Kevin Canterbury
What Caused the 2008 Financial Crisis?
The 2008 Financial Crisis- also known as the Great Recession- is a notorious event in US history largely caused by rampant deregulation in the financial industry. Kevin Canterbury of Arizona’s Redstone Capital Management notes that it is crucial that financial professionals recognize many of the key players in the crisis as this knowledge will help reduce the risk of future economic turmoil. Here, Kevin explores a few of the root causes of the financial crisis and how these pieces worked in tandem to cause on of the worst recessions in U.S. history.
Deregulation in the Industry
One of the primary reasons that the Great Recession could happen is a period of deregulation in the financial sector. For example, in 1999 the Financial Services Modernization Act repealed the Glass-Steagall Act of 1933. This let banks use deposits to invest. Later, the Commodity Futures Modernization Act further loosened regulations on derivatives. A big issue with this set foundation was that the banks had promised to protect their customers by only investing in low-securities, but that is not how the situation ended up playing out. Because watchdogs were paid by banks making transactions, there was an incentive to be less than transparent regarding the risks of certain investments. In addition to this, industry watchdogs could have stepped in to lessen the impact of some of these deregulation moves; however, many did not sound any alarms at this time.
Securitization and Predatory Lending Practices
The issues with the banks that contributed to the financial crisis were compounded through securitizations. Loans for mortgages provided by the bank could be sold on the secondary market, allowing the entities to make additional loans with the money received from the sale. Naturally, investors were the ones who took the risk of default because of this setup, but they were protected via credit default swaps. Seeing the financial incentive to seek out derivatives without fear of defaulting, soon everyone from individual investors, pension funds, and large banks had amassed them- but there was a problem. Since banks were incentivized to make money through derivatives, they wanted to have more mortgages as backing. This meant that many banks would offer loans for mortgages to people even if they were unlikely to be able to pay them back. The strategy would later come back to bite them.
Subprime Mortgage Crisis Followed by Interest Hike
At the turn of the millennium, the Federal Reserve cut interest rates, kicking off a period of rampant home financings. By 2003, the mortgage debt had increased from $460 billion in 200 to $2.8 trillion. Homeowners took advantage of the opportunity to pull equity to spend on their various needs and wants during this time, extracting $2 trillion in home equity from 2000 to 2007. This did not last and the and interest rates began do raise do to fears of inflation, and more problems began to occur in short order.
Home prices were peaking in 2006 while the market was slowing down, and the bubble eventually began to burst as prices spiraled downward. Interest rates were up 4% in 2006 versus 2004 and housing prices had fallen significantly, creating a situation where it was difficult for buyers to make their payments. After defaults on subprime mortgages began to increase, the real estate industry was imperiled- however, because funds had extended into so many other industries, the situation was the perfect storm for a stock market crash.
The IRA Penalty: Sometimes It’s a Small Price to Pay
The human condition drives people to avoid penalties with all their might. From sports to taxes, dodging fines is simply in our DNA. But sometimes, Kevin Canterbury of Arizona says paying can be worth it to increase assets and secure a wealthier future.
Investment-hungry individuals realize the potential of incurring an IRA penalty on purpose. The trick appears to be paying at the right time, as showcased by this middle-aged couple, Grant and Wendy.
A Brief Background
Grant and Wendy were a run-of-the-mill couple in many ways. They earned decently, but everything they made fluttered away to pay for three children and a mortgage.
Despite that, the couple was diligent with their finances. Wendy had a traditional IRA worth $30,000. Grant had a 401(k) filled with $200,000 and $40,000 in an IRA.
When questioned, Grant stated he accumulated much of this wealth “ahead of time.” He mentioned, “Wendy and I used to live in a smaller home. It allowed us to save larger chunks of our salaries every year. Plus, my 401(k) plan came with a generous match offer, which has got us this far.”
The IRA Penalty Debate
However, the couple’s situation shifted. As their economic environment became tighter, Grant stopped contributing to his 401(k) plan.
When speaking to a financial planner, he stated that continuing to contribute would force him to take money from elsewhere to pay the bills. Ultimately, he didn’t want to touch his $35,000 savings account unless it was an emergency. After that, the only other place he could tap into was his IRA.
So, Grant contacted his CPA to discuss accessing the money held in the IRA but was quickly put off by the idea when told the distributions would be subject to a 10% penalty and regular income tax.
And thus, the IRA penalty debate begins.
Innately, the decision to avoid the penalty makes sense. However, they were missing a potentially substantial wealth-building trick:
Restart 401(k) Contributions and Pay the IRA Penalty
When advised to restart $5,000 salary deferral contributions per year (matched by Grant’s company), he was initially distraught — the thought of paying income tax and a penalty on his IRA distributions was simply too much.
But by taking a step back and looking at a longer-term picture, all became clear.
The deferrals lowered his income, ensuring his IRA distributions did not affect his income tax payments. Plus, he had an extra $10,000 in his 401(k) growing tax-deferred. True, he owed a $500 penalty that wasn’t canceled out by the 401(k) contribution. However, he began to view that as the cost of having a larger retirement fund.
The trade-off is marvelous.
The Crux: Thinking Big
Estate planning, penalties, and taxes aren’t black and white. So while a general understanding of big-picture tax issues is essential, avid retirement savers should consult a financial advisor to determine whether purposefully paying the IRA penalty makes sense.
Many believe taking pre-59 distributions is never a good idea. But Grant and Wendy’s situation highlights that the word “never” doesn’t apply to paying the IRA penalty.