Financial Markets Questions

[adciv]

Ok, it seems we've got enough things going on today, between the financial crisis and a few other things. So, I'm starting this thread for questions into how they work or are supposed to work. Continuing from before.

Why was it so low in 2003-2004, when the economy was doing (or at least seemed to be doing) fairly well?

Ok, here's basically how the Federal Reserve target rate (among other things) is used.

There are two things the Federal Reserve worries about, inflation and growth. There job is to minimize the former and encourage the latter. Raising the target rate lowers inflation and growth. Lowering the target encourages inflation and growth.

If inflation is getting high and growth is not being worried about, they raise the rate.
If growth is slowing and inflation is of less concern, they lower the rate.

The fact that the rate was so low in 2003-2004 is because we were still coming out of the 2001 drop. Comparing two different dates purely in the interest rate is meaningless. It is possible to have the rate at 3% and (inflation at 10% and growth at 2%) or (inflation at 2% and growth at 10%), it all depends on the economy at the time. The rate is used as one of the levers to try to control the economy and inflation. The Federal Reserve generally tries to control inflation to remain under 2% (I believe). Lowering the rate increases the money supply, raising the rate decreases the money supply.

There is another thing the Federal Reserve controls, and that is what portion of a banks deposits they are allowed to lend out. Currently, the FDIC insured banks are allowed to lend out ~88%-90% of their deposits. If the Fed needs to enlarge the money supply, they can lower this number. If they want to shrink the money supply, they raise the number. However, the Fed does not like to change this number often. It is more of a 'coarse' control where the Fed Rate is more of a fine tuning control.

[collegestudent22]

Thanks for that. Now I get it.

Also, if someone can explain. How exactly does the bailout affect the economy here in the US?

And why are the markets so volatile right now? (i.e. why does the market vary so much during the day = -200 to +500 and back again in one day)

[adciv]

Ok, starting with the bailout. There are three main portions of it. The first is to stabilize the financial system by stabilizing and solodifying the main banks. To do this, they are loaning the banks money (and taking major stakes in them). This is to keep them from going under and having to pay out from the FDIC insurance fund. Additionally, for other main financial instutions, they will loan them money to keep disorderly failures from happening. Orderly failures are fine (basically, selling the company over months), disorderly (here today, gone tomorrow) are not.

Another part of this is to get interbank lending and the credit markets moving again. This is what drives business. If a company can not get a loan, they generally can not buy something. Home heating oil distributers are having trouble. They can not get a loan to pay the refiners, and a lot of the home owners are late on payments and winter is coming. You start having problems when you run low on money. Companies also borrow money to finance operations, expansion and other things. They also need to re-fianance to extend existing loans. Not being able to do this causes a cash crunch that leads some companies to (s)lower job growth and others to job cuts.

The last thing is to address the root of the problem, the TARP fund (Troubled Assets Relief Program). Basically, the Treasury/Federal Reserve (Sorry, I forget which) will act like Fannie and Freddy (only more responsibly), buying and insuring loans. The idea being that the Government can have much more patience with this than any troubled company can right now, partly due to funding requirements.[1] The Government[2] will buy the assets at a discount and pay cash. This will get the assets off the ballance sheets and get money flowing in the market. As the items generate money, the Government gets what it paid back. Also, when the markets recover, it can sell them if it so chooses [3].

[1a] Remember loaning out that 88-90% I mentioned above? The remaining 10-12% has to be either cash or cash equivalent. Treasuries count as cash equivalent. This program is designed to help transfer some of the 88-90 to the 10-12.
[1b] A screwy thing with this is the market-to-market accounting rule. Basically, the banks have to have a total of how much their assets are worth at the end of each trading day. How much is a mortgage worth if you can't sell it? It is not worthless, as it is generating income from the mortgage payments. Or what happens if you don't know the actual value, but know it is above the current fire-sale prices that everything is trading at?
[2] Private Companies are supposed to be encouraged to participate. A lot are not right now, due to various things. They hope private companies will also participate, getting the market for the mortgages working again. Fannie and Freddie accounted for ~50% of the market before all this.
[3] Or it can just wait until the mortgages are all paid back. The length on this depends on how much time is left on the mortgage.

Now on valitility. The markets are volatile as everyone is nervous. Anyone generating cash right now is God, those who are in dire need of it are leppers. Also, earnings are uncertain. Earnings as a whole are going to go down, this lowers the price of stocks. Those who are meeting, or exceeding, earnings expectations are going up. Pretty much, the market is trying to figure out how much everything is worth and it is taking a while.

Additionally, you have to problems leading to further volatility. First, a lot of people are pulling out. This causes stocks to be sold, forcing the prices lower. Second, a lot of funds (mutual, hedge, other) are de-leveraging. Leveraging is this, I put up $1,000 my broker allows me to buy $10,000 of stock. The broker charges interest based on the difference. I am fine so long as the price goes up, if it goes down, I have a margin call where I either have to put up more money to make up the difference or sell stock (de-leveraging). A leverage ration is defined as the amount of cash or collateral you have put up in relation to the price of stock. Some funds were leveraged at 40-to-1. That is, they had 40 times the value of stock than they had collateral for. They are currently de-leveraging down to 10-to-1, the norm for the past 100 years. This sell off has depressed the price as they have been forced to sell to deleverage. Basically, fire sale to get money they need.

Also, people are nervous about who will win the election. Nervous about what the government is going to do and who will benefit. Nervous about what companies are going to survive and who is in trouble.

[ampersand]

Okay, speaking of economics, I read where some analysts are thinking that the interest rate might need to be slashed to 0% in order for the markets recover. A) Would they even consider this? B) How would this effect the other rates (credit card/debt interest rates, savings account rates, etc.)?

Japan did this, and it's hurt their central bank badly. I remember when there was a worry about Japan buying up everything in the United States; that lasted until the late 1980s, when their economy imploded as their commercial real estate market collapsed (sound familiar?). They kept lowering rates until they got to zero, and had no maneuvering room, because every bit of talk about raising it to even a quarter percent sent shudders through the financial market.

That wasn't the only bad decision, but it had psychological effects ("nothing else we do is going to work!") and economic effects (some shaky deals went through because credit was so cheap). Even a marginal cost of a service makes people stop and think for a moment whether they really need it. That's one of the reasons why even some of the most expensive health plans have a $5 or $10 copay for an office visit. That minimal cost actually does deter patients from using the service as much as they otherwise might.

I remember reading a lot about this (and if I recall correctly Japan still hasn't fully recovered from that crash) which makes me wonder if such a move would be a wise decision. That brings me to another question: my parents could not afford to develop a savings plan into their budget because they had a paradigm of that there was no way with their meager income they could actually set aside anything to save other than for necessities. (This is why my mother will probably work until she dies at the age of 90.) Is it possible to develop a savings plan for even the most meager of budgets (let's say someone working the federal minimum wage working 40 hours a week and no more)?

I will note that in my parent's case, since their own their own farm, they paid themselves as little as possible so that the farm could prosper to the point where they could afford to pay themselves more, but that wasn't possible until the year 2000. But, a lot of what they did have actually belonged to the farm (including their current home).

[adciv]

Too many possible variables to say for sure one way or another. One alternative to look into though, is having the farm pay your parents through a dividend rather than as a salary. Depending on the numbers, it could lower the taxes. (It bypasses medicare and social security, for starters)

[ampersand]

Okay, so the Federal Reserve has cut the Overnight Target Interest Rate to 0.25%. Any lower, it would be at zero and it couldn't go any lower. And there's talk that this won't help because banks and consumers are hoarding it instead of lending or spending it (basically no one trusts anyone at this point and it's every pillow for himself). So, I have to ask, what the hell else could the Federal Reserve do at this point? Is it basically up to the mercy of an Obama Administration? Are we looking at the modern version to the New Deal? Reflate the economy (which I don't know what it means but it sounds like artificially causing inflation to happen)?

2009 is definitely going to be a very rough year.

[adciv]

There are two things I can think of off the top of my head. The first is reducing the fractional funds rate, the percentage of assets the banks must keep on hand to how much they lend out. The 2nd is putting money directly into the credit markets by buying up short term bonds. Look at what the Libor (London Interbank Offered Rate) does today to see how much of an effect this has.