Wednesday, July 28, 2010

Why You Should Avoid Debt

Many voters are clamoring for the federal government to reduce its debt levels. There are a few simple, bottom-line reasons for all of us to avoid borrowing, and to pay off the debts that we have.

You can't go bankrupt if you don't have debts. You can be poor. You can have a modest lifestyle. But you won't have to plead with debt collectors, seek out credit counselors, get painful scowls at the Bank of Mom and Dad, or file for bankruptcy.

You can't lose your home if it's not mortgaged. Pay off your mortgage, and no bank will have a reason to foreclose. Whether you're gaining equity or losing it, you won't go underwater. Of course, you have to keep paying property taxes and similar assessments. But if you have the money management skills to pay off your mortgage, those other obligations will be easy.

You won't have to sweat your credit rating if you don't borrow. For obscure and arcane reasons, your credit rating can fluctuate from month to month. It won't matter if you're not trying to borrow.

You'll live better in the long run if you spend less on interest payments. Why enrich banks? Pay less interest and you'll have more money to buy stuff.

You'll have a more secure retirement with no debt. Once you're on a fixed income, debt can be a real monster. Retire your debts and your retirement will be better.

It's hard to avoid borrowing for some things. Many can afford college, cars and homes only by taking out loans. But keep the borrowing to a minimum, and pay off the loans that you have as fast as possible. You'll enjoy the peace of mind.

Sunday, July 25, 2010

Does the Sherrod Incident Signal a Larger Problem in the Administration?

By now, just about everyone has heard about the firing and immediate unfiring of Shirley Sherrod, the Dept. of Agriculture official who was falsely accused of racism. The unfairness of her treatment is beyond doubt, and apologies from right to left have beaten a path to her door. But the hyper speed at which the administration made decisions about her, before all the facts were known, suggest a larger problem in the Obama administration: panic.

The administration seems to have made a terribly hurried decision about Sherrod, evidently to pre-empt the Internet-driven 24/7 news cycle. The administration's apparent fear of right-wing cable TV commentators and Tea Party chat rooms seems to have prevailed over reasoned analysis, a sense of fairness, and old-fashioned levelheadedness. One wonders whether the swiftness of Sherrod's firing reflected a calculated attempt to have a Sister Souljah moment. But the overall impression isn't one of political maneuvering, but discombobulation.

This is a bad thing, not just for the next Sherrod-type incident (and you can bet there will be more, since right wing activists will surely be emboldened by the administration's missteps), but for the larger problems facing the President. Terrorists, renegade nations with nuclear ambitions, and a resurgent Taliban present daily difficulties. The economy is slowing, and the Lake Wobegon style stress tests recently conducted on European banks not surprisingly showed almost all banks above average, thus providing limited assurance. The federal deficit mostly waxes, rather than waning.

A White House in panic mode could make bad decisions in a wide variety of situations, causing much avoidable harm and embarrassment. The question isn't whether high ranking administration officials botch their careers. The question is whether the nation suffers needlessly. If George Washington had panicked after his army was driven out of New York in 1776, he would not have won Christmas victories at Trenton and Princeton. There would be no United States.

The game of gotcha politics has a sucking quality that draws everyone into a vortex of point-counterpoint, summoning unpleasant memories of elementary school playgrounds. The celerity of the Internet leverages the childishness and cheapness. Sound decision making requires steadiness, dispassion, reasoned analysis based on a complete picture, and fairness. Grace under pressure isn't an anachronism extolled by Ernest Hemingway that's emblematic of the World War II generation. It's a vital characteristic of good leadership. Barack Obama can look calm and sound cool, but the handling of the Sherrod incident belies that image.

The pressure from ongoing events is enormous. The war in Afghanistan is bogging down. The re-defection to Iran (if that's what it was) of nuclear scientist Shahram Amiri must have thrown the intelligence community for a loop, at a time when the potential for a negotiated resolution over Iran's nuclear ambitions is shrinking. Unemployment levels remain stubbornly high, and there is no chance of significant reductions before the fall mid-term elections. The economy is slowing, and the fact that so many prominent officials and economists insist there won't be a double-dip recession suggests the growing possibility of one. North Korean megalomania looms ever larger.

With events moving so fast, the President can't afford more than a 20-second timeout. But he'd better call one, get his people in a huddle, and calm things down. Perhaps no government officials should be carted to the guillotine on account of the Sherrod incident. Perhaps the next time a right wing blogger tosses a cheap shot into the 24/7 news cycle, it should garner contempt instead of a hasty misjudgment. When an important issue of national security or national economic policy comes up, ignore the enfilade of gotchas from cable TV and the blogosphere. Get all available information, think the problem through, and do the right thing. Fear and insecurity can destroy a Presidency. (Google "Richard Nixon" for more on this point.) The great Presidents became great in spite of their critics, not by pandering to them.

Wednesday, July 21, 2010

Safe Investments

[As updated July 11, 2011]

There are many reasons for wanting to keep money safe. You may be saving up a down payment for a house or car, bracing for next year's college tuition and board bills, putting together an emergency cash fund, seeking shelter from lunatic stock, real estate and other asset markets, or harboring plain old curmudgeonly mistrust of all the fast-talking salespeople ready to take your money. Even with all of today's uncertainties, there are a few safe places to put your money.

Bank Accounts. FDIC deposit insurance covers, at each member bank, $250,000 per customer (along with another $250,000 per co-owner for joint accounts and yet another $250,000 for retirement accounts like IRAs). All of your accounts of each type at that bank are combined when determining coverage. You don't have $250,000 of coverage per account. For example, if you have $240,000 in CDs in your name, $20,000 in your checking account, and $505,000 in a joint money market account with your spouse, $10,000 in your individual accounts is uninsured, and $5,000 in your joint account is uninsured. But $750,000 at that bank is insured. If you're approaching the FDIC limit at any one bank, move some money over to another bank to get additional deposit insurance coverage. For more information about FDIC insurance, go to There is a service called CDARS offered by certain banks which takes large deposits and splits them up among a number of participating banks such that your funds and the interest they earn are fully covered by FDIC insurance. For more information, go to

U.S. Treasury Securities. Direct obligations of the U.S. Treasury will be paid, even if the government has to print the money to pay you. So these investments are secure. You can buy traditional Treasury obligations, like 4 week, 3 and 6 months, and 52 week Treasury bills, 2, 3, 5, 7 and 10 year Treasury notes, and 30 year Treasury bonds. You can also buy TIPS, a type of Treasury security that offers inflation protection. There are good old U.S. Savings bonds, still alive and kicking, which come in traditional Series EE bonds, and also I-bonds offering inflation protection. One disadvantage of Savings Bonds is that you can buy only $10,000 of each type per year, $5,000 of which must be bought directly from a government service called Treasury Direct. So large amounts of savings can't be invested in Savings Bonds. For more information about buying directly from the government, go to U.S. Treasury securities can also be bought through brokerage firms (although you'll have to pay commissions and/or markups). U.S. Savings Bonds can be bought through banks as well as Treasury Direct.

There is no limit on how much you can invest in U.S. Treasury obligations (aside from the Savings Bonds limits). Every penny will be repaid by the government, so you get a greater amount of coverage than with FDIC insurance.

Money Market Funds Investing Solely in U.S. Treasury Securities. There are a few money market funds that invest solely in U.S. Treasury securities. For all practical purposes, they are as safe as U.S. Treasury obligations. Because they are money market funds, their returns are very, very, and let us emphasize, very low. But the money is safe. Not all such money market funds are open to new investors. But if you want the safety of U.S. Treasuries and the convenience of a money market fund, look for one that is.

If you crave safety, forget about gold. It's a speculation that booms and busts like stocks. Some foreign government bonds, such as those of Switzerland and Germany, may have very low credit risk. But they present currency risk, and that's not to be underestimated. In just the past few months, the Euro has fallen more than 10% against the U.S. dollar, making German government bonds losers (in dollar terms) for Americans who held them. If your native currency is the U.S. dollar, stick to the above-mentioned dollar-denominated investments for safety. They won't pay very high interest rates. But safety isn't free and the low interest rates are the cost of safety.

Monday, July 19, 2010

Warning from Weird Financial Markets

The financial markets are getting weird (as if they weren't already). Interest rates for mortgages are at or near all-time lows, but home buying interest is dropping. Stocks are trading in tandem with each other more than ever, seemingly in disregard of the fortunes of individual companies. The dollar and U.S. Treasury securities have improbably rallied, in spite of already low interest rates. When markets behave strangely, it's prudent to check if any canaries have stopped chirping.

The decline in home buying interest stems from two factors: (a) the end of the $8,000 first time buyers credit (and $6,500 repeat buyer's credit), and (b) the large quantities of foreclosed homes and homes with defaulting mortgages sitting in bank inventories. Buyers know that home prices are likely to stagnate or drop, because banks will have to offload their moribund inventory eventually. There's no point rushing to buy now. Lower interest rates may reduce monthly payments, but buyers have learned that monthly payments aren't the only problem. They realize that a loss of equity can be devastating. Something like a quarter to a third of all homes with mortgages are now underwater. Whether the owners of those homes can still afford the monthly payments is becoming a less important question than whether a strategic default makes sense.

Today's stock markets are dominated by powerful hedge funds and other institutional traders. Many use high speed trading strategies. These big boys frequently trade the stock market as if it were a commodity. The notion of stocks as ownership of a piece of a continuing business enterprise is becoming outdated as computerized trading techniques treat the stock market like a bulk commodity to buy or sell alongside oil, copper and pork bellies. Individual investors see their modest portfolios gyrating for no reasons relating to the companies they hold. It's tough to ride a bicycle among tractor trailers, and lots of Moms and Pops are stepping back from the chaos.

The dollar and the U.S. Treasuries rallies were flights to safety at a time when the European Union seemed about to fall apart. It's still shaky, and may get shakier if there's a lot of grade curving on the bank stress test results to be announced this week or next. That the dollar would be seen as a safe haven in a time when the U.S. economy's running on flat tires doesn't bode well.

The markets are mispricing assets. Real estate prices are too high to compensate buyers for the risks of the inventory dump that's coming. But a host of government subsidies, policies and programs buffers home prices from market forces. So buyers hold back, reluctant to pay a non-market price.

Stock prices are too high to compensate individual investors for the stomach churning volatility created by the big boys. But the stock markets today are of, by and for big traders. Volatility is profitable for the short term, high speed strategies many of they employ. These big dogs don't care which way the market moves as long as it moves somewhere because they can't make a profit if prices don't change. Small investors are removing liquidity from the market and finding tranquility in bank CDs.

The dollar and U.S. Treasury securities are issued by a politically unified nation (okay, so bipartisanship ended about 2.04 seconds after Barack Obama was sworn in as President, but compared to Europe the U.S. is as solid as a rock). The Euro is backed by a loose confederation of separate nations that are devoted to passing the buck to someone else. The financial markets undervalued the dollar, not adequately factoring in the value of political cohesiveness. But a rising dollar impairs America's ability to increase exports, foreclosing one path to economic recovery.

Then, there is the biggest market dysfunction of all. For over one and a half years, the Federal Reserve has held short term interest rates to near zero. Bank profits have rebounded sharply but the stimulative effect of this policy has been disappointing. Banks aren't lending. They invest excess reserves in U.S. Treasury securities, mortgage backed debt guaranteed by the U.S. Treasury, and accounts at Federal Reserve banks (in effect, investing in the federal government). The credit markets for banks now operate smoothly. But the credit markets for everyone else are discombobulated. This massive dysfunction remains an enormous barrier to recovery.

While the reasons for these problems vary from market to market, they each impede America's long term economic prospects. Their simultaneity only exacerbates things. When so many important markets are mispricing assets and discouraging participants, canaries may fall quiet.

Thursday, July 15, 2010

SEC v. Goldman Sachs: Is Contrition a New Trend in SEC Enforcement?

Today's settlement between Goldman Sachs and the SEC contains a novel provision: contrition. In a court filing called the Consent, Goldman acknowledged "that the marketing materials for the ABACUS 2007-AC1 transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was 'selected by' ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure."

For the last 40 years, the SEC's settlement policy has allowed defendants to resolve enforcement cases without admitting or denying the SEC's allegations. Highly refined thought processes can be required to figure out what it means to neither admit nor deny. It is not an admission of liability. Or even an acceptance of responsibility.

Goldman's settlement--which also includes the usual boilerplate about neither admitting nor denying--takes a small step away from the agnosticism of the old policy. Contrition is not an admission of legal liability or even an acceptance of responsibility. But the settlement papers indicate that Goldman was--and very possibly future defendants will be--expected by the SEC to express regret or something comparable. The public at large might well see this as an improvement over a defendant neither admitting nor denying. After all, even three year olds are taught to say sorry when they make a boo boo. And contrition is likely to make settlements more palatable to presiding judges, who have to sign off on settlement proposals. Balky judges have recently made the settlement process more challenging, and it's in the interests of both the SEC and defendants to persuade judges not to nix deals that have been meticulously negotiated.

Lawyers will have a field day with the ambiguity of Goldman's expression of contrition. It may help customers and shareholders suing Goldman--but to what degree will be the subject of judicial rulings. Goldman might choose to avoid too much judicial clarity, because there remains the risk that a judge could consider the statement of contrition to be probative of Goldman's legal liability. Settling with customers and other private litigants before judges rule allows Goldman to put off to another day the legal significance of contrition. One way or another, look for more Goldman settlements (i.e., the cost to Goldman here is probably not limited to $550 million).

Many readers may wonder what the big deal is with Goldman's statement of regret. It's this: the SEC made the most powerful firm on Wall Street accept a disadvantageous change to 40 years of SEC enforcement policy. We don't know yet how disadvantageous to Goldman the change will be. But the fact that the recently ineffectual SEC Enforcement Division could extract even a smidgen of contrition from a defendant that had the means to litigate until the end of time shows that the SEC has gotten its mojo back.

The larger features of the settlement--a $535 million civil penalty, the largest in SEC history, $15 million in disgorgement, a court injunction, and undertakings by Goldman to improve the way it conducts business--are in the range of what one might have expected. This deal gives both sides bragging rights. Goldman paid less than the $1 billion or so in damages that the SEC alleged was caused to its customers who invested in ABACUS 2007-AC1. The SEC got a record setting penalty and Goldman's commitment to change the way it does business. But, most significantly, the SEC's victory (and that's what this was, even though Goldman's stock is rising in afterhours trading) means that power is shifting from Wall Street to Washington.

Tuesday, July 13, 2010

The Financial Markets Are Regressing

It's been widely noted recently that individual investors are leaving the stock markets and shifting their savings into bank accounts or bonds. The bond market has improbably rallied in recent months, despite ultralow interest rates. That brings to mind investment patterns from the late 19th Century and early 20th Century. In the Gilded Age, stocks were volatile and viewed as little more than a form of gambling. Ordinary citizens made do with bank accounts. Bonds were a preferred investment for the wealthy. When British and other European investors financed much of the construction of America's railroads, they bought bonds, not stock. (Chinese, Japanese and other foreign investors holding dollars today are similarly conservative, with a preference for bonds.) Individuals with large amounts of savings were advised by financial professionals to choose bonds over stock, and they did. Not until the 1950s did stock investing attain widespread popularity among individual investors.

Most of today's stock trading comes from market pros--hedge funds (including high speed trading firms and other hedge funds), mutual funds and other institutional investors. Such was also the case in the late 19th Century.

Stock markets today are fragmented, with much opaque trading taking place in black pools patronized by big traders. Back in the late 19th Century, there were dozens of stock markets in America--every sizable city had one. Trading information was limited, and known mostly to market insiders. Individual investors in those days didn't have a good idea of what price they might get if they bought or sold. That's also the case today during increasingly common periods of high volatility.

The resurrection of risk accounts for the change in investor behavior. The financial markets of the Gilded Age brimmed with risk, and investors acted accordingly. Today's volatile markets reflect the renewal of risk, and modern investors have rediscovered ancient wisdom.

The big banks have enough power to command bailouts and a gusher of subsidies until they recover profitability. Individual investors take losses on the chin. The first order of business with your hard earned savings is to avoid losing them, particularly as you get older and it becomes more difficult to replace losses. You know you can't count on the government. The administration is tapped out. There won't be more stimulus spending after the funding currently in the pipeline runs out. The Fed can't renew its quantitative easing measures without admitting that the economy is sliding back toward the porcelain bowl, potentially panicking the markets. The government is boxed in. You're on your own.

The flight of investors from risk undermines one of the Fed's goals. By keeping interest rates ultralow, the Fed has implicitly been encouraging investors to put their money into riskier but hopefully higher yielding assets. Such a shift in investing would provide capital to the private sector at a time when banks continue to pull back from lending. But the Fed is fighting human nature--in uncertain times, people seek to avoid loss, not hope for gains.

The financial system is reversing a trend of the last 60 years and moving back to intermediation. Many people are depositing their savings with guardians--i.e., banks--who then have the responsibility of lending it out at a profit in order to pay interest (at meager rates currently) on depositors' savings. Banks, too, steer away from risk and invest customer deposits to a large degree in U.S. Treasury securities or federally guaranteed mortgage-backed securities. About a trillion dollars of banks' excess reserves have simply been deposited with the Fed. In other words, banks are investing in the U.S. government. This is one respect in which the current financial situation differs from the Gilded Age. One hundred years ago, in an era of balanced federal budgets, banks invested scarcely a nickel in U.S. Treasury debt. When they eventually resumed lending, it went to the private sector and the economy recovered.

The key to unraveling the current mess is to promote economic growth. Growth won't come from banks transferring more and more resources to the government. Banks need to go back to their traditional role as lenders to private enterprise and provide more credit to the real economy. That's what they did in the 19th Century, helping the United States industrialize and prosper in spite of all the volatility of the Gilded Age. That's what they need to do again, and federal regulators should push them harder in that direction. With investors regressing and further government deficit spending off the table, there are no other options.

Sunday, July 11, 2010

ETFs After the Flash Crash

The SEC's recent proposal to apply circuit breakers to certain ETFs highlights the strengths and weaknesses of ETFs. Conceived as instruments you can trade all day long while the markets are open, they actually don't serve this purpose all that well. Because the price of an ETF is derived from the prices of the underlying securities, it will always lag behind underlying price changes. When underlying prices are moving rapidly, as they were during the flash crash, the pricing lag of an ETF may create an arbitrage opportunity for the high speed trading firms whose massive computing power lets them spot and exploit price anomalies faster than the typical retail investor can blink. As the big boys pile in, jarring price movements may scare away market makers, who ordinarily provide liquidity, faster than disaffected voters are abandoning incumbents. Ordinary individual investors trying to make a buck or two can (and sometimes did) lose their shirts.

Experience shows that even though ETFs were conceived and marketed as trading instruments, they're really better for long term investment. They often have low management fees and many are quite tax efficient. Used as a long term instruments, ETFs can be competitive with the cheapest traditional index funds. (See Granted, faith in long term investment has fallen as the Dow has fallen. But it's probably still a better idea than short term, in and out trading where you pay commission costs, bid-ask spreads, and sometimes unpredictable prices, only to have your head handed to you.

Thursday, July 8, 2010

Now for the Biggest Financial Regulatory Reform: Residential Mortgages

If we likened the efforts to prevent another financial crisis to the government's program to combat the flu, here's what it would look like. The financial reform legislation now working its way through Congress changes structure and process. Regulators will operate in a new structure, with an overarching systemic risk council and a new consumer protection bureau. Processes for trading in derivatives would change, as would proprietary trading by banks. Heightened capital requirements would be imposed on banks, and troubled financial institutions would be subject to seizure and wind down by the government. Comparable changes in government programs to combat the flu might consist of structural change at the CDC and FDA, together with heightened reporting requirements for hospitals and medical professionals concerning all actual or potential cases of the flu.

But what about the vaccine? The government's primary weapon against the flu isn't structure or process. It's fostering the manufacture of vaccine. Vaccines do the most to prevent illness. New flu vaccines are produced every year. Where's the vaccine for the financial crisis?

The biggest single reason for the financial crisis of 2007-08 was the way residential real estate transactions are financed. The large majority of purchases were (and still are) made with long term mortgages--those that contemplate a 30-year or comparably long repayment period. Although many of those mortgages had adjustable rates, the amortization schedules for those mortgages (i.e., the anticipated repayment of the principal of the loan) involved only gradual reductions of principal or none whatsoever (in the case of interest only loans). Whether or not the loans had fixed or adjustable rates, they were all structured with long repayment periods and very gradual amortization of principal, in order to make home purchases more affordable.

Long term obligations are subject to a high degree of interest rate risk. Stated otherwise, when interest rates change, the obligation imposes large burdens on one party or another. If the debt has a fixed rate, the creditor takes the loss. If the debt has an adjustable rate, the borrower takes the loss. It the loss has been transferred by means of a derivatives contract, the counterparty bears the loss. The important thing to understand is that losses are sustained and someone must bear those losses. The losses cannot be made to go away. This is a crucial reason why long term mortgages are so risky.

The long repayment schedules of these mortgages were meant to serve a governmental purpose: making it easier to buy a home. The private mortgage market didn't develop a 30-year mortgage on its own. Government policy, beginning in the 1930s and 1940s, created it. To accommodate financial institutions that didn't want to hold these puppies (and there were many), the government created first Fannie Mae, and then Freddie Mac. Fan and Fred bought the hot tamales, in effect passing the long term risks onto taxpayers. However, the federal government's numerous subsidies for housing and the nation's recovery from the Depression caused home prices to rise steadily on a national level. The risk to taxpayers seemed theoretical. So more and more 30-year mortgages were written, prices rose more, and demand for housing grew apace. The secondary market for mortgage-backed securities blossomed, supported by a seemingly golden asset that never fell in value. Institutional investors far and wide piled into the mortgage markets, believing they'd found the pot of gold at the end of the rainbow. But as the mortgage markets ballooned, so did the systemic risks presented by the ever increasing number of outstanding mortgage loans. The sheer quantity of loans (encouraged by the government to increase home ownership) puffed prices up into a bubble, and that meant systemic risk was skyrocketing.

Certainly, bad lending practices made things worse. The plethora of subprime, Alt A, no money down, no doc, no verified income, more stupid than stupid loans that came into fashion added a shipload of credit risk to the the interest rate risk inherent in long term obligations. But much of the reason these loans were so toxic is they too were structured along the same lines as the traditional 30-year mortgage: a long repayment period, with amortization of principal almost imperceptible in the early years of the loan. They presented the same risks as traditional 30-year fixed rate loans, along with a big helping of credit risk. And all this was possible because of the government policy of sponsoring and subsidizing long term real estate lending.

Once the real estate bubble burst, prices fell and numerous homeowners went underwater on their loans. Many defaulted due to unemployment. Increasing numbers are defaulting for strategic reasons. The real estate market remains in the septic tank for now. When it will recover is anyone's guess, because the sheer quantity of defaulting mortgages from the 2000s weigh heavily on the financial system and the economy.

It is unrealistic to believe that changing the structure of financial regulation and the processes of the financial system are sufficient to prevent another crisis. We need to reduce the levels of systemic risk. The 30-year mortgage and its first, second and other cousins create systemic risk of the first order. Because this risk was the biggest factor leading up to the credit crisis, federal regulators should treat it as their highest priority. Structure and process won't suffice. No package of new rules, more thorough examinations, heightened capital requirements and other measures can shield the financial system from the uncontrolled growth of risk from mortgage markets gone wild. The creation of risk must be moderated, and that means limiting access to long term mortgage finance.

Credit standards are already tightening. But perhaps not enough. There is still no meaningful secondary market for home mortgages without a federal guarantee, which means that the private market adjudges them to be overpriced compared to the risks they present. When long term mortgages can be sold to private investors without a federal guarantee, then we can be comfortable that their downpayment requirements, interest rates and other terms are reasonably priced in relation to the risks they present. That they cannot now be sold signals that taxpayers are still subsidizing real estate purchases to a significant degree.

There is little indication that the mortgage markets will be privatized. Talk now is of nationalizing Fannie Mae and Freddie Mac, which would formalize the federalization of housing finance. And why not? They're functionally nationalized already, and any privately owned-publicly backed hybrid would only perpetuate the outrage of the 2000s: private profit at public risk. But nationalizing them could contribute to the problem--the opacity of governmental accounting (which would apply to the nationalized Fannie and Freddie) would make the extent of taxpayer subsidies, already in the hundreds of billions, even less clear and therefore subject to abuse. As it is, Americans suffer grievously from taxpayer abuse syndrome in subsidizing residential real estate. One can only rationally assume the abuse would continue unabated and rarely seen if Fannie and Freddie are nationalized.

Nationalizing Fannie and Freddie may, in the end, be how the government controls the systemic risk presented by the gargantuan hordes of long term mortgages rampaging around the financial system. That would be a poor outcome, since it would continue costly policies of taxpayer subsidies, with most of the benefit probably going to the higher income brackets. And if the housing market makes another gigantic u-turn, as it did in recent years, the risks of taxpayer support of the real estate market would be realized. While most likely the federal government would simply increase the federal deficit to finance these costs in the near term, they remain real costs that eventually would be visited on taxpayers.

It's important to have a way to measure these potential costs. One way would be for federal authorities to require Fannie and Freddie to offer mortgages for sale in the private market without a federal guarantee, simply to see what price they would command. The discounts that private investors would demand could be used as a proxy to calculate the extent of taxpayer exposure. The numbers would probably be Brobdingnagian. But ignorance won't be bliss. Such a calculation would be a useful way to measure how much systemic risk is quietly building up in housing finance. Large figures would trigger alarms--and that's the idea.

Sunday, July 4, 2010

How to Think About Saving

Saving is easier if you think of it an opportunity. Each dollar you earn is part of your finite lifetime income. While most people don't reflect on the finiteness of their lifetime income--the finiteness of their monthly income is painful enough--you do have a limited lifetime income. Each dollar spent represents a saving opportunity lost. You can't save a dollar spent. It's gone forever. You can earn more dollars in the future. But those dollars further reduce your finite lifetime income. You can't earn more dollars and still have as much future income as you previously had.

Yes, you can work longer than you expected. That appears to increase your lifetime income. But it's really an illusion. The reason people work longer is usually because they didn't save enough (including enough to compensate for market volatility as well as day-to-day retirement needs). So, all along, even though they didn't realize it, their habits and lifestyle doomed them to work longer than expected. Their expectations changed, but not the finiteness of their lifetime income. The only thing they might have gained, perhaps, is greater self-knowledge.

If you save nothing during your working years, you can look forward to retirement on Social Security. Most people think old age and eating dog food are incompatible. But if all you have is Social Security . . .

With the financial crisis of 2007-08 and the Great Recession, many now have the savings jones. Stocks rose, but are falling again. Real estate fell and now is stagnating. If you don't save, your net worth can go negative on you. The savings rate in the U.S. is around 4% of disposable income (i.e., the amount of earnings you have after paying income taxes). This is low by the standards of the last 100 years. But it's the highest savings rate in most of a generation. While some months, Americans seem to waffle on their newly found prudence, the slow economic growth and high unemployment levels predicted for years to come indicate that saving will not go out of style for a while.

Is 4% enough? Let's assume you're part of a household having an annual income of $100,000 dollars, with a marginal federal income tax bracket of 28% and a marginal state income tax bracket of 6%, and pay $25,000 total in federal and state income taxes (this figure may vary, depending on your state, deductions and credits). Your disposable income would be $75,000. Let's further assume that you save 4% a year, or $3,000, with $2,500 going into a retirement account and $500 in a regular bank account. Assuming you work 40 years, with an average inflation rate of 3% per year and an average return of 6% per year on your savings (stocks have a higher historical average return, but you shouldn't put everything in stocks), you'll have about $445,000. Adjust that figure for inflation and you'll have about $131,500 current dollars.

Conventional financial planning wisdom dictates a person retiring at age 65 shouldn't spend more than about 4% of his or her retirement savings a year. With $131,500, that comes out to $5,260 a year (a figure that can be adjusted for inflation each year). We're still scanning grocery store flyers for dog food sales. But, of course, just about everyone gets some Social Security. A relatively high income married couple that averaged $100,000 a year for 40 years might get something like $40,000 a year in Social Security (assuming one member of the marriage earned the bulk of the income and the other takes spousal benefits). A person living alone with an earnings history averaging $100,000 a year might get around $28,000 a year. Add either figure to $5260, and there's a much better chance the dog food will stay on the store shelf.

Retired persons tend to have greater medical expenses, and savings can disappear in a flash when a medical crisis comes up. While $131,500 is nothing to sneer at, it won't cover two years in a nursing home. And you'll have plenty of out of pocket medical expenses before you have to move to the nursing home. So you can't count on the $131,500 to be there late in life. Most people in their 70s and 80s probably wish they had more savings.

The finiteness of your income means that saving is essential to retiring on more than Social Security. Every dollar spent now is a saving opportunity lost, one that can never be replaced. Saving isn't a sacrifice. You're buying a better retirement. If you want to maintain the lifestyle you have during your working years, save about 15% to 20% of your pretax income for 30 to 40 years (here's why such a strategy works: Such a savings rate can be difficult, but so is eating dog food (we assume; haven't personally tried it). You can economize now or economize later. There's still no free lunch. Rugged individualism, America's cultural essence, today consists of having a stable financial foundation. The frontier is still there, but you no longer carve a homestead out of the wilderness and fill it with amber waves of grain. Today, savings and investment accounts substitute for horse, plow, ax, scythe and long rifle.

Thursday, July 1, 2010

How the Chinese Yuan Re-valuation Will Affect the U.S. Real Estate Market

The re-valuation of the yuan recently announced by the Chinese government has implications for the balance of trade, capital flows into China, and political relations between the U.S. and the People's Republic. What seems to have gone unnoticed is the consequence of this re-valuation for the U.S. real estate market.

As the dollar falls in relation to the yuan, it will make less and less sense for the Chinese to lend to America. They would need interest rates that covered not only lending costs and risks, but also currency risk in an environment where the yuan will almost surely rise. Current low U.S. mortgage rates, a boon to buyers who are financially qualified, are like cold pizza to lenders. And the Federal Reserve appears dead set on keeping interest rates low, lower and even lower. During much of the past decade or so, the Chinese were big buyers of American mortgage-backed investments. The mortgage crisis cooled their jets big time. Even though the secondary market for mortgages today consists almost entirely of U.S. government guaranteed investments, currency risks will make the flow of funds from China less unpredictable. It's true that Europe and the Euro don't, at the moment, provide China with attractive alternatives to the dollar. But China is working on boosting domestic demand and building an internally focused economy. Over time, it will demand fewer dollars and Euros, and provide less real estate financing in the States.

The excess inventory from foreclosures, short sales and the like will be a drag on the real estate market for years. The shrinkage of foreign credit due to the falling dollar will add to the stagnation. We'd better hope the falling dollar gives U.S. exports one helluva jump start, because it will probably tighten up an already parsimonious mortgage market.