Wednesday, July 29, 2009

Mellow Out Your Portfolio As You Grow Older

One lesson from the recent stock market crash is that you should reduce your portfolio's risk levels as you grow older. In particular, if you're retired, you should moderate your exposure to potentially volatile assets like common stocks, commodities and long term bonds. When the markets for these assets turn down (and market downturns are inevitable, something we now know quite well), you'll have less time to recover your losses. Thus, gradually reducing your exposure to bouncy assets provides greater stability to your portfolio's value and better quality sleep.

The importance of portfolio stability can be seen in the ongoing controversy over target date retirement funds. These funds supposedly diversify your savings for you, and change the allocation as you grow older to protect an increasing portion of your gains. However, some target date funds for those already retired seem to have suffered losses in the range of 25% during the stock market crash. That would imply that they had half to two thirds of their assets in stocks.

Was it wrong for these target date funds to allocate so much of their portfolios to stocks when they were meant for investors already in retirement? It depends on how you look at things. Many financial planners tell you to prepare for a 30-year retirement. This is because a healthy 65-year old has about a 25% chance of reaching age 90. And some nonagenarians will chug along for years. It's tough to run out of money when you're, say, 93, because few people at that age can work. So, one school of thought is that you should keep a pretty large percentage of your portfolio in stocks to capture 30 years of gains in case those gains are needed.

Planning for the long, long term in this way leaves you exposed to shorter term risks, such as today's financial mess. Most people won't live 90 or 95 years. The majority of 65 year olds will be gone by age 85. Planning for a 20-year retirement might make more sense for most retirees. Of course, if you come from a family with longevity, you would be well-advised to think in terms of 30 years.

A fairly well-known rule of thumb is that your age specifies the percentage of your assets that should be in stable investments. In other words, if you're 65, then approximately 65% of your assets should be in cash and a diversified portfolio of bonds and/or a laddered set of CDs. The remaining 35% could be in stocks, with perhaps a small proportion in commodities (such as 5% or less). If you're 80, then 80% of your assets would go into cash, bonds and CDs. The rest would be invested in stocks. This is a highly conservative approach and leaves the retired and elderly largely out of stock market gains (such as this year's surge from March to July). But if you want to be cautious, then follow this rule of thumb.

Whatever you choose, remember that you're making a choice. A conservative portfolio means getting a relatively small boost from stock market gains. But you'll see less shrinkage of your portfolio in bad times. A more aggressive portfolio may be better if you live a long time. But you should be prepared for volatility, and the need to cut back on spending during down times. The target date funds with large losses didn't make a mistake by having a large stock component for their portfolios. They made a choice, one that perhaps not all of their investors understood. Their mistake, if any, was in not clearly explaining to investors what risks they were taking. Perhaps these funds should have suggested that skittish investors put at least some of their money in a more conservative investment. A target date fund may be a good choice for those that don't want to devote a lot of time to money management, rebalancing portfolios, and altering asset mixes as one progresses through the years. Just remember that it, like all investments, will have good days and bad days.

If you don't have confidence in target date funds, then allocate your savings among cash, bonds, CDs and low cost index funds, in whatever proportion makes you comfortable. There's nothing wrong with 100% cash. It's just another choice. Just remember that it gives you little protection against inflation and no participation in stock market gains. If you can live with that, make sure the cash goes into FDIC guaranteed accounts, and best of luck to you.

Tuesday, July 28, 2009

Reappoint Bernanke, But Don't Deify Him

As America, the homeland of immigrants, grew in diversity, its culture came to be secular and commercial. While the Pilgrims, Puritans, Quakers and others landed on the shores of Britain's North American colonies with the hope of attaining grace through freedom of worship, America came to be the land of opportunity, where the pursuit of happiness evolved (or devolved, as the case may be) into making your fortune. Wherever you or your ancestors might be from, the one thing you have in common with all other Americans is a national culture of commerce.

A nationwide economy, especially in a country 3,000 miles wide (and with two other states much farther away), requires a national referee to ensure fair dealing between people thousands of miles apart. Thus, as the economy grew from Jefferson's ideal of yeoman farmers to fulfill Hamilton's much larger vision, the federal government took on the roles of national referee, guardian of the financial system, and promoter of economic growth and full employment.

This has been ever more the case during the economic crisis of the last two years. The federal government took de facto control of the financial system, and became the majority owner of America's largest car company. Front and center in all this governmental activity has been the Federal Reserve, the central bank and also much more. Today, the Federal Reserve is not merely the regulator and lender of last resort for the banking system. It's the ultimate source of credit for much of the economy, providing trillions of dollars of credit facilities that keep the financial system--and thus the economy--above the septic field.

President Obama has to decide soon whether or not to reappoint Ben Bernanke as the Chairman of the Fed, or chose a successor. He should reappoint Bernanke.

There are reasons to question a reappointment of Bernanke. The man has clearly demonstrated that he has feet of clay. He was slow to recognize the severity of the subprime and related crises, and has left unresolved the still highly troubling problem of trillions of dollars of toxic assets held by the major banks. He and his erstwhile compadre, former Treasury Secretary Henry Paulson, bailed out Bear Stearns, Fannie Mae and Freddie Mac; let Lehman collapse; and then gave AIG a blank check bailout that paid its creditors 100 cents on the dollar even though they were consenting adults who voluntarily took the risk of AIG's creditworthiness. Bernanke's and Paulson's decisions to bail out, or not, were seemingly driven by reasons known only to them. That instilled a fear of the unknown in the financial markets that left credit frozen and the economy on the brink of Depression.

But, to Bernanke's credit, he demonstrated the ability to move up the learning curve, a quality greatly needed but not commonly found in senior federal officials. He came to understand that there are vast pools of raw sewage in the financial system and that dramatic action was necessary to keep them from polluting the national economy. He was highly innovative, and the economy seems to have skirted the edge of the septic field.

As has been well-publicized, the Fed's rescue efforts contain the seeds of inflation and asset bubbles. Bernanke and other Fed governors have insisted they can withdraw the accommodative measures instituted in the last 18 months in a timely enough manner to avoid these consequences. Maybe so, maybe not. But could anyone else do better?

Bernanke seems to understand that his butt was nigh deep-fried sixteen times over during the past two years. Having been so thoroughly acquainted with the potential for disastrous and tremendously embarrassing failure, Bernanke is probably running somewhat scared. That's a good trait to have in the most powerful government official next to the President. Bernanke's predecessor seems to have been overly confident of his ability to discern new paradigms and we're still paying the price for that certitude.

Bernanke is reputed to be as a much a listener as a talker. That's a rare attribute in Washington, but valuable. The current economic problems are far from over, and could easily get weirder before they get better. A Fed Chairman who listens, learns and innovates has a good chance of coping.

At the same time, the Fed's powers should not be expanded. Bernanke wants the Fed to address consumer protection issues in the financial markets. The Fed already had its chance and failed. It simply has too many priorities on its plate. Consumer protection would conflict with other Fed responsibilities. If the banks are tottering and need greater profits to beef up their capital, would the Fed institute and enforce potentially expensive consumer protections? Yet, consumer protection is needed. A newly formed, independent consumer protection agency is in order.

By the same token, the Fed shouldn't be the overseer of systemic risk. As we discussed in, controlling systemic risk could conflict with Fed desires to maintain the financial strength of the banking industry. When banks are undercapitalized, the Fed might be tempted to let them take greater risk in the hope of making greater profits and enhancing their ability to raise capital. But that could let the horse out of the barn in terms of systemic risk, and as we know today all too well, risk that's been unleashed cannot easily be corralled. Our pick for the czar of systemic risk: the FDIC. An insurer won't let the insureds run amok.

Thus, reappoint Bernanke. But don't deify him by adding to the Fed's powers. It's the grandest of doyennes in our national culture of commerce and tremendously powerful already. Increasing its powers would complicate its job and exacerbate existing concerns about its lack of accountability. Economic well-being is the archstone of our national culture, and we shouldn't make it dependent on any single regulatory agency.

Saturday, July 25, 2009

More Mortgage Relief

The Department of Housing and Urban Development has announced an expansion of its Making Home Affordable Refinancing Program. Homeowners who are as much as 25% underwater on their mortgages may be able to refinance. In other words, if your mortgage balance is as much as 125% of the current value of your house, and your mortgage was bought or guaranteed by Fannie Mae or Freddie Mac, you may be able to refinance. This is a considerable improvement over the original criteria for this program (only mortgages not more than 5% underwater were eligible for refinancing), and over commercial refinancing standards (you probably need 20% equity or more in the house). The interest rate for the new program's refinancings is likely to be higher than current market rates for prime borrowers, and naturally there will be charges and fees for refinancing. But underwater homeowners can't get prime borrower rates anyway for refinancings.

If you have a loan with a high interest rate, or one that could adjust upward, you may want to see if you can refinance under this program. Don't wait until you're close to defaulting because the process for refinancing takes time. To participate in the expanded program, you need to have been current on your monthly payments for at least the last twelve months. Also, it will probably be several weeks before lenders have their computer systems set up to handle applications using the new 125% underwater standard.

For more information about the new program, go to We also discuss a number of other resources for mortgage payment problems at

Thursday, July 23, 2009

Wall Street Bails Out Obama

Just when he was falling onto the ropes over health insurance reform, President Obama got a bailout from Wall Street. We learned today that bonus pools at the biggest banks rose to $74 billion this year, up from $60 billion last year. The political news was starting its summertime slowdown. Now, prominent members of Congress and the administration can recoil in faux Kabuki style and present carefully crafted soundbites denouncing the spectacle of taxpayers making wealthy financiers more prosperous. An electorate worried about the cost of health insurance reform can be diverted by populist outrage over greater inequality of wealth in a time of rising unemployment. Goldman Sachs individually assisted the President with its grumpiness over the amount it would pay to redeem the government's TARP warrants even as it aimed to award employees record levels of compensation. For the tabloids, a supposedly sterling investment bank that turns out to have feet of clay is a better story than a President who is trying to help people, even if the help involves a lot of money.

The stock market has also given the President a boost. Beginning with optimism over less bad economic data in March, the market has shot almost straight up on the basis of a few green shoots and a lot of hopeful thinking. Most recently, a number of federally subsidized banks have reported better than expected earnings. It's astonishing what you can do with trillions of dollars of subsidies and government-guaranteed survival.

Additionally, some business corporations have reported better than expected financial performance, much of it attributable to frantic cost-cutting. In the arithmetic sense, cost cutting improves earnings. But no seasoned executive will tell you that a corporation can attain lasting prosperity from cost cutting (GM, Ford and Chrysler serve as Exhibits A, B and C in this regard). Nevertheless, the stock market is so desperate for any good news that less negative has become the new fabulous.

Momentum traders, who feed off upwards stampedes like today's market, may feel good. Rational investors will remember than in the last ten years, every up-market frenzy, beginning with the Great Illusory Surge of late 1999 and early 2000, has ended badly. It's unclear if the market will test its early March lows. But we should remember the lesson so recently taught by the real estate markets: no asset class continually rises in value.

Still, the financial markets have short term memories. Probably more than a few bottles of champagne are being bought tonight in Manhattan and other places where investors lurk. That's good for President Obama, who doesn't have to fight a fearful stock market even as he struggles for traction with health insurance reform.

Everyone, including the medical profession and the private health insurance industry, agrees that reform is needed. But current efforts are bogging down in the quagmire of the debate over who will pay for it. That's a necessary debate, but its NIMBY-like obsessiveness overlooks the morass we already have. The insured are paying something like $1,000 each to cover the cost of care for the uninsured. Since the the insured tend to be better off than the uninsured, the well-off already pay. The principal question is how that payment will be made--in insurance premiums or federal income taxes.

Let's also remember that we all benefit from universal health coverage. If you're well-off and allergic to tax increases, consider this: the nice restaurant meals you enjoy might be prepared by uninsured workers who can't afford to see a doctor and might pass swine flu onto you or your family. The uninsured folks who clean your office and its bathrooms at night could leave bacteria or viruses to infect you the next day. The uninsured passengers on the subway, bus or airplane might be a health threat to dozens at a time. That annoying cough behind you at the theater could do much more than interrupt your enjoyment of the movie.

Also consider that health insurance isn't guaranteed for most people. Once your child graduates from college, he or she probably will be dropped by your policy. Many young people don't have jobs with employer-sponsored health insurance. Will your child take the initiative to buy an individual policy? Also, a lot of people of all ages who operate or work at small businesses are uninsured. If an uninsured close relative of yours--an adult child, parent or sibling-- gets sick or is injured, who might have to chip in to cover the costs? You probably wouldn't simply let a family member slide into the gutter, so it would be your net worth that would shrink. We all have a stake in health insurance reform. It's not just a matter of costs. It's also a matter of benefits.

Tuesday, July 21, 2009

Economic Forecast: the Great Stagnation

By the norms of the post-World War II era, current economic data send conflicting messages. Corporate profits, especially in the banking sector, have exceeded expectations. The stock market has enjoyed renewed exuberance. The Fed predicts that the economy will stop contracting by the end of the year and start growing slowly.

However, unemployment levels keep rising. Unusually for a recession, labor productivity is also rising, which suggests that employers won't rehire as much when the economy turns around. New housing starts rose recently but remain at very low levels. Home prices keep falling and the inventory of houses for sale is still very large (with lots of foreclosed properties waiting in the wings to be placed on the market later). Banks are stable, and even thriving with the benefit of extraordinary government subsidies and support. Companies and industries not protected by the government are hurting. The economy is still shrinking, although probably at slower rate. Just about everyone predicts that unemployment will keep rising into 2010. Unless you work at a large, government subsidized Wall Street bank, your salary or wage, and bonus (if any), probably aren't growing. Many have had their compensation reduced.

The situation doesn't look like the downturn and then nicely executed upturn that characterize most post-World War II recessions. Instead, the economy is balkanizing. Some sectors are doing well, especially the big banks that the government protects at all cost and the oil companies, which benefit from mysterious levitations in petroleum prices. Other sectors struggle to stay minimally viable.

There is little chance of a brisk upturn. New lending by the big, government subsidized banks is about as commonly observed as Brontosaurus. Thus, neither consumer spending nor corporate investment is likely to be the locomotive to pull the economy upwards. The big banks continue to hold trillions of dollars of toxic assets. Those assets consist mostly of real estate loans (personal and commercial), along with some consumer loans and corporate debt, all mixed together in a complex mish-mash of CMOs, CLOs, CDOs, and CDOs squared. Newly capitalized courtesy of the taxpayers, the big banks have been able to sweep many potential losses on these assets under the rug of relaxed accounting standards that Congress forced on the accounting authorities. In other words, we're all supposed to pretend that those assets ain't pigs wearing lipstick. But as the real estate market continues to decline, the banks will have to record losses eventually. (That, indeed, is likely to be a strong reason why they don't lend; they're hoarding money against the eventual writeoffs.)

The continued tightness of credit (except in the banking system, where Uncle Ben provides as much credit as any big bank wants before breakfast, essentially free of charge) means that a crucial reason for the Great Depression--a contraction of the money supply--exists today. Credit, especially in the recent days of credit card and home loan ubiquity--is the money supply. Since 2008, credit has contracted for everyone outside the banking system. Importantly, small businesses have suffered sharp reductions in credit. Since they tend to do much of the early hiring in an economic revival, credit cutbacks limit their potential role as an economic locomotive. While the situation doesn't appear to be as dire as it was in, say, 1933, the shrinking of today's money supply via the credit contraction is likely to have the same type of effect it had in the 1930s--stagnation.

That's also what happened in the 1870s, when a financial panic in 1873, coupled with a law that ended the government's usage of silver for currency, produced an economic downturn and a reduction of the money supply that led to a five and a half-year period of stagnation. Credit contraction also contributed to Japan's Long Stagnation following its 1989-90 stock market and real estate market crashes (from which it still hasn't recovered).

Continued over-allocation of America's capital to the banking industry won't produce lasting benefits--Iceland's wild and ultimately destructive spree into banking bet the entire nation on finance, and now that entire nation is paying the price for believing that shuffling money around is the path to prosperity. Lasting wealth won't come from more mucking around with the creation of derivatives that consist of interests in other derivatives. Wall Street thought it could get rich by selling risk--that's essentially what the derivatives market did. But this eventually became little more than an unregulated casino, where the house wound up holding the bag because it didn't know how to manage its risks (and ultimately survived only by passing the bag onto the taxpayers). Finance doesn't produce true wealth. In its best form, it may facilitate the production of true wealth. But that's all.

Government stimulus programs will produce statistical improvements to GDP. But the mere distribution of government cash doesn't produce lasting benefits (see Japan, post-1989). Our best hope lies in producing things that have tangible value, which can be sold domestically and to people around the globe. We should look to the sectors of the economy that take advantage of America's strengths--innovation and creativity. High tech, biotech, green tech, entertainment and perhaps aviation could serve as the engines of America's future growth. These sectors would take a long time to revive the economy. There isn't much credit or other capital around for a quick jump start because so much of our national wealth is tied up saving big banks. Until then, expect the economy mostly to muddle along and the stock markets to bounce around in mini-bull and mini-bear markets.

Friday, July 17, 2009

A Survival Kit for Layoffs and Unemployment

As Updated June 5, 2011

Someone who has just been laid off will suddenly have a lot of things to think about. With the world spinning out of focus, it will be hard to keep them all straight. Here's our survival kit for the jobless. It may not cover all the issues that would be important to any particular person, but will hopefully serve as a useful guide in difficult circumstances.


When leaving your old job, make sure you get everything you're entitled to have, and negotiate for as much else as you can. Here are some typical issues.

(a) push for as many weeks or months of termination pay as you can get;

(b) ask for payment of any bonuses, awards or commissions you’ve earned or accrued, or which you can reasonably expect based on your job performance to date (if the award was in non-monetary form, like a trip to Hawaii, ask for the monetary value of the trip);

(c) request payment for accrued vacation and sick days, and any other time off you've earned or been awarded;

(d) ask for continuation of health insurance benefits (remember that you have COBRA rights to retain your employer’s health insurance for 18 months even if your employer doesn’t offer anything else; even though you’d have to pay the entire cost of COBRA coverage yourself, it's still worthwhile); also see our discussion of health insurance further below;

(e) ask for continuation of other insurance benefits, such as dental coverage or life insurance;

(f) obtain a written statement of the balance in your 401(k) account and any other retirement accounts you might have with the employer, such as an employee stock option plan--the assets in these accounts are yours (except possibly for matching funds from your employer if you haven’t had the job all that long) and you don’t have to negotiate for them; but you should make sure you know how much is there;

(g) claim any stock options, restricted stock and similar incentive compensation benefits that you have earned or are entitled to;

(h) ask about retaining any employer provided equipment, such as a laptop computer or a car, if this equipment is important to you;

(i) ask for the employer’s agreement not to contest your claim for unemployment compensation (if it looks like you’d qualify for unemployment comp);

(j) ask for your employer’s agreement to give you a good reference (or at least a neutral reference such as only a confirmation of dates of employment and positions held); and

(k) ask your employer for assistance from an outplacement or headhunter firm (that the employer pays for).

Your ability to obtain these benefits will depend on the circumstances of the situation, but they are something for you to think about. Certainly, if you don't ask for them, you probably won't get them. If you are represented by a union, consult with a union representative about your rights and options.

Some people try to negotiate for a temporary continuation of employment while they search for a new job, on the theory that it’s easier to find work if you are employed. Others may aim for the use of an office and telephone line at the old employer’s office while they search for a job, to maintain the appearance of being employed. You may want to consider these possibilities. But don’t lie to a prospective employer about your actual employment situation.

Carefully read anything your employer asks you to sign in connection with your termination. Almost always, an employer offering termination benefits will ask you to waive your rights to sue for discrimination, wrongful discharge and other potential legal claims or rights. If you’re seriously considering a lawsuit, don’t sign anything even if that means losing some of the termination benefits. You should be able to use COBRA rights to maintain your health insurance (unless you’ve engaged in “gross misconduct”). If you sign a document that waives your COBRA rights, you can still revoke that waiver for a limited period of time (which should be at least 60 days after your regular employer sponsored health insurance plan’s coverage ends). The assets in your 401(k) or other retirement accounts are yours in any event, so you don’t have to waive any rights to get them.


Apply for unemployment compensation if you think you qualify. Unemployment comp will help you extend your financial resources, and is a modest but valuable benefit. State government agencies administer the unemployment compensation program, so go to your state's website for details.

While you should diligently search for a new job, you'll probably have some down time. Do part-time and temporary work. Even a few dollars coming in the door will help. And don't forget the psychological value of working. Even if it isn't high-paying or permanent, a part-time or temporary job gives you the dignity of work. Maybe that sounds corny, but those unlucky enough to be laid off know it's true.

Consider selling stuff you don't use any more. This isn't likely to bring in much money, but unneeded possessions become a burden. Why not get rid of the burden and bring in a few bucks?

Check to see if you have unclaimed money from old bank accounts, uncashed checks and other sources. See

If you're really scraping the bottom of the barrel, keep in mind your community's food banks, food pantries, and soup kitchens. In addition, you may qualify for food stamps if your income falls enough. It may be difficult to use these resources. But if you and your family get hungry enough, keep them in mind. The food stamp program is federally funded but administered by the states, so check your state's website for details.

Also remember that welfare programs still exist. Although the controversial federal Aid to Families with Dependent Children program closed back in 1997, the federal government provides funding for state welfare programs. Check with your state website for details. Most of us would find it difficult to accept welfare. But if you find yourself surrounded by rocks and hard places, welfare may be better than the alternatives.

If you're 65 or older, or blind, or disabled, and really broke, you may qualify for Supplemental Security Income. This is a joint federal-state program that supplements the income of people who are right at the edge. The formula for qualifying varies from state to state and can't be summarized in a blog like this. Suffice it to say that only those with very little or no income and few assets qualify. Contact your local Social Security office for information. Some five million or so people are on this program, so it's a (quite modest) lifeline for many.


Maybe you think this is obvious. But a lot of people, especially those accustomed to a nice lifestyle, have trouble cutting back. This only accelerates the arrival of insolvency. Yes, cutting back means potential embarrassment with one's family, friends and neighbors. Perhaps above all, it means truly confronting your own feelings of failure and disappointment. Try to view the situation as a challenge. Our finest moments don't come when the sun is shining and the going is easy. They come when everything seems to go wrong. Cutting back is a rational and intelligent step toward survival and future prosperity. Tightening your belt is much better than spending like mad and ending up in bankruptcy. You might be surprised at now liberating a lower intensity lifestyle is.


The one insurance coverage you'll surely need sooner or later is health insurance. No one has perfect health, and a major health problem can blow up an uninsured person's finances in a flash. Many of those who are laid off have rights under a law called COBRA to keep employer-sponsored coverage for 18 months. COBRA is expensive because you have to pay the full premium; the employer no longer subsidizes you. The recent economic stimulus bill provides some assistance with COBRA costs. See

Those that can't use COBRA may be able to find coverage through a variety of other resources. See and None are cheap. Be wary of inexpensive health insurance policies, often peddled to individuals by insurance agents, because they often contain nasty holes in coverage. Health insurance is one thing where you tend to get what you pay for. That doesn't mean you shouldn't shop for the best policy for your needs. But make sure you understand what you are and are not getting.

If you have a moderate income or less and children who are 19 or younger, your children may qualify for subsidized coverage under the State Childrens Health Insurance Program (SCHIP). Check your state's website for details.

If your income is low enough, you and your family may qualify for Medicaid. This too is a state-administered program, so your state's website should have details. Some states combine the administration of SCHIP and Medicaid, but these remain separate programs with different eligibility requirements.

Of course, if you are 65 or older and have no other health insurance, enroll in Medicare.


No matter how bad things get--you lose your home, your savings, your whatever--it's important to keep the basic tools of the trade for people in the 21st Century. These are the things you need to keep going, stay connected, and find a new job.

Computer. Vast amounts of information needed for daily life (like new employment opportunities) are placed on the Internet. And who doesn't use e-mail? A computer is essential. The waiting times for the computers at public libraries can be hours. It's best to have your own computer. A laptop is preferred, since it can be easily carried (in case you have to change living arrangements) and Internet access is as close as the nearest WiFi source. If you have a Windows based machine, don't skimp on the anti-virus software.

Cell Phone. You understand why you need a telephone. A cell phone is better than a land line because it can be used anywhere you get reception, and doesn't need to be re-connected in case your living arrangements change. If your monthly plan is too expensive, switch to a pay as needed account and don't talk or text so much on the phone.

Credit Card. It's almost impossible to get by on cash alone. Debit cards tend not to have as much consumer protection as credit cards. So it's a good idea to have a credit card. Minimize the number of credit cards you hold (fewer cards will tend to have a positive impact on your credit rating). Try not to carry a balance over from month to month. If you're carrying a balance, try to pay it down because, recently, banks have gone wild raising rates on credit cards.

Car. Unless you live in New York City, you pretty much need a car. Maybe a few people with narrowly focused lifestyles in Boston, San Francisco and Washington, D.C. can get away without a car. Many of those find themselves signing up for car sharing services after shelling out too much money to hostile cabbies. The other 97% of Americans find it really difficult to get by without a personal vehicle. Downsize your wheels if you find the lease on the Escalade too expensive. Besides, real millionaires are more likely to drive a Camry, Accord, Taurus, or Impala, so chose a more modest vehicle and project the image of quiet prosperity.

Cash. When economic times are tough, cash is the emperor. Even if you've lost your job, try to keep some cash in a safe place because, as bad as things may be, there's always a chance they'll get worse.

Flexibility. Flexibility about what job you'll take, and what region you'll move to in order to get a new job, can make a substantial difference in your future. Bear in mind the cost of living. Quality housing in nice suburbs with good schools is available for a small fraction of the Northeastern U.S. or coastal California cost in cities between the Alleghenies and the Sierra Nevadas. A couple in Dallas making $150,000 a year and living a middle class lifestyle can retire as millionaires, while a couple in the suburbs of New York making $200,000 a year and having a similar lifestyle might just manage to get by. If you have an open mind, you'll probably find more possibilities and potentially position yourself for prosperity.


In the days when portable transistor radios were the hot, new high tech product, it was axiomatic that the mortgage be paid no matter what. That's not necessarily today's accepted wisdom. Many and perhaps most who bought homes since 2005 are underwater on their mortgages. Some are $200,000 or more underwater. There is a point where it may seem rational to walk away from the house. For most people, that won't be the first option. They may have the kids enrolled in the school district they want. Their spouses may still be working and not want the negative impact on their (the spouses') credit ratings--remember that joint debtors on a mortgage would both see their credit ratings adversely affected by a default. They may like the house and want to keep it for the long term, with the expectation that housing values will rebound eventually.

Unfortunately, meaningful assistance for distressed homeowners is about as easy to find as water in the Sahara. None of the federal programs have had much impact. And other initiatives--by state or local governments, nonprofit organizations, and so on--have only had limited success. For what they may be worth, here are a variety of resources for defaulting homeowners: and

But if the mortgage payment is the one thing that is breaking your budget every month, and you can't relief from your lender or anyone else, leaving the house behind may be sad but sensible. What you need to do is stay above water until you can get another job. Then think about buying another house. Even if you have a damaged credit rating, re-establishing a solid financial base is probably better for your long term welfare than grinding your finances down trying to pay the mortgage, and then winding up in bankruptcy. Lifelong renters who are scrupulous about saving and investing can build significant wealth. Don't sacrifice everything for the house.


The temptation to tap into your retirement accounts will grow stronger as your other cash resources diminish. Avoid tapping into the retirement accounts unless it's absolutely essential, because you'll pay the price of doing so when you're too old to work.

Remember that your retirement accounts are protected from creditors if you go into bankruptcy, and are largely otherwise protected from creditors. Thus, if you don't use them, you'll probably get to keep them. Tap into the retirement accounts only if you're pretty sure that doing so will tide you over until you can get a new job and revive your finances. But don't drain the retirement accounts if you're likely to be sliding into bankruptcy. Leave them alone, and keep them safe from your creditors. That way, you'll have some retirement savings already stashed away when you try for a fresh start.

Thursday, July 16, 2009

Goldman, Fannie and CIT: Are Things Better Now?

The stock market views Goldman Sach's recent exceptional earnings report as a cause for celebration. The Dow Jones Industrial Average has popped up about 500 points so far this week, to a large degree on the strength of Goldman's earnings announcement four days ago. But, in the spirit of contrariness, we must ask whether things now are really better.

Goldman and a few other really large banks have the implicit guarantee of the U.S. government, whether or not they hold TARP money. Their creditors will be repaid. The events of the last year make clear that the anointed few cannot be allowed to fail, and Goldman is perhaps the most exalted among the anointed. By contrast, CIT, a major lender to small businesses, is told no bailout for you, because it's not deemed to have enough systemic impact to qualify for admission into this most exclusive of clubs.

Creditors therefore will be forgiven if they eschew CIT debt in favor of lending to Goldman and the other megabanks in the inner circle. After all, there's nothing like a sure bet. And, in spite of its Brobdingnagian budget deficits, the U.S. government is still a sure bet in the financial markets. Goldman, in turn, can receive the blessings of the ordered liberty of government in the form of lower interest costs on borrowed funds. This increases its profit margins and supports higher risk levels. Higher risks, if shrewdly evaluated, can produce greater overall profits--and Goldman's long been a shrewd player. Thus, the backing of the U.S. government gives Goldman and the other doyennes of the financial markets a synergistic dynamic that multiplies their profit potential. They seem to have, in essence, taken a page from Fannie Mae's and Freddie Mac's playbook: use the implicit guarantee of the U.S. government to secure lower funding costs and boost profits. No wonder Goldman's stock is doing well.

But shouldn't we be concerned? After all, Fannie and Freddie implemented their game plan all too well, taking on too much debt and too much risk, and facilitating a massive bubble in the real estate markets that ultimately made houses resemble tulip bulbs. Is there a possibility that the government guaranteed brotherhood of big banks will hog up capital desperately needed by the real, underlying economy in order to recover from this, the worst downturn since the days of Bonnie and Clyde? Might they not, as many of them did not long ago, misjudge systemic risks in the financial markets and create another asset bubble and bust (aided and abetted by the Fed's easygoing, tie-less attitude toward monetary policy)? Perhaps something like this is already happening in the oil market.

The federal government has significantly restructured the financial services industry over the last year. There are now fewer major firms, and the ones left standing can snap up market share formerly held by the ones that collapsed or were forcefed via mergers into larger firms. This consolidation of market power reduces competition and is good for the bottom line--monopolies and oligopolies are generally more profitable than competitive industries. What's disturbing is that the U.S. government's policies produced this outcome. Incentive compensation at Goldman is up, but the American electorate at large is experiencing higher unemployment, stagnating or falling salaries and wages, falling home values, and little prospects for improvement in the foreseeable future. As gratifying as Goldman's bonuses will be, they won't trickle down enough to significantly affect the larger economy.

No doubt financial regulators are cheered by the upbeat earnings reports from Goldman and J.P. Morgan Chase. But the stabilization and protection of the financial system seem to have become an end, rather than the means to a stimulating the recovery of the larger economy. The major banks have done little of consequence to revive the real estate markets. Virtually all lending for home purchases is the province of the newly nationalized Fannie Mae and Freddie Mac, and the FHA. Mortgage modifications for distressed borrowers are done between 8:30 a.m. and 8:31 a.m. on Sunday mornings just before bankers head for church. Lending by federally bailed out banks is, if anything, less active now than before the bailouts. Indeed, small businesses, key players in any revival of the economy, relied on the now-scorned CIT and other nonbanks for loans.

All across the land, little boys have stuck fingers in dikes to hold back the flood waters of the recession, and they desperately wait for assistance. Night is falling fast, and the waters are cold. High level federal officials drop hints about green shoots, but people at the ground level don't see any green in rising unemployment levels and falling real estate values. The federal government seems to be creating a class of oligarchs on Wall Street. But a battered economy won't recover because of the extraction of monopoly rents (as economists would put it) by, or an undue allocation of capital to, an ever smaller and more powerful group of banks.

Tuesday, July 14, 2009

Financial Regulatory Reform: We Should Taketh From, As Well As Giveth To, the Fed?

The wide scope of the Obama administration's regulatory reform proposals has triggered an economic recovery for lobbyists, and their frenzied paid, professional bewailing and whining has obscured some basic issues. We already knew, without being told, that banks wouldn't like the idea of a financial consumer protection agency. It also comes as no surprise that Wall Street would like to limit as much as possible the intrusion of regulators into their high margin derivatives business, even though that business brought the economy down last year with its reckless pursuit of profits without regard to risk.

But one issue that deserves more attention is whether the Federal Reserve should have responsibility for safeguarding the economy against systemic risk. This is the biggest regulatory reform issue. The reason why the current economic downturn has proven so intractable is the failure of a major part of the banking system due to uncontrolled systemic risk. We're talking about the unregulated multi-trillion dollar asset securitization market underlying the real estate and credit bubbles that popped so painfully. Banking collapses presage painful economic contractions (see, e.g., the history of the Great Depression and the Panic of 1907 for further details). The securitization market operated with virtually no meaningful risk management, either from Wall Street or the government. That's why things spun out of control and its risks became hideously large.

The Fed seems to be the principal nominee to serve as the systemic risk czar. It, after all, has played the biggest role in combating the current downturn and has regulatory authority over all the major Wall Street banks anyway. But is the Fed the best choice?

The Fed's current regulatory responsibilities already fill its plate. It is required to serve as the central bank--the lender of last resort to the banking system. It also is supposed to manage the economy. Section 225a of Title 12 of the United States Code provides that "[t]he Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." In other words, the Fed is supposed aim for "maximum employment, stable prices, and moderate long term-interest rates."

This is mandate makes the Fed a regulatory pushmi-pullyu. When the Fed is confronted by a slowing economy, it is supposed to lower interest rates to promote growth and employment. But doing so can run the risk of price inflation and asset bubbles. In the 1970s, the Fed chose to favor growth and employment, instead of raising interest rates to control inflation. The result was price inflation and little growth (the now infamous stagflation). In the late 1990s, the Fed lowered interest rates to promote growth, facilitating the expansion of the money supply that fueled the tech stock bubble. Then, in the aftermath of that bubble bursting, and the threat of recession from the 9-11-2001 terrorist bombings in New York and Washington, the Fed again lowered interest rates. This time, it fueled the real estate and credit bubbles that produced the train wreck we're now on. In other words, the Fed's legal mandate, as it has been interpreted for much of the past 40 years, appears to be inherently destabilizing.

If the Fed became the czar of systemic risk, things would only get murkier. In the world of commerce and economic enterprise, risk is a predicate to growth. Systemic risk is a predicate to systemic growth. Given its competing legal responsibilities, would the Fed be tempted to favor growth while allowing "some" systemic risk? Could the Fed, given its seemingly unlimited ability to print money, subsidize (at taxpayer risk and expense) Wall Street firms and others taking systemic risk in the hope of fostering more growth? The Fed's performance in the last 15 years reveals a tendency to underestimate systemic risk. People with a history of driving too fast usually have their licenses suspended or revoked. Why should we give a regulator that has a history of incautiousness the job of safeguarding the economy against systemic incautiousness?

The literary pushmi-pullyu exists only in fiction, and perhaps the regulatory pushmi-pullyu should no longer be a reality. Wouldn't it be better to relieve the Fed of the responsibility for promoting growth and employment? Shouldn't that responsibility rest in the hands of the elected government--the President and Congress? After all, fiscal policy, not monetary policy, fostered America's recovery from the Great Depression. The massive wartime spending that was required to fight World War II made America prosperous again. The federal government financed the war by sharply raising income taxes and borrowing record amounts of money. There were no Hail Mary pass-type policy measures by the Fed to print money in new and ever more creative ways.

The Fed's primary monetary policy tool--the level of interest rates--operates as a government price control. The government sets the price of short term credit. Doesn't the evidence now allow us to stipulate that such price controls have had the perverse impact that government price controls usually have? The government's underpricing of credit has produced repeated booms and busts in the asset markets during the last 15 years. We're now slogging through the worst recession since the 1930s as a consequence. Isn't it clear that government pricing of credit has produced distorted allocations of capital that may hamper long term economic growth? Cheap money goes into investments that produce the greatest short term returns. Higher interest rates induce more disciplined and thoughtful investing aimed at longer term gains. Don't we want more capital invested in ways that would produce the greatest long term returns--which tend to benefit workers and communities, as well as investors, instead of the privileged few that have profited from the short-mindedness of recent years? Have we just seen the latest manifestation of this perversity with the 60% jump in oil prices this year, in the face of a terrible recession? One wonders who, besides oil producers and perhaps Goldman Sachs, a noted commodities trader that just reported exceptional earnings, would have benefited from this latest asset bubble? Wouldn't systemic risk be fueled by lower interest rates? From a borrower's standpoint, as money becomes cheaper, higher risks become logical. If the Fed lowers short term interest rates marketwide, it may be increasing the levels of systemic risk. This, indeed, is likely an important reason for the astronomical size of the recent credit bubble.

Relieving the Fed of the responsibility to manage the economy would allow it to serve as the czar of systemic risk in a way consistent with its other legal responsibilities. After all, a central bank primarily focused on maintaining the health of the banking system would want to prevent high levels of systemic risk. It would no longer be tempted to compromise the safety and soundness of banks, and the moderation of systemic risk, in order to maximize employment and economic growth.

In Washington, it is axiomatic that government agencies do not readily give up power. After all, the more powerful you are, the more important you become. Minor bureaucrats are not invited to soirees in Georgetown. It would be unlikely that the Fed would give up its responsibility for the management of the economy without the mother of all bureaucratic battles. And Congress and the White House might not want to take it away because then they'd have the hot tamale in their laps.

So how do we avoid making the regulatory pushmi-pullyu even larger? Give the systemic risk job to the FDIC. Such a responsibility would be consistent with the FDIC's mandate to safeguard the banking system--no pushmi-pullyu problem there. And the FDIC is perhaps the only federal agency that has distinguished itself in the recent financial markets debacle, spotting problems earlier and proposing better solutions than more powerful players. Good performance and sensible ideas are rarely rewarded in Washington, a city where the well-connected and undeserving manipulate power to triumph over the meritorious. But perhaps once, just this once, we could make an exception.

Sunday, July 12, 2009

The Silence in the Health Insurance Debate

There's a really big elephant in the room where the question of universal health insurance is being debated. And everyone is assiduously avoiding any mention of it. That's the question of how medical care is allocated. Yet, allocation is crucially important to the question that is vigorously debated: costs and who should bear them.

The subject of allocation of medical care is taboo, at least in America. This is the nation that enshrined the pursuit of happiness in its creation myth. To this day, the notion of limits is unacceptable. Just last fall, the American Dream was renewed when voters chose a nonwhite boy from a broken family of modest means as its President. The idea that the latest in medical care shouldn't be available to all in need isn't accepted.

However, you can't provide unlimited amounts of anything and health care is no exception. Allocation happens early and often in America, and it isn't pretty. Nonprofit hospitals (which probably comprise a majority of all hospitals) are required to provide a modicum of free or discounted care to those who cannot afford to pay. And they do. But it appears that charity patients don't receive the same quality of care as the well-insured and well-to-do. It should come as no surprise that money matters. Even in countries with universal health insurance (like Canada and various European nations), the well-off are free to plunk down cash on the barrelhead for more and better health care--and they do, going to other nations if necessary.

Allocation decisions are also made in the regulation of health insurers. Health insurance companies are principally regulated today by state governments. These regulators decide, among other things, what policies sold in their states must cover. In some states, group health insurance contracts must cover acupuncture treatments, while other states do not require such coverage. The federal government decides what Medicare, Medicaid, and other federal health insurance programs, will cover. The regulatory process is a place where politics can affect the way health care is allocated, and has played an increasingly important role in recent years.

Allocation also is done on the front lines, by physicians. They, presumably, make determinations based on medical need and appropriateness. However, concerns over malpractice claims lead some physicians to recommend more, rather than less, testing. And, unfortunately, there have been all too many allegations that some physicians stood to gain financially from diagnostic tests or treatments they recommended. Thus, we have a degree of misallocation, a crucial problem in controlling costs.

Health insurers compete for the most desirable business (group insurance contracts) by trying to keep costs under control while providing expansive looking coverage. Thus it is that delivering mothers are often discharged the day after giving birth, and many breast cancer surgery patients as discharged a day or two after surgery. Physicians are unhappy because their professional judgment is superseded. Patients are unhappy because they are booted out of the hospital before they feel ready for the outside world. This, however, is another way health care is allocated.

Then, there are "exogenous" factors, like layoffs and unemployment, when formerly well-insured persons are suddenly scrambling for any sort of coverage. As unemployment levels rise, health care allocations shift away from the laid-off and their dependents. They have limited measures like COBRA to continue coverage for a while, albeit at a high cost. See and Some assistance with the costs is provided by the administration's recent stimulus bill. See

There is no simple resolution to the allocation problem. The seemingly arbitrary and almost cruel limits of some private insurance policies have led a majority of Americans to support the formation of a federal health insurance plan. To avoid this result, the private sector needs to get it together fast, and effectively. There is reason to doubt it will succeed. Private insurance companies could have competed for the revenues that Social Security now gets, by offering low cost annuities and similar contracts that would guarantee a fixed (or even inflation adjusted) income during the golden years. Instead, insurers endeavor to sell high-cost, high commission, complex, and confusing annuities that sometimes seem to contain more surprises than benefits. Something comparable seems to be happening with many private sector health insurance policies, which have high administrative costs, incomprehensible complexity and a surfeit of surprises that don't involve the payment of benefits.

Conflicts of interest that physicians may have when making recommendations for tests or treatments should be prohibited, especially with respect to Medicare, Medicaid and other federally funded payments. Medicare and Medicaid might control costs better if conflicts of interest were eliminated, instead of the current approach of cutting physician reimbursements to the bone and pressuring honest physicians to provide quality services for little or no income.

We should have a more open dialogue about how much medical care we are truly willing to pay for. There is nothing wrong with having the Cadillac of national health insurance programs. We have the Cadillac of national defense systems. The U.S. Navy rules the high seas and safeguards shipping lanes for all. The U.S. Army and Marine Corp have more combat capability than any other nation's ground forces. The U.S. Air Force provides the finest air defense in the world. If we want, we can have the finest of national health insurance programs. We just need to be willing to pay for it.

Much of the opposition to the Obama Administration's plan has coalesced around the question of who will pay for the national health insurance program. This is politically savvy because no one wants to pay more taxes. As we can see from California's politics, focusing on tax burdens has an uber-NIMBY quality that paralyzes the political process and prevents anything constructive from being done. The naysayers on national health insurance are desperately trying to throw the health insurance debate into the tax burden briar patch, because that's where nothing gets done.

The administration should openly discuss the elephant in the room. Talking about what the government can provide presents the problem in positive terms: here, electorate, is what you get. It may be limited--indeed, of course it has to be limited because there can't be unlimited health care. But Medicare started off as a limited program, and still is a limited program. No politician in Washington who has functioning survival instincts would suggest repealing Medicare. Medicare can be and is supplemented by private insurance coverage--and so could any general federal health insurance program.

The administration would take a positive step by openly discussing how much health care insurance the government would provide. That would also clarify how much the cost would be. Taxpayers have only the example of the private sector as a frame of reference, and are understandably frightened by its history of skyrocketing premiums, very high administrative costs, and coverage limitations that most severely affect those in the greatest need. The government program should leave room for private insurance programs. Americans don't want anyone uninsured and they also want choice. These seeming inconsistencies can be accommodated by extending the mixed public-private health insurance system that, with Medicare and Medicaid, we already have. It is important to accentuate the positive, and doing so could help make national health insurance a reality.

Thursday, July 9, 2009

The Simplest Financial Plan of All

A very simple financial plan--the simplest of all, in fact--is to save a significant percentage of your income. If you save about 15% to 20% of your pretax earnings, work for 30 or more years, and invest in a reasonably well-diversified portfolio, you'll have a good chance of maintaining your pre-retirement standard of living during your golden years. It's not easy to save this much. But if you can, you'll probably build a good-sized portfolio while keeping your standard of living under control and sustainable in your golden years. If you save a smaller percentage of your pretax earnings, like 5% or 10%, you'll have to make some cutbacks in retirement (although you'd still be better off than most Americans).

One advantage of the percentage of earnings approach is that you won't need to fuss around with calculators that give you seemingly impossible retirement targets in the millions of dollars and which need to be revised every year or two to account for inflation. Any reasonable estimation of your needed retirement savings will result in a figure in the high hundreds of thousands or in the millions. These numbers seem so intimidating and impossible that many people don't even bother to start saving. That's a mistake. Forget about the seemingly impossible dollar amount and instead focus on saving a percentage of this year's income, then next year's income, and so on. After a few years, saving becomes easier and your wealth will grow visibly.

Another advantage of using a percentage of your earnings as a saving target is that you won't have to budget specific expenses. You can spend as much as you like on lattes, clothes, cars and whatever, so long as you save the requisite percentage of your earnings. You can still indulge and spoil yourself in some ways, even excessively, provided you feed the retirement savings. No need to input each day's expenditures into your PC, or debate whether chocolate is an extravagance or a necessity. Anything goes, as long as you fund your retirement adequately.

Saving isn't easy. But a simple financial plan will make it easier.

If you want a more detailed explanation of why the percentage of earnings method works, keep reading. But . . .

Warning, Alert, Danger: Math lurks below.

The simplest financial plan of all is based on a straightforward idea: the more you save, the less you spend today and the less extravagant your current lifestyle. Because you have a less expensive lifestyle, you’ll need less money to maintain that lifestyle in retirement, yet will have more resources today to save for a nice retirement. In other words, by controlling your spending today, you leverage your ability to save for a comfortable retirement. If you’re a really good saver, you’ll have the means to provide for a retirement that involves little or no reduction of lifestyle.

Look at the numbers. If you’re spending 100% of your current income, you’ll save nothing for retirement, and have just Social Security benefits. Get used to eating dog food.

If you spend 95% of your pre-tax earned income (we count taxes as spending because you don't save the taxes you pay), and save 5% in a 401(k) account—adjusting your contributions upward annually for inflation--you’ll have a decent sized nest egg after 30 years. If we assume annual investment gains of 7% compounded, you'll have enough at age 65 to start withdrawing an amount equal to about 19% of your average annual pre-retirement income. (This assumes you're drawing down 4% of the initial value of your retirement assets per year in retirement, which is about as much as you'd want to withdraw if you don't want to outlive your money.) You can use an Internet financial calculator like's ( to do these calculations. Adding 19% of your working years' annual income to your Social Security benefits may not sound like a lot, but it’s a damn sight better than zero.

If you're middle class, Social Security could amount to about 30% of your pre-retirement income. With another 19%, you'd retire on a total of 50% or so of your average annual pre-retirement income.

If you save 10% of your earned income in a 401(k) account for 30 years and get 7% returns compounded annually—again adjusting your contributions annually for inflation—you’ll end up with enough in retirement assets to provide about 38% of your average annual pre-retirement earned income, starting at age 65 (assuming a similar 4% annual drawdown). But your standard of living will be based on 90% of your earned income, so you’d be withdrawing enough for 42% of your average annual pre-retirement living expenses. (This is because 38% of 90% is 42%.) In other words, a little restraint in your lifestyle today leverages your ability to save and to maintain your current lifestyle in retirement. Add the 30% or so that Social Security would provide if you're middle class, and you'd retire on about two-thirds of your average annual pre-retirement income.

Using the same assumptions, if you save 15% of your earnings each year, then you'd be able to withdraw about 57% of your average annual pre-retirement income during your golden years. Because you'd have been living on 85% of your income, the withdrawal would approximate 67% of your average annual pre-retirement spending. If you're middle class, add 30% or so for Social Security, and you would be able to spend about as much each year in retirement as you did, on average, before retiring.

If you can save 20% or 25% of your earned income per year, you could actually end up with more lifestyle in retirement than you had while working. Let the good times roll.

It’s important to note that these numbers are for your average annual earnings over the course of your life. Your average annual income for your entire working life will probably be lower than the income levels you enjoy in your 40’s and 50’s, since many people start off with lower incomes early in their careers and see their incomes rise over time. If this has been true for you and you want to maintain the lifestyle to which you’ve become accustomed in your 40’s and 50’s, save a higher rather than lower percentage. At least 20% of your earned income would be a good idea. We also don't count investment earnings saved, since that is embodied in the compounding of earnings that leverages the growth of your savings.

What’s the right level of saving? That’s for you to decide. Each of us has a point where the trade-off between saving and current spending feels right. It won’t be the same for everyone. Pick a point along the continuum that makes you comfortable, and stick to the savings plan. Some people want or need to spend a lot now, and are willing to accept a modest retirement as the price. Others want to be prepared for the future as much as possible, and their personal sweet spot would be farther along the continuum toward a modest lifestyle now and a higher level of savings. If you want to avoid a drop in your lifestyle in retirement, and you have 30 years to build a retirement portfolio, save 20% or more of your current earnings. While 15% has a good chance of getting you there, 20% is a safer number in case investment gains are lower than historical averages during the next 30 years (which is quite possible since go-go years in the stock market--like the 1990s and 2000s up to 2007--are often followed by long periods of below average performance). Also, if you have fewer than 30 years to go before retiring, save more, like 20%, if you want to avoid a drop in lifestyle during your shuffleboard years.

Good luck.

Tuesday, July 7, 2009

California IOUs: This Year's October Surprise?

Short of cash, the State of California has started to issue IOUs called "registered warrants" to pay some of its obligations. While the state hasn't entirely run out of cash, it will pay out some $3.36 billions in IOUs in July, and probably more than that in August if the state still hasn't solved its fiscal crisis. The IOUs will be due on October 2, 2009 and bear interest at an annual rate of 3.75%. However, they won't be paid unless the state has obtained enough money to cover them.

Some banks are cashing the warrants at face value, at least through July 10, 2009. These include Bank of America, Wells Fargo and J.P. Morgan Chase. After that, IOU holders may have to turn to smaller banks, credit unions and check cashing stores if they want to convert the registered warrants into cash on the barrelhead. The smaller banks, credit unions, and especially the check cashing stores, are likely to charge fees that will result in IOU holders receiving less than face value. The check cashing stores could really clean up if banks and credit unions get nervous and step back.

The July 10 deadline was set by the big banks apparently as an incentive to the state to resolve its fiscal mess. But California is famous for being ungovernable. Since the 1970s, California voters have wanted Cadillac quality state and local government services with a Chevrolet tax burden. Municipalities have given extremely generous pay and benefits to their employees. The California electorate has avoided fiscal responsibility the way teenagers avoid homework. What are the chances California will put together the cash to pay the IOUs on October 2? Both voters and state legislators have seemingly done their best to preclude any solution.

The problem could extend to bond defaults, and the "borrowing" of tax monies from municipalities (that would otherwise receive these tax revenues). A lowered credit rating and straitened municipalities would only exacerbate the Golden State's difficulties. The governor has already made a variety of cuts in state spending, and more cuts are on the way. But there is only a modest chance a solution will be found before the registered warrants become due.

By October, California may have issued something like $10 billion or so in registered warrants. Most likely they will largely be held by banks, which will either have accepted them from customers or received them as collateral for loans to check cashing stores. If California defaults on the IOUs, the financial system wouldn't collapse. The Federal Reserve would simply print some more money and throw it at the banks. Moreover, the state and its government would get by, albeit more spasmodically.

But there is something about October and the stock market. In 1929, 1987, 1989 and 2008, October did nasty things to investor portfolios. No one knows why it's so bearish. But even bold investors tread carefully when the fall foliage reaches the height of color in the Blue Ridge Mountains. California's failure to pay the IOUs in October would add to the general shakiness of the market. We've already seen the market drop close to 8% in the last four weeks. Prospects for this summer seem clouded. The fiscal meltdown of the largest state would lower investor confidence when it is already ebbing.

Government is the only thing we have going for us in the current economic crisis. The federal government has responded reasonably well, although at the expense of an ominous boost to the federal deficit and potentially inflationary measures by the central bank. The federal government is close to being tapped out. If the government of the largest state, which has the 8th largest economy in the world, can't get it together, we may run out of cards to play.

It's always something unexpected that leads to October surprises in the stock market. Last year, it was the collapse of Lehman Brothers, followed by the panicky no questions asked bailout of AIG (in which AIG's creditors got a pass from responsibility for the risks they took). California has repeatedly dodged the bullet on its fiscal messes. But if the real estate collapse of 2007 to 2009 (and into the future) teaches anything, it's that chickens eventually come home to roost and recklessness and irresponsibility aren't free. The Obama administration hasn't shown any interest in bailing out financially troubled states, nor should it. See California's fiscal dysfunction can be expected to continue--there's no reason why the state should suddenly ascend to adulthood when it's spent the last 30 years in adolescence. And its likely default might be just the thing to tip the stock markets downward, renewing October's reputation as the cruelest month for investors.