October 13, 2008
Opinion: The sky is not falling
by Michael Parker, Professor of Finance
Key questions to ask: what is the crisis all about, how did we get to this point, why is it so big and what should we do? The bright spot in all of this chaos is northern Louisiana is in a unique position to weather this storm in relatively good shape.
The financial crisis is actually a crisis in the credit market that has spilled over into the stock market. Fear, uncertainty and non-stop press coverage have fueled the problem. It all began in the 1980s with rounds of market deregulation under the Reagan administration. Wall Street responded with development of exotic instruments, and we began an unprecedented period of economic expansion.
Under the Clinton administration, initiatives were put into place to get more people into their own homes. All of this activity, coupled with low interest rates, led to soaring housing prices and everyone from Wall Street to Main Street making heavy use of debt.
Over the last 12 months, 43 percent of households have spent more than they made. The average college freshman is $2,000 in debt, and by graduation the average college student owed $21,000. To add to the problem, average U.S. households have $14,000 in consumer debt with the average credit card balance being about $8,000.
All of the above facts and figures can be debated, but one thing is evident: Not one political party or one group has gotten us into this. In placing blame, do we blame Wall Street, politicians, lenders, Realtors or ourselves? I like to make an analogy of drug dealers and drug users. Who causes the drug problem? It's a matter of perspective.
The economic shine began to fade when housing prices began to dip. With falling prices people began defaulting on mortgages and the value of mortgage-backed securities held by Wall Street firms plummeted. These firms became strapped for cash, which caused big players in the Credit Default Swap market such as AIG to get squeezed.
All of this fear eventually caused banks to tighten their credit to each other leading to a general paralysis in the credit market.
How frozen? McDonald's Corp. was turned down for a loan by Bank of America in late September. All of this news spooked investors who began pulling out of the stock market for no other reason than fear and misunderstanding.
Why has this gotten so big? Fear, sensational new stories and conflicting advice are all contributors. Fear derives from the fact that you may be dealing with your life savings with incomplete information. Bloggers are busy predicting that we are facing another 1929 scenario. In fact, this is extremely unlikely with the presence of FDIC Insurance, stock market circuit breakers and the Federal Reserve playing an active role in the financial system.
Sensational news stories are another aggravating factor. Not only are stories sometimes sensationalized, but they are constantly available on any small slice of the crisis. For example, early last week the Dow experienced its biggest one-day points loss in history. This was reported as if the sky were falling. The fact is that it was only a 6 percent decline, which was not even close to the 22 percent drop we saw in 1987.
If the Dow declines, that does not mean your investment has declined by a dramatic amount. The Dow is a broad market indicator and not a specific investment indicator.
Conflicting information also contributes to this crisis. We are bombarded with people giving us financial advice, which is usually worth what you pay for it. We have so-called experts giving us mixed signals. Some groups are urging people to sell, while others are saying buy as much stock as you can afford right now. The problem is this conflicting advice fuels fear and generates large amounts of news. The key thing to remember is general advice is not tailored to your specific situation.
What should you do?
Reassure yourself. You should take comfort in knowing that our Louisiana banks are strong; the last Louisiana bank failure happened in 2002.
Area-wide, our housing prices haven't collapsed like the rest of the country.
Finally, the stock market always bounces back, exhibiting an average positive return over the past 78 years.
You should educate yourself, avoid making emotional financial decisions and begin working to get out of debt.