By Jeffrey A. Miron
Special to CNN

Editor’s note: Jeffrey A. Miron is senior lecturer in economics at Harvard University. A Libertarian, he was one of 166 academic economists who signed a letter to congressional leaders last week opposing the government bailout plan.

CAMBRIDGE, Massachusetts (CNN) — “Congress has balked at the Bush administration’s proposed $700 billion bailout of Wall Street. Under this plan, the Treasury would have bought the “troubled assets” of financial institutions in an attempt to avoid economic meltdown.

This bailout was a terrible idea. Here’s why.

The current mess would never have occurred in the absence of ill-conceived federal policies. The federal government chartered Fannie Mae in 1938 and Freddie Mac in 1970; these two mortgage lending institutions are at the center of the crisis. The government implicitly promised these institutions that it would make good on their debts, so Fannie and Freddie took on huge amounts of excessive risk.

Worse, beginning in 1977 and even more in the 1990s and the early part of this century, Congress pushed mortgage lenders and Fannie/Freddie to expand subprime lending. The industry was happy to oblige, given the implicit promise of federal backing, and subprime lending soared.

This subprime lending was more than a minor relaxation of existing credit guidelines. This lending was a wholesale abandonment of reasonable lending practices in which borrowers with poor credit characteristics got mortgages they were ill-equipped to handle.

Once housing prices declined and economic conditions worsened, defaults and delinquencies soared, leaving the industry holding large amounts of severely depreciated mortgage assets.

The fact that government bears such a huge responsibility for the current mess means any response should eliminate the conditions that created this situation in the first place, not attempt to fix bad government with more government.

The obvious alternative to a bailout is letting troubled financial institutions declare bankruptcy. Bankruptcy means that shareholders typically get wiped out and the creditors own the company.

Bankruptcy does not mean the company disappears; it is just owned by someone new (as has occurred with several airlines). Bankruptcy punishes those who took excessive risks while preserving those aspects of a businesses that remain profitable.

In contrast, a bailout transfers enormous wealth from taxpayers to those who knowingly engaged in risky subprime lending. Thus, the bailout encourages companies to take large, imprudent risks and count on getting bailed out by government. This “moral hazard” generates enormous distortions in an economy’s allocation of its financial resources.

Thoughtful advocates of the bailout might concede this perspective, but they argue that a bailout is necessary to prevent economic collapse. According to this view, lenders are not making loans, even for worthy projects, because they cannot get capital. This view has a grain of truth; if the bailout does not occur, more bankruptcies are possible and credit conditions may worsen for a time.

Talk of Armageddon, however, is ridiculous scare-mongering. If financial institutions cannot make productive loans, a profit opportunity exists for someone else. This might not happen instantly, but it will happen.

Further, the current credit freeze is likely due to Wall Street’s hope of a bailout; bankers will not sell their lousy assets for 20 cents on the dollar if the government might pay 30, 50, or 80 cents.

The costs of the bailout, moreover, are almost certainly being understated. The administration’s claim is that many mortgage assets are merely illiquid, not truly worthless, implying taxpayers will recoup much of their $700 billion.

If these assets are worth something, however, private parties should want to buy them, and they would do so if the owners would accept fair market value. Far more likely is that current owners have brushed under the rug how little their assets are worth.

The bailout has more problems. The final legislation will probably include numerous side conditions and special dealings that reward Washington lobbyists and their clients.

Anticipation of the bailout will engender strategic behavior by Wall Street institutions as they shuffle their assets and position their balance sheets to maximize their take. The bailout will open the door to further federal meddling in financial markets.

So what should the government do? Eliminate those policies that generated the current mess. This means, at a general level, abandoning the goal of home ownership independent of ability to pay. This means, in particular, getting rid of Fannie Mae and Freddie Mac, along with policies like the Community Reinvestment Act that pressure banks into subprime lending.

The right view of the financial mess is that an enormous fraction of subprime lending should never have occurred in the first place. Someone has to pay for that. That someone should not be, and does not need to be, the U.S. taxpayer.”

Article found here.

Last night, 9/29/08, Larry King asked “internationally acclaimed personal finance expert” Suze Orman many questions about the losses on wall street. One particular question and response from the expert made me thoroughly confused, it went a little something like this: Larry speaking.. “We lost something to the tune of 1.2 trillion dollars in the stock market today, where did it go Suze?”

Suze responds with somewhat of a dumbfounded look (if that isn’t her typical look - I’m not sure, really) “It Vanished Larry, yep poof, gone forever.” Now, you have a personal finance expert telling people that the money just disappeared, like some sort of Colombo mystery. Well Suze, people that held onto the stocks may have lost money - but it didn’t just float away. People sold off their shares and took their funds back out of the stock market, to the tune of 1.2 trillion dollars, it didn’t simply vanish, it exchanged hands from the market to the investors. I understand people can’t and won’t know everything, I sure as hell don’t, but what I don’t think should be done; is act like you know and give ignorant answers.

On a side note, Ben Stein (another annoying turd) had an interesting point about the impending credit swap crisis.

Many prominent economists are looking at history for a bit of guidance versus making an illogical, irrational, fear based decision that may create an potentially larger financial problem. How have other countries whom faced similar crisis’ handled their problems? Sweden seems to be the glaring example of another country whom has faced a similar situation to our own in the early nineties. Below is how they handled the situation and why it is likely better than providing the government with nearly a trillion dollars in discretionary spending financed on the general public’s back.

Sweden and their situation: “Newly deregulated credit markets after 1985 stimulated a competitive process between financial institutions where expansion was given priority. Combined with an expansive macro policy, this contributed to an asset price boom. The subsequent crisis resulted from a highly leveraged private sector being simultaneously hit by three major exogenous events: a shift in monetary policy with an increase in pre-tax interest rates, a tax reform that increased after tax interest rates, and the ERM crisis. Combined with some overinvestment in commercial property, high real interest rates contributed to breaking the boom in real estate prices and triggering a downward price spiral resulting in bankruptcies and massive credit losses. The government rescued the banking system by issuing a general guarantee of bank obligations. The total direct cost to the taxpayer of the salvage has been estimated at around 2 per cent of GDP.” (1)

Wait, this sounds like what we’re doing doesn’t it? Yes, very similar, however, instead of simply pumping in dollars to help the companies pay their bills, the Swedish Government forced the banks to sell off their assets to help meet current bills and drain down shareholder value. Basically, they made the shareholders of the companies take a complete loss before allowing the bank to get aid. So, whatever money the government put in was completely owned by the public through their government. When the banks stabilized and eventually began to turn profits again, the government sold back shares to the public. Whatever they made went against the debt they had incurred.

So, how is this different again then what we’re trying to do? The current proposals on the house floor more or less reward the shareholders of the banks (or insurance company or whatever industry we’re talking about that is proposed to recieve aid) at the cost of the general public versus first forcing the company shareholder to lose their interest. In other words, if you don’t make the true shareholders lose their interest, they stand to benefit twice. This is especially unnerving when it comes to seeing the way those executives prospered in the form of salaries and bonuses off of fake profits in the first place.

Not to mention: Our current proposal, compared to Sweden’s, will cost around 3% more. The Swedish government reassurance in its backing of the financial industry helped curb the runs on banks and unwarranted devaluations of similar company stocks that had little fundamental problems simply because of a credit crunch.

Coming to a theater near you: Credit Card default swaps will be the next mortgage crisis

(1) “The Swedish banking crisis: roots and consequences,”  P Englund
Stockholm School of Economics, Stockholm, Sweden

“Baby boomer is a term used to describe a person who was born during the Post-World War II baby boom between 1946 and 1964.^[1][2] Following World War II, several English-speaking countries – the United States, Canada, Australia, and New Zealand – experienced an unusual spike in birth rates, a phenomenon commonly referred to as the baby boom.^[3] The terms “baby boomer” and “baby boom”, along with others expressions, are also used in countries with demographics that did not mirror the sustained growth in American families over the same interval.^[4] ”

That would make the oldest baby boomers 62-63, and the youngest about 45. Basically, the oldest of the group are entering into retirement now or are just a couple of years from retirement. On the other hand the youngest are around 20 years away. By now the oldest of this group should have changed their portfolio holdings to accomodate their low risk tolerance, and the youngest are likely to have half of their retirement investments tied up in equities or stocks or more likely in mutual funds through a 401k plan. What about those in the middle? Hopefully they’ve changed their asset mix from the riskier to something safer, however, it is unlikely and they’re overexposed to risks they may not be able to recover from in a few short years.

This brings in some harsh realities in finding ways to survive for many of our parents. As a generation “x’er” myself, I can see that there is the potential that I will have to support them financially some time down the road. Otherwise, mom and dad may be forced to work until they’re physically incapable, possibly resulting in the inevitable financial drain on us. So, not only is it important for us to pay attention to our own portfolios as we age, it could be argued that making sure our parents understand what is going is equally or even more important. Even more, it is important not to act irrational at times like these, trying to bail out your parents by making large changes may actually hurt them more than help them. Be wise, read my site and learn more about evaluating their current situation and their (and your investment horizon) options to address this financial crisis properly.

The only bright side to the picture for us x’ers is the fact most of us still have 30 years of investing left, and if history is any indication the market will rebound and we will all make back far more than we’ve currently lost.

Confused about the bailout? Read my article that explains what is going on in really simple terms.

So, the US House of representatives rejected the bailout plan, what does that mean for your 401k you ask? Well, right now the markets are adjusting themselves down on the premise that their will be no bailout, in other words, people are acting scared and are pulling their money out faster than people can buy it - hence the reason the value of the market is going down so rapidly. In a nutshell, you will see paper losses in your 401k for the next few days, weeks, months, or even years (unless you too want to realize them now by withdrawing your money), however, the amount of shares you have still remains the same. Sooner or later your portfolio will rebound above and beyond current losses, and keeping to your long terms goals will allow you to buy up additional stocks (or mutual funds) at bargain basement prices through dollar cost averaging (See below for further explanation). Please, please don’t jump ship now or you will regret it as you will be forced into taking the loss when you don’t have to. Stick to your plan, markets are cyclical and for every up there is a down and vice-versa, however over the life of the entire stock market - the trend has been up, up and away.

Dollar cost averaging — also known as a constant dollar plan or in the United Kingdom as pound-cost averaging — is an investing technique intended to reduce exposure to risk associated with making a single large purchase. The idea is simple: spend a fixed dollar amount at regular intervals (e.g., monthly) on a particular investment or portfolio/part of a portfolio, regardless of the share price. In this way, more shares are purchased when prices are low and fewer shares are bought when prices are high. The premise of dollar cost averaging is that the investor wants to guard against the market losing value shortly after making his investment. Therefore, he chooses to spread his investment over a number of periods.

Since the market has a positive mean rate of return, dollar cost averaging usually requires the investor to give up some expected return for the benefit of reduced variance in his eventual outcome. In fact, research has shown that investing a lump sum according to these principles generally results in worse performance as compared to investing the entire sum at separate times (Constantinides, 1979). However, the investor can expect a reduction in the variance of his performance by implementing dollar cost averaging. While dollar cost averaging can help to limit the downside of a worst-case scenario of an immediate drop in asset value after the lump sum is invested, most market research has shown that such drop-offs are relatively rare compared to the strong emphasis the strategy puts on avoiding them.

The first true Black Monday occurred at the beginning of the Stock Market Crash of 1929. The second one occured some 21 years ago, in 1987. Today, could arguably be coined Black Monday - Part III, however, it doesn’t even compare to the one day loss of 23% in 1987 or the lesser one day loss in 1929. How long did recovery for the two prior Mondays take?  Actually, the 1987 stock market ended the year higher even though they had such an anomally. The 1929 crash however, took much longer to recuperate from, in fact, nearly 25 years.

As of 4 PM EDT, the DJIA has dropped 6% and the Nasdaq has tanked even further at over 9%. Many people are trying to hoard their money in fear they will lose everything, so what we are witnessing is just that, people are switching from the riskier equity markets to government insured bonds. The greatest thing about this is that stocks are a steal right now, and are set to rebound as soon as a positive announcement regarding a bailout comes. You can expect the markets to continue a decline until good news comes and an explosion in the market, as too many people fear the unknown. I’m telling you now people, buy, buy, buy - you won’t see prices like this for a long time to come.

With the way the economy is going, you have to look at your options when it comes to hedging your investments, and gold is a great option. Not only does it hedge against a volatile stock market, it hedges against currency fluctuations as it relates to the dollar or your local currency. Since the US Federal Reserve no longer has the requirement to back the dollar with any collateral, and the dollar is fiat money, it is a good idea to make that investment in gold. You may have noticed the price of Gold has skyrocketed to unprecedented levels in the past few recent months, as investors flocked for the safety in Gold. Other types of hedging may include Oil and various other commodities.

So you’re thinking of putting your 401k up as collateral for a loan - or you’re simply thinking about ways to raise funds without mortgaging your future away. Ask yourself these questions to see if you’re ready to mortgage your nest egg:

Are you willing to give up hundreds and thousands of dollars your investment would have made?

Are you sure there is no other way to get the money you need. What about a home equity line of credit or loan?

No matter what you choose, at least consider the pros and cons of doing something such life changing. Good luck!

Sometimes you don’t have a choice as people lose jobs and other issues arise. However, it should truly be your last resort to tap your 401k for the emergency funds you need. A tax saving idea would be to obtain an home equity loan where you have the ability to write off the associated interest payments. One risk, however, would be if the market were to collapse and you owe more than the house is worth. So be careful and remember, anything you can do to preserve your 401k will reap you healthy rewards when it comes to retirement, not to mention you have compound interest working for you.

For more information on 401k loans or hardship withdrawals check out my article here.