Last week, the stock market dropped the most in a single day since directly after Sept. 11. Lehman Brothers closed its doors. And if AIG had not received the largest government bailout of a private company in U.S. history, it too would have collapsed.
We are in the middle of the biggest financial crisis of our times. The crisis is very real, and it is very scary.
Some Brown students may feel like they are insulated from the crash because they will not enter the job market for at least another 3 years. But they aren't. This crisis will directly affect our financial condition in the next decade. And although Washington seems to be taking some steps to mitigate the impact of the collapse, a sound financial future begins with habits we develop on College Hill.
What happened? Although there is not complete consensus among experts, it seems the major source of the downturn is a slump in housing prices that began in 2006. Many financial institutions, fueled by a dangerous mix of wildly overconfident expectations, an extraordinary amount of greed and poor risk-management metrics, made a series of loans that should not have been made.
The loans were made to people with poor credit ratings. Because these credit ratings are below the ideal or "prime" levels of lending they are referred to as "subprime loans." Sometimes, the borrower did not fully understand the terms of the agreement or failed to predict the effect that rising rates would have on his ability to pay. Credit rating agencies failed to predict the risk of these loans, and last summer, more borrowers than expected defaulted on their payments. House prices dropped, loan rates spiked, people were unable to pay and the loans went bad. Huge deficits in Washington did not help the problem, but it seems the subprime lending crisis is most at fault for the current crisis.
How severe is the crisis? Catastrophic.
It is impossible to emphasize enough how unsteady the economy is at the moment. The stock market went haywire: the Dow Jones Industrial Average, a pretty good indicator of the health of the economy, plunged on Monday, Sept. 15, rose slightly on Tuesday, plunged again Wednesday and finally came back up Thursday and Friday, buoyed by a Fed commitment to solve the problem, only to slightly dip again on Monday. It was erratic and unpredictable. But the crisis was not limited to the stock market.
There are two places to store money in an economic crisis: in the bank and under a mattress. The federal government only insures bank accounts up to $100,000, which is more than good enough for individuals, but companies and funds often need to store much more. Treasury bills, T-bills, are the alternative. They guarantee an amount at appreciation, backed by the U.S. government, and can be bought in bulk. Buying T-bills is effectively a way for a company or fund to store money under a mattress.
With that in mind, while the markets were scary, the scariest event, one that spells severe and lasting economic troubles, occurred Wednesday morning when T-bill rates went negative for a brief period of time.
If banks are unlikely to go into bankruptcy, they are the preferable place to store this money, as they will often offer a better interest rate than T-bills. But if banks default and file bankruptcy, any account over $100,000 will likely be lost. So T-Bills, though they offer a worse interest rate, are a safer bet than banks.
Even T-bills do not perfectly protect value. Because of inflation, $1,000 today will be worth less than $1,000 in three months. So, even though they are guaranteed amounts of money in the future, T-bills trade for less money than they will receive at maturity. If a T-bill is worth $1,000 in three months, it will often trade for $990 today.
But on Wednesday, for a brief period of time, three-month T-bill rates went negative. That means people were buying them for more than $1,000, when they know with absolute certainty that they will only receive $1,000 at maturity.
That's like lending a guy on the street 10 dollars and asking him to pay you back eight bucks tomorrow.
A negative T-bill rate means that a lot of people with a lot of money, mutual fund managers, companies, hedge fund managers and the like, would rather take small, guaranteed losses on their money than let it sit in a bank or the stock market. Essentially, the market flipped. Rather than trying to make as much money as possible, people were so sure the economy was going to tank that they wanted to lose as little money as possible. They were simply hoping to avoid a depression.
This crisis will be a landmark in economic history. It felled Lehman Brothers, a company that survived the Depression. The last time T-bill rates went negative was in the early stages of World War II.
In response, the government is trying to organize a trust that will buy assets and slowly sell them off to prevent a meltdown, but it is unclear what will be included, how long it will take and what it will cost. Then again, the alternative could be a decade-long worldwide depression.
What can Brown students do to protect themselves?
Nothing can protect any of us from a turbulent job market, but learning good spending and saving habits is the key to financial security. If you receive a monthly paycheck, get in the habit of taking a small amount, maybe even only 5 percent, off the top of every paycheck and deposit it into a separate savings or retirement account. By clearly drawing a line between saving and spending money and letting the money accumulate interest, you will be used to setting aside money that will help in the event of a financial downturn.
Carefully read all loan, mortgage or credit card agreements you sign. If you don't understand them, or don't want to deal with them, find someone you trust and bring them with you. Companies can be predatory, often hiding charges and rate increases in the fine print.
Put your money where you are most comfortable with it. If that means playing the stock market or putting it in a mutual fund, that's fine. If that means buying T-bills and storing them in a safe in your room, that's fine too. Because the worst thing you can do is panic, put your money in a dangerous asset, and lose value. That is what got us into this situation in the first place.
Finally, if you find yourself flummoxed by the current crisis or this column - take ECON 0110: "Principles of Economics." It's worth it.
Jake Heimark '10 hides T-bills under his mattress.
