The perfect financial storm: getting ready
to weather an economic downturn
By Laura A. Bruce and Michael D. Larson • Bankrate.com

July 19, 2000 -- You have a good job; not saving as much as you should, but now's the time to get a new car while the getting is good.

"...U.S. manufacturing activity grew in June at its slowest rate in a year and a half ..."

The market's been great, your 401(k) is looking fat -- why not tap it for a loan? After all, you'll be paying yourself interest.

"... a record $4.5 trillion in debt has been accumulated by U.S. nonfinancial corporations ... "

Man, a week in the Bahamas this winter sounds good.

"... the Federal Reserve has raised rates six times since last June ..."

In a financial sense we're a lot like the crew of the Andrea Gail heading out to sea on a beautiful day: What could go wrong? The economy looks unstoppable. It's a different world than it was in '87. That kind of crash couldn't happen again, can it? OK, there are signs of inflation, but Alan Greenspan and his gang at the Federal Reserve Board will nip that.

Maybe. Or maybe they'll sink us.

In The Perfect Storm, three weather factors united as one storm, reigniting a dying hurricane into a monster that sank a now-famous swordfish boat, killing its six-man crew after pounding them for hours.

We've been getting pounded due to a combination of three factors, too. Banks and other commercial lenders have been too quick to lend money. Consumers and businesses have been too quick to scoop it up and spend it, and the Fed's emergency response has been to make borrowing more and more expensive.

So here we are: the stock market has been making us seasick, interest rates are up, filling the gas tank costs a small fortune -- but we're still spending like drunken swordfishermen home for a week's leave. What happens if the economy goes south? What if the Greenspan gang goes too far and the economy slows too much? People could lose their jobs. How many paychecks could you miss before getting in trouble?

Inflation on the horizon
What's wrong with everyone having a job and spending money? If I spend some of my paycheck on something your company makes, that keeps you employed. So how come Wall Street does everything but pop a champagne cork when unemployment rises? Why is Alan Greenspan so interested in keeping our paychecks as small as possible?

The answer, of course, is fear of the dreaded inflation. Everybody spends a lot of money, prices go up and poof! -- we're paying too much for things. Greenspan is trying to tap the brakes on that potentially nasty scenario without coming to a screaming stop -- something that could spin the economy in the opposite direction, a recession. Businesses feel the pinch of those interest rate hikes, start laying off people, people stop paying their bills and we've got trouble!

How do we, the consumers, fit into this picture -- what are we doing wrong? Stephen Barnes, certified financial planner at Barnes Investment Advisory in Phoenix, says our spending and saving pattern is out of whack.

"There are two meaningful things I've seen -- higher consumer spending and a substantial reduction in savings out of current income," says Barnes. "Both are the result of the wealth effect. The better your investments do, the more secure you feel and the more you spend, the less you save."

It doesn't matter what your income is. If you don't save, you're going to rely on credit during bad times to buy essentials and maybe even to pay bills. You could dig yourself a hole that will take years to get out of.

Oddly enough, it can be harder, emotionally, to save when times are good and paychecks are steady. You feel as though your job is secure and, heck, even if you lose it or quit, plenty of companies are begging for good employees. "I'll save later, I want a DVD player now!"

Barnes says: get real.

"People kid themselves into believing 'I'm young, I'm starting out, it's OK to have the things the family wants.' There are no excuses. There are only two ways to get rich -- spend less than you make or inherit family money."

Check your family tree.

The perils of too much debt
While consumers have been spending too freely, complicit lenders have aided and abetted their binge. In the hunt for ever-increasing profits, banks, mortgage companies and the Wall Street financing machines that feed them have loosened lending restrictions and come up with other aggressive methods to separate Americans from their money.

Some financial experts worry they've dug so deep that even a mild economic slowdown or recession could bring many institutions to their knees under a wave of consumer defaults, bankruptcies and foreclosures.

"If we have a downturn, especially a severe downturn, then we've got a serious problem," says David Olson, managing director at Wholesale Access, a subprime mortgage and home-equity lending research firm based in Columbia, Md.

"Over the past 10 years, people have gotten loans that never would have gotten loans in the past and they are paying much less than in the past," he adds. "You're taking on people who are fundamentally more unstable and it doesn't take much for them to go into default. It's clearly higher risk."

So just how far will lenders go? Consider this e-mail credit card solicitation from mid-July:

"Charge Offs? No Pays? Slow Pays? No Credit? -- NO PROBLEM! You can establish or re-establish your credit with a brand new MasterCard in your name. There are NO Credit Checks and NO Credit Turndowns plus GUARANTEED* Instant Online APPROVAL!"

Visitors who leave the company's Web site see a new browser window launch with the header:

"Online Credit NOW >> Because Everybody Deserves Credit."

Mortgage lenders in for rough seas
But credit card lenders aren't the only ones pushing the envelope. Mortgage companies have stretched themselves too, experts say, even though they have thousands more dollars on the line. Lenders long ago abandoned the 20 percent down payment requirement of yesteryear. Today, consumers can buy houses at conventional rates without putting a penny down -- and even get an extra 3 percent to cover closing costs. Those who want to go even further can pay more and get home equity loans that raise their overall debt level to 125 percent of the value of their properties.

Brokers also prowl industry message boards looking for companies willing to loan to people with recent bankruptcies, foreclosures, late mortgage payments and collections accounts. They aren't disappointed either, because wholesale lenders these days dole out money at lower rates and on less onerous terms than ever before. As a result, some consumers have borrowed more money than they'll ever be able to pay back if the economy falters.

"If you were a kid in a candy store and the owner said, 'You can have any candy you want,' wouldn't you take it?" asks Randolph J. Shine, a certified financial planner with Shine Financial Inc. in Deerfield Beach, Fla.

"All these are appealing to the hedonistic concept that we have brought about to ourselves over the last 10 years."

Fueling the lending machine
The secondary market, where banks and mortgage companies can go to replenish their money supply, has helped fuel the lending machine and shift some loan risk to investors. But some are concerned the system still poses a threat to lenders and the economy.

Fannie Mae and Freddie Mac buy loans from lenders so they can either hold them in their portfolios or package them together into mortgage-backed securities for sale to Wall Street investment firms. The industry calls the process securitization. Anything that meets Fannie Mae's and Freddie Mac's purchase criteria is considered "conforming" and therefore has the best rates available in the market.

As long as homeowners make their payments on time, the system works well by lowering everyone's cost of borrowing and making loans. But over the past five years or so, the agencies have consistently lowered the underwriting bar to get more people into homes. Now, loans with 3 percent down or less can qualify for purchase. Lenders say that higher debt-to-income ratios and credit glitches don't pose a problem the way they once did, either.

For their part, the agencies say that their computerized underwriting systems allow them to extend their definition of conforming without jeopardizing their financial standing. That's because the systems supposedly measure risk better and allow strength in one area of an applicant's file to compensate for weakness in another.

Yet Shine wonders why, if the loans are so good, banks, lenders and the agencies are so eager to sell so many of them off to investment firms and the everyday investors who trust those firms' mutual funds and pension funds with their savings.

"The banks have serialized the money and they've gotten rid of it to the public," he says. "But nobody asks why the banks are serializing these things."

Sinking subprime industry
What happens when the securitization process breaks down? Look no further than the subprime lending industry. Since 1998, many lenders who thrived on making loans to weak-credit borrowers and selling them off have folded or sold themselves to larger players. That's because demand for their subprime securities dried up due to market turmoil almost two years ago. Many companies misjudged their loans' risk, too. Now that thousands of those less-than-perfect loans are reaching the point in their terms where defaults historically peak -- roughly 18 months to five years after origination -- the fallout has begun.

"The problem loans from those periods are beginning to show up now and you're really beginning to see an escalation in the rates of (subprime) delinquency and losses," says Shiv Rao, a vice president at Moody's Investors Service in New York. He tracks the performance of securities made up of bundled subprime and home equity loans.

"Many lenders underestimated or did not correctly estimate the credit risk of the loans they were originating."

Lax mortgage lending isn't the only problem facing financial institutions. Several banks have warned recently that they've had to boost reserves against loan losses due to loans going sour. Among the victims: First Union Corp. and Wachovia Corp., the nation's fourth- and 15^th-biggest banks by assets, respectively. First Union said it would sell $900 million in bad loans, taking a $155 million loss on the sale, and boost its loan loss reserve by $260 million. Wachovia took a $200 million second-quarter charge to cover its problems.

First Union also decided to shut down its Money Store subprime loan division, which it had just bought in 1998 for $2.1 billion. A National Mortgage News front-page headline about the development read, "Worst Deal in Mortgage History?"

Loan losses are only part of the problem, though.

Low deposit, few returns
Consider that banks can get money for loans from a variety of sources, including other banks in the Federal Reserve Board system, Federal Home Loan Bank advances, loan securitizations and depositors. Traditionally, they have relied heavily on depositors because they can pay those depositors one rate, then turn around and loan that low-cost money out at a higher rate to borrowers, making money off the interest rate spread.

With interest rates falling during the second half of the 1990s, however, banks found it more profitable to get money from other sources. Many stopped paying depositors a decent yield because they didn't need their money as much, and as long as rates stayed low, it didn't matter. As a result of this process, core deposits shrunk to 47 percent of bank assets in 1999 from 62 percent in 1992, according to Federal Deposit Insurance Corp. figures cited in a June Community Banking article.

But now that the Fed is hiking rates, banks are feeling the pinch. They don't have as much depositor money to draw upon at the same time that borrowing money in the financial markets has gotten more expensive. Many have low-rate loans that haven't matured, too, meaning the margin between the rate at which they can borrow money and the rate at which they leant it out has narrowed. All of this erodes profit and jeopardizes bank bottom lines.

"Deposits, or rather the lack of them, lie at the root of banks' margin woes," the Community Banking article reads.

The case for optimism
Will the banking, mortgage and credit card industries collapse as a result of their recent practices, dragging borrowers and savers down with them? Experts certainly don't think so unless there's a serious recession. Most say that's an unlikely outcome too because jobs remain plentiful, the Fed seems to be wrapping up its rate hikes and inflation hasn't gotten out of control. So far, numbers bolster the optimist case.

The seasonally adjusted delinquency rate for residential mortgages fell 34 basis points between the first quarter of 1999 and the first quarter of this year, according to the Mortgage Bankers Association of America. At 3.72 percent, it's the lowest since the second quarter of 1972 -- almost three decades ago. That suggests most borrowers with decent credit aren't having trouble making their payments, yet.

"Really, what's behind that is the refinance wave from 1998 into early 1999," says Brian Carey, an MBAA economist. "It helped to bring the delinquency rate down and, more recently, the economy has been as strong as ever and that's helped bring it down further.

"The unemployment rate is at 30-year lows, so basically everyone who wants a job basically has a job."

Other types of consumer loans have performed well, too. The American Bankers Association found that only 2.14 percent of closed-end consumer loans, such as auto and home equity loans, were 30 or more days overdue in the first quarter of this year. That's in line with last year's delinquency rate and down several basis points from the rates seen in 1997 and 1998.

It comes down to jobs
"I think, ultimately, you have to say the strong economy has really been something that's been beneficial to consumers," says Keith Leggett, an ABA senior economist. "One of the strongest indicators with regard to performance deals with job growth. As long as job growth remains healthy, that is going to cause delinquencies to remain fairly favorable."

Still, there are signs unemployment may start to rise in the next several months. Monthly growth in private sector employment has already tapered off to an average of 177,000 this year from 202,000 during 1999, according to recent figures from the Bureau of Labor Statistics. Because Fed rate hikes take time to reverberate through the economy, more companies could curtail hiring in the future as well. That could leave marginal borrowers and even some better-off ones scrambling if they don't prepare now.

"I look at people who are up against the wall in the greatest expansion in history and they can't make their payments," says Shine, the South Florida CFP.

In over his head
One client he's dealing with now bought a $180,000 home for just 3 percent down a few years back. A techie with 17 years of experience who can program in four computer languages, the client was in the financial sweet spot, making $72,000 a year -- until recently, when he lost his job. Because many other workers have hit the streets recently thanks to problems in the technology and dot-com sectors of the economy, he had to take a position that pays $20,000 less. Now he's trying to figure out how to make his mortgage payments.

"It kind of put him into a place where he can't afford his house," Shine says. "As long as he was making the bucks, things were OK. But if you multiply this event a thousand times, if we have a slowdown, how many people are going to walk away from their homes?"

So heed the warning signals. Look at some of the signs that are saying a big problem could be ahead, then see what you can do to build a financial future that can withstand the perfect storm and help you make it safely through the dark and stormy seas. Come back tomorrow for some ideas.

-- Posted: July 19, 2000