By Rick Willeford, CPA, CFP, and Kate Willeford, CPA, CCPS
There is hope! Uncertain times call for deliberate measures. The current financial crisis should have little long-term effect on your financial investments, if you are not planning to live off of your investments within the next few years. That being said, the current situation will have a short-term effect on your dental practice and personal spending. The next two years will be especially difficult if you were hoping to sell your home, refinance your debts, or borrow money.
In addition, you will certainly feel the impact if your patients suffer job losses, have difficulty getting credit, or have a tough time filling their gas tanks. Their problems will be exacerbated by the emotional stress and angst brought on by uncertainty and general turmoil. Needless to say, any discretionary dental wants will be delayed.
Still, hope remains! In 2008, some of my clients have been experiencing their highest production months in years. Established practices that offer value-added patient experiences, and are willing to be cost conscious, will continue to be successful during this crisis.
Would you like to learn more about what this financial crisis is about and how we got into this position? If so, here is a little refresher course in economics.
Economics 101 — the multiplier effect
You may not recall the "multiplier effect" that is at the heart of all economic systems. Spending $1 generates a ripple effect that may have the impact of spending $5. Suppose you own a company that sells light fixtures. You have a good year in sales, so you borrow money to buy a car. The car dealer has a good year, so he buys a boat. The boat dealer has a good year, so he buys some new boat building equipment. The equipment company has a good year, so the owner buys a new house. The new house needs light fixtures, and the whole cycle helps you sell more light fixtures. The entire economy prospers, and by an amount far greater than the original car purchase.
As you can imagine, the whole cycle is energized even more when we're not limited to just the funds we have on hand. Instead, the process is supercharged when we can use credit. Credit is the lifeblood and lubrication that drives not only consumer spending, but also business spending in the same way. (Anyone bought a CEREC for cash recently?)
The amount of available credit is generally based on the amount of a bank customer's deposits, capital, and the quality of a bank's investments, which include its outstanding loans. (I use the term "banks" loosely, but I'm referring to any number of "financial institutions," including those in the recent headlines.) Many of the bank investments are real estate-based, such as construction loans and mortgage-based assets. As the real estate bubble burst, those investment values dropped — and so did the bank's ability to provide more credit to the community.
So, the sucking sound you hear in the economy is that of credit drying up. Just as the effect of injecting $1 into the system is multiplied many times over, withdrawing $1 is multiplied many times over. Using debt, "leveraging," "other peoples' money," etc., magnifies your profits — when things are going up. It can be a millstone around your neck when things are going down. Hence, the cyclical nature of the economy.
So what went wrong?
Your last house purchase
Do you remember long ago that it was a given you had to have about a 20% down payment to buy a house? But laws and regulations changed, and in recent years lenders were willing to make you a second loan to cover the 20%! Seemed odd at the time, but who was going to complain about 95% or 100% financing?
It used to be that banks and mortgage companies serviced your mortgage debt by accepting your monthly payments, handling property tax escrow, etc. But then you started sending your payments to strange folks you had never heard of. Your mortgage had been "sold," but that did not really affect you. However, it helped the bank because it meant they had fresh money to make more loans. But selling your mortgage meant that the bank no longer had a responsibility to collect on the mortgage. So they were less concerned about the quality of the borrower.
At the same time, "mortgage brokers" came into existence. Rather than deal with the bank directly, you got your loan through this middleman who collected a fee. He only got paid if the loan went through. He could care less about the quality of the borrower. Hence a number of "sub-prime borrowers" were able to take advantage of easy money and easy lending standards. A scary pattern was emerging. But if the value of real estate kept going up, what difference did it make? The property was the collateral, not the borrower's ability to repay the loan.
Mortgage-backed investments
Who was buying up all the mortgages, and why? Let's jump to the end product, and then come back.
What if you could only get, say, 5% to 6% return on CDs, but your financial advisor/salesperson said that you could buy an investment paying, say, 9% to 10%. The investment was collateralized by mortgages and the underlying real estate. Sounds like a no-brainer, especially since no one is making anymore land, and who would default on a mortgage in the first place? Thus were born "collateralized debt obligations," (CDOs), which are a bundle of mortgages packaged together. So plain old mortgages ("debt") were bundled together ("securitized") and sold as "securities," along with stocks and bonds and other traditional securities.
The investment bankers and other financial institutions (Fannie Mae, Freddie Mac, Merrill Lynch, etc.) who created the CDOs were trying to be prudent by getting insurance from folks like AIG to protect against the risk of mortgage defaults. This was called a "credit default swap." Such insurers presumed the risk of default was low, so they got aggressive to earn more fees, and they sold more "insurance" than they could cover. The insurers did not have enough cash on hand to pay the claims that were being filed.
Creative investment bankers began selling the credit default swaps themselves, along with other esoteric investments derived from the mortgage-backed business, or "derivatives." Fortunately, those investments were not sold to individuals like us, but the big financial institutions sold these back and forth to each other, to large private investors, and to other countries.
The meltdown
As the value of real estate declined, the pervasive, yet unthinkable, meltdown began. The drop in values was exacerbated by the fact that the initial "teaser" interest rates were going up to true market rates. The sub-prime borrowers, and many others caught up in the 100% financing spree, simply could not afford the new payments, and they could not refinance with the values deteriorating. While the CDOs and other related investments were designed to handle traditional minor defaults, the current magnitude was never envisioned. The party was over, and the hangover was about to begin in earnest.
We think nothing of accepting and using paper currency for everyday transactions because we have faith in the government standing behind that paper. A similar faith and trust pervades the entire financial system at the highest levels as they deal in unsecured "commercial paper" issued by the big institutions. As their financial strength deteriorated due to the bad real estate-based assets, they lost confidence in the market, whether deserved or not. It's as though the first big Wall Street name, Bear Stearns, was suddenly radioactive. The other institutions would not accept their paper or trust them with their deposits. Other big names soon had the same problem. On top if this, the big insurer, AIG, was not prepared to cover everything it had insured. (Just like State Farm would be in trouble if every house in the U.S. caught fire at the same time.)
The last shoe that hasn't fallen yet would be if the consumers lose faith in their banks and begin withdrawing their savings ("run on the bank"). Foreign investors could do the same if they dump all their treasury bills and notes. Credit tightens even further &mdash or disappears — and the entire market goes into a tailspin, like the Great Depression.
The FDIC
Basic FDIC insurance covers up to $100,000 of deposits per account holder per bank, and up to $250,000 per account holder for deposit retirement accounts. For more information about whether your own money is insured, log on to www.myfdicinsurance.gov.
Many banks offer "CDARS," a tool that gives you the opportunity to keep one main bank but have money over $100,000 fully insured. These spread your money across multiple banks (for instance, if you have $500,000 sitting in a money market, you can use a CDAR instead of your money market and the bank will spread out the money into $100,000 at each institution). You would receive one 1099 form at the end of the year rather than five. Be aware that, for this added insurance protection, your interest rate earning potential is a little lower than the single money market would have been.
Recovery plan or "bailout"
The bailout that passed on Oct. 4 hopes to bolster confidence in the system at all levels. By buying up the bad investments from the banks, the banks once again have liquidity and can offer credit again. This may also provide a "floor" for falling real estate prices so that the market can return to normal sooner — although that may still mean several years. It will take at least a year before we feel the effects of the rescue plan.
Historically, we are a resilient nation, and we will not stand idly by as we continue to search for solutions. Even though things should "technically" improve, the day-to-day economy and consumer spending will be a problem until consumer confidence is restored. And we can't legislate that!
Raymond F. "Rick" Willeford, MBA, CPA, CFP, is the financial and tax planning columnist for Dental Economics. Rick is the president of Willeford Haile, CPA, PC, and Willeford CPA Wealth Advisors, LLC, a Registered Investment Advisory firm. He has specialized in designing financial planning, tax, and transition strategies for dentists since 1975. His firm provides accounting and tax services for about 150 dentists each month in 23 states — from Atlanta to Albuquerque to Alaska. Rick is the founding president of the Academy of Dental CPAs, an association of 25 firms that provide specialized services to 6,000 dentists nationwide. He teaches financial management at the Medical College of Georgia and the University of North Carolina Dental Schools. He can be reached at [email protected].
