The Best Asset in a Time of Volatility

All markets are volatile these days.  Stocks are gyrating, bonds are falling as interest rates increase, oil is bouncing up and then down, bitcoin has fallen all year, and even the real estate market seems to be going wobbly.  Gold and silver have been slipping away.  And foreign markets look even gloomier.

Investors naturally look for opportunities when prices fluctuate.  Whether you're a buyer or a short seller, price movements create the potential for profit.  Volatility is gut wrenching if you're taking losses, and can stimulate panicky selling when prices are low.  But it can be exhilarating if it looks like a lucky break.

That's why cash is often the best asset to hold in a time of volatility.  It gives you the means to take advantage of fortuitous price movements, while its stability insulates you from the emotional roller coaster that often drives people to sell when prices are dropping.  Don't think that you have to remain fully invested all the time.  What you have to do is remain unemotional, as emotion is the enemy of careful investing.  A nice, comforting cushion of cash can prevent an unwanted flood of adrenaline.

Cash may appear to have a low rate of return, with greedy banks still paying miserly rates of interest on deposits even though interest rates have been rising.  But cash also offers the potential to profit from price volatility.  You can dive into an asset when its price is low and make a bundle when it rebounds.   That potential makes the effective return from cash much higher.  So don't be afraid to hold a lot of cash in a time of volatility.  That's when it's an investor's best friend.

The Truth About Housing Prices

Ten years ago, this blog predicted that housing prices, which had fallen sharply in the mortgage crisis of the mid-2000s, would not recover until 2024.  http://blogger.uncleleosden.com/2007/09/when-will-housing-prices-recover.html.  That prediction may have seemed preposterously negative to many.  But real estate prices have meandered and stagnated since then.  Although some markets have recently enjoyed brisk gains, many others remain sluggish and below their earlier peaks.  Trulia, the real estate website, yesterday released a study that predicted real estate prices nationwide would not recover until 2025.  https://www.trulia.com/blog/trends/home-value-recovery-2017/.  Looks like my prediction of ten years ago was pretty accurate.  While my analysis and Trulia's aren't directly comparable (I focused on nationwide average prices adjusted for inflation and Trulia used nominal prices unadjusted for inflation while measuring recovery in all housing markets nationwide), the basic conclusion is similar.  It will take a shipload of time for housing prices to fully recover, and the mid-2020's may be when the housing market as a whole could once again start to accentuate the positive. 

Housing historically has increased in value about 1% faster than inflation.  Stocks have tended to average around 3% above inflation.  Buy a house if you need shelter and can afford it.  But pay off the mortgage, don't borrow against the equity, and save and invest in retirement and other accounts for your golden years.  Some people who can't save money end up relying on their homes to finance retirement.  But that's a much poorer choice (pun intended) than taking advantage of the greater potential of stocks and other financial investments.  Your house is your castle.  But it's not your best option for financing retirement.

Would You Invest in Government?

Investors have an unusual problem today:  should they invest in government?  No, that's not political rhetoric.  It's perhaps the biggest question facing anyone with cash to allocate.  Asset prices have been manipulated upward by central banks and other government policies.  Stocks and bonds would not be trading at today's prices had it not been for all of the merry money printing by the major central banks during the past few years.  Indeed, the Federal Reserve takes credit for over half the rise in stock prices since 1994.  See http://blogger.uncleleosden.com/2012/07/stocks-are-not-cheap.html.  If you buy stocks or bonds now, you're betting that central banks can continue this juggling act. Is that possible?  Let's look at real estate.

Real estate prices for decades received government support on a massive scale.  Beginning in the 1930s and 1940s, various government lending and finance programs (think Fannie Mae, Freddie Mac, Ginnie Mae, FHA, etc.), along with tax deductions for mortgage interest and property taxes, plus more specialized programs like federal flood insurance, have combined to create a vast support network for real estate, worth trillions of dollars.  Add Federal Reserve easy money policies starting in the 1990s going forward, and real estate prices were boosted leaps and bounds by government largess.  We know, however, how this story ends.  Humpty Dumpty had a great fall, and all the government's programs and bailouts since the financial crisis of 2007-08 haven't put Humpty together again.  To be sure, a great deal of private avarice and stupidity played central roles in the real estate catastrophe.  But the presence of the government, lending a helping hand at every turn, made it easy to believe that real estate prices would never drop. 

Stock and bond prices now seem similarly invincible.  Even though Europe is sliding into recession, China's growth is slowing, and America's economy sputters and coughs just above recession level, stocks keep bubbling up.  Any positive economic statistics add to the ecstasy.  Negative ones slip from short term memory.  Many investors skittish about stocks have no qualms about diving into bonds, even though bond values have been driven to extreme heights.  Central bankers worldwide issue virtual carbon copies of each other's press releases declaring their unswerving commitment to keep printing money until . . . well, until . . . well, it's not clear where the process will end because the printing presses are now set to run ad infinitum.

To invest today, you have to pay the government prescribed price. To assess the risks of financial assets, you have to give heavy weight to political considerations--and those ain't pretty.  Buying financial assets like stocks and bonds is essentially an act of faith--faith in governments, and especially in central banks.  But faithfulness in this respect may not get you through the Pearly Gates.

The Key to Long Term Investing: Liquidity

Paradoxically, liquidity is a very important component to success at long term investing. Stocks have a good long term record, if you measure in decades. Real estate is less profitable overall, but is the long term investment of choice for many Americans since they are homeowners. Having to sell unexpectedly early, though, can ruin the value of either stocks or real estate as investments. If markets are shaky when you have to sell, you can be a big loser.

To increase your chances of long term success, you need liquidity--cash to keep you going without having to sell your long term investments. This includes having a bulked up emergency fund to cover unexpected cash needs (like unemployment or a medical crisis). It also means having a stable source of cash for a long period of time. Most people work for that stable source of cash. Those with pensions have a steady cash flow in retirement. Highly rated bonds and stocks with a strong record of paying dividends can also serve this need. Immediate fixed or inflation adjusted annuities from highly rated insurance companies can provide long term liquidity. Don't forget Social Security. It's like a pension. Even if it doesn't cover all your needs, its predictable inflation-adjusted monthly payments are the financial foundation for most retired Americans.

If your day-to-day liquidity needs are met, you can hold your long term investments until the moment you, and not circumstances, choose as the time of sale. Avoid borrowing to meet these liquidity needs. Debt tends to destabilize your finances. (See http://blogger.uncleleosden.com/2010/07/why-you-should-avoid-debt.html.) Instead, securing a steady income and living within your normal cash flows can give you a good chance to win over the long haul.

The Weird and Unknown From the U.S. Credit Rating Downgrade

We learned in a big way during the 2008 financial crisis that what we don't know can really hurt us. That would still be true today, after S&P lowered America's credit rating from AAA to AA+. We also know that weird stuff happens when the financial markets get a tummy ache. They seem likely to be queasy from the downgrade when the markets open tomorrow. The weird and unknown may surface soon.

Complex Trading. Major banks and hedge funds frequently trade esoteric investments in multi-investment positions involving U.S. Treasuries as hedges or otherwise. Quite often, these market players embrace leverage in playing this game, since it boosts potential profits. The downgrade shouldn't have come as a complete surprise, since the rating agencies have been loudly frowning at the U.S. debt situation for several months now. But the downgrade's timing was uncertain and its impact uncertain. Complex trading positions may become unhinged for unanticipated reasons. These large institutional traders may find their positions exposed, or may receive unexpected demands for collateral from brokers or counterparties, and then struggle to keep things on an even keel. If so, that could prove unsettling for the markets, especially if the exposures from such trading are directly or indirectly concentrated in one or two companies, a la AIG circa 2008. The reform of the derivatives market has proceeded slowly, if at all, and regulators likely have no idea if there exists the potential for another meltdown. So all we can do is wait and see what happens. If there is another AIG lurking out there, expect very bad consequences.

Housing Market Hassles. Fannie Mae and Freddie Mac provide almost all the financing in the residential real estate markets, primarily because their debts are effectively 100% guaranteed by the U.S. government. It's logical to expect that Fannie and Freddie will be downgraded, since their sugar daddy was just downgraded. This could make mortgage loans harder to get. Not necessarily because interest rates would rise, because the U.S. Treasury downgrade could trigger a flight to safety that ironically would increase demand for U.S. Treasuries (there being few alternatives). But a Fan/Fred downgrade would make it harder to find investors for the mortgage backed securities that Fan/Fred backed loans go into. Investors in those securities are the true source of liquidity for the mortgage market, and may demand higher quality borrowers than current already stringent credit standards require. The housing market could slip on yet another banana peel in its path.

Chinese Communists Strengthened. China's Communist government has been coming under increasing domestic political pressure, because of rising unemployment, poor protection of consumers, sporadic protection of the environment, corruption and co-optation by China's capitalist plutocracy. The S&P downgrade of U.S. Treasuries, however, highlights the fundamental strength of the Chinese economy and its levitating currency, the yuan. That makes the Communist government look good, at a time when it needed some positive spin. Of course, S&P wasn't trying to influence internal Chinese politics. But the law of unintended consequences is the supreme authority in the world of finance.

Obama-Boehner in 2012? Increased factionalism in both political parties is stretching current party delineations close to the breaking point. The Republican Party is held hostage by a limited number of Tea Party ideologues. Respected mainstream conservative voices have labeled Tea Partiers "hobbits, " which, albeit an affront to hobbits, captures the fantastical quality of the thinking on the far right. At the same time, the fissure between President Obama and liberal Democrats has been outed. Emotions are red hot. Ralph Nader publicly, and likely others nonpublicly, predict a primaries challenge to President Obama next year. No one is naming names yet. The most obvious challenger, Secretary of State Hillary Clinton, has publicly said she isn't running for elective office again. Neither a liberal left agenda, nor a Tea Party-style conservative platform, will win the White House in 2012. Both Obama and Boehner know that. Their problems with their parties will increase, because the debt ceiling deal creates a bipartisan committee to squabble more about deficit reduction, giving all factions many opportunities for further raucousness. With so many shouting past each other instead of having a dialogue, the conditions for a realignment of parties are ripening. It's impossible that Obama and Boehner would actually team up to run in 2012. But the pressures for a functioning U.S. government come from powerful forces in the financial markets and the economy. We're no longer debating political philosophy or ideology over beer and pretzels or coffee and Danish. Lots of jobs, careers, wealth, and retirements are on the line. The will of the people is for a functioning government, and ambitious politicians will find a way to give them one. Current party alignments may be endangered.

Taxpayer Liability for Banks: the Missing Link in Balancing the Federal Budget

As if the federal budget balancing debate weren't complicated enough, a key issue is absent from the discussion. Virtually no attention is being paid to the potential budget-busting problem of taxpayer liability for the banking system. Although this is a contingent liability, it can wreak astounding havoc when the banking system hits the fan. Ireland illustrates the problem.

Like so many other nations, Ireland rode to seeming prosperity on a rising real estate market. Its banks were instrumental in financing this bubble. When Lehman Brothers collapsed in September 2008, Irish banks rapidly slipped off the precipice. Their stock prices fell and a liquidity crisis loomed. The Irish government moved posthaste to stem the panic, guaranteeing some $570 billion of bank liabilities (which should be compared to Ireland's GDP of approximately $170 billion). Eventually, the Irish government nationalized one major bank, Anglo Irish. While the Irish government's direct debt is about 65% of GDP (not much different from the U.S. government's direct debt), its guarantee of bank liabilities vastly increased its potential obligations. The resulting morass was so bad that Ireland needed an EU bailout earlier this year.

The U.S. government (and American taxpayers) are on the hook for the liabilities of the largest American banks. Not officially, but we all know they'll get a bailout if they need one. In addition, taxpayers are liable for the housing banks--Fannie Mae, Freddie Mac, the FHA and Ginnie Mae. The amounts of all these contingent liabilities are unclear but likely very large. Illiquid real estate assets held by banks (so-called Level 3 assets) may be overvalued by hundreds of billions. Vast numbers of defaulted mortgages remain in limbo as the foreclosure mess crawls toward a resolution that will probably entail more losses for banks. The continued decline of the real estate market means more mortgages going underwater, and probably more defaults.

In addition, the largest banks have trillions of dollars of derivatives exposure. Much of the derivatives exposure is hard to see right now. Current accounting standards allow banks sometimes to net derivatives assets against derivatives liabilities. Netting means we don't see them on balance sheets. Once international accounting standards replace U.S. generally accepted accounting principles (probably within a couple of years), a lot of current netting of derivatives holdings would likely have to be unwound. Balance sheets of the largest banks could balloon by more than $7 trillion, in the aggregate. America's GDP is around $14 trillion, while annual federal spending is around $3.5 trillion. Readers may painfully recall that during the 2007-08 financial crisis, derivatives assets had a scary way of losing value while derivatives liabilities remained unwavering. Taxpayers would be on the hook for the losses. Reining in the amounts of bank derivatives exposure may be necessary to reducing the potential bite on taxpayers.

So, we can see that balancing the budget doesn't just mean getting expenditures down and government revenues up. It also means limiting contingent liabilities. Ireland's government didn't flagrantly overspend. Profligate lending by too big to fail Irish banks made it fail. Fortunately, Ireland's not too big to be bailed out by the EU. But there's no brother big enough to bail out America. Truly balancing the U.S. government's budget requires limiting taxpayer exposure to the banking system.

Progress on that front is painfully slow. The Volcker Rule is constraining some of the riskier activity. But reform of the derivatives market is hard to spot, even on sunny days at high noon. Banks remain Brobdingnagian in size, and executive compensation may soon run wild again. Implementation of the Dodd-Frank provisions for improved financial regulation is hindered by lack of funding. Fannie, Freddie and the FHA guarantee almost all new mortgages. Proposals for limiting the burdens they place on taxpayers will be obstinately contested by the real estate industry. Although neither Republicans or Democrats want to face the tough issues in balancing the budget--entitlement programs like Medicare, Medicaid and Social Security--we will eventually have to reform those programs. But all the pain and controversy we will endure squabbling over entitlements will be for naught if there is another financial crisis. And another crisis hardly seems any less likely than the one we still haven't recovered from.

Hope For the Financially Lost

Financial plans can be blown up because of job loss, illness, elderly parents who need support, or bad investments. Some people simply can't save. Whatever the situation, there remains hope for the financially lost to have at least a decent retirement.

Boost your benefits. Work as long as possible to build up Social Security and, if available, pension benefits. This is especially important for those that can't save. Even if you aren't working, delay taking Social Security benefits as long as you can (unless you're 70 or older). Delaying Social Security increases benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_02.html.

Stay together. Couples generally are better off than singles, because they can pool their resources. Even if their only resources are Social Security benefits, a couple are usually better off together than individually. Of course, togetherness isn't always possible. When it is, there are financial, as well as other, benefits. For more, see http://blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement_03.html.

Get a job with a pension. Government, law enforcement, military and educational jobs usually offer a pension or other retirement plan. Although pension benefits in many state and municipal jobs are being adjusted to meet fiscal realities, they will still be better than nothing. Not everyone is cut out for these lines of work. If you find a private sector job with a pension, then try to stay there long enough to accrue meaningful benefits. For those who can't save, a pension is golden. You just have to work long enough to vest; saving isn't necessary. If you need assistance figuring out if the amount of pension benefits your employer promises is correct, contact the American Academy of Actuaries at http://www.actuary.org/palprogram.asp. They'll give you up to four hours of free help. If you think your benefits are too low, contact a regional pension counseling project for free assistance. http://www.pensionrights.org/counseling-projects.

Buy a house and pay off the mortgage. Buy a house, pay off the mortgage, and don't borrow against the house until you retire. This strategy will build equity in a piece of real estate that you can add to your Social Security benefits (and pension benefits, if any). Even though strategic defaults have become fashionable, the unfashionable may have an advantage in the long run.

None of these strategies will finance a yacht. Remember that it's never too late to save, even if you're living on just Social Security. Cash is sublime when times are tough.

Foreclosure Robo-Blob Grows

Like a blob in a low-budget horror film that grows larger and larger until it smothers everything, the foreclosure robo mess is ballooning. We now learn that there are robo signing problems with notices of foreclosure in at least some states having nonjudicial foreclosure procedures. (See http://www.cnbc.com/id/41250862). In nonjudicial foreclosure states, where a creditor doesn't need to go to court to foreclose, the trustee bank handling the foreclosure has to give notice to the homeowner of the impending foreclosure, and file the notice in a public office. One of the tiresome requirements of the law is that the person signing the notice should ascertain that there is a valid legal reason for foreclosure. However, it may be that employees of trustees or their agents were robo-signing notices of foreclosure--i.e., affixing their John Hancocks without first bestirring themselves to review the facts of the case and ensure that a valid basis for foreclosure existed.

Nag, nag, nag, nag, nag. The law is such a pain in the . . . assssssk a lawyer what the effect of a defective notice might be and you'd probably be told that it means questions come up whether the bank can obtain clear title from the foreclosure. The bank may be unable to resell the property. Bad debts would remain on its books. The real estate market would linger in its current morass, with the Sword of Robo-Damocles dangling over foreclosed properties the banks have resold or try to resell.

The robo-mess revealed last fall, with robo-signers gone wild in judicial foreclosures, mucked up the foreclosure process in close to two dozen states. The kicker about the latest revelations is that if robo-signing permeated the nonjudicial foreclosure states, then the robo-mess will have reached every state. We've previously suggested the foreclosure crisis needs a national solution. (See http://blogger.uncleleosden.com/2010/10/foreclosure-crisis-time-to-put-mortgage.html.) This would be all the more so, now that robo-signers seem to lurk the length and breadth of the nation.

When you think about it, the robo problem is the problem in the real estate markets. We got to where we are today with mortgage lenders robo-lending to every Tom, Dick and Harry who had a signature and a pulse, without regard to income, employment, assets, past credit history, or anything else that might be relevant to a borrower's ability to repay. Then, the big banks on Wall Street bought up vast quantities of hinky mortgages that the robo-lenders churned out and robo-stuffed them into asset pools underlying mortgage-backed securities and derivatives, making financial sausages containing a lot of things you really wouldn't want if you knew about them. (Investors are now trying to regurgitate the bad mortgages by making underwriters buy them back.) Then, when things fell apart, the big banks tried robo-signing their way through the foreclosure process, disregarding the dreary requirements of the law that might interfere with the bottom line. Somehow, all this robo-banking has to stop. If it doesn't, only a matter of time separates us from the next financial robo-wreck.

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.

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.

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.

Taboos of the Real Estate Crisis

Today's housing news was that contracts to purchase existing homes fell 7.6% in January from the December 2009 level. Last week, we learned that new home sales fell 11.2% to the lowest level ever recorded since 1963, when the Census Bureau began tracking new home sales. Clearly, in spite of an expanded buyer's tax credit, the housing market remains a sick puppy.

Relief measures have treated symptoms. Defaulting homeowners get opportunities to restructure their mortgages, but lasting success is infrequent. Homeowners who haven't defaulted have trouble getting relief, especially if they are underwater. Underwater homeowners are increasingly tempted to walk away from their mortgages, especially if the loans are nonrecourse.

Treating symptoms often doesn't cure illnesses. Dealing with underlying causes is usually more effective. But the underlying causes of the real estate crisis are taboo. They cannot be discussed openly, not by government officials, nor Wall Street bankers, nor real estate industry professionals, nor consumer advocates. Candor would reveal the intractability of the crisis. At the risk of offending everyone having anything to do with real estate, we offer a little candor.

The 30-year fixed rate mortgage doesn't make commercial sense. It is a difficult loan for banks to manage, since their costs (i.e., the interest expense of deposits and other borrowings) fluctuate while the rate on the mortgage remains fixed for a very long time. Before the 1930s, the 30-year mortgage didn't exist. For all practical purposes, it wouldn't exist today except that, since the Great Depression, the government has promoted it as a way to make home ownership affordable. We can't get away from it, because real estate values would probably take a great fall without its easy terms. Even today's shorter term adjustable rate loans have amortization schedules that contemplate a long term loan of 30 or sometimes more years, so they're really just an elaboration on the 30-year fixed rate.

Banks don't like to hold 30-year mortgages. These loans can be made only by mismatching a bank's shorter term liabilities (like deposits) against a long term fixed rate asset. This mismatch is a formula for lending disaster when short term rates exceed long term rates, and they have periodically, going back to the 1970s. That's why the secondary mortgage market grew so large, first through federal agencies like Fannie Mae, Freddie Mac and Ginnie Mae, and later through private sector innovations like the mortgage-backed security, the CDO, the CDO squared, and so on. Banks became accustomed to offloading their mortgage risks. But the securitization market blew up along with the real estate crisis and remains moribund. Banks haven't been able to adapt to a world without securitization. Mortgage loans are almost entirely unavailable except when they can be guaranteed by Fannie Mae, Freddie Mac, or another federal agency, and resold. Securitization is now a federal program, not a commercial market.

The government and many others continue to believe that if home ownership is good, more home ownership is better. While this argument might make some abstract sense in a middle school civics class, reality is that home ownership in America usually requires credit. Even if some level of home ownership acquired with credit is good, that doesn't make more credit-fueled home ownership better. Only so many people are good bets for mortgage loans, and after that borrowers become riskier. We found that out the hard way in the 2000s, when defaults by the risky borrowers drove down home prices. In a society where home ownership is largely based on credit, there is an optimal level of home ownership, and after that it's a bad idea. However, not one policymaker in a trillion will openly endorse this point.

Another taboo is the proposition that banks should book the full extent of their home loan lending losses. America's banking system continues to hold hundreds of billions of dollars of losses attributable to home financing. Booking these losses would require more embarrassment on the part of banks (along with more capital raising efforts), more official consternation over the stability of the financial system and kabuki outrage over banker bonuses, and more houses in foreclosure sales pressuring prices downward. But not booking them is clogging up the banking system. Banks are afraid to lend because they want to hold onto their cash as a reserve against these unbooked losses. The paucity of bank credit is a crucial reason why the economic recovery is so tenuous. Economic stagnation is likely with the banking system in neutral.

So the wheels spin, caught in the muck of mortgages that don't make commercial sense, a secondary mortgage market that doesn't function except as a government program, the assumption that we need to make more, and then even more, bad mortgage loans in order to advance the goal of home ownership, and the unwillingness of banks and their regulators to fully face up to the losses of the mortgage mess. There's hardly any room for market forces to operate--and that's why they hardly do. Housing isn't a market. It's a government program. It's kept on life support by government subsidies, and can't be weaned off of them because the price collapse that would follow would bankrupt America's middle class.

Perhaps over the next ten years, the housing market will gradually revive. But it will surely continue to be built on the precarious edifice of taboos. Too much of America's capital will be misdirected into housing. Government borrowings will absorb vast amounts of what's left. Manufacturing and other activities fundamental to economic strength will be left with scraps. Growth will be stunted. Americans will squabble over who pays for health care, Social Security and other obligations that seem overwhelming when a slow growing economy doesn't produce wealth commensurate with society's generosity. But taboos cannot be discussed, so we end this essay. Good luck.

The Donkey-Backwards Housing Finance Debate

One of the biggest questions in housing finance is how to revive the securitization market. During the housing boom of the early 2000s, banks earned massive amounts of fee and commission income by packaging mortgages into mortgage-backed securities. These securities were often sliced and diced into CDOs, CDOs squared and what not, in order to further entice investors (and speculators). What happened next is all too well known. The banks, eager to bulk up low-risk fee revenue while offloading lending risk, thought that if writing a lot of mortgage loans was good, then writing a shipload more would be even better. Lending standards dropped, to the point where banks didn't always document borrowers' incomes, as if to avoid learning that they shouldn't extend the loan. There were plenty of times when they shouldn't have, but did anyway.

That insouciance toward prudence dug a very deep grave for investor interest in securitized loans. Today, just about the only mortgage-backed securities that can be sold carry explicit U.S. government guarantees. Housing finance has become a federal program, and today's housing stock enjoys what is effectively a federal price support policy.

Needless to say, taxpayers can't support housing values indefinitely. In the view of bankers and many regulators, securitization must be improved and revived. The two potential improvements most often discussed are (a) requiring the banks that package mortgages to keep some of the lending risk, or (b) improving underwriting standards without requiring underwriting banks to keep some "skin in the game." The first concept is intended to keep the banks honest. But banks holding increased amounts of lending risk also must increase their capital levels. That is likely to lower profits, anathema to their executives suites and also not to the liking of some bank regulators, who seem to equate lower bank profits with greater aggravations for themselves. The second notion--improved underwriting standards--is clearly necessary, but insufficient by itself. Investors aren't prepared to put down their money with just promises of improvement.

The problem is the discussion focuses on what the banks (and regulators) want, not what investors would like. This is donkey-backwards. A revival of a private securitization market depends on the willingness of investors to plunk their cash onto the barrelhead. There used to be a notion in American business that the customer is always right. A little fillip of customer service--i.e., investor protection--needs to be added to the mix.

First, there's the issue of trust. Trust is the true foundation of the financial system. Investors no longer trust the banks at the heart of the securitization process. That's why the only mortgage-backed securities acceptable to investors today bear a federal guarantee. Banks hoping to securitize on their own seem to be viewed as little more than potential scofflaws. Serious regulatory reform--of both banking and the derivatives market--is essential. Consumer protection must be greatly strengthened, lending standards bearing a reasonable resemblance to prudence have to be enforced, and the derivatives market must become much more transparent. But the scope of reform evolving in current legislative proposals may be inadequate to reassure holders of capital.

Second, the securitization market as it existed in the early 2000s ceased to be risk-sensitive. Investors had no effective way to discern that they were buying bags of digestive waste, and banks securitizing loans ceased to care that they were selling the same. The absence of risk sensitivity created grotesque market distortions that resulted in millions of bad loans being made, which may have enriched underwriting banks but also led to the defaults and foreclosures that have been driving down real estate prices.

Risk insensitivity is the problem that the skin-in-the-game requirement is intended to fix. The continued desertification of the securitization market is a signal that not enough is being done. Further product development is required. Perhaps banks should agree to limit investor losses to a predetermined number of cents on the dollar invested. After that, the underwriting bank would bear all losses. The less the investment resembles a pig in a poke, the more likely people will buy. Such a provision would improve the quality of mortgages in the pool, which would benefit investors--and homeowners. Fewer low quality loans would be made. Even if home ownership levels fall, bad loans do not, in the medium (let alone, long) term, increase home ownership. They do, however, drive down real estate values when borrowers default and end up in foreclosure.

Another improvement would be for banks to open up their databases concerning the underlying mortgages to credit rating agencies, and indeed, investors, for analysis. People are more likely to buy if they can kick the tires and lift up the hood. Any competitive issues would be unimportant if all offerings are subject to inspection. Of course, this may make pricing more accurate, or, stated otherwise, fairer to investors. And that's the idea. People will pay a fair price for what they understand, but not a penny for the opaque, black box CDOs of yore. Bank profits would be lower. But the current miserly dialogue about minimizing the extent of improvements to the securitization process may be holding down underwriting banks' costs, at the expense of expunging investor interest.

The bank-centric orientation of reforming the securitization market isn't even leading investors to water, let alone inducing them to drink. However, if banks and regulators would give a nod to the holders of capital who've been taking it on the chin for the last few years, maybe they'd see the phoenix rise from the ashes.

Bankers' Bonuses and the Tilt in the U.S. Economy

There isn't a level playing field in the U.S. economy. The government gives major advantages to banks and other financial companies. Banks are subsidized by the Federal Reserve, which gives them very cheap credit compared to say, Boeing, Ford or Disney. It also buys funky assets (like mortgage-backed securities) from them and stabilizes their counterparties (like AIG) when the latter get into trouble. When the going gets rough in the financial markets, the banks don't have to get tough. The government brings in a stretch limo and drives them to Easy Street.

The government also tilts the playing field in favor of residential real estate. Government alter egos like Fannie Mae, Freddie Mac, Ginnie Mae and the FHA provide financing at interest rates lower than market forces would justify, and tax benefits like the mortgage interest deduction and now buyers' credits. When liquidity for mortgages dries up, the Fed buys a trillion dollars plus worth of mortgage-backed securities with printed money, holding down interest rates and propping up residential real estate while putting wage earners at risk of inflation.

Thus, capital flows into financial services and residential real estate, where the generosity of taxpayers reduces the chances of loss and increases the potential for profit. Other sectors of the economy can only imitate Oliver Twist holding an empty bowl. Since those other sectors, especially medium-sized and small businesses, might otherwise create jobs crucial to economic recovery, putting them on a starvation diet for capital steers the economy toward stagnation.

News media stories report that Wall Street is about to reveal record or near record earnings, and pay record or near record bonuses. Although no one in the government will admit it, this is a problem created by the government. By giving the banks such massive subsidies and benefits, humongous profits were predictable. Indeed, they're exactly what the Fed and Treasury intended, as buffers to stabilize the financial system. But putting huge profits on bank financial statements is like putting mountains of corn and rice in front of ravenous hogs. What do we think will happen? That bankers will retain profits in the banks' capital accounts for the good of the nation?

No doubt, senior officials at Treasury, the Fed and the White House, as well as almost all members of Congress, are preparing their statements of outrage over the soon-to-be announced bank mega-bonuses. They should save those statements and back them up--twice--because they'll be using those statements a lot. Given the way the government has tilted the playing field in the economy, banks will be making headline profits at taxpayer expense, and paying headline bonuses, as far into the future as one can see.

America is more like to prosper long term if there is a level playing field for capital. But undoing a federal subsidy is greater challenge than climbing Mt. Everest blindfolded. Practically no one in the government, in either party, wants to make major changes to these rules of the game. Meanwhile, back at the ranch, unemployed formerly middle-class Americans are hoping for one day a week when they can have franks and beans instead of rice and beans. Small businesses are looking for anyone who can lend them a dime.

When Will Housing Prices Recover?

Today, September 25, 2007, the National Association of Realtors reported that sales of existing houses had fallen again, for the sixth straight month. Sales in July 2007 fell to a seasonally adjusted annualized rate of 5.5 million, down more than 12% from last summer. The NAR reported that prices of homes sold had actually risen 0.2% from a year ago. But another source, the S&P/Case & Shiller Index, reported that home prices were down 4.5% from July 2006 to July 2007. Most other data indicate falling home prices.

A question on the minds of all homeowners, home sellers and home buyers is when will prices stabilize and recover? Of course, no one knows for sure. Predicting the weather is much more certain in economic prognostication. There is, however, an investment technique that may provide insight.

Many money managers subscribe to the notion that assets have predictable values that can be discerned from historical information. For example, bond traders posit that interest rates will generally be higher the longer the maturity of a financial instrument. Thus, a 30-year Treasury bond should usually have a higher interest rate than a 2-year Treasury note. This phenomenon is called an upwards sloping yield curve. The yield curve can also invert, with rates on longer term debt becoming lower than rates on shorter term debt. That was the case for much of the last few years. Treasury markets traders sometimes employ trading strategies based on the idea that the anomalies in the yield curve will disappear eventually and the yield curve will revert to its normal upwards sloping shape. This strategy is called a reversion to mean, because it posits that the yield curve will eventually revert to its mean (or average) relative values.

The concept of reversion to mean can be employed with other assets. Let's look at housing. Housing prices, over the last century, have increased at a rate of about 1% per year, net of inflation. For most of this time period, the rise in housing prices was gradual. In some periods, like the Depression of the 1930s, prices fell.

However, from 2001 to the end of 2005, housing prices rose about 30% net of inflation, a rate vastly in excess of the historical mean. This eye-popping rate of increase is why housing prices were in a bubble, and why the bubble eventually had to burst. Growth in household incomes, which has been virtually negligible, couldn't begin to finance prices increases like these. The creativity and recklessness of the financial markets was strained to the limit to devise new and increasingly implausible mortgage loans. But even the stupidest of teaser rate option ARM mortgage loans eventually became untenable when used to finance prices increases wildly beyond the growth in buyers' true ability to pay.

Housing prices have fallen about 7%, net of inflation, since the 2005 peak. Thus, they are about 23% above 2001 levels, net of inflation. If we assume that housing prices had risen at their historical average rate of 1% since 2001, we'd have a total increase of 6% (after inflation). Current housing prices, however, are about 17% above that level.

The implication of this analysis is that if you buy a house at today's prices, you may not see any increase in value, net of inflation, for about 17 years. This conclusion is dependent on a number of variables, such as the rate of growth of the U.S. economy, growth in individual and household incomes, the availability of credit for home mortgages, government policies toward housing, so on and so forth. And it is based on national average figures, which may not entirely apply to many individual housing markets. But if we assume that housing, like other assets, adheres to a predictable pattern, returns from owning a home, after adjusting for inflation, will probably be modest for over a decade, and perhaps for much longer.

During the first 40 years of the 20th century, housing values meandered. From 1989 to 2000, housing values, net of inflation, showed losses rather than gains. There's no reason to think that another 15 or 17 years of no net gains after inflation aren't possible. Stocks, by comparison, have risen around 2% t0 3% a year after inflation. That's why putting your retirement money in a diversified portfolio containing a significant stock component is likely to work out better than betting the ranch on, well, the ranch.

Tech News: Is someone listening in on your Internet phone calls? http://www.wtop.com/?nid=456&sid=1254975.

The Subprime Mortgage Mess on Wall Street

You're probably familiar with the problems on the home front created by subprime and other adjustable payment mortgages. Monthly payments are rising. Many homeowners are defaulting, and some face foreclosure. The problems are particularly acute in areas where housing prices rose abruptly and have now plummeted, or where economic distress is spreading.

The pain has spread to Wall Street. In the last week, the financial press has reported on difficulties at two hedge funds sponsored by an investment bank called Bear Stearns, which had invested indirectly in subprime mortgages. Bear Stearns agreed to provide a $3.2 billion loan to stabilize one fund. It's unclear what will happen to the other fund. What's going on here? How did we get from some defaulting homeowners in places like Michigan and Florida to a $3.2 billion bailout on Wall Street?

Here's an overview. We are speaking generally, and not about the Bear Stearns-sponsored hedge funds.

Fifty years ago, mortgage lending was primarily done by specialized banks usually called "Savings and Loan Associations" or "Building and Loan Associations." Broadly referred to as thrift institutions, these specialized banks held onto many or most of the mortgage loans they made. They earned profits from the difference between the interest they paid to depositors and the higher interest rate they charged for mortgage loans. Interest rates were stable in those days, and thrift institutions were able to make a comfortable living without working real hard.

In the 1970's, however, interest rates began to fluctuate widely, and the thrifts had a harder time maintaining profits. Regulatory restrictions on them were loosened in the early 1980's, but that resulted in a some poorly conceived lending strategies that led to the collapse of a number of thrift institutions. By 1990, the thrift industry was diminished and other players, like mortgage companies and banks, began to make more mortgage loans. They, however, did not hold onto the loans, but instead tended to sell them.

A mortgage provides a flow of cash, and can be bought or sold like a bond or other investment providing a cash flow. Investment banks pool large numbers of mortgages together into an entity often called a CDO (or collateralized debt obligation). These mortgage pools provide a large, aggregate flow of cash. Investment banks "subdivide" the aggregate flow of cash into classes called "tranches." Each tranche has different claims on the cash flowing from the pool of mortgages. The result is a tier of tranches, with the most "senior" having the best claim to the cash flow from the mortgage pool, the next most senior having the second-best claim, and so on, down to the most "junior" tranche, which basically has a speculative claim to the residual value of the pool.

The CDO issues bonds that correspond with the various tranches. The most senior bonds have the best claim to payment from the mortgage pool. The next most senior bonds have the second-best claim, etc. The potential returns from these bonds varies by the position of the bond in the hierarchy for repayment. The interest paid on the most senior bond will be the lowest, since its likelihood of repayment is the highest. The interest rate on the more junior bonds will increase, since they have greater risk of not being fully repaid. The most junior bond may even be called the "equity tranche," a term that reflects its high risk levels (not unlike the risks of equity investments like stocks).

Why did Wall Street create these CDO's? Because subdividing the mortgage pool into different tranches allowed them to sell a variety of investments that might serve the needs of different investors. Some investors want conservative, reliable investments with a low risk of default. They would be interested in the senior bonds. Other investors want bonds that pay a higher return, even if there's a greater risk of default. They'll take the risk of the default in order to get a better return, and would be interested in the more junior bonds. Some investors want to speculate, and the equity tranche, with its high returns and high risks--might fit into their strategy.

There has been, as you probably know, a hedge fund craze in recent years. Hedge funds have proliferated, and as their numbers have grown, their interest in new and different investments has grown. CDOs have drawn their interest. Hedge funds have borrowed, sometimes heavily, to invest in CDO bonds. Borrowing increases the quantity of bonds a hedge fund can buy and therefore leverages the returns it might receive if all goes well. However, borrowing also leverages the losses the hedge fund would receive if things go badly.

Things have gone badly. The real estate boom is over in most markets and defaults are occurring at well above normal levels. CDOs aren't receiving the cash flow they expected, and CDO investors like hedge funds are taking losses. Those that invested on a leveraged basis may be taking sharp losses.

How did this happen? On the most basic level, the market pros didn't correctly predict the level of defaults. That means they over-estimated the investment quality of many CDO bonds, and priced them too high. Losses are now resulting.

Who's responsible? Homeowners who took out mortgages they should have known they couldn't pay? Mortgage brokers, mortgage companies and banks that made loans to people who shouldn't have qualified? Investment banks packaging CDOs that didn't look close enough at the quality of the mortgages they were buying? Investors that borrowed to invest in illiquid assets like many CDO bonds? All of the above? Now that things are hitting the fan, Congress is holding hearings, government agencies are investigating, and lawsuits will be filed.

There has been very little regulation of the mortgage markets, especially at the Wall Street level, where hedge funds roam unsupervised among herds of CDOs. An absence of regulation sometimes allows markets to grow and evolve more quickly. But markets are created by humans and are therefore capable of error (as is evidenced by all the bubbles, booms and busts of recent years). The enormous growth of the mortgage market included many loans that never should have been made in the first place, and, once made, never should have been purchased for packaging in CDOs. Some of the losses from CDO investments are falling on wealthy individuals who invested in hedge funds to get money to buy a larger yacht. Such a shame. But other losses are falling on pension funds that ordinary people count on for retirement, or on university endowments that could help cover some of the costs of your child's education. In the end, many people will be hurt.

Congress, government agencies and state governments will be confronted by the question whether the mortgage industry should be more heavily regulated. If thrift institutions were still at the heart of the mortgage business, the problems we see today might never have happened. Thrift institutions were heavily regulated, and it's highly doubtful they would have been allowed to make the large numbers of low doc/no doc, don't-have-the-means-to-repay subprime mortgage loans that now weigh down on parts of Wall Street. Had those loans never been made, the losses wouldn't have occurred. And let's not think that subprime loans are a boon to home ownership. Extending loans that people can't pay and result in foreclosures not only doesn't increase home ownership, it damages the borrowers' credit ratings and impairs their future ability to own a home.

On an individual level, stay away from loans that have the potential for increasing monthly payments. As we discussed earlier, the right mortgage loan helps you build wealth. http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html.

Animal News: the search for Bigfoot continues. http://www.wtop.com/?nid=456&sid=1175579.

How to Retire Without Saving

Many people can't save. Sometimes it's for good reasons--illness, an aged parent who needs support, a child with special needs, or too low an income. Other times, the reasons are not so good--serial spending, reckless investing or indifference to the future. Whatever the reasons, good or bad, these people need to retire, too. How can they do it? Here are some ideas.

1. Get a job with a pension. Government jobs, military service, law enforcement and educational jobs usually offer pensions. Some of these employers also offer retirement savings accounts similar to the 401(k) plan--the federal government's Thrift Savings Plan is an example. These jobs aren't for everyone. Governments are often bureaucratic, and action-oriented people may have a hard time fitting in. Teachers sometimes find that their jobs involve as much babysitting as teaching. Military and law enforcement personnel perform yeoman's duty for everyone else, but they have to be disciplined, motivated and able to deal with a highly structured and high-pressured environment. It often takes 20 or more years to qualify for a pension, so this isn't a cakewalk. But if you think you're cut out for one of these jobs, and your retirement savings hover around zero on a good day, give it a try.

Corporate pensions continue to exist, especially at the larger, old line companies. But most corporations are fleeing the traditional defined benefit pension (the good kind) faster than rich folks left New Orleans before Katrina. New hires often are unable to participate in the older pension plans. If you have the opportunity to participate in a corporate pension plan, consider yourself lucky. But don't rely entirely on the company pension. You may be disappointed.

2. Buy a house and pay off the mortgage and all home equity debt. Many people who can't put $20 into a savings account always manage to pay the mortgage one way or another. The house can be used as a vehicle for forced savings. Just don't mess things up by taking out a home equity loan or home equity line of credit. You'll get only a finite amount of home equity in your life. If you take out home equity debt, you use up some of your finite lifetime home equity. Yes, you can repay the home equity loan, but you have to use cash that could otherwise have been devoted to retirement savings. If you enter retirement with a home that's free and clear of all liens, you'll have a valuable asset that could add much to your golden years.

3. Work longer. The longer you work, the more your Social Security payments will be. We explained how this works in our earlier blog, Mysteries of Social Security Retirement Benefits, Part 1 (blogger.uncleleosden.com/2007/05/mysteries-of-social-security-retirement.html). An added benefit of working longer is that it gives you more time to save, and, if you are lucky enough to have a pension, it may help you earn a larger pension. While working longer isn't the fastest way to the cabana on the beach, you may end up with a nicer cabana.

4. Stay together. This is something we discussed in our blog "Love in a Time of Financial Planning--Part Deux" (blogger.uncleleosden.com/2007/04/love-in-time-of-financial-planning-part_20.html). Two people together can often do better than if they were alone. Consider the following example. Each member of a couple gets $15,000 in Social Security benefits, and has $250,000 in savings, enough to allow withdrawal of $10,000 a year in retirement beginning at age 65. Individually, they'd each have $25,000 a year, enough to be okay, but not more than that. Together, they'd have $50,000 a year, enough to be solidly middle class. The idea of staying together for financial reasons conjures up images of bedraggled housewives stuck in loveless marriages with unshaven, potbellied louts who drink too much and smoke cheap cigars. That's not what we mean. Sometimes, no relationship is better than a bad one. But you have many reasons to make your relationship work and your financial well-being may be one of them.

None of these strategies will get you luxuries. You need savings for that. But if you feel like you're financially lost, don't give up. There's still hope for you.

Strange News: Trying to make fast food faster--www.nbc4.com/news/13326368/detail.html?dl=headlineclick.

How to Maximize Your Investment Gains

Profiting from investment consists of two things: (a) making money; and (b) keeping it. There is risk in almost every investment--even federally insured bank deposits are subject to loss of value from inflation--and risks can cause losses.

Risk and reward walk hand-in-hand down Wall Street. The higher the potential rewards of an investment, the greater the risks it involves. If you invest in something that offers large potential gains, understand that it's likely to have high risks of loss as well.

From time to time, you may hear of investments that are sure bets. When someone offers you a chance at one of these sure bets, put your hand on your wallet and go for a walk around the block from which you don't return. There are no sure bets in the financial markets.

Maximizing your investment gains involves a balancing of risks and rewards. Look for investments with reasonable returns and moderate risks, and you have a good chance of making money and keeping it in the long run.

So, if you are an ordinary investor, what are good investments? We mean the ones where you have a reasonable chance of receiving gains and then keeping them. Here are some ideas:

1. Stocks and stock mutual funds: stocks give you ownership of a small piece of a company. Stock mutual funds own a large number of different stocks, and give you a tiny bit of ownership in all the stocks that the mutual fund owns. Stocks are generally a good long term investment. Of course, we all know that the stock market fluctuates. But if you ride through the ups and downs, you'll likely do well over the years. Stock mutual funds smooth out some of the ups and downs by giving you a diversified pool of investments. As a mutual fund investor, you put your eggs in many different baskets, and therefore have a smaller chance of taking major losses from any particular stock.

2. Bonds and bond mutual funds: bonds are an investment where you invest an amount of money (the "principal") in the bond. The company or government that issued the bond pays you interest from time to time, and eventually repays the principal. In this sense, bonds are like bank certificates of deposit (except they aren't federally insured, although U.S. Treasury bills, notes and bonds are safe). A bond doesn't offer great potential for gains. However, it tends to have low risks, especially U.S. government bills, notes and bonds. A bond mutual fund holds a number of different bonds and helps to diversify your bond investments. You would invest in bonds and bond mutual funds to provide stability to the value of your financial portfolio. Every portfolio should have some stable assets, especially as you get older.

3. Lifecycle or target date mutual funds: these mutual funds hold both stocks and bonds. They are a blended mix of financial assets and are designed to give you the potential of stocks for good long term growth while somewhat stabilizing the value of your portfolio by investing some assets in bonds. The company managing these funds does the investment selections for you, so all you have to do is pay in your money and let them do the rest of the work.

4. Real estate: we now understand that real estate is not a wonder asset that will make everyone rich through no effort whatsoever on their part. Real estate historically has increased in value more slowly than stocks (about 1% after inflation versus approximately 3% after inflation for stocks). Nevertheless, everyone needs a roof over their heads and buying real estate is a good way to pay for that roof while adding to your investment portfolio. Owning a home provides some diversification away from the financial markets, and the home could serve as an asset of last resort in retirement, especially if you own it free and clear of debts.

5. Education: last, but certainly not least, is education. The gap in earnings between those who have a four-year college degree and those who don't has been growing over the years. The U.S. economy has shifted away from traditional manufacturing to knowledge and informational based activities, and it rewards those who know how to utilize knowledge and information. A college education doesn't provide everything you need for a job or a career. But it teaches you how to learn. You have to absorb information faster and on a more sophisticated level in college, and therefore you learn how to learn. That skill is highly rewarded in an economy based on knowledge and information. Education is one of the best investments you can make. Don't worry a great deal about which college you attend. Statistically speaking, there is little evidence that going to an expensive Ivy League school will make you significantly wealthier than attending a good state university. Just make sure you graduate.

Strange News: Apes with expensive tastes--http://abcnews.go.com/Technology/CSM/story?id=3158484&page=1.

Automate to Accumulate Wealth

To get to work on time, you probably set the alarm on your clock radio and let yourself hit the snooze button no more than three times. This automates the process of waking up. That makes you a more reliable, and therefore valuable, employee.

It's a good idea to automate the process of building wealth. Don't make saving something that you have to remember to do. If you automatically send part of each pay check into a retirement, investment, or savings account, the process of building wealth becomes much more reliable, and eventually, rewarding. You are paying yourself first. By making saving a priority, you are more likely to accumulate wealth.

Automating the wealth building process can be done a number of ways:

1. Payroll Deduction. Retirement accounts sponsored by your employer, such as a 401(k) account, will typically be funded through payroll deduction from your salary or wages. People who are 50 or over and want to make "catch up" contributions will have to separately authorize them; do so if you can afford them. You may also be able to buy other investments, such as U.S. Savings Bonds, through payroll deduction.

2. Automatic Transfers. You can arrange to have money automatically transferred from your checking account to another account at a specified time, such as the first of the month. The other account can be an IRA, a savings or money market account, an investment account, a mutual fund, a money market fund, or a variety of other accounts. It can be at a different financial institution than the one where you maintain your checking account. All you need to do is a little bit of paperwork (or online authorization), and the process will begin.

3. Extra Mortgage Payments. One way to reduce your housing costs is to prepay your mortgage bit by bit. In other words, if your mortgage payment is $3,000 a month, add a little bit more to each month's payment. Even an extra $100 or $200 a month is helpful. Your mortgage payment coupon may even include a line for adding an extra payment (but make sure you won't be charged a prepayment penalty). The extra payment will be used to reduce the principal balance of your mortgage. As a result, you'll repay the loan sooner and build equity in your house faster. Building equity matters. The real estate markets in many parts of the country are backsliding by day and by night. But extra mortgage payments remain a reliable way to build equity in your house. It doesn't matter that you might plan to live in this house only a few years. This method builds equity even if you stay in your current house only a short while.

One way to prepay your mortgage gradually is to make payments every two weeks. The amount of each biweekly payment would be half your monthly payment. You'd make 26 biweekly payments a year, or the equivalent of 13 month payments annually. You could repay the mortgage several years early this way and save tens of thousands of dollars or more. If you're interested in this idea, see if your bank will automatically deduct the payments from your checking account every two weeks. If not, you might have to pay a service company to make the biweekly payments, and that will involve fees that make the idea less attractive (although not necessarily a bad idea).

Once you routinize the process of building wealth, it will become largely painless. Even more important, it will become reliable. That takes you down the path toward champagne and caviar.


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