In what is beginning to look like a rerun of last year, stock markets around the world have been extremely volatile this summer. The causes of the volatility remain the same; sovereign debt problems and little growth in the developed world. Of course, if your primary response to economic problems is kicking the can down the road, one shouldn't be shocked when you encounter that can down the road.

In the U.S., the debate over the Federal government debt ceiling has taken center stage. As a refresher... the U.S. Constitution gives Congress the sole right to borrow money. Congress used to vote to authorize every Treasury issuance but starting in 1917 they instead authorized the executive branch to issue bonds as needed as long as they do not exceed an aggregate limit (the debt ceiling). We are up against that limit now, but the Treasury department has been directing cash flow so that all payments have been made up to this point. They say they will no longer be able to do that by August 2nd. Congress and the President have been debating what combination of spending cuts and taxes will accompany any bill to raise the debt ceiling. The failure to reach a deal up to this point has some commentators warning of 'catastrophe' , and S&P and Moody's threatening  downgrades to the U.S. credit rating.

Color us skeptical on the threat of the debt ceiling to our immediate financial future. Firstly, investors have factored in zero risk premium to U.S. Treasuries during this entire debate. Here is a chart of the yield on the U.S. 3 month T-bill over that time:

Yes, Margaret, that yield is 0.02%. Secondly- the silliness of the argument that we threaten our financial stability if we do not borrow more money right now. Yes, if there was a sustained period without an agreement on the debt ceiling, there would be some affects on the financial system as U.S. debt obligations act in many ways as the lubrication within that system. Even in that case though, we are sure participants in those markets would figure out some type of workaround until a deal is made. Comparisons of a debt ceiling default to AIG and Lehman make no sense because in those situations there absolutely were debts that could not be paid back. Financial crisis occur because holders of financial instruments all try and sell what are perceived as the bad debts. There is no question that the U.S. has the ability, and the intention to honor all its debt. We think the fact that both political parties in the  U.S. are starting to address the $14 trillion debt (see clock here ) is a positive move in terms of our fiscal wellness.

In Europe, the sovereign debt issue of the periphery countries continues to fester and spread. In recent weeks, fixed income investors have started fleeing Italian bonds :

While Italy does have a large debt load and low growth, it has a relatively low budget deficit and does not rely on outside funding sources for as much of its debts as do Greece, Ireland, and Portugal. This shows how ineffective Europeans actions to halt the contagion have been. Officials will have to come to the realization that they need to act in a decisive manner to halt this type of fear from spreading from country to country. This will involve either significant outlays from Germany and its northern neighbors- either directly to their southern compatriots or to recapitalize their banks when those nations default. If European officials do not act, we think they will wake up one day to find Greece or Portugal declaring exit from the Euro and themselves with little control of the events that follow. Our opinion is that the European financial situation is much more serious than the U.S. debt ceiling and, if events go poorly, would have a negative impact on global financial markets.

We do think there are some possibilities for upside surprises in the financial markets. While the public vitriol has been high between President Obama and Republican congressional leadership, there is at least the potential for a large deal that would set the country on firmer financial footing. In Europe, while the situation within the periphery countries is dire (bordering on desperate), they represent a small proportion of the larger European economy. The bigger fear is that if now small problems go unchecked (cans kicked) they will fester and spread throughout the banking system. If European officials come to recognize that fact and start to act in a manner that assures markets fallout from a Greek or Portuguese debt restructuring would not result in losses spreading throughout the finance system, that would relieve a lot of the overhang currently over the markets.

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A survey caught our eye this month, showing an uptrend in loans being taken from 401(k) plans during this recent economic downturn. We share it with you here and take some time to explain the nuances of making a loan to... yourself. 

According to this Aon Hewitt survey,  the percentage of accounts with loans taken against them increased from 22.3% to 27.6% between 2007 and 2010. Looking into this, our research found that sometimes a 401(k) loan is in fact your best option... and other times it compounds an already bad situation. As always, circumstances matter and it always helps to make an informed decision. We review the rules for taking these loans and the situations when it makes sense, and when it doesn't.

The Rules

How Much - You can generally borrow 50% of your vested account balance, up to a maximum of $50,000... ok, pretty straight forward. Now, try to comprehend this next part on your first try (we didn't): If you have had an outstanding loan in the previous 12 months, then the amount you can borrow will be reduced by the highest outstanding loan balance during that period minus the outstanding balance on the day of the new loan. 

How Long - It must be paid back within five years if you are using the loan for anything other than purchasing your primary home. If the loan is for your primary home you can stretch out the payments over a longer period of time as detailed in the plan documents. *If you get terminated from your job, the loan is payable immediately. Huge bummer, but a point so important we will pick it up again later.

Why These Loans Are Grrrreat!

Convenient - Simple application, usually low or no fees involved, no credit check. Far more convenient than any bank we know of.

Low Interest - Most plans charge prime rate plus a percentage point or two. This is cheaper than most of us can obtain from traditional loan sources.

Interest Paid to You - Because the loan is from an account you own, the interest you pay will go to your account. That is a lot better than paying a bank or credit card company.

Why They'rrrre Not!

Risk of Termination - Under most 401(k) plans, if you are terminated from your job you must pay back the entire balance within 30-60 days or the loan is considered in default (the equivalent of a distribution). What this means: you owe income tax on the loan amount and, if you are younger than 59 1/2, a 10% penalty to boot. Not the kind of news you need on top of a job loss.

Lower Potential Returns - Taking a loan is like buying a low yielding bond (at whatever rating you give yourself!) within your 401(k). If you had that money in  ...ahem... better performing holdings you could earn a higher return on your investment.

Lower Long Term Savings - The Aon Hewitt survey mentioned above also notes that 401(k) participants who take a loan tend to lower their retirement income from 7%-25%. This is due to lower returns, lower contributions, and defaults by those who take loans.

Should You?

Shakespeare said to be neither borrower nor lender, and here you are both! More seriously, a loan from your 401(k) can make sense when used to pay off higher interest debt, or for buying a house when rates are much higher than your 401(k) loan rate. If you are looking to pay for your trip to Vegas or examining credit options that support a lifestyle beyond your means, then... not so much. If you choose to take a loan, your first step is to protect yourself from the its downside. Most important, if there is uncertainty in your employment status, you must have the means to repay the loan if it is called due to termination. Also, the loan repayment should not be seen as a 401(k)contribution. If you do not pay the loan and continue making your regular contribution you will have less money in retirement (note: some plans stipulate you repay entire loan before resuming contributions). If you are worried about the lower return on your account due to the low interest then you can increase your allocation to equity-based assets with the remainder of your 401(k) balance. Remember this,  for asset allocation purposes the loan should be viewed as a low yielding bond issued by yourself to your 401(k) account.

**I Am Getting Double Taxed. No, Suze, You are Not**

A common held misconception, most visibly by Suze Orman , is that you are getting double taxed on a 401(k) loan because you have to use after tax dollars to fund a tax deferred account. The idea is that because you have to use your current income to make the loan repayment, you get taxed right now on the income and then you get taxed when you withdraw the money. Fair point, but remember a loan from the bank requires repayment using after tax dollars as well. The real difference is that you are now paying the interest to your 401(k) account rather than the bank. Suze is confusing a loan repayment with a contribution. They are not the same.

 As always we welcome your comments or suggestions. Stop in, call 212.949.0494,  or simply 'reply' to this email.