Saturday, November 28th, 2015

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Lessons from the Financial Crisis

There are several lessons that we can take away from the current financial crisis. These lessons include personal and business lessons as well. We are all learning more about the economy and various industries than what we probably ever wanted to know. Perhaps as we weather this storm and actively try to resolve it, we can take away some of these lessons and come out the other side a bit stronger, economically and financially.

Lesson #1 – Leveraging your debt is risky

Most of us know this basic lesson. If you invest $10,000 into a $100,000 house and the house goes up in value by just 10%, then your initial investment goes up by 100%. Leveraging is the only way that works. But we can’t forget the other lesson. There is a balance between risk and reward. What happens when the house value drops 10%? You LOSE 100% of your investment. What happens if it drops 20%? You lose all of your initial investment, plus you lost an additional 100% of your initial investment. Unlike purchasing a share of stock, where you can only lose what you put in, leveraging your money can result in losses much greater than you initially wanted to invest. In theory, you could invest $10,000 in a $100,000 house and end up losing a total of $100,000! All from a $10,000 investment. Ouch. I am not saying you should never leverage, but let’s keep in mind what the downside risk is as well as the upset potential. "What doesn’t kill you makes you stronger… or leaves you permanently injured."

Lesson #2 – Reacting, rather than responding, can lead to chaos

Just look at what Congress did. It was an election year on top of everything else, so they reacted to the crisis rather than responding to it. Now we are squabbling over which industries can get the money. The Treasury Secretary has changed his mind about what to use the money for. The banks are not lending it the way they were supposed to. Congress has a difficult time fixing anything over the course of a few years. Why would anyone have believed that Congress could fix anything in two weeks? While I appreciate the desire to act quickly, I don’t appreciate acting recklessly… with $700 billion nonetheless.

Gas prices? The speculators started it all, but we all got caught up in the hysteria of rising gas prices. The world demand for oil did not triple. The production did not get cut by 75%. Then why did the prices spike? The financial markets, consumers, government officials, auto industry insiders, oil companies, and so on got caught up in the same type of bubble that we just saw with the housing markets, and previously with the tech stocks. Between the weakening dollar and the mass hysteria, gas skyrocketed and has now come down almost to the 2004 prices. Again, instead of responding, the proverbial "we" overreacted and look where it got us? Probably permanent price increases in food and airline prices, even though gas is finally coming back down. Of course the industry also learned that a 100% jump in gasoline prices only resulted in a small decrease in use.

Page Two: Tomorrow may be different and live within your means


Lesson #3 – Tomorrow may look completely different than yesterday

Housing prices. Gasoline prices. Employment. Union contracts. They all look significantly different than they did three years ago, or even just six months ago. Housing prices skyrocketed throughout the 90’s and the 2000’s. So everyday you could see a house worth more than it was the day before. Now that same home is worth significantly less from one day to the next. Million dollar homes are going for $600k – $700k. Half million dollar homes are going for $350k or less.

Gas went from about $1.65 per gallon in 2004 to nearly $4.00 just a few short years later, causing Americans to make significant changes in their spending patterns. Now gas is back down to about $1.90 per gallon, but the uncertainty will still affect holiday spending this year. Job losses and unemployment are creeping up, creating even more uncertainty. The fate of the Weak Three auto companies may result in even more significant job losses. We can’t keep spending like tomorrow will be a little better than yesterday.

The union contracts have always been a problem, particularly for GM. The problem is that during every profitable contract year, the unions demanded more money and benefits, but nothing in the contract allowed for those benefits to be rolled back during periods of losses. Similar to entitlement programs in our country, which expand during good times, we are stuck with larger fixed costs that cannot be met during the weaker years. The new union contracts that come out of this restructure, or whatever happens with the auto makers, are going to have to account for tougher times. For instance, if 95% of your profits go to benefits and salary, what do you do when your profits drop by 10%? You can’t even meet payroll.

Lesson #4 – Living within your means during good times gives you more options during lean times

Wouldn’t it be great if our federal government had money so that they could help people or industries in times of need? Wouldn’t it be great if we had the money in our federal coffers to help victims of natural disasters? What about money to pay for wars or conflicts? Unfortunately, there is no money. Our government just has to borrow, which cannot go on forever. Borrowing is like a pyramid scheme, and it will eventually collapse. If we had this money, instead of having to borrow it, that would be great. We would be so strong with the ability to step into bad situations to make them better. Maybe someday.

In our personal lives, the same holds true. If we were saving money during good times, we would be able to handle a few months of unemployment without borrowing or losing our home. We could step in and take care of our friends and neighbors when they are in need. We could be so strong with the ability to step into bad situations to make them better. We need the citizens to live within their means, and then we need to hold our government officials accountable to do the same. We now have the chance to make this correction and become the “Financial Revolution” generation.

Bill Pratt is a former credit card executive turned student-advocate. He is the author of Extra Credit: The 7 Things Every College Student Needs to Know About Credit Debt & Ca$h. Bill speaks at colleges to educate and entertain students about real-life issues in money, leadership and success. His goal is to help students succeed personally and financially so they can improve the lives of those around them. You can learn more at www.ExtraCreditBook.com.

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