February 1, 2009
One might think of the economy as a horse drawn wagon loaded with goods and services. Three of the four horses pulling the wagon are consumers. The other horse is government spending. The wheels allowing the wagon to move are the four spokes of the financial system providing credit, namely: (1) consumer and mortgage borrowing (2) business borrowing (3) state and local borrowing and (4) U.S. Treasury borrowing. The axel grease allowing the wheels to turn is confidence for every financial transaction is a series of promises we trust will be kept. When a criminal like Bernard Madoff breaks a promise, we discount his behavior as abnormal. But, when sincerely made promises are broken by the system at large our confidence is badly shaken.
Today the three consumer horses have stopped galloping out of depression, fear and uncertainty. Three of the four credit wheels have broken off from their axels; and, even if we could get them back on, there is no axel grease to start them turning.
In his inauguration address, President Obama stated, “The question we ask today is not whether our government is too big or too small, but whether it works…” Clearly, he means to steer the economic recovery by flexible pragmatism as opposed to a fixed ideology.
A MULTI-PRONGED ASSAULT
President Obama intends to assault the worsening economic catastrophe in a number of different ways, namely:
1. Economic Stimulus: Stimulus measures are intended to create jobs and boost confidence that consumers will awaken from the spending slumber like Sleeping Beauty. The House last week passed a huge stimulus bill intended to jump start the economy. The Senate this week will take up a similar measure. There are, however many views about what this bill should and should not include that will eventually be resolved by compromise. Some issues are:
a. Economic Recovery versus systemic change: The House bill goes beyond direct job producing provisions like road projects and veers into social engineering on issues such as health care and education. Some feel all of the dollars should be directed at infrastructure and military projects that are needed and produce jobs. There is merit to this argument since the thrust of stimulus is to substitute government spending for consumer spending. When the system returns to equilibrium it is intended that spending would be rebalanced although perhaps to a lesser formula than 70% consumer and 30% public sector.
b. Sound economic policy versus protectionism: The House bill contains some ‘buy American” provisions such as requiring that iron and steel in infrastructure projects come from American suppliers. Some feel these populist measures are counter productive, create bureaucratic bottlenecks and increase costs in addition to inviting tariffs and subsidies in other countries. Some argue that similar protectionist measures exacerbated the Great Depression.
c. Direct spending versus tax reductions: The House bill contains both. Republicans and some conservative democrats oppose the huge spending fearing the creation of new entitlements that will be difficult to end when the economy resumes growth.
d. Lesser of two evils: The paradox is that while spending and leverage got us into this mess, we are relying on spending and borrowing to get us out of the mess. In effect we are giving away part of our future in the costs of borrowing from China and other foreign investors. The big unknown is whether China and others will be willing to continue to finance our deficits. If China loses confidence in our ability to repay debts, it could greatly reduce its investment in U.S. Treasury obligations with the result that interest rates and the cost of our borrowing would rise dramatically. In that case, the slice of our future we would be giving away would be much larger.
2. Bank clean up: These measures are intended to get the frozen financial wheels turning again by restoring confidence in bank financial statements. Within two weeks the administration is expected to announce a comprehensive plan to revitalize the balance sheets of banks which presently, evidenced by bank stocks trading at less than book value, lack credibility in the eyes of investors. This will be accomplished primarily by either guarantees of bank loses above certain base amounts (loss sharing) and/or by establishing a new bank (bad bank) to purchase the toxic assets now tainting bank balance sheets. Under the Bush administration these rescue measures were trickled out on an ad hoc basis. New Treasury Secretary Grietner is said to favor a “Big Bang” announcement of coordinated and comprehensive measures.
a. Creeping nationalization: As bank stocks decline in traded value, government investment may become government de facto ownership. This fear militates against further direct investment by the government and has contributed to a sell off in financial stocks since nationalization would dilute common shareholder equity.
b. Some feel that we should let the insolvent banks and auto companies fail. Otherwise, we are simply rewarding incompetent management. That may be true but most fear an economic calamity if banks are not rescued.
3. Stemming the tide of foreclosures: A skeet shooter knows to shoot where the target will be. For where the target is immediately becomes where it was.
a. Modification programs: Presently, the Federal Reserve, Treasury, FDIC, Freddie Mac and Fannie Mae, and banks have programs to avoid foreclosures. These programs, less than effective, would have been more successful one year ago. Then, sub prime borrowers were defaulting on loans as adjustable rate mortgages passed the teaser period and monthly payments skyrocketed. The plan was to modify the mortgage payment to an affordable monthly amount. Now, as the economy has worsened, a growing number of good and prime borrowers become unemployed and cannot afford a mortgage payment of any amount. Thus, the modification programs, better late than never, may not produce the desired effect.
b. Lowering interest rates: The Treasury and Fed are attempting to lower mortgage interest rates by various means in hopes of stimulating home sales. A rate of 4% is expected. In normal times, homeowners would take advantage of lower rates to move up to a larger home and first time buyers would enter the market. Fear of job loss is discouraging move up purchasers and first time buyers are excluded because loans remain available only to those with very good credit and sizable down payment cash. Presently, short sales and foreclosures rule the market and these distress sales further depress home prices.
NOT MUCH TAX HELP FOR LOSSES
While there are many proposals offering increased tax benefits in various areas such as mortgage debt forgiveness, those with stock loses in portfolios are given little relief.
1. Loses in your portfolio afford no tax benefit whatsoever until you sell a security with a built in or unrealized loss. Thus, if you had a portfolio worth $1 million three years ago that is now worth $600,000, there is no tax write off unless and until you sell part of the portfolio.
2. Losses incurred in selling investments, are capital loses, short term or long term if held for more than one year. These loses can be used only against capital gains, or, if you have no capital gains in a year against $3,000 of non-capital gain income (such as wages). Even if you’ve been paying tax on reinvested income that now has vanished, you may not go back and recapture the taxes paid on that income or other income. You can indefinitely carry forward your realized capital loss to use against future capital gains in each succeeding year and if none, against $3,000 of other income in each such year. Thus, absent capital gains, not likely soon, it would take over 133 years to fully utilize the capital loss resulting from the current downturn, assuming you were to abandon the market entirely in a sell off of your portfolio.
3. On the other hand, had you lost $400,000 in Bernard Madoff’s Ponzi scheme, you could be permitted, subject to various limitations, to recover taxes paid in the three most recent years by carrying back the loss, treated as an ordinary and not capital, created by the theft. I have also been developing a legal theory for attempting to recover erroneous taxes paid on fictitious Ponzi scheme income in years barred by the tax refund statute of limitations. The tax issues surrounding Ponzi scheme losses are tricky and complex and should be considered by a tax lawyer familiar with such matters.
4. Losses incurred in tax favored accounts such as traditional IRAs or 401(k) retirement accounts offer no tax write off whatsoever. You will have less retirement income on which to pay tax and live. Ponzi scheme losses in these accounts also offer no tax relief although there may be an argument for a loss if Roth IRA investments are distributed out while the likelihood for some recovery exists.
Caveat: I am not a certified financial planner and do not offer advice on specific investments. I offer old common horse sense.
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© 2009 by Robert S. Steinberg. All rights reserved.