitously on what had become an apparently successful means to provide easy access to credit for the average American and bolster investor returns? The answer to this question is rather simple in that it involves the relationship between leverage and the cost thereof.
 |
| Chart 2: Total Societal Leverage (Household, Farm, Corp. Government and Financial) - June 2007 |
| Source: Federal Reserve |
So with the dual effect of high 2008 energy costs (recall gasoline at around $4 per gallon) alongside the higher interest rates that followed the mortgage teaser rates, the economy began to sputter. But more importantly, investors began to discount a recession into their pricing of securities and willingness to bear risk. This in turn created a positive feedback loop that hit the economy with higher credit costs as investors now required greater compensation for bearing risk given the fragility of the U.S. economy and peoples' ability to service their interest payments. See Figure 3.
 |
| Figure 3: Spread Between Moody's AAA and U.S. 10-Year Treasury |
| Source Federal Reserve |
 |
| Figure 4: Total Borrowing/Lending in U.S. Economy And Annualized Real GDP Growth |
| Source: Federal Reserve, BEA |
The point of this article is two-fold. The first is to serve a big picture history lesson for what the shadow banking system was, what caused its failure, how that failure contributed to the 2008 economic woes, and also to provide a demonstration of how important this system is to our economy given societal leverage. Albeit people always seek to demonize someone or something when things go wrong, it's important to remember that the shadow banking system could never have existed if there had been no demand for its services - the demand created the supply.
Like it or not, this aspect of our economy is essential given our country's penchant for borrowing to support consumer spending. Can we regulate it for the betterment of society and preclude such future meltdowns? Well, that remains to be seen. (Find out how this economic cycle affects both small and big business. Read The Impact Of Recession On Businesses.)
by Eric Petroff
Parties For Taxes: Republicans Vs. Democrats
We often boil down the tax policy of our major political parties into its simplest form: Democrats raise taxes to fund social programs, and Republicans lower taxes to benefit big businesses and the wealthy. Both ideas simplify the policy of each party, yet both ideas are essentially true.
Whether you agree with more government spending or tax breaks for corporations, each party's agenda will affect your taxes.
Political Ideology: Republican"We believe government should tax only to raise money for its essential functions," the Republicans state their case plainly on the Republican National Convention web site. That is, Republicans believe government should spend money only to enforce contracts, maintain basic infrastructure and national security, and protect citizens against criminals.
The literature of the House Republican Conference goes on to illuminate the role of the government and how tax policies affect individuals: "The money the government spends does not belong to the government; it belongs to the taxpayers who earned it. Republicans believe Americans deserve to keep more of their own money to save and invest for the future, and low tax policies help drive a strong and healthy economy."
Tax relief is the Republican route to growing the economy. A Republican government would reduce taxes for businesses to allow businesses to grow and thus hire more employees. Republicans also seek to limit income taxes for individuals so that people can hold on to more disposable income, which they can then spend, save or invest.
Political Ideology: DemocratThe tax policy for the Democratic Party calls for raising certain taxes to provide money for government spending, which in turn generates business. The party platform asserts that government spending provides "good jobs and will help the economy today."
Many Democrats are adherents to Keynesian economics, or aggregate demand, which holds that when the government funds programs, those programs pump new money into the economy. Keynesians believe that prices tend to stay relatively stable and therefore any kind of spending, whether by consumers or the government, will grow the economy. (Check out Giants Of Finance: John Maynard Keynes, to learn more about Keynes' theories.)
Like the Republicans, Democrats believe the government should subsidize vital services that keep cities, states and the country running: infrastructure such as road and bridge maintenance and repairs for schools. Democrats also call for tax cuts for the middle class. But who benefits most under each platform? The conventional wisdom is that corporations and the wealthy will benefit more with a Republican tax policy while small businesses and middle-class households will benefit from a Democratic tax policy.
A Misunderstood ConceptMany of the quarrels that flare up when people debate tax policy evolve out of misunderstood concepts. Possibly the most misunderstood concept is the tax rate. We hear that a politician wants to raise taxes on income and we cringe, convinced that higher taxes will whittle away every dollar we earn. But we don't pay a flat tax; we pay income taxes on a marginal rate.
The marginal tax rate is the rate you pay on the last dollar of income you earn. For example, if you were single in 2008 and you brought in $50,000, you fell into the 25% tax bracket. But that doesn't mean that every dollar was taxed at 25%. It means that your first $8,025 was taxed at 10%, then everything up to $32,550 was taxed at 15% and everything above $32,551 was taxed at 25%.
Thus, when a Republican administration announces lower taxes, it is lowering the marginal tax rate - and critics grumble that the decrease benefits folks sitting on the higher rungs of the income ladder. Similarly, when Democrats announce an increase to the marginal rate, critics gripe that the increase will burden only high-income earners. (Read The Market And Presidential Promises to see how, no matter who you vote for, announcements like tax changes can affect the markets.)
Tax ReformOf course, filing taxes is never as simple as plugging in your income and calculating your marginal rate. The IRS has bequeathed us a mishmash of regulations, deductions, credits and other magical formulas to thwart our efforts to file a quick federal return. Both political parties agree that the colossal tax code needs to be restructured and simplified. And, of course, each party has its own plan for how to tackle the problem.
The Democrats state that they "will shut down the corporate loopholes and tax havens and use the money so that we can provide a … middle-class tax cut that will offer relief to workers and their families."
The Republicans assert that they "support giving all taxpayers the option of filing under current rules or under a two-rate flat tax with generous deductions for families. Religious organizations, charities and fraternal benevolent societies should not be subject to taxation."
A Recent History of Taxes and SpendingTax policy and the marginal rates we pay have volleyed back and forth, as Republicans and Democrats each took the reins of the White House. Under the Reagan administration, Congress passed the Economic Recovery Tax Act of 1981, which gave a 25%, across-the-board tax cut to individuals in all tax brackets - an act that became associated with the term supply-side economics. Then Congress passed the Tax Reform Act of 1986, which, among other changes, lowered the highest marginal tax rate from 50-28%, and reduced the corporate tax rate.
In 1993, the Clinton administration repealed some of the Reagan tax cuts with the Omnibus Budget Reconciliation Act of 1993, which tacked on 36% and 39.6% marginal tax rates for individuals and a 35% rate for corporations. Note, however, that as inflation fell after the 1981 tax cuts, and the economy began to slow, Reagan agreed to repeal some of his own tax cuts, with the Deficit Reduction Act of 1984. The Reagan and Clinton tax increases served to reign in a budget deficit, which then allowed Clinton to announce a budget surplus of $230 billion in 2000.
Under Clinton, The Taxpayer Relief Act of 1997 offered a new tax benefit to families through the Per-Child Tax credit. This credit was refundable for many lower-income families and began a new trend of individual, refundable tax credits.
Under George W. Bush, in 2001, Congress signed into law a $1.35 trillion tax cut, which gave tax relief to individuals and families, with $300 to $600 rebates, doubled the child tax credit and again dropped the top marginal rate from 39.6-35%. The Bush tax cuts also provided major tax incentives for businesses. The Bush administration followed up with more rebates in the Jobs and Growth Tax Relief Reconciliation Act of 2003. (Not all promises were acted upon in previous years. Read Talk Is Cheap: Campaign Promises And The Economy, to take a look at a couple of past promises, and why they were not implemented.)
Political DogmaConservative think tanks denounce the Democrat tax policy and its Keynesian ideology as wasteful spending that injects only temporary money into the economy, as they praise Republican tax policy for protecting business, investments and personal income. The liberal establishment condemns the Republican tax approach - and supply-side economists - as funneling money only to the wealthy and big corporations, as they commend Democrats for spreading the wealth, supporting small business and reaching out to lower-income workers.
Both sides have their own experts and statistics lined up to support their economic dogma, but tax policy is complicated and tightly interwoven with many other aspects of government. The benefits of one approach may take years to materialize, which can frustrate our ability to distinguish which tax cuts or which tax increases fuel growth. (To learn more about party differences, read our related article For Higher Stock Returns, Vote Republican Or Democrat?)
by Stephanie Barton
Political Ideology: Republican"We believe government should tax only to raise money for its essential functions," the Republicans state their case plainly on the Republican National Convention web site. That is, Republicans believe government should spend money only to enforce contracts, maintain basic infrastructure and national security, and protect citizens against criminals.
The literature of the House Republican Conference goes on to illuminate the role of the government and how tax policies affect individuals: "The money the government spends does not belong to the government; it belongs to the taxpayers who earned it. Republicans believe Americans deserve to keep more of their own money to save and invest for the future, and low tax policies help drive a strong and healthy economy."
Tax relief is the Republican route to growing the economy. A Republican government would reduce taxes for businesses to allow businesses to grow and thus hire more employees. Republicans also seek to limit income taxes for individuals so that people can hold on to more disposable income, which they can then spend, save or invest.
Political Ideology: DemocratThe tax policy for the Democratic Party calls for raising certain taxes to provide money for government spending, which in turn generates business. The party platform asserts that government spending provides "good jobs and will help the economy today."
Many Democrats are adherents to Keynesian economics, or aggregate demand, which holds that when the government funds programs, those programs pump new money into the economy. Keynesians believe that prices tend to stay relatively stable and therefore any kind of spending, whether by consumers or the government, will grow the economy. (Check out Giants Of Finance: John Maynard Keynes, to learn more about Keynes' theories.)
Like the Republicans, Democrats believe the government should subsidize vital services that keep cities, states and the country running: infrastructure such as road and bridge maintenance and repairs for schools. Democrats also call for tax cuts for the middle class. But who benefits most under each platform? The conventional wisdom is that corporations and the wealthy will benefit more with a Republican tax policy while small businesses and middle-class households will benefit from a Democratic tax policy.
A Misunderstood ConceptMany of the quarrels that flare up when people debate tax policy evolve out of misunderstood concepts. Possibly the most misunderstood concept is the tax rate. We hear that a politician wants to raise taxes on income and we cringe, convinced that higher taxes will whittle away every dollar we earn. But we don't pay a flat tax; we pay income taxes on a marginal rate.
The marginal tax rate is the rate you pay on the last dollar of income you earn. For example, if you were single in 2008 and you brought in $50,000, you fell into the 25% tax bracket. But that doesn't mean that every dollar was taxed at 25%. It means that your first $8,025 was taxed at 10%, then everything up to $32,550 was taxed at 15% and everything above $32,551 was taxed at 25%.
Thus, when a Republican administration announces lower taxes, it is lowering the marginal tax rate - and critics grumble that the decrease benefits folks sitting on the higher rungs of the income ladder. Similarly, when Democrats announce an increase to the marginal rate, critics gripe that the increase will burden only high-income earners. (Read The Market And Presidential Promises to see how, no matter who you vote for, announcements like tax changes can affect the markets.)
Tax ReformOf course, filing taxes is never as simple as plugging in your income and calculating your marginal rate. The IRS has bequeathed us a mishmash of regulations, deductions, credits and other magical formulas to thwart our efforts to file a quick federal return. Both political parties agree that the colossal tax code needs to be restructured and simplified. And, of course, each party has its own plan for how to tackle the problem.
The Democrats state that they "will shut down the corporate loopholes and tax havens and use the money so that we can provide a … middle-class tax cut that will offer relief to workers and their families."
The Republicans assert that they "support giving all taxpayers the option of filing under current rules or under a two-rate flat tax with generous deductions for families. Religious organizations, charities and fraternal benevolent societies should not be subject to taxation."
A Recent History of Taxes and SpendingTax policy and the marginal rates we pay have volleyed back and forth, as Republicans and Democrats each took the reins of the White House. Under the Reagan administration, Congress passed the Economic Recovery Tax Act of 1981, which gave a 25%, across-the-board tax cut to individuals in all tax brackets - an act that became associated with the term supply-side economics. Then Congress passed the Tax Reform Act of 1986, which, among other changes, lowered the highest marginal tax rate from 50-28%, and reduced the corporate tax rate.
In 1993, the Clinton administration repealed some of the Reagan tax cuts with the Omnibus Budget Reconciliation Act of 1993, which tacked on 36% and 39.6% marginal tax rates for individuals and a 35% rate for corporations. Note, however, that as inflation fell after the 1981 tax cuts, and the economy began to slow, Reagan agreed to repeal some of his own tax cuts, with the Deficit Reduction Act of 1984. The Reagan and Clinton tax increases served to reign in a budget deficit, which then allowed Clinton to announce a budget surplus of $230 billion in 2000.
Under Clinton, The Taxpayer Relief Act of 1997 offered a new tax benefit to families through the Per-Child Tax credit. This credit was refundable for many lower-income families and began a new trend of individual, refundable tax credits.
Under George W. Bush, in 2001, Congress signed into law a $1.35 trillion tax cut, which gave tax relief to individuals and families, with $300 to $600 rebates, doubled the child tax credit and again dropped the top marginal rate from 39.6-35%. The Bush tax cuts also provided major tax incentives for businesses. The Bush administration followed up with more rebates in the Jobs and Growth Tax Relief Reconciliation Act of 2003. (Not all promises were acted upon in previous years. Read Talk Is Cheap: Campaign Promises And The Economy, to take a look at a couple of past promises, and why they were not implemented.)
Political DogmaConservative think tanks denounce the Democrat tax policy and its Keynesian ideology as wasteful spending that injects only temporary money into the economy, as they praise Republican tax policy for protecting business, investments and personal income. The liberal establishment condemns the Republican tax approach - and supply-side economists - as funneling money only to the wealthy and big corporations, as they commend Democrats for spreading the wealth, supporting small business and reaching out to lower-income workers.
Both sides have their own experts and statistics lined up to support their economic dogma, but tax policy is complicated and tightly interwoven with many other aspects of government. The benefits of one approach may take years to materialize, which can frustrate our ability to distinguish which tax cuts or which tax increases fuel growth. (To learn more about party differences, read our related article For Higher Stock Returns, Vote Republican Or Democrat?)
by Stephanie Barton
Parties For Taxes: Republicans Vs. Democrats
We often boil down the tax policy of our major political parties into its simplest form: Democrats raise taxes to fund social programs, and Republicans lower taxes to benefit big businesses and the wealthy. Both ideas simplify the policy of each party, yet both ideas are essentially true.
Whether you agree with more government spending or tax breaks for corporations, each party's agenda will affect your taxes.
Political Ideology: Republican"We believe government should tax only to raise money for its essential functions," the Republicans state their case plainly on the Republican National Convention web site. That is, Republicans believe government should spend money only to enforce contracts, maintain basic infrastructure and national security, and protect citizens against criminals.
The literature of the House Republican Conference goes on to illuminate the role of the government and how tax policies affect individuals: "The money the government spends does not belong to the government; it belongs to the taxpayers who earned it. Republicans believe Americans deserve to keep more of their own money to save and invest for the future, and low tax policies help drive a strong and healthy economy."
Tax relief is the Republican route to growing the economy. A Republican government would reduce taxes for businesses to allow businesses to grow and thus hire more employees. Republicans also seek to limit income taxes for individuals so that people can hold on to more disposable income, which they can then spend, save or invest.
Political Ideology: DemocratThe tax policy for the Democratic Party calls for raising certain taxes to provide money for government spending, which in turn generates business. The party platform asserts that government spending provides "good jobs and will help the economy today."
Many Democrats are adherents to Keynesian economics, or aggregate demand, which holds that when the government funds programs, those programs pump new money into the economy. Keynesians believe that prices tend to stay relatively stable and therefore any kind of spending, whether by consumers or the government, will grow the economy. (Check out Giants Of Finance: John Maynard Keynes, to learn more about Keynes' theories.)
Like the Republicans, Democrats believe the government should subsidize vital services that keep cities, states and the country running: infrastructure such as road and bridge maintenance and repairs for schools. Democrats also call for tax cuts for the middle class. But who benefits most under each platform? The conventional wisdom is that corporations and the wealthy will benefit more with a Republican tax policy while small businesses and middle-class households will benefit from a Democratic tax policy.
A Misunderstood ConceptMany of the quarrels that flare up when people debate tax policy evolve out of misunderstood concepts. Possibly the most misunderstood concept is the tax rate. We hear that a politician wants to raise taxes on income and we cringe, convinced that higher taxes will whittle away every dollar we earn. But we don't pay a flat tax; we pay income taxes on a marginal rate.
The marginal tax rate is the rate you pay on the last dollar of income you earn. For example, if you were single in 2008 and you brought in $50,000, you fell into the 25% tax bracket. But that doesn't mean that every dollar was taxed at 25%. It means that your first $8,025 was taxed at 10%, then everything up to $32,550 was taxed at 15% and everything above $32,551 was taxed at 25%.
Thus, when a Republican administration announces lower taxes, it is lowering the marginal tax rate - and critics grumble that the decrease benefits folks sitting on the higher rungs of the income ladder. Similarly, when Democrats announce an increase to the marginal rate, critics gripe that the increase will burden only high-income earners. (Read The Market And Presidential Promises to see how, no matter who you vote for, announcements like tax changes can affect the markets.)
Tax ReformOf course, filing taxes is never as simple as plugging in your income and calculating your marginal rate. The IRS has bequeathed us a mishmash of regulations, deductions, credits and other magical formulas to thwart our efforts to file a quick federal return. Both political parties agree that the colossal tax code needs to be restructured and simplified. And, of course, each party has its own plan for how to tackle the problem.
The Democrats state that they "will shut down the corporate loopholes and tax havens and use the money so that we can provide a … middle-class tax cut that will offer relief to workers and their families."
The Republicans assert that they "support giving all taxpayers the option of filing under current rules or under a two-rate flat tax with generous deductions for families. Religious organizations, charities and fraternal benevolent societies should not be subject to taxation."
A Recent History of Taxes and SpendingTax policy and the marginal rates we pay have volleyed back and forth, as Republicans and Democrats each took the reins of the White House. Under the Reagan administration, Congress passed the Economic Recovery Tax Act of 1981, which gave a 25%, across-the-board tax cut to individuals in all tax brackets - an act that became associated with the term supply-side economics. Then Congress passed the Tax Reform Act of 1986, which, among other changes, lowered the highest marginal tax rate from 50-28%, and reduced the corporate tax rate.
In 1993, the Clinton administration repealed some of the Reagan tax cuts with the Omnibus Budget Reconciliation Act of 1993, which tacked on 36% and 39.6% marginal tax rates for individuals and a 35% rate for corporations. Note, however, that as inflation fell after the 1981 tax cuts, and the economy began to slow, Reagan agreed to repeal some of his own tax cuts, with the Deficit Reduction Act of 1984. The Reagan and Clinton tax increases served to reign in a budget deficit, which then allowed Clinton to announce a budget surplus of $230 billion in 2000.
Under Clinton, The Taxpayer Relief Act of 1997 offered a new tax benefit to families through the Per-Child Tax credit. This credit was refundable for many lower-income families and began a new trend of individual, refundable tax credits.
Under George W. Bush, in 2001, Congress signed into law a $1.35 trillion tax cut, which gave tax relief to individuals and families, with $300 to $600 rebates, doubled the child tax credit and again dropped the top marginal rate from 39.6-35%. The Bush tax cuts also provided major tax incentives for businesses. The Bush administration followed up with more rebates in the Jobs and Growth Tax Relief Reconciliation Act of 2003. (Not all promises were acted upon in previous years. Read Talk Is Cheap: Campaign Promises And The Economy, to take a look at a couple of past promises, and why they were not implemented.)
Political DogmaConservative think tanks denounce the Democrat tax policy and its Keynesian ideology as wasteful spending that injects only temporary money into the economy, as they praise Republican tax policy for protecting business, investments and personal income. The liberal establishment condemns the Republican tax approach - and supply-side economists - as funneling money only to the wealthy and big corporations, as they commend Democrats for spreading the wealth, supporting small business and reaching out to lower-income workers.
Both sides have their own experts and statistics lined up to support their economic dogma, but tax policy is complicated and tightly interwoven with many other aspects of government. The benefits of one approach may take years to materialize, which can frustrate our ability to distinguish which tax cuts or which tax increases fuel growth. (To learn more about party differences, read our related article For Higher Stock Returns, Vote Republican Or Democrat?)
by Stephanie Barton
Political Ideology: Republican"We believe government should tax only to raise money for its essential functions," the Republicans state their case plainly on the Republican National Convention web site. That is, Republicans believe government should spend money only to enforce contracts, maintain basic infrastructure and national security, and protect citizens against criminals.
The literature of the House Republican Conference goes on to illuminate the role of the government and how tax policies affect individuals: "The money the government spends does not belong to the government; it belongs to the taxpayers who earned it. Republicans believe Americans deserve to keep more of their own money to save and invest for the future, and low tax policies help drive a strong and healthy economy."
Tax relief is the Republican route to growing the economy. A Republican government would reduce taxes for businesses to allow businesses to grow and thus hire more employees. Republicans also seek to limit income taxes for individuals so that people can hold on to more disposable income, which they can then spend, save or invest.
Political Ideology: DemocratThe tax policy for the Democratic Party calls for raising certain taxes to provide money for government spending, which in turn generates business. The party platform asserts that government spending provides "good jobs and will help the economy today."
Many Democrats are adherents to Keynesian economics, or aggregate demand, which holds that when the government funds programs, those programs pump new money into the economy. Keynesians believe that prices tend to stay relatively stable and therefore any kind of spending, whether by consumers or the government, will grow the economy. (Check out Giants Of Finance: John Maynard Keynes, to learn more about Keynes' theories.)
Like the Republicans, Democrats believe the government should subsidize vital services that keep cities, states and the country running: infrastructure such as road and bridge maintenance and repairs for schools. Democrats also call for tax cuts for the middle class. But who benefits most under each platform? The conventional wisdom is that corporations and the wealthy will benefit more with a Republican tax policy while small businesses and middle-class households will benefit from a Democratic tax policy.
A Misunderstood ConceptMany of the quarrels that flare up when people debate tax policy evolve out of misunderstood concepts. Possibly the most misunderstood concept is the tax rate. We hear that a politician wants to raise taxes on income and we cringe, convinced that higher taxes will whittle away every dollar we earn. But we don't pay a flat tax; we pay income taxes on a marginal rate.
The marginal tax rate is the rate you pay on the last dollar of income you earn. For example, if you were single in 2008 and you brought in $50,000, you fell into the 25% tax bracket. But that doesn't mean that every dollar was taxed at 25%. It means that your first $8,025 was taxed at 10%, then everything up to $32,550 was taxed at 15% and everything above $32,551 was taxed at 25%.
Thus, when a Republican administration announces lower taxes, it is lowering the marginal tax rate - and critics grumble that the decrease benefits folks sitting on the higher rungs of the income ladder. Similarly, when Democrats announce an increase to the marginal rate, critics gripe that the increase will burden only high-income earners. (Read The Market And Presidential Promises to see how, no matter who you vote for, announcements like tax changes can affect the markets.)
Tax ReformOf course, filing taxes is never as simple as plugging in your income and calculating your marginal rate. The IRS has bequeathed us a mishmash of regulations, deductions, credits and other magical formulas to thwart our efforts to file a quick federal return. Both political parties agree that the colossal tax code needs to be restructured and simplified. And, of course, each party has its own plan for how to tackle the problem.
The Democrats state that they "will shut down the corporate loopholes and tax havens and use the money so that we can provide a … middle-class tax cut that will offer relief to workers and their families."
The Republicans assert that they "support giving all taxpayers the option of filing under current rules or under a two-rate flat tax with generous deductions for families. Religious organizations, charities and fraternal benevolent societies should not be subject to taxation."
A Recent History of Taxes and SpendingTax policy and the marginal rates we pay have volleyed back and forth, as Republicans and Democrats each took the reins of the White House. Under the Reagan administration, Congress passed the Economic Recovery Tax Act of 1981, which gave a 25%, across-the-board tax cut to individuals in all tax brackets - an act that became associated with the term supply-side economics. Then Congress passed the Tax Reform Act of 1986, which, among other changes, lowered the highest marginal tax rate from 50-28%, and reduced the corporate tax rate.
In 1993, the Clinton administration repealed some of the Reagan tax cuts with the Omnibus Budget Reconciliation Act of 1993, which tacked on 36% and 39.6% marginal tax rates for individuals and a 35% rate for corporations. Note, however, that as inflation fell after the 1981 tax cuts, and the economy began to slow, Reagan agreed to repeal some of his own tax cuts, with the Deficit Reduction Act of 1984. The Reagan and Clinton tax increases served to reign in a budget deficit, which then allowed Clinton to announce a budget surplus of $230 billion in 2000.
Under Clinton, The Taxpayer Relief Act of 1997 offered a new tax benefit to families through the Per-Child Tax credit. This credit was refundable for many lower-income families and began a new trend of individual, refundable tax credits.
Under George W. Bush, in 2001, Congress signed into law a $1.35 trillion tax cut, which gave tax relief to individuals and families, with $300 to $600 rebates, doubled the child tax credit and again dropped the top marginal rate from 39.6-35%. The Bush tax cuts also provided major tax incentives for businesses. The Bush administration followed up with more rebates in the Jobs and Growth Tax Relief Reconciliation Act of 2003. (Not all promises were acted upon in previous years. Read Talk Is Cheap: Campaign Promises And The Economy, to take a look at a couple of past promises, and why they were not implemented.)
Political DogmaConservative think tanks denounce the Democrat tax policy and its Keynesian ideology as wasteful spending that injects only temporary money into the economy, as they praise Republican tax policy for protecting business, investments and personal income. The liberal establishment condemns the Republican tax approach - and supply-side economists - as funneling money only to the wealthy and big corporations, as they commend Democrats for spreading the wealth, supporting small business and reaching out to lower-income workers.
Both sides have their own experts and statistics lined up to support their economic dogma, but tax policy is complicated and tightly interwoven with many other aspects of government. The benefits of one approach may take years to materialize, which can frustrate our ability to distinguish which tax cuts or which tax increases fuel growth. (To learn more about party differences, read our related article For Higher Stock Returns, Vote Republican Or Democrat?)
by Stephanie Barton
Jobless Recovery: The New Normal Since 1990
Economist Nick Perna coined the phrase "jobless recovery" following the recession of 1990-1991 to describe a situation in which the economy recovered from a recession but the job market does not. In 1990, this phenomenon was a new development. In the decades following, with numerous fluctuations in the economic cycle, 1990 is now viewed as the beginning of the new normal.
The History and the NumbersPrior to 1990, the unemployment that accompanied economic downturns began to reverse itself, shortly after the recessions reached their troughs as employers began to recall workers. The cycle was broken after the recession that took place from July 1990 to March 1991, as unemployment continued to rise even after the recession ended, and did not rebound to pre-recession levels until 1997.
The new pattern continued in the aftermath of the recession that took place at the beginning of the new millennium, following the collapse of the dotcom bubble. Unemployment continued to rise following the end of the recession, and pre-recessionary employment levels were not revisited, even prior to the start of the next recession. Before the global financial industry experienced a meltdown in 2008, unemployment continued to fluctuate around the levels witnessed in the previous recession.
CausesWhy did a cycle that held true for decades change? Why doesn't employment rebound following a recession? The experts cite a variety of causes, including structural changes in the economy and increased worker productivity. Globalization is one well-known factor, as jobs once based in the United States are sent overseas to lower-paying labor markets. (The Globalization Debate provides a closer look at thistopic.)
Executive compensation is another factor. Since the 1980s, executive pay has been increasingly linked to stock options. A high stock price is directly related to high personal profits for the CEO, so labor costs must be minimized to maximize profits and keep the price of the stock rising. (To learn more about executive compensation, see Reining In CEO Rewards and Lifting The Lid On CEO Compensation.)
It's simply a case whereby a minority of the population has strong financial incentive to act in their own best interests. In colloquial terms, those benefiting from the arrangement would say that it is capitalism at work, while the opposing view would say that the rich get richer at the expense of the middle class and the poor.
Consumer behavior also plays a role. Consumers want to spend as little as possible when they shop. By choosing to purchase less expensive imported goods rather than more expensive domestically produced goods, they minimize their expenses. Here again, there is a financial incentive to act in their own self interest. The down side of this behavior is that the money they spend creates jobs overseas and simultaneous unemployment at home. Although there is much debate regarding whether or not opening domestic borders to international exports reduces jobs, some economists justify a jobless recovery with the preceding logic. The significant presence of imported clothing, cars, steel and other items once produced domestically supports the argument with regard to a variety of formerly high-paying manufacturing jobs. In more recent years, the outsourcing of white-collar jobs from engineering and computer programming to journalism and radiology has also attracted significant attention.
Technology and increased productivity are also considerations. As companies demand greater productivity from workers and replace manual processes with machines, fewer employees are required to complete the necessary tasks. Jobs that once required an assembly line filled with workers are now done by automatic processing technologies. Manufacturing plants that once employed hundreds of workers now require only a few highly skilled technicians to monitor the process.
The nature of the recessions themselves is something else to consider. From 1969-1982, recessions typically occurred when the Federal Reserve raised interest rates to control inflation. In the more recent downturns, economic bubbles and other factors beyond the Fed's control contributed to the malaise.
When these factors are combined, white collar workers begin to experience what blue-collar workers in the steel and auto industries had been living with for years. The dynamics of employment change. Layoffs and call backs that once ebbed and flowed in response to supply and demand become permanent. It's not that workers can't find jobs, but rather that those jobs no longer exist.
Impact: Financial Planning and Investment Implications Looking to the future, none of the factors that lead to jobless recoveries are going away. Long-term unemployment following economic downturns is likely to be an expected outcome. With this in mind, there are some steps you can take to prepare for this environment.
The first is to live below your means, so that you are not financially devastated by the temporary loss of a job. Working a second job is also a consideration. Having another source of reliable income provides a safety net should your primary source of income disappear. (5 Signs That You're Living Beyond Your Means will help you evaluate your current spending habits, and Two Roads: Debt Or Financial Independence? provide additional information.)
You might also consider a more flexible approach to your job search. While people are often reluctant to relocate, willingness to move can be an advantage if there are no jobs where you currently live. (Once you've made the commitment to watch your spending, The Beauty Of Budgeting will help you accomplish your task.)
Conclusion
During economic downturns, consumers do tighten their belts, but some purchases (food, water and toilet paper for instance) cannot be avoided. When times are tough, firms that sell life's necessities tend to fare better than firms that sell discretionary items. It is often in these industries where job safety can be ensured, despite stagnating economic activity.
by Lisa Smith
The History and the NumbersPrior to 1990, the unemployment that accompanied economic downturns began to reverse itself, shortly after the recessions reached their troughs as employers began to recall workers. The cycle was broken after the recession that took place from July 1990 to March 1991, as unemployment continued to rise even after the recession ended, and did not rebound to pre-recession levels until 1997.
| Unemployment prior to and following the recession of July 1990-March 1991 | |
| Year | Unemployment Rate |
| 1989 | 5.3% |
| 1990 | 5.6% |
| 1991 | 6.8% |
| 1992 | 7.5% |
| 1993 | 6.9% |
| 1994 | 6.1% |
| 1995 | 5.6% |
| 1996 | 5.4% |
| 1997 | 4.9% |
| Unemployment prior to and following the recession of March 2001-November 2001 | |
| Year | Unemployment Rate |
| 2000 | 4.0% |
| 2001 | 4.7% |
| 2002 | 5.8% |
| 2003 | 6.0% |
| 2004 | 5.5% |
| 2005 | 5.1% |
| 2006 | 4.6% |
| Unemployment prior to and following the recession of December 2007-November 2010 | |
| Year | Unemployment Rate |
| 2006 | 4.6% |
| 2007 | 4.6% |
| 2008 | 5.8% |
| 2009 | 9.3% |
| 2010 | +9.5% |
Executive compensation is another factor. Since the 1980s, executive pay has been increasingly linked to stock options. A high stock price is directly related to high personal profits for the CEO, so labor costs must be minimized to maximize profits and keep the price of the stock rising. (To learn more about executive compensation, see Reining In CEO Rewards and Lifting The Lid On CEO Compensation.)
It's simply a case whereby a minority of the population has strong financial incentive to act in their own best interests. In colloquial terms, those benefiting from the arrangement would say that it is capitalism at work, while the opposing view would say that the rich get richer at the expense of the middle class and the poor.
Consumer behavior also plays a role. Consumers want to spend as little as possible when they shop. By choosing to purchase less expensive imported goods rather than more expensive domestically produced goods, they minimize their expenses. Here again, there is a financial incentive to act in their own self interest. The down side of this behavior is that the money they spend creates jobs overseas and simultaneous unemployment at home. Although there is much debate regarding whether or not opening domestic borders to international exports reduces jobs, some economists justify a jobless recovery with the preceding logic. The significant presence of imported clothing, cars, steel and other items once produced domestically supports the argument with regard to a variety of formerly high-paying manufacturing jobs. In more recent years, the outsourcing of white-collar jobs from engineering and computer programming to journalism and radiology has also attracted significant attention.
Technology and increased productivity are also considerations. As companies demand greater productivity from workers and replace manual processes with machines, fewer employees are required to complete the necessary tasks. Jobs that once required an assembly line filled with workers are now done by automatic processing technologies. Manufacturing plants that once employed hundreds of workers now require only a few highly skilled technicians to monitor the process.
The nature of the recessions themselves is something else to consider. From 1969-1982, recessions typically occurred when the Federal Reserve raised interest rates to control inflation. In the more recent downturns, economic bubbles and other factors beyond the Fed's control contributed to the malaise.
When these factors are combined, white collar workers begin to experience what blue-collar workers in the steel and auto industries had been living with for years. The dynamics of employment change. Layoffs and call backs that once ebbed and flowed in response to supply and demand become permanent. It's not that workers can't find jobs, but rather that those jobs no longer exist.
Impact: Financial Planning and Investment Implications Looking to the future, none of the factors that lead to jobless recoveries are going away. Long-term unemployment following economic downturns is likely to be an expected outcome. With this in mind, there are some steps you can take to prepare for this environment.
The first is to live below your means, so that you are not financially devastated by the temporary loss of a job. Working a second job is also a consideration. Having another source of reliable income provides a safety net should your primary source of income disappear. (5 Signs That You're Living Beyond Your Means will help you evaluate your current spending habits, and Two Roads: Debt Or Financial Independence? provide additional information.)
You might also consider a more flexible approach to your job search. While people are often reluctant to relocate, willingness to move can be an advantage if there are no jobs where you currently live. (Once you've made the commitment to watch your spending, The Beauty Of Budgeting will help you accomplish your task.)
Conclusion
During economic downturns, consumers do tighten their belts, but some purchases (food, water and toilet paper for instance) cannot be avoided. When times are tough, firms that sell life's necessities tend to fare better than firms that sell discretionary items. It is often in these industries where job safety can be ensured, despite stagnating economic activity.
by Lisa Smith
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