Planning In Fearful Times

Shakespeare and Ben Franklin Had It Right

Reprinted from The Estate Analyst, April, 2009

By Robert L. Moshman, Esq.

"We have nothing to fear, except fear itself."
- Franklin Delano Roosevelt

hese are fearful times in which we plan. Set phasers to "stun" as we assemble a landing party and beam down to planet Earth to assess an assortment of alien adversaries affecting financial planning.

Stranger Than Sci Fi

Captain, the tri-corders are picking up strange readings!"

This is certainly an uncharted and hostile part of the universe and it has provided threats no one ever heard of before: Sub-prime mortgages, structural macroeconomic debt overhang, collateralized debt obligations, mark-to-market valuation manipulation, toxic assets, and even zombie banks. This is pretty far out there.¹

Our economy isn't on Star Trek or the Twilight Zone, this is reality. The financial world has turned on a dime and financial planning has been turned on its ear. Stock market bubbles, real estate bubbles, and various other bubbles have burst and bubbled over. Planning has always coped with uncertainty and change, but there is a pervasive new element shaping planning models and it isn't a new tax law or new technology or even a new world order. It is something more basic: Fear.

Let's take inventory of these extraordinary threats that are affecting the context of planning, allay what fears we can, and consider a few practical perspectives and ideas.

Identifying Dangers

Sudden Dramatic Losses: The net worth of American families dropped 18% during 2008. That's $11.2 trillion in declining values with $8.5 trillion of the damage in the stock market and another $2.7 trillion in real estate. A theoretical person with a stock portfolio tracking the Dow Jones Industrial Average has lost more than half the value of his or her holdings through early 2009. The Dow Jones Industrial Average surpassed 14,000 in October 2007 but closed at 6,594 in early March. And if you invested with Bernard Madoff, you lost it all.²

Lack of Stimulation: It's as though the earth has stopped spinning. The economy has gone limp, vapid, melancholy, and flat lined. It needs caffeine, adrenaline, a Jamba Juice boost, and defibrillators. Instead it got an unhealthy dose of …

Credit Creation: When things are sluggish in the economy, one way to jump start things is by extending credit so that people buy homes and businesses produce products and the whole economy gets up a head of steam and runs on its own. But too much credit creation has a downside in that it can lead to…

Sub-Prime Stew: Don't eat the stew! There was a credit crunch in 2007 and borrowers not meeting prime lending standards, i.e., with shakier finances and who were less likely to pay back mortgages, found lenders who enabled them to buy homes with little or no money down. Those lenders then packaged up such mortgages and sold them. When the economy soured, borrowers lost jobs and couldn't make mortgage payments and the homes fell in value and were worth less than the outstanding mortgages. Entities extending the loans or purchasing the mortgages in packages were left foreclosing on assets that couldn't cover the face value of the loans.

Toxic Assets: How many times has this happened to you? You go to a flea market and buy a giant pink elephant weighing 3,000 pounds, haul it home, and then realize that nobody is buying 3,000-pound pink elephants. Same thing has happened to some financial institutions that bought up lots of these unusual assets. Doesn't matter that they got terrific deals on their purchases at the time if there is no longer any trading market to sell them…anywhere. Those financial entities holding Collateralized Debt Obligations (CDO) (a type of asset-backed security first designed in the late 1980s) have no place to sell them at all…they are stuck with them. If you can't sell it and can't use it, then its value is zero.

Debt Overhang: Also known as "flat broke." When debts exceed assets, businesses can't reorganize under Chapter 7 bankruptcy and end up out of business with a receivership under Chapter 11. The only thing worse than debt overhang is…

Structural Macroeconomic Debt Overhang: Okay, this one definitely sounds worse, debt overhang on steroids. This is where latent underemployment and debt build up until banks fail and private debt has to be replaced by public debt in the form of…

Bailouts: Instead of allowing entities to fail, the Federal government takes over entities that are deemed essential to the national interest. How does the government throw lifelines out to banks, auto makers, insurers, and other businesses when it has no funds? By borrowing funds from other nations such as China and engaging in…

Deficit Spending: The newly proposed federal budget has $1.7 trillion of deficit spending.³

Mark-To-Market Flu: In 1997 the tax law started allowing securities and commodity traders to make an accounting election. Wall Street regulars quickly found ways to exploit this and the same fraud then spread to banks and corporations like the flu and also has hurt valuations. The Emergency Economic Stabilization Act of 2008 that was enacted in October 2008 provided the SEC with the authority to suspend mark to market accounting. In December the SEC declined to do so. However, the Financial Accounting Standards Board has recently relaxed mark-to-market standards in circumstances such as inactive markets.

Zombie Banks: No, banks were not re-animated by gamma rays and they don't walk around eating brains. Banks which got stuck holding too many of those toxic assets or assets affected by skewed valuations are like hollow shells.

A Combo Sandwich: Now lets use all the new jargon in a sentence: The zombie bank was holding toxic CDOs that were valued with mark-to-market accounting rules and as a result the bank appeared to own next to nothing.

We Are The World: When the United States catches a cold, the rest of the world sneezes. We provide foreign aid and purchase foreign products and funds from around the world are invested in our treasury bonds, real estate and stock markets. So we are not alone; a recession here is felt all over the world. And things will be improving. Recessions are cyclical, there are positive signs amidst all the negativity, and financial planning means taking advantage of current conditions like lower values and tax breaks to shape a more prosperous future.

TECHNICAL REFERENCES

¹These new financial demons are as intimidating as the energy beings encountered by Captain Janeway in the dark matter nebula of the Delta Quadrant-and possibly as mind blowing as the phenomena experienced by Captain Archer in the Delphic Expanse. But one suspects that the Borg encountered by Captain Picard might appreciate the zombie banks.

²Unless less you made money from Madoff, in which case, his other investors would like a word with you right away. Bring a lawyer.

³The National Debt is currently at $11 trillion.

Temporary Rules & Tax Breaks

There are several tax breaks and financial rules with deadlines that will expire.

FDIC INSURANCE LIMITS: Depositors should be wary of taking FDIC insurance coverage at $250,000 for granted. That level of coverage had been $100,000 and was raised temporarily to $250.000. This is set to expire on December 31, 2009. Would there be strong reason to reassure depositors by extending and making permanent such insurance coverage? Sure. Will it happen on time? Don't count your chickens until they hatch. Joint accounts currently get coverage of $250,000 per owner. Trust accounts can have $250,000 per owner beneficiary. Adding co-owners to accounts and other strategies can be implemented to maintain FDIC coverage if we revert to the former limits in 2010.

FIRST HOME TAX CREDIT: The new stimulus package includes a tax credit for persons buying their first home on or between January 1, 2009 and November 30, 2009. This is worth up to $8,000 and does not have to be repaid. Other rules apply.

MORTGAGE FORGIVENESS TAX BREAK: Normally, if a lender forgives debt, the amount forgiven would be included as taxable income of the debtor. In the case of homeowner who can't pay the mortgage and makes a short sale deal where the bank accepts the proceeds of the home in lieu of the full mortgage, the homeowner catches a mortgage break but is losing his or her home. The federal government will stop adding insult to injury, at least temporarily. Under the Mortgage Forgiveness Debt Relief Act of 2007, taxpayers may exclude debt forgiven on their principal residence if the balance of their loan was $2 million or less. The limit is $1 million for a married person filing a separate return. Details are on IRS Form 982. The break applied for debts discharged from January 1, 2007 to December 31, 2009.

THE TAXMAN COMETH: Not only Uncle Sam is short on tax revenues these days, so are states and counties and cities. New York is considering a temporary surtax on those earning in excess of $300,000. Other states can expect state income tax and local property tax increases. Higher capital gains rates may lie just ahead as well. Shifting income among family members, among state jurisdictions, and from one tax year to the next can be considered.

PENSION RMD HOLIDAY: Required minimum distributions for 2008 really hurt. A plan participant or IRA owner being forced to liquidate assets had various rotten choices such as incurring capital gains or selling positions at the bottom of the market. RMDs for 2009 can be waived under a new provision enacted in December. As a result, plan participants can elect to skip the 2009 RMD. The next mandatory RMD would be for 2010. Note: The deadline for taking this RMD is December 31, 2010, not April 1, 2011.

Shakespeare and Ben Franklin Had It Right

In difficult financial times like these some pithy words of wisdom make more sense than ever.

The Great Bard on Money

"Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry."

So said Polonius in Hamlet by William Shakespeare. In Shakespeare's time, borrowing by the upper class had reached epidemic proportions. He may have experienced debt first hand, by some accounts.

If you owe money you pay a tremendous amount of interest in addition to the principal. The more you owe, the harder it is to catch up or get ahead. That's the rationale behind the Truth In Lending Statement that borrowers must be shown-to make them aware of the huge expense of interest over the course of the loan.

Being a debtor in a bad economy can be dangerous. A borrower who becomes unemployed may default on a loan. A borrower with an adjustable-rate mortgage may face higher rates later as a result of too much deficit spending now.

Being a lender is no picnic either. Shakespeare probably never foresaw structural macroeconomic debt overhang but in hard times, lenders end up with worthless IOUs.

Poor Richard's Wisdom

"Creditors have better memories than debtors."

Benjamin Franklin wrote this in 1758. He had that exactly right as well. He also said, "If you would know the value of money, go try to borrow some; for he that goes a-borrowing goes a-sorrowing."

Okay, this one didn't quite catch on like Shakespeare's line and is a bit corny by Franklin's own standards, but the message is similar. Debt has many significant downsides.

In addition to writing Poor Richard's Almanac, another famous quote came from one of Franklin's personal letters:

"But in this world nothing can be said to be certain, except death and taxes."

Judging from the 220 years since that statement, the facts appear to bear Franklin out; both institutions appear to be going strong.

Franklin's Will

In addition to his legacy of wise aphorisms, Benjamin Franklin set an example reflecting on the time value of money and the use of trusts. In his Will, Franklin left a small amount of money to be held in trust for 200 years to help the citizens of Boston and Philadelphia.

He asked that the funds be loaned out at interest to certain qualified young artisans and apprentices and calculated how the funds would grow to provide these cities with 100,000 pounds silver after 100 years with the rest growing to 4,060,000 pounds sterling. He left instructions for the use of the funds after 100- and 200-year intervals.

Franklin died in 1790 when 1,000 pounds sterling was worth about $4,400. That amount grew and sizable distributions took place in 1890. As of 1990, the remaining funds in Philadelphia had grown to $2 million, while Boston's bequest had grown to $5 million and was used to found the Franklin Institute of Boston.

The difference in growth has been attributed to the level of risk incurred. Philadelphia honored Franklin's intent of providing loans to individuals. But both bequests prove is how dramatic growth can be if assets are protected in a trust and permitted to grow over time.