Tuesday, June 28, 2011

Who’s crazy?

Like the song says: But maybe I’m crazy; Maybe you’re crazy; Maybe we’re crazy; Probably.

The last posting, On Investing: Part 14 (contd.), Some old fashion beliefs had a sophisticated basis, commented: “… it would appear that despite its limitations, the “old fashion” guidance looks pretty reasonable when compared to the nonsense inventive minds can come up with when it is ignored.” But when it comes to inventive minds, nothing beats the lines, “Ha, ha, ha; bless you’re soul; you really think you’re in control… Well,I think you’re crazy….” as in the song by Gnarls Barkey.

It seems that rather than freed from an anchor of old fashion thinking, we collectively became a little unhinged. Now it seems everyone knows what banks should do, and we’ve all arrived at this collective conclusion without having any consensus. Yet, even with everyone knowing what banks should do, there is no stampede by the public to start banks.

Consider some examples of our collective wisdom: A recent direct mail solicitation advised, “By now you’ve heard about President Obama’s Stimulus Plan and the benefits for homeowners. [Name of bank’s subsidiary] is pleased to play a key role in supporting homeownership by offering refinancing opportunities under the federal Making Home Affordable Program. Your current mortgage loan may be eligible for a refinance under this program.”
“This new plan will make refinancing easier for many homeowners. Some benefits to refinancing under this program now include:
Refinancing up to 125% loan-to-value…[explanation of a 125% LTV]
No appraisal required on some single-family homes
With the relaxed qualifying requirements available through the Making Home Affordable Program, it makes sense to review your current situation now….”

It would seem one approach is to encourage banks to lend to people who are underwater. So, if people borrowed too much, the solution is just to refinance it into the next administration. Gee, 125% LTV. Sounds familiar. Hum? If a bank lends 125% LTV it’s predatory, but if it’s a part of a government program, it’s stimulus. Sounds like the Community Reinvestment Act all over again. Subprime anyone?

There is, however, a little wrinkle here. Like the WALL STREET JOURNAL advertisement discussed in “Your Government at Waste, or Worse” the direct mail is a bad joke. There is no mortgage to refinance at this address, there probably aren’t many underwater mortgages in this zip code (no bubble, no bust), and even an inefficient direct mail screen would definitely screen me out for this direct mail solicitation. Is it waste, or an intentional effort to make people who paid off their mortgage feel like suckers? If it’s the later, it failed. The suckers are people who try to borrow their way out of debt, and taxpayers who willingly lend people money they can’t repay.

The WALL STREET JOURNAL article entitled “Tighter Lending Crimps Housing,” June 25, 2011, would make one think the direct mail was a hoax: “The percentage of mortgage applications rejected by the nation's largest lenders increased last year, spotlighting how banks' cautious lending practices are hampering the nascent housing market recovery…..Although lenders were expected to pull back from the freewheeling conditions that helped inflate the housing bubble, some economists argue they are now too conservative, and say that with the U.S. economy still wobbly, mortgages need to be easier to obtain for qualified borrowers, not harder.”

The article continues with two conflicting opinions as to the appropriateness of tighter standards, thus illustrating that the above statement that “some economists argue they [bank lending standards] are now too conservative” is half a fact. It also illustrates that it’s hard to keep journalists from writing opinion pieces as real and calling them reporting. Interestingly, one opinion ends with this: “You had decades where credit standards were tougher than they are even now." That should sound familiar to anyone who read the posting: On Investing: Part 14 (contd.). Some old fashion beliefs had a sophisticated basis.

Today’s news from the same source included an article entitled: “Debt Hamstrings Recovery: Inability of Nations, Consumers to Get Out of Hock Weighs on Global Economy.” It started with: “The Federal Reserve is just days away from ending one of the major steps to aid the U.S. economy—but the effort has done little to solve the original problem: The government and individuals alike are still heavily in debt….Around the globe, the inability of governments and households to reduce their debt continues to cast a shadow over Western economies and the financial health of individuals. Today, U.S. consumers have more mortgage and credit-card debt than they did five years ago, and the U.S. budget deficit is worsening.”

Interestingly at one point it says “Banks, for their part, are hoarding cash, being stingy with new loans.” That’s so absurd as to be laughable. Banks hate having money just sitting there. In fact, the article contradicts itself by going on to discuss consumers increasing their total debt. Seems to me consumers couldn’t increase their debt unless someone lent them money. It wasn’t me. How about you? Egads,could it have been banks?

The madness doesn’t end there. Another story entitled “Capital Rules Tighten for Big Banks” is about “The agreement, hammered out over the weekend in the Swiss city of Basel.” It “will force global banks that are considered ‘too big to fail’ to maintain capital cushions that are significantly thicker than those of other institutions, and several times greater than what they have needed to maintain in the past.” Force them? I thought they were already “…hoarding cash, being stingy with new loans” according to the other story. What gives? See? Unhinged at least.

It gets interesting later on with this quote: “In order to satisfy the new requirements, which won't fully take effect until 2019, some banks might need to curtail dividend payments or stock buybacks to preserve scarce capital, according to a report last week by Morgan Stanley analysts.” Where did the hoarded cash go?

In reality, “Giant banks for months have been lobbying against the planned capital surcharge. They argue it is unnecessary and could tip fragile economies back into recession by tying up resources that could be used for lending to consumers and companies.” Lending is what banks do if left to their own devices. In fact, regulators are well aware that the regulator’s challenge is to keep banks from lending too much and too aggressively. But one must ask: Is that a case of banks being predatory, or is it banks providing too much stimulus?

Well, maybe if all those who are convinced they know what banks should do went out and started a bank, they’d know the answer first hand. I can’t because as Gnarls says: “Maybe I’m crazy; How about you?”

Saturday, June 18, 2011

On Investing: Part 14 (contd.)

Some old fashion beliefs had a sophisticated basis.

This is the third posting on real estate. You might legitimately ask, “When will real estate as a capital allocation issue be addressed?” That’s understandable; the previous posting addressed myths and mistakes associated with the ownership of a house. Remember, however, the oft quoted axiom of investing: “Rule one: don’t lose the capital. Rule two: don’t forget rule one. Rule three: there are only two rules.” So, it seemed appropriate to start with the nonsense and bad advice. It’s now time to allocate capital.

When one addresses home ownership as a capital allocation issue, some interesting questions immediately surface and the answers point to some old fashion beliefs about home ownership. Things like 20% minimum down payment, amortizing mortgages, payments that represent 20-25% on income, total ownership costs under 30-35% of income, little or no other debts that must be services at the time the mortgage is initially taken out, savings (i.e., investments) other than the home, all have often unspoken balance sheet management justifications. Old fashion, but hardly unsophisticated. Similarly, much of the trendy, supposedly sophisticated advice is naïve occasionally bordering on financially suicidal.

A home purchase can be a very low risk-real estate investment. Remember, the primary return, a place to live, doesn’t change. We, inventive creatures that we are, have figured out how to make it risky; just leverage the heck out of it. Nevertheless, it is still a potentially productive way to use capital. First, however, there has to be some capital involved. So, nothing that follows is at all relevant to zero-down-interest-only housing purchases. That’s really a totally different issue; it might be better treated as whether to rent housing or rent money.

Mortgages where there is an interest only option can raise similar issues at times since whether any capital is allocated to real estate is an open issue. In fact, if housing prices are falling, the interest only payment actually involves a reduction in capital when marked to market. Granted, the primary return hasn’t changed (i.e., a place to live), but leverage has increased as discussed previously.

The return isn’t without risk, but it would be naïve to assume that leverage and price are the only risks. The amount of the benefit from having a place to live that is attributable to the capital does vary. Maintenance and real estate taxes vary, so not all of the benefit from a place to live is return on capital.

Since this posting is approaching home ownership as a capital allocation decision, it takes a balance sheet management approach. That’s consistent with a focus on net equity rather than asset value. However, as mentioned in all the previous discussions, leverage often confuses the issue. Further, leverage is an important aspect of balance sheet management.

Therefore, without trying to discuss personal (or household) leverage as a general issue, some comments are essential. Most real estate purchases involve a mortgage. That makes infinite sense. Remember most peoples’ largest asset is their future income stream. Initially it is usually their only asset. Under those conditions, it makes sense to diversify by selling part of the future income stream to purchase a different asset.

Leveraging future income makes sense since selling it outright (i.e., explicitly indenturing oneself) isn’t legal: borrowing is about as close as you’ll be able to come. An amortizing loan such as a mortgage is particularly convenient from a personal perspective. An amortizing mortgage automatically builds equity in real estate as the value of the future income stream decreases with age; thus, it rebalances for you and replaces one asset that is decreasing with another.

Granted, most people do not consciously approach the issue as a balance sheet management issue. Cash flow is often the major consideration. Viewed from the balance sheet management perspective, one can see that just focusing on cash flow can lead to balance sheet management mistakes.

To illustrate, when one is young, wage and salary income tend to go up over time. That has been true over most historical periods and has been especially true during inflation. If that income stream goes up with the passage of time, the value of the discounted future wages and salary income does not keep pace. The length of time decreases since some of the income stream is in the past; retirement’s getting closer. Similarly, the value of the benefit from the home decreases since that benefit is also effected by the short timespan over which the home can be owned; one can’t live forever.

For many people, the values of these two major assets are falling with the passage of time quite independently of price fluctuations. Under those circumstances, amortizing loans make sense. Debt is automatically decreasing with the value of these two assets. From a purely cash flow perspective, this, is occurring at a time when more debt seems to make sense, or at least not be harmful; after all, the income is there.

While a home isn’t most people’s biggest asset, it’s usually the core of the real estate investment of those who choose to accumulate assets. That makes sense from an investment perspective. It’s an investment where the primary return is very predictable: a place to live. Since the leverage issue was addressed above (to the extent this posting is going to address it), now things get quite simple since the focus is equity. With equity in focus, the important questions are: How much real estate should one own, and how should it be accumulated over time?

There is some old fashion wisdom here as well. Buying one’s place to live and retiring the leverage over time are widely recognized as “old fashion,” and they are often honored in the breach. As damaging as that breach has been for many people lately, there is more. The concept of 20% down clearly has balance sheet implications. The implications for leverage are obvious. However, that’s quite minor. It is more important to recognize that it mandates net equity, the down payment, as a starting point.

With 20% down and amortizing loan, there is an implied shifting of portfolio weights. One is increasing home equity. However, if one hasn’t fallen into the cash flow trap discussed above, those assets are replacing the decline in the value of the discounted value of future wage or salary income. Further, a subtle symmetry is automatically built in. As payments accumulate on the mortgage more of each payment applies to principle and less is interest. Thus, the rate at which equity is being accumulated is accelerating. That offsets the fact that the rate of decline in future income accelerates as more of one’s raises, promotions and increases in wage and salary are in the past.

The symmetry doesn’t end there. The initial 20-25% of income falls as a portion of income as wages and salary rise with time in the labor force. However, while the symmetry discussed above is automatic, the benefit of this might require action. As the increases in wages and salary slow down and eventually reverse, a smaller portion of wages and salary is needed to build real estate equity. That drop facilitates allocating more of the employment income to other income-producing assets. Thus, income-producing assets can replace the slowdown in raises common in older workers. Eventually much of the income from employment has to be replaced by income from capital and the drawdown of the capital eventually replacing it entirely in retirement.

Since 20% down payment was viewed as a minimum down payment, it limited the purchase price. The guidance of no more than 20% to 25% of income for mortgage payment also tended to limit the price. However, one could buy a bigger house by increasing the size of down payment. Another popular way to purchase more home is to extend the length of the mortgage. So, the 20-25% of income didn’t put a fixed limit on real estate exposure. It put a limit on the leverage resulting from the home purchase since just borrowing more was not an option. Something else was needed.

“How,” you say, “does that relate to how much real estate one should own?” Well, first, it dictates that one actually own some real estate in the net equity sense. Second, when combined with reasonable guidance regarding the portion of one’s income to obligate to a mortgage, it sets a ball park on how much real estate to own. Interestingly, the concept of “over-housed” (i.e., having too much capital tied up in home ownership) arose almost simultaneously with the rise in the portion of income that it was thought to be OK to obligate to a mortgage. In the 1950s most long-term home loans lasted just 20 or 25 years with 25 year mortgages viewed as boarding on imprudent. Now, 30 year mortgages are common. So, lengthening the term also was at play.

The balance sheet approach provides additional guidance. There the guidance is completely at odds with “Hedging Your Home Value: The Greatest Idea Never Sold,” WALL STREET JOURNAL, May 14, 2011.

The article promotes hedging an overexposure to real estate. The balance sheet approach would dictate diversifying beyond real estate as soon as feasible. In practical terms, don’t go for a larger house; start an IRA or 401(k) well before further increasing one’s exposure to real estate. The balance sheet approach would also suggest investing in income-producing uses of capital so that the discounted future income component of your balance sheet can be rebuilt after using (selling) it to get real estate.

The balance sheet focus would suggest not prepaying your mortgage until some other assets have been added to the balance sheet. Remember the focus is net equity. Prepayment increases the net worth of the asset, but prepayment does it by concentrating the capital in one asset, residential real estate. Prepayment isn’t bad. It is an effective low-risk investment when done within the context of a broad asset base. As always, there is also the leverage issue. If over leverage is introducing too much risk, then by all means debt repayment is the solution.

There is still the issue of how much of a portfolio should be in real estate. Here the owner- occupied house presents an almost unique asset class. It is residential real estate, but it has far less risk than most real estate. Remember, the primary return, the benefit of having a place to live, is pretty predictable. While there is some research, it is putting it mildly to say the resulting “recommendations” are all over the board. That is perhaps why the mortgage-payment-to-income guidance hung around so long.

Some of the research, or at least the advice that comes from it, is ridiculous. Take, for example, the advice that 5% of a portfolio should be in real estate. Clearly, 5% is only reasonable if your home is excluded. So, the issue of how much to invest in real estate has really been ignored. If you’re “over housed,” putting 5% of your other assets in real estate is silly. By contrast, the opposite may be true, in which case 5% is too little.

On the other hand, nonsense about selling your house to finance retirement is dangerous. It encourages portfolio concentration in real estate. Further, it depends upon selling an asset with a very stable return (in the form of a place to live) at exactly the time when assets with fixed predictable benefit are usually needed. The only possible justification would be that it could move assets from a highly illiquid asset (real estate) to some other form. That, however, involves paying a significant transaction cost to secure the liquidity. Selling a house should be a lifestyle choice, not a response to economic necessity.

Thus, in would appear that despite its limitations, the “old fashion” guidance looks pretty reasonable when compared to the nonsense inventive minds can come up with when it is ignored. Yet, refining this limited guidance is possible. There are various studies of how wealth is preserved and grown. Those that The Hedged Economist has read put the portion of the portfolio in real estate at 30% to 60%. Those figures include residences and income-producing properties. Much of the explanation for the range has to do with how other non-liquid assets are treated (private businesses mainly). My own view is that the guidance provided by the “old fashion” approach to home ownership is adequate until the mortgage has been paid off. Then the 30% to 60% guidance should be a target -- always including home sweet home as well as “investment” property in the calculation.

Wednesday, June 15, 2011

Your Government at Waste, or Worse.

Oh my goodness, holy cow, and UNBELEIVABLE!!!

You may have noticed that The Hedged Economist starts the day with a review of a few newspapers or new magazines. Today that review brought me up short. It was in the WALL STREET JOURNAL. It was not a story or an opinion piece, although there was an opinion piece focusing on Government waste. It was an ad.

Before you proceed, think about the WSJ’s U.S. audience. Their website says “affluent:” their average household income is $257,100, and average net worth is $2,616.000.

On page D6 of Wednesday’s print edition there’s a half page ad for “FREE” Government assistance in avoiding foreclosure. The ad is brought to you from the U.S. Department of Housing and Urban Development in partnership with the National Fair Housing Alliance. Let me ask: How fair is this effort to reach out to an audience with WSJ’s demographic when entire blocks of some cities are close to foreclosure? Half page WSJ ads aren’t cheap. For those who never inquired, the cost of a WSJ ad could probably keep a lot of people out of foreclosure. If outreach (Government speak for advertising itself) is the issue, a lot of street corner signs in depressed areas could have been bought with the money.

The ad notes that US law prohibits discrimination based on “race, color, religion, national origin, sex, family status or disability.” Do we really want to add wealth to the list of characteristics when it comes to this particular outreach? It’s a waste at least, but maybe worse.

There are alternative, more sinister interpretations. Here’s one suggested to me. Now, we all favor “fair,” and we all abhor the types of discrimination US law prohibits. In this case, one can question the fairness. It seems reasonable to assume that among people with those demographics, foreclosures aren’t real common. Then the logic goes: Is it fair to tax the readers in order to taunt them with an in-your-face ad highlighting that their tax dollars are being used to help others who haven’t paid their mortgages?

Yet another explanation goes as follows: the WSJ reaches the financial service industry. The ad was designed to reassure the financial service industry (especially bankers and investors holding mortgage bank securities) that the Government won’t leave them holding the bag. Let’s face it, no one wants their loans to default, and no one wants to own the foreclosed properties. Why even the people in the foreclosed properties don’t want to pay for them, and in many cases they just want out. If that’s the reason, how anxious do you think the average taxpayer is to pay taxes in order to reassure bankers and investors that taxpayers will bail them out of this mess? Is that reassurance, even if true, worth the cost of the ad? Is that reassurance even desirable? Seems worse than waste.

The opposite explanation also seems reasonable. It goes: the ad was designed to intimidate bankers and mortgage holders who might be thinking about foreclosing: sort of, “not so fast.” “You’ll have to get through us before you can foreclose.” Well, some people might not like big brother trying to intimidate people in order to benefit their particular favorites in a negotiation. We all know Government does it, but perhaps not advertising it might make sense.

A similar explanation is that HUD just wanted to reassure the public that they’re working on the foreclosure issue. If that’s the case, the ad is just stupid. Anyone who reads the WSJ or listens to the news knows they’re working on it. They probably also know how incredibly ineffective they have been. The ad will just create the impression they are failing because they are wasting money. We all know governments sometime waste money, but paying for an ad to demonstrate waste is downright weird.

Not the sharpest arrow in the quiver was another explanation. Perhaps so, but this seems to be more than just a run-of-the-mill mistake. Another is an ego trip. Bragging rights for big spread ads in the WSJ are often the motivation. The Hedged Economist’s take: big spread ads in the WSJ are often a sign that someone has too much money. That's especially when it's somone else money.

In any case, ‘tis a quandary. Perhaps Congress ought to ask HUD what it was thinking. While a WSJ ad is expensive in most individual’s terms, it is chicken feed in Government waste terms. So, more than an inquiry probably isn’t warranted.

Friday, June 10, 2011

Irony or Hypocrisy?

Mendacity perhaps.

Through the Pension Benefits Guarantee Corporation (PBGC) the Government joined a lawsuit over pension management. The lawsuit claims Morgan Stanley advisers concentrated too much of a particular plan's fixed-income investments in mortgage-backed securities (MBSs). It alleges that Morgan Stanley "irresponsibly" put about 50% of the plan's fixed-income side in mortgage-backed securities, and between 9% and 12.6% in a "particularly risky" subclass of the securities.

The suit alleges that Morgan Stanley made this asset allocation even as it became aware of "rapid and dramatic deterioration" in the mortgage-backed securities market in 2007 and 2008. Does that mean the same asset allocation was OK in other years?

The PBGC contends that those levels exceeded the plan's investment guidelines. In court pleadings last year, Morgan Stanley said that representatives of St. Vincent, who established the pension, "authorized and were aware of" the specific investments that were made.

Yet, the same Government is after Goldman for allegedly shorting housing. Goldman contends the Government misrepresented a hedge.

Consistence at its best: long you’re bad, short you’re bad. Oh yeah; they’re different issues. What’s common is that the Government wants to make money from both. Now, who know what the real facts are? But, something smells fishy. Banks make money investing other people’s money. Not every investment makes a profit.

Remember that while not the same players, this is the same Government that chartered and guaranteed GSEs like Fannie Mae and Freddie Mac that could only invest in mortgages. Gee, a little long MBSs me thinks. It’s the same Government that placed GSE’s bonds high in the hierarchy of Banks’ regulatory capital structure.

Regarding the “particularly risky” subclass, it is the same Government that at the behest of HUD’s Secretary, Andrew Cuomo, got Fannie and Freddie to promise to buy $2 trillion of “affordable” mortgages (affordable being Government speak for low down payment and subprime). That puts HUD in the same role vis a vis the GSEs as Morgan Stanley played for St. Vincent.

It’s the same Government that decided that banks operating under the Community Reinvestment Act (CRA) could meet their obligations by buying up CRA loans (CRA loans often being those same affordable loans) or MBS built from CRA loans. It’s the same Government that let the GSEs operate with lower capital requirements than other financial institutions, and lowered the GSE’s Surplus Capital Requirements in 2008. For icing on the cake, some of the same players were involved.

People who live in glass houses shouldn’t throw rocks; is Government exempt from the glass house wisdom?

Funny thing about bubbles is they suck everyone in. You, me, governments, banks, pensions, you name it.

Wednesday, June 8, 2011

Isn’t It Ironic?

Hey, it’s the nose on your face.

In the last few days the news was full of stories that indicate some people can’t see the nose on their face. These are the same people who want to solve any problems you, me, or anyone might be facing. They just don’t connect the dots.

Let’s start with these two stories.
1) Food-contamination illness in US has fallen over the past 15 years.
2) EPA plans to ban sale of some rodent poisons.
Do you think not having rodents running around our kitchens might contribute to less contamination illness?
Oh, but EPA may have looked into the issue. Want to bet your health on it?
You just did.

But it gets better. Here are two from Tuesday’s WALL STREET JOURNAL.
1) The first few lines of an article entitled “Clock Ticking on New Rules” in the print edition, or online as “Regulatory Delay Stokes Unease over Dodd-Frank” reads: “Banks, investors and companies are scrambling to cope with uncertainty caused by regulators' delays in fleshing out the Dodd-Frank financial-overhaul law.... More than 100 new derivatives requirements in the law take effect on July 16, even though regulators have yet to issue final rules in the affected areas. The holdup raises concerns that a large swath of the financial system might be thrown into legal gray areas.”

2) On the same page, article two, “Geithner Wants Global Rules on Derivatives,” here’s a quote to consider: “Treasury Secretary Timothy Geithner called for global standards in the way derivatives contracts are structured in order to prevent a global ‘race to the bottom.’ Mr. Geithner's comments in a speech Monday could open a new front in the clash among regulators, banks and industrial companies over how rules should be structured following the financial crisis.”

Now, some people never ran a business, or perhaps, never even played sports, so maybe they don’t know it’s important to know the rules. Geithner might think proposed rules are better than real rules people can follow. On the other hand, Geithner’s little income tax embarrassment may indicate he doesn’t think rules are important. If rules didn’t necessitate his paying his taxes, he may be thinking a good show is better. Perhaps he’s positioning for a standup comic job. He would be a great straight man.

The wizards in Congress are easier to understand. Since they spend their time making rules, it really doesn’t matter whether anyone actually follows them. Congress has an out: “It’s not my job.” They made rules. Whether it’s even possible for mere mortals to follow them isn’t an issue that has gotten to Congress. Gods can’t be expected to let mere mortals limit the Gods.

The quotes were included because you can’t make this stuff up. Do you think they understand that the objective is to reduce systemic risk? Or, do they plan to stop the world (yea, yea, it’s just the economy) until they figure it out? I doubt they’ll figure it out until they learn to laugh at themselves.

Keep in mind this comment is from a blog that pointed out the need to regulate derivatives back in March 2010 in “Putting the adults in charge of derivative trades.” It was also a blog that pointed out the need for an international approach even earlier in “Efficient capital allocation doesn’t require perfect liquidity.”

As Sonny and Cher song said, “The beat goes on.” Now it could just be that some editors just have a sense of humor. Why else place these two stories together?
1) California unveils its plan to comply with prison overcrowding.
2) Latino gangs charged with conspiring to drive African-Americans out of a California city.
Well, do you think there might be gang members in prison? If we let them out of prison where do we expect them to live? Or, maybe prison teaches everyone to get along, love thy neighbor, etc.? Perhaps we just have gangs planning for future growth?

Back to economics for more:
1) Another story focuses on Goolsbee’s resignation as the head of the Council of Economic Advisors. It notes “During the campaign, he advised against allowing the capital gains and dividend tax rates to rise back to Clinton-era levels, even for the affluent households…. He based that …on academic work that he said showed high rates of taxation on investments adversely affect the behavior of would-be investors.”

2) Obama lends support to closing loop holes, a euphemism for tax deductions that oil companies use. (The deductions cover more than just oil companies although their business is particularly dependent on the activity involved).

Makes sense to me; if Obama wants a PR person, hire one. If he wants an economist, be aware they have opinions on economic policy. But, for heaven sake, Mr. President, don’t go and learn anything. Lincoln set the bar too high with “you can fool all of the people some of the time and some of the people all of the time, but you can’t fool all of the people all of the time.” Presidents only have to fool the majority of the voters twice. So, if you have an ideology that’s working, why go looking at reality?

3) Peter Diamond on the other hand withdrew his name from consideration for the Federal Reserve Board.

Now why would the administration go looking for another economist? The darn guy may go and disagree with Obama on something. Peter Diamond on the other hand displayed that classic academic inability to respond to Shelby and others who might question his beliefs. How the heck could he function on a board that strives for consensus?

See what happens when you read too much news. You start laughing. Here’s more:
1) Another headline reads: “Fed Sees Recovery Lagging.”
2) Three stories: Citigroup plans to sell $1.7 billion in assets, Bank of America and Wells Fargo plan to cut costs with BofA planning to close 10% of its branches, and Morgan Stanley’s cost cutting extends the Blackberry use.
3) Credit still tight at Banks.
4) FED floats proposal for higher capital requirement for systemically important organizations.

Remember the A-Number-One responsibility of the Fed is maintaining a functioning banking system that supports economic growth. What do item 2 and 3 say about that?

As to 1, 3 and 4 it isn’t rocket science. Like the posting on March 3, 2010 (“Regulatory capital and who’s got the money?”) said: “Increased capital is ultimately the solution. But, timing changes is probably more important than the level. What we know about reserves is that people lower them in good times and raise them in bad times. We also know this aggravates the cycle. Well, surprise, surprise, governments are people; they do the same thing. Unfortunately, the government has a long history of changing capital requirements in the wrong direction over the business cycle. It’s the fallacy of composition writ large. Individual banks are safer with higher reserves, but if every bank raises more capital, oops, no credit even for productive endeavors.”

How could anyone not see this coming?

Does it seem the Fed has lost its way when the sector they supervise is less than healthy and one Jamie Diamond, who seems to know something about banking, openly blames the Fed? Of course he is talking his book, but he isn’t making it up.

The capital requirements mess-up is classic bank regulator pro m-cyclical behavior during downturns. Instead, why not tilt against the trend? That’s what the Fed is supposed to do.

The temptation is to list more, but then given we all make fools of ourselves periodically, the best thing to do is learn from it and move on. We can hope others will do the same.

Sunday, June 5, 2011

On Investing: Part 14 (contd.)

Housing as biggest asset

The last posting discussed mistakes encouraged by the “most people’s largest investment” myth. To some extent those mistakes originate from confusing the verb form, invest, with the noun form, investment. Compound that confusion with mistaken beliefs about sunk cost, and the result is plenty of room for mistakes. With the second myth that “houses are most people’s largest asset,” there is no verb form. Yet, the mistakes the second myth create dwarf the first.

In fact, this “largest asset” myth was a major contributor to the recent financial collapse and the current slow recovery from the recession. Keep in mind that almost everyone’s largest asset isn’t their house; it’s their future income stream. But, everyone seemed to have forgotten that little fact. Banks wrote mortgages based on home prices, ignoring the largest asset of the borrower: their income. Borrowers leveraged up their largest asset, future income, to acquire an asset with a largely fixed return, a place to live, essentially guaranteeing that their capital would not contribute to income growth.

The mischief the “largest asset” myth encourages doesn’t end there. For example, it is now very trendy to discuss rational defaults for underwater mortgages without any reference to the default’s impact on a person’s largest asset. There is no doubt that a default is a quick way to shrink a balance sheet. It eliminates a big asset and a big liability, and, for an underwater mortgage, reduces the negative that “underwater” implies.

It reduces leverage, but unless there isn’t any other debt, it’s no guarantee of a solution to overleverage. It influences other assets’ values, most importantly future income. It has an impact on future income in a number of ways. First, it can affect employment prospects. Second, it can create the need for income to cover new expenses. For example, it increases the interest rate on other loans, not to mention their very availability. Further, the return from the asset, a place to live, has been eliminated. The cash flow effects can, over time, eliminate the initial impact of eliminating the asset and liability.

What makes sense is to put the size of the asset in proper context. The asset may be big and the liability may be big. However, it is almost never bigger that the value of future earnings.

Whether acquiring the housing asset made sense in the first place is more important than asset size. Generally, if the house made sense to purchase in the first place given income and the rest of the balance sheet, it is unlikely a default suddenly makes sense (unless something besides house prices also changed). If the home purchase never made sense in the first place, default is probably inevitable.

Thursday, June 2, 2011

On Investing: Part 14 (contd.)

Superficially simple until reality impinges…or it’s the leverage that matters.

Picking up on “On Investing Part 14,” let’s look at the types of mistakes that misconceptions about housing cause. The easiest to dispense with is the “housing is most people’s largest investment” nonsense. Aside from not being true for most Americans, it is irrelevant. It shouldn’t have any impact on an investor or a policymaker. What has been spent is a historical artifact; it is a sunk cost as economists like to say. What matters to an investor is future return. That really should be all that needs to be said, but alas it’s not.

Isn’t whether the investment is worth more than one paid for it the criteria one should apply to an investment? No, the relevant measure is total return. With housing, that distinction is particularly important. Much of the return on a home comes in the form of having a place to live. Over a lifetime the “place to live” swamps the capital gain. That return starts with the first home and continues until one doesn’t need a home. Throughout that period, whether real estate ownership represents a good use of capital depends on the alternatives available going forward, not looking back. It has nothing to do with sunk costs. If your house is the best place for you to live, it’s the best place for you to live regardless of whether the price went up or down.

“But,” you say, “if house prices go up, one can sell it and move to a nicer house.” Not based on the price move. If the price of housing goes up, the price of the nicer house will go up too. One might benefit from relative price movements if your home’s price went up faster than housing prices in general. That, however, is a totally different issue.

Here is where leverage can cloud the issue. People see the greater equity that house price appreciation creates as a vehicle for the bigger down payment. Bigger down payments are prudent with a bigger house. But, the issue is totally a leverage issue and has nothing to do with house prices.

This is easy to understand, but harder for people to internalize. At the risk of some overkill, here are some illustrations. Let’s use 20% down payments in order stay with reasonable consumer behavior. Let’s start with 20% down on a $200k house which equals $40k initial equity. Now imagine moving in and having housing running up 25% before any of the monthly payments appliy to principal. The person now has $90k in equity.

With $90k equity and 20% down, a $450k home is feasible assuming an adequate income. Leverage ratio when applied to equity on the new home is the same as when the first house was bought (original position: $40k = 20% of $200k. new position: $90k = 20% of $450k). However, when applied to income the leverage ratio changes (unless the persons income when up by 25% also). Similarly and importantly from an investor’s perspective, the leverage ratio relative to total assets, and especially relative to non-real estate assets, changed (unless all the persons assets also went up 25%). The person’s portfolio has the same $90k in real estate equity regardless of which house the person lives in.

More than likely, other assets and income didn’t increase at exactly the same rate as housing. If that more likely scenario occurred, the asset on which the leverage has concentrated is also an asset on which the majority of return is NOT going to increase; the person may have a nicer place to live, but that’s the trade. It is totally due to increasing the dollar value of the leverage. Essentially, the person has increased their aggregate leverage by concentrating it in an asset with a largely fixed return. The house isn’t going to increase in niceness. They have a nice asset, but all assets tend to be nice. It has a fairly secure return in the form of a place to live.

If instead of increasing 25%, the home price went down 25%, eating up the equity and then some, has the person been wiped out? Not at all. The person has no equity, but the return of having a place to live hasn’t changed much. The leverage relative to the home equity has grown phenomenally. The person is leveraged in excess of 100% on the real estate investment. The real estate equity portion of the portfolio has been wiped out. The leverage (debt) relative to income hasn’t changed, nor has the leverage relative to other assets. The aggregate leverage ratio has gone up.

What are logical responses to these two scenarios? If housing prices run-up faster than other assets or income, modern portfolio theory (MPT) would advise reducing real estate exposure and rebalancing into other income producing assets. In the inverse situation, rebalancing into real estate from other assets would be the MPT response. That would rebuild the real estate equity. Simple isn’t it? Not really because it’s the leverage that matters.

In scenario one, the run-up in housing has created a greater equity in an asset with a largely fixed return in the form of a place to live. It has also reduced the leverage relative to what is for most people their most leveraged asset. Neither is bad; in fact both are highly effective risk reduction strategies. Here’s the rub. Overall leverage is also reduced. Some people believe they should spend every cent they can beg, borrow or…. Thus, the reduced leverage isn’t appealing to many people.

While the point of departure for this discussion was the mistaken conventional wisdom about “most people,” what is true for most people is that leverage is more readily available on their home than any other asset. There are powerful incentives encouraging people to concentrate the focus of their leverage on real estate. But, that has a lot to do with government policy, not investment returns.

The more relevant scenario currently is the price decline scenario. Unfortunately the “largest investment” nonsense is used to encourage behavior that only makes sense in very narrow circumstances. Specifically, much of what is said about mortgage default is both false and terrible financial advice.

Defaulting on a mortgage is seldom a good idea and certainly not one that should be based on the profit or loss on the real estate when subjected to mark to market accounting. Remember, the key issue is the return on future cash outlays, not past outlays. Most of the return comes in the form of “place to live.” Cases where defaulting will put one in a better place to live are rare. The usual outcome is relegation to rentals for some amount of time. Further, although less an issue for some people, there is also the psychological cost of living with the failure to live up to one’s promise.

From a purely financial perspective, the return on investment (i.e., a place to live) hasn’t changed. The price relative to other assets has. If income hasn’t changed, the logical response is to allocate more investment capital to real estate. Again, leverage is the rub. Overall leverage has increased. If the leverage has gotten too great, then a default may be the outcome, but overall leverage, not real estate investment, is the issue. In fact, it would be quite legitimate to argue that an underweight in real estate in the form of equity was the source of the overleverage.

One would think a price increase scenario and a price decline scenario would cover mistakes encouraged by “biggest investment” nonsense. Alas, this is a brave new world where once a myth has been established it will be played for all the mileage possible. Witness “Hedging Your Home Value: The Greatest Idea Never Sold,” WALL STREET JOURNAL, May 14, 2011. Here’s advice on how to waste money regardless of whether housing prices change or not. All that’s required is ignoring the fact that living in a house is a form of consumption. Just start thinking of it as investing.

The confusion extends to what to hedge, what hedge is being discussed, and why to bother hedging at all. Whenever discussing any hedge it is important to understand what risk is being hedged. Otherwise one can end up getting an ugly surprise. The WALL STREET JOURNAL article discusses hedging housing prices without addressing whether it is recommending hedging the risk associated with the amount invested, the equity, the asset’s value, or the leverage. It totally ignores the fact that the primary return to a house is having a place to live.

It is easy to illustrate the confusion this creates. Consider this quote, the first line of the article: “…. why is it so fiendishly difficult to protect yourself against the risk of a further drop?” Now if the risk is leverage, it not hard to “protect yourself against the risk.” Since the article goes on to fret about “roughly one in four homes ‘underwater,’ or worth less than the outstanding mortgage,” there is at least passing concern about leverage risk.

That same quote about underwater would lead one to think that how much has been invested isn’t a major concern since getting to negative equity is usually associated with not having invested much in building equity in the first place. However, that seems to be contradicted by another quote: “People can always rent, of course. But once you own a home free and clear, you have the option of selling it and using the proceeds to fund your retirement. That makes a fall in home prices worth protecting against.” Aside from avoiding the real issue, whether renting makes sense (i.e., is the best way to secure retirement housing), the quote implies it is equity that needs to be hedged.

There is always a plausible argument for hedging the price of an asset if the hedge doesn’t decrease the total return to the asset. However, the article never addresses total return nor does the hedge being touted. That leaves open the question the article seeks to address (i.e., whether hedging home prices makes sense).

If “largest investment” can lead to mistakes, the mistaken notion of largest asset is even more dangerous. That’s a topic for another day.