What does this mess mean for my finances?

/ Source: msnbc.com

Where to begin? An extraordinary week in the financial markets brought a flurry of questions from readers about their personal finances: from the price of gold to the outlook for the Fed to the safety of annuities issued by failed insurance giant AIG

Amidst current financial turmoil, why are gold prices shooting up? And why are T-bill rates dropping?

Throughout history, strong demand — combined with limited new supply — has made gold a favorite “safe haven” during times of financial crisis. It’s also viewed by many as a hedge against inflation or the devaluation of paper assets. That’s why demand is surging, forcing prices higher. But it’s not entirely safe: Gold prices can, and do, fall from spikes like this.

The same is true of T-bills. Since it’s highly unlikely that the U.S. government will ever default (make that unthinkable — we don't want to think about it), T-bills are one of the safest places to stash cash. The recent financial panic has created so much demand for the safety of Treasuries that investors are willing to buy T-bills with little or no interest — just for the peace of mind they’ll get their money back.

At one point this week, short-term Treasuries briefly had a negative yield: Investors were willing to get back a little less of their money in return for knowing they’d get most of it back.

If no one buys American debt, what will happen?
— Randy C.,Mesa, AZ

If no one bought American debt, the government would have to shut down.

Because our government spends more than it charges its citizens for the services it provides, it has to borrow the money from investors and countries that live within their means and have money left over to invest. For the moment, it looks like growth in the global economy will keep producing plenty of surplus cash that needs to be invested somewhere. And, also for the moment, the U.S. Treasury is about the safest place to stash that cash. That’s because even though our government is running huge deficits the U.S. economy is still the largest and most diversified in the world.

But the recent move by the Treasury to take over hundreds of billions in bad debts from private lenders creates more risk for anyone who decides to lend their money to Uncle Sam. Before they stop buying Treasury debt altogether, investors will demand higher interest rates to make up for that added risk.

That’s a real worry right now: If interest rates on Treasuries rise, it will raise the cost of borrowing on all forms of debt. With money already getting tougher to borrow, any increase in the cost of borrowing would only make matters worse — for the financial system and the global economy.

AIG annuitites: Are they insured? What happens with them?
— Maureen, Va.

Annuities are not insured. In effect, they’re a form of insurance — a promise of lifetime income. In return for a chunk of money, the insurance company invests that money and agrees to pay you an agreed-upon amount, no matter how long you live.

While they’re not insured, the insurance companies that offer annuities and other insurance policies are heavily regulated, state by state. Each state enforces rules and restrictions designed to make sure insurance companies based in that state keep enough money invested safely to back all the promises they’ve made. 

The problems that sank AIG were risky bets made by the parent company. AIG's 70-odd subsidiaries that back insurance policies are in good shape. Some of them may be sold to other insurance companies, which will assume responsibility for the claims of policyholders — not unlike what happens to your savings account if your bank gets bought out by another one.

States also maintain guaranty funds, backed by a pool of money paid by insurers, that can be tapped if an insurance company goes bust and can’t pay all its claims. There are limits (which vary state by state) on how much the fund will pay to cover any individual claim. The Fed’s rescue of AIG makes it even less likely that any policyholder would lose money.

My 401(k) has been pummeled this year, as have most people's. I'm 31 years old, so I still have many years until retirement. If history is our guide, will the market tanking and allowing me to buy shares of my funds at a much cheaper price end up actually being a good thing over a long period? Or is that just something I am telling myself so I can sleep at night?  
— Peter B.,Arlington, Va.

If history is your guide, the odds are in your favor. Unfortunately, the current financial mess is like nothing that’s ever happened before.

There have certainly been financial panics on the scale of what we’re currently seeing. The Great Depression comes to mind. But like every financial cycle, the specific circumstances are unique.

The modern financial system is a marvel of man’s creation; trillions of dollars of capital fly around the world with the speed of electrons. While past panics were confined to stocks or bonds, we now live in a world of complex, interdependent securities that have been created only recently. Some of the professional investors who created these securities are now learning (the hard way) that these pieces of paper are, in fact, much more complex and risky than their computer models predicted.

That uncertainty is at the heart of the current crisis. When the stock market crashed in 1987, for example, the damage was widespread but highly visible. But within a few days, the panic was over and the market resumed its upward climb.

Today, while it’s clear the financial system has taken an enormous hit, no one knows exactly where the damage is. Think of it like a ship taking on water, with no way to figure out where the leaks are. The crew is now desperately trying to pump the water out of the hold while it searches for the leaks. Despite reassurances that everything will be fine, if the ship keeps sinking, you’ll probably see more people decide to take their chances in a lifeboat.

How likely at this point is it that the current economic slippery slope is going to take us all the way to the crash of the Federal Reserve System?
— Angela H.,Portland, Ore.

At this point, it’s hard to rule out anything: There has never been a panic quite like this one. But for the moment, the Federal Reserve System — and the U.S. banking system — are in better shape than the events of the past few weeks would lead you to believe.

For one thing, the Fed and the Treasury have now acknowledged that the turmoil in the U.S. credit market is too big for the Fed to handle by itself. That’s why Treasury Secretary Hank Paulson and Fed officials have been meeting with congressional leaders to work out a plan for  cleaning up the mess.

It’s also worth noting that banks that rely heavily on depositors for their capital are in much better shape than the big investment firms that bought big piles of mortgage-related paper with borrowed money. That’s why Bank of America and Wachovia have emerged as buyers for these failed companies. For the moment, it looks like the banking system as a whole has a fairly comfortable cushion of cash.