Thursday, July 31, 2008

The Housing Recovery Act: Who's Zoomin' Who?

The Housing and Economic Recovery Act that President Bush signed into law yesterday is a good example of how politics drive the government response to the financial and economic crisis. For many months, the Republicans have blocked Democratic legislative efforts to provide assistance to homeowners. Then, the stock prices of Fannie Mae and Freddie Mac nosedived, and the Bush administration was forced to cobble together a bailout for them. A crucial part of the bailout was legislation giving the Treasury Department the authority to provide capital to Fannie or Freddie under whatever terms and in whatever amounts it considered appropriate. When the Republicans tried to get the Democrats to sign off, the Democrats said that homeowner assistance had to be a part of the package. The Republicans wanted the Fannie/Freddie bailout so badly that they swallowed hard and agreed to homeowners assistance.

But the question remains, who really benefits from this legislation? The Republicans--and Fannie and Freddie--got what they wanted: a blank check for Treasury, good until the end of 2009, to make loans to Fannie and Freddie or invest in their stock in order to prop them up. This provision was a clear victory for the Republicans and Wall Street.

What about homeowners? The law authorizes the FHA to help distressed homeowners by insuring up to $300 billion of new 30-year fixed rate mortgages if the lender agrees to write down the mortgage debt to 90% of the home's current appraised value. While $300 billion is a pretty big number, the Congressional Budget Office estimates that only about $68 billion of this authority will be used and that about 325,000 people will be assisted. When you consider that there are several million homeowners who have defaulted or are expected to default on their mortgages, assistance for 325,000 isn't likely to have a big impact on the housing market.

The law also provides for a tax credit of up to $7,500 for first time home buyers. But calling this a "credit" is politics at its most political. The provision is really an interest-free loan, which you have to pay back over 15 years. If you can take the maximum $7,500 credit, you're really getting a loan with an average balance of about $3,750 over its duration. Assuming an implied interest subsidy of 6% (around the interest rate for 15-year mortgages), you're getting about $225 a year on average. Whoop-de-doo. There won't be a surge of new buyers into the market on account of this provision.

The law increases the loan limits for Fannie, Freddie and FHA guarantees to as much as $625,000. However, Fannie and Freddie have already been working with temporarily increased loan limits (to higher levels than $625,000), so this provision doesn't add much except to make higher limits permanent. But Fannie and Freddie's weakened financial condition means they don't have enough capital to underwrite that many new loans. So increasing the limit permanently isn't likely to have a rapid impact on the real estate markets.

The law provides $4 billion to the states to buy and rehabilitate distressed properties. That's an average of $200 million per state. Given that our real estate market runs in the trillions, does anyone think $4 billion will make a big difference?

The law also includes provisions that may actually impede the recovery of the real estate markets. Downpayments for FHA guaranteed mortgages have been increased to a minimum of 3.5%, from 3%. Given the American allergy toward saving, this provision may reduce the number of qualifying borrowers. The law also prohibits seller assistance for downpayments in FHA guaranteed loans. It increases federal regulation of Fannie and Freddie (which also surely will require them to raise more capital). These provisions should strengthen the financial system and discourage some of the stupid lending that has taken place in recent years. But the cost will be less mortgage credit available to home buyers and a longer recovery time for the current real estate market.

When you get down to it, the Republicans and Wall Street got the better part of the deal for the Housing and Economic Recovery Act. They wanted a blank check to support Fannie and Freddie, and got it. Their nightmare, that Fannie or Freddie might land in bankruptcy court before the Presidential elections this fall, is much less likely now than before the new law. The Democrats might claim victory, but coming up with tangible proof of it (especially before the election) could be difficult. Who was zoomin' who when this deal was struck? Almost all the crucial factors in the upcoming election favor the Democrats: the economy is stagnant, unemployment is increasing, inflation is rising sharply, U.S. military adventures overseas haven't produced lasting successes, and no rebound in the real estate market is in sight. But the Republicans displayed a bit of the agility that has kept them in power during most of the last 40 years. This fall's election remains up for grabs.

Monday, July 28, 2008

Covered Bonds: an Idea Whose Time Has Yet to Come

Today, July 28, 2008, the Bush 43 administration announced, with great fanfare, another idea for alleviating the mortgage crisis which it had seemingly sketched out on the back of an envelope: covered bonds. Covered bonds consist of a pool of mortgages, like mortgage-backed securities, in which investors buy interests. What makes covered bonds different is that the bank that packages the mortgages retains an interest in the pool, effectively guaranteeing some portion or all of the mortgages. This structure ensures that the sponsoring bank keeps some skin in the game. That way, it will have an incentive to underwrite mortgages that actually comport with reasonable credit standards, unlike the no income, no doc, no chance of repayment mortgages that became so fashionable in recent years. And, perhaps, best of all from the Republican standpoint, covered bonds can be underwritten privately, without seeming to require governmental assistance (including involvement by Fannie Mae and Freddie Mac, which are part of the government even though their profits accrue to their managements and shareholders).

This is a nice idea. It is logical. Covered bonds are already found in European financial markets, and may have helped to limit the extent of the mortgage losses there. So there is a track record that may lead one to think they could work here. In fact, the basic concept underlying covered bonds--that the underwriting bank guarantee the soundness of the loans--was commonplace in the U.S. 30 or more years ago, in syndicated bank loans. These loans were made to business corporations by a bank (the "lead bank"), which sold off portions of the loans to other banks (the "syndicate"). The lead bank was typically responsible for buying back the loan if the debtor defaulted, at least under some circumstances. The buyback obligation provided a strong incentive to the lead bank to make sure it dotted its "i's" and crossed its "t's." It couldn't afford to play fast and lose with credit standards.

The problem with the covered bond idea today is that banks need to have a nice cushion of capital in order to underwrite them. The sponsoring bank would have to keep the covered bonds on its balance sheet, and that would require capital. As we know from every day's financial news, banks are kind of short of capital right now, and there ain't no easy way for them to lay their hands on more. In the ordinary course of business, it will be years before banks have enough capital to issue covered bonds in volume. The only way the covered bond concept could be rapidly adopted would be to make massive infusions of taxpayer money into the capital structures of banks. Sadly to say, one suspects that senior officials at the Treasury Department may not have dismissed this idea as ludicrous.

What the covered bonds proposal reveals is the enormous dependency of the real estate market on securitization as its principal means of finance. And that, in turn, reveals the great extent to which the government relies on rising real estate values to keep the economy growing. But, as we now know, real estate values can't rise continuously. And asset speculation isn't a sound basis for an economy. Production of goods--manufacturing and agriculture--is at the heart of any healthy economy. However, instead of building for the long term, the Bush 43 administration, having only six more months in office, is acting like a short timer by proposing a supposed boost to the real estate markets it can't effectively implement. The upcoming presidential election can't come soon enough.

Thursday, July 24, 2008

Is the Federal Bailout of Fannie and Freddie Too Clever?

Today, July 24, 2008, the Dow Jones Industrial Average fell 283 points. Fannie Mae stock dropped almost 20% and Freddie Mac stock fell more than 18%. The financial press attributed the stock market's swoon to bad news on the housing and unemployment fronts.

The downturn in Fannie's and Freddie's stock wasn't supposed to happen. Late last week, the Bush 43 administration announced with great fanfare policies to prop up Fannie and Freddie. Prominent among these policies was a proposal that the Treasury Department be given wide discretion to lend to and invest in Fannie and Freddie as much as it wanted on whatever terms it considered appropriate. The announcement of the bailout plan sent Fannie's and Freddie's stock, along with bank stocks, bounding upwards. It appeared that the administration meant to protect not only Fannie's and Freddie's creditors, but their stockholders as well. Who wouldn't buy a stock that has government protection?

But this plan may have been too clever by half. The idea is that by supporting Fannie's and Freddie's stock prices, the two companies would be able to raise capital by issuing more equity, which would absorb the mortgage losses that we all know are coming. The cost to the taxpayers would supposedly be relatively small because taxpayer dollars would only provide support while private equity would do the heavy lifting (and take the big hits). Presumably, private equity would get greater profit potential to compensate it for taking the risks of the big hits.

The problem, though, is that we all know the big hits are coming. Estimates of the losses from the mortgage mess and credit crunch tend to run over $1 trillion, and have gone as high as $2 trillion. Most of these losses haven't been realized yet. Fannie and Freddie, who either hold or underwrote about half of all mortgages issued in the U.S., have some serious exposure. It won't be a small number. Many tens of billions seem almost a certainty. Over $100 billion wouldn't be surprising.

Private, often foreign, investors have done poorly investing in mortgage-bedeviled banks over the past year. Many of the major banks are looking for more capital as the flood of write downs continues. The foreign investment funds that got burned the first time around may be just a wee bit hesitant to step forward and accept Treasury's invitation to take a bullet for Fannie or Freddie. It's one thing to invest with the risk of further losses. It's another when further losses are a virtual certainty. At some point, when the mortgage and credit crunch losses loom large enough, the Euro, yuan, rupee, won, baht, yen and so on begin to look like better bets than the dollar.

If private investors shy away from providing fresh equity to Fannie and Freddie, the Treasury Department's plan could be in serious trouble. The Congressional Budget Office estimated the likely cost to taxpayers of the Fannie and Freddie bailout at $25 billion. But this seems low, especially considering that the Treasury Department requested that the borrowing it did to bail out Fannie and Freddie not count against the federal government's debt ceiling. The debt ceiling is currently $9.815 trillion, with $9.5 trillion in debt outstanding. If the cost of bailing out Fannie and Freddie could so seriously implicate this ceiling that Treasury wants it excluded, that would mean that the current buffer of $315 billion probably isn't enough. Not a good sign.

Private investors might indeed refrain from investing in Fannie and Freddie even with Treasury warming up in the bullpen. Perhaps the stock market figured this out, and decided that discretion would be the better part of valor. That would explain the sharp dropoff in financial stocks today.

The baseline problem for the current financial crisis is that a shipload of losses remain to be recognized. These losses were created by the reckless and downright stupid lending done in the Fed-fueled credit bubble. The crisis won't pass until the losses are booked. One way of doing this would be to create a new mortgage agency, which could implement federal policy with a clean slate and no pile of liabilities that may be known or unknown. Fannie and Freddie could be gradually liquidated, with their stockholders, bondholders and other creditors taking losses that would be appropriate to their standing in the companies' capital structures.

Treasury's current approach of throwing taxpayer dollars at these losses is reminiscent of the mistakes Japan made in the 1990s, trying to squirm its way out of its stock market and real estate bubbles. Among its policies were government subsidies to failing banks and businesses that were called "zombie businesses." The Japanese economy stagnated, and then stagnated some more, only to continue stagnating, even to this day. The Japanese finally figured out what they had to do and booked their losses. But they took so long to do it (and wasted so much national wealth subsidizing zombie businesses) that they still are going sideways economically speaking.

We can learn from Japan's mistakes. But that would require putting expediency aside and doing the right thing. In Washington, especially in an election year, that's definitely not something to bet on.

Tuesday, July 22, 2008

Carl Icahn's Untakeover of Yahoo Vindicates Dog Owners

Dog owners everywhere can take satisfaction from the latest in the Yahoo-Icahn-Microsoft saga. Icahn, an acerbic critic of Yahoo’s board of directors and management, has now decided to join them. He and two pals will become members of an expanded Yahoo board. This, after Legg Mason Capital Management, a major Yahoo shareholder, announced that it would back the current board, and not Icahn, at the upcoming shareholders meeting. Icahn was probably counting on major institutional shareholders like Legg Mason to support him in the proxy contest. However, even though they likely haven’t been thrilled by the performance of Yahoo’s current management and board, the big institutional shareholders didn’t all flock to Icahn’s banner.

Icahn’s impending election to the board leaves his erstwhile semi-ally, Microsoft, in the lurch. As a dissident shareholder, Icahn increased Microsoft's negotiating leverage to buy some or all of Yahoo. His joining the board means the proxy contest he threatened won't happen, and Microsoft will have to think harder about how much it's willing to pay for some or all of Yahoo. Since its feet were getting rather cool anyway, the likelihood of a deal between Microsoft and Yahoo has grown ever more faint.

Icahn's agreement to join Yahoo’s board may be the smartest move he’s made here. If Yahoo stock has any potential for outsized performance in the future, it will come not from a battle between dissident shareholders and the current management and board. It will come from the company figuring out where the herd-like behavior of heavy users of the Internet is likely to go next, and capitalizing on the stampede. That's where Internet companies have made big money.

T. Boone Pickens, another corporate raider of Icahn’s vintage, may have been left somewhat in the dust by Icahn’s entente with Yahoo. Pickens bought a significant stake in Yahoo when Icahn emerged as a dissident shareholder. Boone may have been hoping for the kind of quick payoff that Icahn often engineered in years past. But years past are years past. In today’s stock market, companies tend to be fully valued. The takeover game of the 1980s was premised on companies being seriously undervalued, with much hidden value that could be made to blossom if a noisy shareholder slapped management around a bit. Hidden value is harder to find today, except maybe for well-capitalized companies holding lots of Euros. For the corporate raiders of yore, the fast money in the takeover game was made a long time ago.

Icahn, Microsoft, Pickens and perhaps others have once again learned the timeless lesson of Wall Street: if you want a friend, get a dog. Put another way, in the financial district, money talks and bull chips walk. Yahoo’s shareholders may benefit from all this in the long term. Icahn will be yanking chains behind the scenes, and he’s a chain yanker par excellence. Yahoo’s story isn’t over. But the attempted takeover of Yahoo is over.

Sunday, July 20, 2008

Benefiting from a Weak Dollar

The dollar is going to be weak for a long time. That's clear. The Fed isn't raising interest rates any time soon. With oil prices still sky high, trade imbalances will remain seriously imbalanced. The U.S. economy is slowing. The U.S. stock markets are falling, a disincentive for foreigners to buy American stocks.

Nevertheless, when times get tough, look for opportunities. A valuable life skill is the ability to turn adversity to your advantage. There are things we can do to benefit from the weak dollar.

Exports. Businesses can expand their export markets. Drops in the value of the dollar make American products more competitive overseas.

Manufacturing. The lower dollar means that manufacturing costs here are relatively lower. Domestic investment becomes more profitable than investing in a country with a rising currency. This is true for foreign companies as well as American companies. Toyota recently announced that it will start producing the Prius in America. Volkswagen has just announced that it will open a plant in Tennessee.

Tourism. Okay, the idea of making a living working on a dude ranch or a sightseeing bus doesn't quite carry the prestige of being an MD or an Esq. But many folks in Europe and Asia make comfortable livings fleecing tourists. The weak dollar will bring hordes of visitors to our shores. We, the fleecees, now have a chance to turn the tables on the fleecers. Shopping malls emptied by the credit crunch can once again hear the ring of cash registers. Sellers of t-shirts and cheap ceramics can prosper. Kitschy restaurants can scheme with tour bus operators to serve bland, mediocre American dishes to foreign people who don't know the difference. The dollar slots are cheaper than the Euro slots, and casinos nationwide could lure in the reckless and shortsighted from overseas.

Consumers. Shop for bargains and you'll increasingly be buying American. Imports are getting more expensive not only because the dollar is weakening, but also because rising energy prices have pushed transportation costs through the roof.

Governments. The federal, state and local governments should pursue policies to take advantage of the weak dollar. Now is a good time to promote investment in manufacturing, exports and tourism. America needs more than bailouts for large financial institutions to recover its economic footing. Financial firms are just intermediaries, and they can't become truly healthy unless the rest of the economy is healthy. Make the rest of the economy healthy, and they won't need government bailouts.

Thursday, July 17, 2008

The U.S. Government's Fight Against the Markets

America, the great bastion of free enterprise, now confronts the spectacle of its government trying to fight the markets. When the real estate, mortgage and stock markets began tumbling last year, the Federal Reserve sharply reduced interest rates in an effort to stem losses. It may have softened the blow, but the losses nevertheless remain gargantuan. When banks stopped lending to each other, the Fed stepped in with billions of dollars of loans, taking mortgage-based derivatives and other kitchen sinks as collateral. When Bear Stearns tottered at the brink, the Fed guaranteed a bunch of its hinky assets in order to induce J.P. Morgan to make an acquisition it might well not have otherwise made. When Fannie Mae and Freddie Mac's stock lost most of their value, the Fed stepped in with yet more promises of credit, and the Treasury Department announced a plan for the government to invest in Fannie and Freddie. Brilliant. Treasury wants authority to invest taxpayer money in companies that no private investor in its right mind would invest in.

The SEC made a cameo appearance and issued an order limiting the ability to sell short the stock of Fannie, Freddie and certain large financial institutions that are primary dealers of the Federal Reserve. Shareholders of these firms can momentarily wipe the perspiration from their brows. But shareholders of GM, Ford and all of the other thousands of public companies in America might wonder why firms so badly mismanaged as Fannie, Freddie and some of the primary dealers are insulated from market realities.

The U.S. government is trying to fight the markets--the real estate market, the stock market and the derivatives market. This isn't likely to be a winning proposition. The losses that have been or will be sustained in these markets are in the trillions, too great for any government to absorb or control. Governments that try to take on massive market forces eventually lose. The Communist governments of the Soviet Union and China couldn't beat market forces and wound up joining them. The U.K. government's attempt to defend an overvalued pound in 1992 against short sellers ended in failure and devaluation. The U.S. government's decades long efforts to fight market forces in the agricultural commodities markets has resulted in unjustified and irrational farm subsidies. The Japanese government's efforts to avoid recognizing the Japanese banking system's losses from the collapse of real estate and stock prices in that country in 1990 resulted in failure and stagnation that still bedevils Japan.

In its waning days, the second Bush administration appears to be placing on the federal government responsibility for all liabilities and even share values of the core players of our financial system. This is a really bad idea, not only because of the moral hazard it creates--incentivizing the financially powerful to take exorbitant risks--but also because it ultimately puts the government in the position of trying to combat market realities.

What can be done? Organize a new mortgage agency to replace Fannie and Freddie, this time with a very clear statutory articulation of the extent, if any, of the government's responsibilities for its liabilities. Then, wind down and liquidate Fannie and Freddie. This is what the government did with the bad savings and loan associations in the early 1990s. They weren't bailed out and their shareholders were wiped out. Their poorly performing managements lost their jobs. The government thrashed around through most of the 1980s, trying to avoid the reality of the S&Ls' losses in the real estate markets. During that time, the S&Ls continued on their merry way, incurring more and more losses. The price to taxpayers of all this governmental squirming was about $3,000 apiece. If the federal government thrashes around more with Fannie, Freddie and the major financial firms in an effort to avoid confronting their losses, the outcome won't be particularly different. All of this administration's principal actors will be out of office before the full implications of the current policy emerge. But we schlemiels (read taxpayers) will have a firm grip on the bag for a long time.

Tuesday, July 15, 2008

How to Protect Your Money

Jimmy Stewart is no longer with us, so a run on a bank is likely to lead to its collapse. That's the lesson of Bear Stearns, and the lesson was repeated again with the recent federal seizure of IndyMac, just last year the 9th largest mortgage bank in the country. IndyMac's collapse was precipitated by the flight of hot money--brokered deposits that are paid high interest rates but which can evaporate in nanoseconds. In this case, they did evaporate in nanoseconds after publicity about IndyMac's problems. Oddly, following the Federal Deposit Insurance Corp.'s seizure of IndyMac, large numbers of depositors lined up outside its branches to withdraw their money. After the FDIC seizes a bank, making a withdrawal doesn't change things. If your account(s) are fully insured, they will be entirely protected after the federal takeover. If your account(s) are only partially insured, you took your loss at the moment of federal seizure and withdrawal thereafter won't make you any better off.

In order to protect your money, you have three options:

FDIC Insurance. The FDIC insures your deposits at any particular bank up to $100,000 per customer. The FDIC totals up all your accounts to calculate your coverage, so if you have $10,000 in your checking account and $98,000 in a CD, you are uninsured to the tune of $8,000. If you have an interest in one or more joint accounts, your interests in all joint accounts will be totalled up and you will have an additional $100,000 of coverage. For example, if you have a joint account with your spouse which has $120,000 in it and a joint account with a parent with $90,000 in it, your personal interests total $105,000 and you are $5,000 uninsured. IRAs are separately insured for an additional $250,000. There are nuances to the FDIC's rules and you should go to for more information. You can count on the federal government to stand by its deposit insurance commitment, because anything less would lead to the collapse of the financial system. If a portion of your bank accounts is uninsured, pull it out of that bank and put it in another bank. You get a clean slate with each bank. The rules for credit unions are the same, and you may get a slightly higher interest rate from a credit union.

U.S. Treasury securities. You can invest in U.S. Treasury bills, notes and bonds, and get unlimited protection for your money. These are direct obligations of the United States, and will be paid, period. U.S. savings bonds are also entirely safe, but there is a $5,000 per year limit on your purchases of savings bonds, so they aren't of much use when you have a large sum of money you prefer not to lose. You can buy these investments directly from the Treasury Department (at Treasury bills, notes and bonds can also be purchased through brokerage firms. Savings bonds can be purchased through banks and credit unions. Among other things, you can get inflation protection from Treasury securities called TIPS and savings bonds called I-bonds.

Money market funds that invest only in U.S. Treasury securities. If you want to keep your money liquid, but still get the protection of U.S. Treasury securities, invest in a money market fund that holds only U.S. Treasury securities. There are a number of such funds offered by mutual fund companies--use your favorite search engine to find them.

None of these options pays very high interest rates. But, given that almost all asset classes are dropping in value, low interest rates are better than a poke in the eye with a sharp stick. While you can always keep your cash in a safe deposit box or in your mattress, you have the problems of physical security and inflation. Cash earns zero interest, so its value is sure to diminish as the inflation monster roars.

Sunday, July 13, 2008

A Fair Bailout for Fannie and Freddie: Create a New Mortgage Agency

The Bush administration is once again winging its way through a financial crisis, this time trying to keep Fannie Mae and Freddie Mac on their feet. The Fed has announced that it's given the Federal Reserve Bank of New York the authority to make loans to Fannie and Freddie. The Treasury Department has announced a plan to seek authorization from Congress to increase the credit line Fannie and Freddie have with the Treasury Department (currently at $2.25 billion, lunch money in today's mortgage markets), give Treasury the authority to make equity investments in Fannie and Freddie, and give the Fed greater regulatory authority over Fannie and Freddie.

These proposals look like more rubber bands and chewing gum. The Treasury Department plan is just a proposal. Treasury currently has no authority to do anything except lend Fannie and Freddie $2.25 billion, which may be enough to keep them going for a day or two. The Fed's loan authorization is a tad misleading. It says that the loans will be collateralized by "U.S. government and federal agency securities." How much in the way of U.S. Treasury bills and notes do we think Fannie and Freddie hold? Not much, we'd guess. But if Fannie and Freddie submit agency securities as collateral to the Fed, those securities could be obligations of Fannie and Freddie (which are among the biggest issuers of agency securities). In other words, such collateral would be impaired in value, just like Fannie and Freddie. That's a great deal for Fannie and Freddie, but the taxpayers may be getting yet another stick in the eye from the bailout boys of the Bush administration.

The Fed's loan authority may be enough to keep Fannie and Freddie afloat for the near term. But that would likely be at the expense of more socializing risk while privatizing rewards for wealthy people.

The Treasury Department's plan is aimed at working with Fannie and Freddie as they now exist. That seems more expedient than sensible. Fannie and Freddie's financial conditions remain unclear years after accounting scandals left them unable for a number of quarters to report their financial condition. They've also sent hundreds of billions of dollars worth (or more) of mortgages into special purpose entities, investment vehicles that for accounting purposes are supposed to be separate from Fannie and Freddie. But these vehicles are cousins of the SIVs and conduits that bedeviled banks, and which some banks eventually had to bring onto their balance sheets at great cost. Will Fannie and Freddie have to take on some undisclosed liabilities from these special purpose entities? If so, how many billions are we talking about?

The truth is that Fannie and Freddie are pigs in a poke. The taxpayers shouldn't have to bail them out or prop them up any more than absolutely necessary to prevent a collapse of the financial system. But Fannie's and Freddie's shareholders should have to take their lumps (taxpayers shouldn't protect the value of private equity investments). And Fannie's and Freddie's creditors should have to assume the credit risk that can fairly be laid on them for lending to such severely undercapitalized and mismanaged institutions. In other words, they should take their fair share of losses.

The people who really deserve a bailout here are America's future homeowners, the ones that Fannie and Freddie are supposed to be helping. If they have to borrow through mortgages bought by Fannie or Freddie, the interest rate they'd pay would be elevated because creditors would demand greater returns on account of Fannie's and Freddie's past miscalculations, shenanigans and mismanagement. Why should a young family, starting out, in Indiana, Mississippi or Oregon, have to pay higher interest rates because Fannie or Freddie messed up?

The best thing for the future would be a new mortgage agency, one that starts with a clean slate: new management, prudential lending standards, clean accounting process, no undisclosed liabilities from special purpose entities overhanging the picture, and no loss of credibility with investors. Fannie and Freddie have botched things up badly, and in a free enterprise system, those who botch things up should pay the price. Of course, this proposal is just a pipe dream. If anyone in Congress or the administration actually seriously pushed this idea, Fannie and Freddie would roll out their lobbying juggernauts and quash any attempt to give taxpayers and new homeowners a square deal. After all, in Washington, insiders always win.

Thursday, July 10, 2008

Financial Mistakes That Are Okay in Down Times

Almost all asset classes are stagnant or falling in value. Even oil is treading water. There don't seem to be any good investments. It's easy to step back from saving and investing when you think you'll lose money tomorrow, next week, next month and even next year. Add growing inflation to the equation and the mentality of the 1970s could set in, when it seemed smarter to spend immediately on consumer durables like cars, TVs, washing machines, air conditioners and so on because the price would only be higher in the future. Conventional investment wisdom teaches that you should continue to invest on a disciplined basis, dollar cost averaging as markets sink and thereby lowering your overall investment costs. But when investing in stocks feels like choking down fried liver and stewed beets, this is more easily said than done.

The worst financial planning mistake of all is to stop saving. If you don't save, you won't have much of a financial future. Life on only Social Security is dreary at best, especially after you run out of ketchup to put on the dog food you bought on sale. Unless you're laid off, the one thing you should always do is keep saving. If you're having trouble stepping up to the plate and buying more assets likely to sink in value, feel free to make a few investing "mistakes." These are things that you shouldn't normally do. But every rule has exceptions.

Keep it in cash. Put your savings in a money market fund, money market account or other short term investment. (See for short term investing ideas.) This insulates you from losses. You also won't get much in the way of returns, and could miss out on market gains. Don't keep the money in cash indefinitely. But if this is what it takes to let you save and sleep at the same time, do it for at least the time being.

Time the market. Ordinarily, investment gurus frown on market timing. It's impossible for almost all people to identify market trends accurately. If you feel better about saving with the idea that you'll keep your money in cash until the market appears to hit a bottom or turning point, give it a try. Your chances of success at market timing aren't high, but at least you're still saving.

Build up cash instead of paying down high interest rate debt. If your cash reserves are low or nonexistent, it makes sense to build them up in these times of recession. You don't know when you might be laid off, or your bonus cut. Cash is king when times are tough, because these are the times you won't be able to get a loan when you need it the most. Even if you have to maintain some high interest rate debt, building up a cash reserve of three to six months living expenses (including minimum payments on your debt) is a good idea.

Borrow, if you must, from your 401(k) account. Normally, borrowing from a retirement account is a big no-no. But if your back is to the wall, and you're permitted by your 401(k) plan to borrow from your account, it's a better loan than borrowing from a credit card at a very high interest rate and very possibly easier than wrangling with a bank over your rapidly evaporating home equity line of credit (which nowadays banks are yanking left and right with little notice). You'll lose investment gains on the borrowed amount while the loan is outstanding. But at least those funds will eventually return to the role of funding your retirement. If you withdraw them from your 401(k) account, you'll pay taxes, and a 10% penalty if you're less than 59 and 1/2 years old, and lose the potential investment gains on the money forever.

If you make these "mistakes," return to a habit of steady saving and investing as soon as possible. That's how to build wealth over the long term. Don't chase returns by investing in the latest "hot" investment. You'll end up being a sucker for every asset bubble just before it bursts. And don't give up on building wealth. This is one aspect of life where it's abundantly true that quitters aren't winners.

Tuesday, July 1, 2008

Mortgage Payment Resets Peak

Old MacDonald had an ARM.

The payments started low.

Then the payments took a jump,

And caused a lot of woe.

With a jump, jump here.

And a jump, jump there.

Here a jump, there a jump,

Everywhere a jump, jump.

Old MacDonald lost his farm.

Now he is quite po’.

Monthly payments on hundreds of thousands of subprime loans are resetting to higher levels now. We're close to the peak level of resets. Over the next six months, we'll see the impact of the resets on foreclosure rates. With the economy slowing, real estate prices dropping, gas and food prices absorbing more and more of household budgets, and interest rates trending upwards, the prognosis is for more defaults and foreclosures. If that happens, real estate values will drop even more, making even more foreclosures probable. And to make things worse, large numbers of option ARMs will begin to require amortization of the principal of the loans, which will mean more payment increases.

All this, because lenders made two fundamental errors. First, they forgot that loans should be made on the basis of the borrower's ability to repay, not on the value of the collateral. Back in the bad old days when lenders were prudent, this was a serious no-no. Second, many subprime and option ARM loans were made on the assumption that the collateral--real estate--would always increase in value, allowing a troubled borrower to refinance or sell in the case of default. That they were wrong is now obvious. The downturn in real estate values illustrates why a lender should never make a loan based on the value of the collateral.

Lenders now face increased regulation. And rightly so. If they lend or invest customers' money in such a disastrous way, a few stern regulatory frowns are in order.

Perhaps more disturbing is all the talk of propping up and reviving the real estate market with public money. In particular, talk inside and outside the Fed about the economy not recovering unless taxpayer funds are provided only makes the government an enabler of all the bad things that mortgage lenders did. You can't build an economy by pumping up asset values. The wealth of nations is derived from production, not asset speculation. Japan, Korea, China and India became players in the world economy through manufacturing, not by pumping up their real estate values. Indeed, when Japan did do that, it got burned in the crash that began in 1989 and didn't end until recently.

There's a fin de siecle feeling in the air. A few people are getting astoundingly wealthy, often through asset speculation. Disparities between the wealthy and everyone else grow. The government resorts to expediency at every turn to maintain social equanimity--we don't just mean subsidies for real estate, but also agricultural price supports, federally subsidized flood plain insurance, and the like. The United States deploys a volunteer military to fight an unpopular war in a distant place (a hundred years ago, it was the Phillipines; today it's Southwest Asia). An unexpected fire from the prairies has produced a presumptive Democratic presidential nominee who is the first African-American to receive such an honor.

A century ago, America lived through unrest of the Gilded Age and the Progressive Era, and emerged the strongest nation in the world, one that put an end to the enormously destructive European war called World War I and World War II (which really were one war). But America then was a manufacturing nation, which furnished the resources to quell the fighting in Europe. Today, with its asset-based economy and gargantuan foreign debt, America is in a much more precarious position. So as mortgage resets further batter our economy, we should consider that we didn't get here simply because some lenders allowed their standards to slip. We got here because we want to have things without working for them. And that's not a prescription for prosperity.