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How to Get the Best of the Fear Economy

How to Fix what Ails Wall Street

He had inherited a crisis of historic proportions, and in his inaugural address the new president spoke candidly. He described recent, devastating losses on Wall Street, an economy frozen by uncertainty and massive layoffs, a government stretching to meet its obligations, and the precarious state of millions of families whose savings had been lost in the carnage. The suffering he cited was real; the monster that had crushed their confidence, less so.

“The only thing we have to fear,” Franklin Delano Roosevelt declared in 1933, “is fear itself.”

On January 20 many of us will look to President Barack Obama for the sober reassurance that FDR provided three quarters of a century ago. Since September, when bad mortgages toppled some of the biggest players on Wall Street, the U.S. economy has moved with terrifying speed into its worst crisis since 1933. In a chain reaction, stocks plummeted as investors ran for the safety of cash, while many banks—suddenly short of capital and long on questionable loans—froze lending. More than a few, such as giant Washington Mutual, went bust. Consumer confidence fell to an all-time low by October. Fear had cast its long, dark shadow over a shell-shocked nation.

The Birth of the Beast

The image of Godzilla pulverizing your 401(k) may be the result of an overly vivid imagination, but, according to respected Wall Street investor Wilbur Ross, the fear is real enough. He notes that in the five years up through 2006, an average family’s inflation-adjusted income declined, and “the solution people found to that problem was borrowing.”

“When house prices were going up, there was a kind of wealth effect,” he explains, “so people tended to spend more. Now you have the reverse, a kind of poverty effect, whereby people will be less willing to spend.”

That psychological shift poses a very real threat to an already weak economy, says PIMCO founder Bill Gross, who manages the world’s largest bond fund: “Loss of confidence is perhaps the most dangerous thing. A patient with hope, most doctors will agree, has a better chance of recovery.” But with home values down 20 percent in two years and investors fleeing the stock market, hope has given way to concern, which erodes confidence, which fosters more fear, and—well, you get the picture. “[If] you’re a baby boomer and you’re a few years from retirement, that’s a psychological blow,” says Allen Questrom, former CEO of J.C. Penney. “This is a real issue that’s related to bad credit policy that’s been going on for many years.”

Feeding the Beast

At the root of our fears is debt. During the “Roaring Nineties” and continuing through the better part of this decade, low interest rates spurred lending—and bank profits—even as it produced a triple-headed hydra of defaults on home loans, cars loans, and credit card debt. That this behemoth would one day rise from the deep and overwhelm the system that cultivated it seems obvious in retrospect. Yet, until September, few noticed the flaw in the easy-credit economy: How could banks continue to profit while increasing numbers of their own customers were going broke?

What will it take to restore faith in the market and in our market-driven economy? Regulation—and self-regulation.

The stock market collapse gave the answer. By the time Congress authorized a $700 billion rescue of the banking industry last October, a fear-fueled selloff had already devoured $2 trillion in retirement assets. (Another $4 trillion in value has vanished from housing since the bubble popped in 2006.) Older Americans are being hit especially hard—and they were in a weakened condition to start with: in a June 2008 study that Harvard University law professor Elizabeth Warren coauthored for AARP, Americans 55 and over accounted for nearly one in 4 bankruptcies in 2007—up from one in 12 in 1991. Another study, by the nonpartisan Employee Benefit Research Institute, revealed that among families headed by people 55 and older, average family debt, including mortgages, car loans, and credit card debt, rose 76 percent from 1992 to 2004.

Angela Wilson, a legal assistant for a large law firm in Dallas, is one of the many older Americans living with chronic anxiety over debt. Only three years ago, at age 50, she was feeling pretty secure. She’d raised a daughter and founded her own theater company. She had never saved money, though she did have excellent credit—“the key to your financial future,” as money guru Suze Orman likes to say.

Wilson had accumulated nine low-interest credit cards and had owed money on all of them. She considered her situation “dumb but manageable” until a few of the banks lowered her limits, instantly maxing out those cards, which in turn triggered higher rates on the other cards. At first she thought it was all a mistake. “The interest rates started really going up, and I couldn’t figure out why,” she remembers. By the time she read the fine print buried in her credit card agreements, it was too late. “Where I could manage everything before and make progress, I suddenly couldn’t make any.”

Before long, Wilson was losing sleep, crying constantly, and binging on peanut butter sandwiches for comfort. On the advice of a friend, she reluctantly approached a credit-counseling agency, which put her on a budget and negotiated lower rates for her debt. Now Wilson makes one payment every month to the counseling agency, which, in turn, pays the credit card companies. She has shed $13,000 in debt in 12 months and she can sleep again, but only by refusing to think about all the little things that could go wrong before her cards are paid off five years from now. She has learned that thrift—not a high credit score—is the key to her financial security.

Banishing the Beast

What will it take to restore faith in the markets and in our market-driven economy? Two things: regulation—and self-regulation.

For banks and Wall Street, regulation means playing by a new set of rules. (Some might say any rules at all would be a good start.) That the party was finally, irrevocably over was apparent last October when the former maestro of the credit markets admitted to Congress that he had relied too much on the system to regulate itself. Said former Federal Reserve chairman Alan Greenspan: “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself especially, are in a state of shocked disbelief.”

For individuals, self-regulation means developing a new mindset—one closer to the attitude children of the Depression grew up with—that says if we don’t have it, we don’t spend it. That’s admittedly tough advice to follow when prices are rising and your income isn’t.

But do we have a choice? On this one point everybody agrees: to relieve the fear that holds the economy hostage, we must restrain debt, the toxin that feeds the fear. “The individual savings rate is at a deficit. The government savings rate is at a deficit. Everything is operating at a deficit,” says Ira Rheingold, executive director of the National Association of Consumer Advocates (NACA). “Long-term, there will be pain for the consumer. People will have to work longer and tighten their belts.” There’s plenty of blame to go around for the fix we’re in, Bill Gross adds: “The institutions that lent the money should have known better. The people who took the loans basically must have known that they really couldn’t afford them. Federal regulators didn’t do their jobs in terms of regulating the entire situation.”

Consumer advocates such as Elizabeth Warren have been calling for new regulations to rein in lenders for years. “You can’t buy a toaster in America that has a one-in-five chance of bursting in flames,” she observes. “But someone can sell you a mortgage they know has a one-in-five chance of your losing your home—and they don’t have to tell you. It’s a market that simply doesn’t work.”

Last fall both presidential candidates promised to rebuild our confidence in the financial system by introducing new consumer protections and imposing stricter regulations on lending. First up for President Obama and Congress may be a credit card holder’s “bill of rights” that would outlaw universal default— he gimmick that nearly bankrupted Angela Wilson—and make credit agreements more understandable. That legislation stalled early last fall, but Democratic leaders have promised to bring it to a vote in 2009.

Also high on consumer advocates’ agenda is repeal of the bankruptcy-reform act of 2005, which passed with overwhelming bipartisan (and lender) support. By restricting eligibility for a bankruptcy that fully discharges debts, “Congress made it harder for families to get a fresh start, and less risky for lenders to target those already living on the edge,” NACA’s Rheingold says. Lenders knew borrowers would have a harder time wriggling off the hook, which left the lenders free to offer low teaser rates that seduced the naive, and “liar loans” that made it easy for borrowers to misrepresent their incomes.

Because loans of all kinds were securitized—meaning lenders quickly bundled and sold them to investors around the globe—bad debt has not only infected banks and insurers but also has hurt any enterprise that relies on a healthy trade in debt—your municipality, your pension fund, and companies of all kinds. And while the amount of bad debt has been estimated at a monstrous $2 trillion, the real number won’t be known for years. Consumer “fear is well founded,” says Warren, who in 2007 became rattled enough to withdraw most of her and her husband’s savings from the stock market. “But that fear costs us a lot.”

Perhaps no president understood the power of fear better than Franklin Roosevelt at his first inaugural. “If I read the temper of our people correctly,” he said on that cold March day in 1933, “we now realize as we have never realized before our interdependence on each other; that we can not merely take but we must give as well.” Ultimately, Roosevelt buried his beast not by bailing out the banks themselves but by creating sweeping new protections for their customers—in other words, by restoring confidence. President Obama and Congress will both feel extraordinary pressure to move quickly and do the same. Understanding, as Roosevelt did, that we’re all in this together would be a good place to start.

James D. Scurlock is the author of Maxed Out: Hard Times in the Age of Easy Credit (Scribner, 2007), winner of the Ridenhour Book Prize, and director of the documentary of the same name. King Larry, his biography of Larry Hillblom, founder of DHL, will be published this summer.

Additional reporting by Rachel Katz and Walecia Konrad.

For black-and-white reprints of this article call 866-888-3723.


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