March 2007 Archives

The subprime market is imploding. Home foreclosures are surging. Millions of new homeowners could be thrown out on the street. So, it's hardly surprising that a growing number of economists are raising the recession alarm. For instance, Stephen Roach of Morgan Stanley says "subprime is today’s dot.com--the pin that pricks a much larger bubble." Seven years ago, the bursting of the dot.com bubble eventually swamped the rest of stock market, and the economy tanked into recession.

Now, I'm not a card carrying member of the Pollyanna Club. But it seems to me that the economy remains primed for growth. The Fed has a lot of experience dealing with crisis in the housing and mortgage markets. If the subprime market's credit woes spread to the rest of the credit market the Fed can always cut its benchmark interest rate and flood the system with liquidity. I like the slant Mike Mandel, chief economist at Business Week, has on the current situation.

He says if you want to worry, fret about the slowdown in productivity growth. (I would add too much bad investment in China; someday there will be a day of reckoning.). But Mandel argues to keep the subprime market is going through a correction, not a meltdown.

So the real question to ask is this: How does the crisis in the subprime mortgage market stack up against previous meltdowns? Is this going to be the Big One?

But remember, the tech bust devoured about $9 trillion in corporate equity; next to that, the subprime problem looks like an insect bite—unless it spreads to the rest of the mortgage market. But at least so far that doesn't appear to be happening: Mortgage rates for good borrowers have actually been going down. In early February, for example, the average rate for 15-year fixed rate mortgages was 6.06%, according to Freddie Mac. As of Mar. 8, that was down to 5.86%. If low rates continue, they should actually prop up most of the housing market (see BusinessWeek.com, 2/19/07, "Out of the Basement for Housing").

On March 17 I flew from New York to the Twin Cities. On the plane I read the New York Times and I noticed an intriguing juxtaposition of headlines. The NYT lede story on its business page was "Wall-Mart Abandons Bank Plans." The story right underneath it was "Lawmakers Aim to Curb Loan Abuses."

It's bad news that Wal-Mart pulled its application to get into the banking business. The implosion in the dark corners of the subprime market and growing evidence that lenders preyed on the poor do suggest that regulatory changes are in order. Among them is greater transparency and ease of understanding mortgage loans, payday loans, etc.

But regulation isn't enough. Why not also unleash the forces of competition? Let Wal-Mart into the banking business. Wal-Mart is a fierce competitor that knows how to deliver low prices to its consumers, many of them living below the median income. My guess is that competition from Wal-Mart would drive a lot of abusive payday lenders and subprime lenders out of business. Wal-Mart's customers would be the beneficiary. It's a disgrace that banks, so-called consumer activists, and other lobbyists managed to put enough pressure on Congress that the behemoth threw in the towel.

At the American Economics Association's annual meeting in January of this year, one of the sessions I attended was Hedge Funds: Performance and Persistence. It was presided over by Cliff Asness, head of AQR Capital Management, LLC. One of the commentators was Peter Muller, a special advisor to Morgan Stanley (and hedge fund manager). If I remember right, the essence of his story was that the hedge fund structure was fundamentally flawed. To be sure, the best and brightest financiers have every incentive to do their best work at first. They need to establish a track record. But once they've gained a reputation for savvy money making the name of the game changes. What matters to the hedge fund managers is gathering an ever larger pot of money. The reason is that their pockets are lined not from investing well, but in pocketing the 1.5% to 2% of assets fee. It's a lot more lucrative to run a $1 billion hedge fund than a $100 million one—let alone $10 billion. The money managers do well no matter how well their investors fare.

I was reminded of his talk while reading the latest shareholder letter by Warren Buffett at www.berkshirehathaway.com/letters/2006ltr.pdf.

I'm going to quote from it at length. It's worth reading. And the same skepticism and lesson holds when hiring any money manager. Ask yourself: Where do the incentives lie?

In last year's report I allegorically described the Gotrocks family - a clan that owned all of America's businesses and that counterproductively attempted to increase its investment returns by paying ever-greater commissions and fees to "helpers." Sad to say, the "family" continued its self-destructive ways in 2006.

Paul McCulley, managing director at the giant money management company Pimco, writes an astute newsletter on Fed policy at www.pimco.com. (Bill Gross, his boss and legendary bond investor, writes a fascinating, witty investment column.) His latest delves into the subprime market.

McCulley notes that the housing market during the boom years was dependent on a traditional source of buying power: The first time homeowner. But adding to the buying pressure was a relatively new phenomenon: The first time speculator. "As the bubble was forming, riding on first-time homebuyers with first-time access to credit on un-creditworthy terms, and first-time speculators riding the same with visions of bigger first-time fools to take them out, all looked well," writes McCulley. "Such is reality presently in the U.S. residential property market, which has flipped from a sellers' market on the wings of buyers with exotic mortgages to a buyers' market of only the creditworthy."

Although housing market woes doesn't mean recession, he does expect that the Fed will eventually wake up to what's going on, and start easing. Let's hope that day of reckoning is sooner rather than later.

John Maudlin, the investor and newsletter writer, has a good post on the woes in the sub-prime mortgage market at www.frontlinethoughts.com/index.asp. He has a link to a fascinating in-depth study of the current housing downturn and mortgage problems by equity research analysts at Credit Suisse. The 67 page report is bearish, and rightly so. It's worth reading at www.billcara.com/CS%20Mar%2012%202007%20Mortgage%20and%20Housing.pdf

One aspect of their analysis I'd like to highlight: At a time when much of the focus is on the subprime market implosion and the overall tightening of credit standards, rising foreclosures and delinquencies will have impact the supply side of the market. The analysts "are of the opinion that there is a real threat of 'pent-up supply' that will hit the market in the next six-to-twelve months as a result of the lax underwriting standards of recent years."

For instance, they estimate that there are approximately 565,000 homes in foreclosure process around the country, and 135,000 that are already listed or on the verge of being listed as must-sells. To put those figures in perspective, they note that the National Association of Realtors reported existing inventory of 3.55 million units in January, implying that total inventory may be 20% understated when taking foreclosures into account. Ouch.

Housing prices are heading lower, much lower. So far, the price drops in major metropolitan areas has been muted, with Detroit and Boston showing the biggest prices declines, over 5% each. But that's only a taste of what will unfold in coming months.

Demographics may not be destiny, but America is getting older and an aging population will need plenty of long-term care. The cost of a nursing home is mind-boggling, and Medicare covers surprisingly little. The solution is long-term care insurance, right? Hardly. This is a business marred by scandal. The product is complex, difficult to understand. The costs are high. And this story from the New York Times is all too typical of the results.

Beware of the sales pitch. It's seductive. It's frightening. The need is there. But the product isn't.

It's starting to get dated, but Consumer Reports did a good piece on long term care insurance in 2003. Here's the link.

Here's the bottom line from the report: A CR investigation, for which we reviewed 47 policies, reveals that for most people, long-term-care insurance is too risky and too expensive. As with health insurance, you must keep paying to keep it in force. If premiums rise, you may have to drop the coverage, possibly losing everything that you've paid. The policy's benefits may cover only a portion of the total expense. Many policies are packed with catches that can keep you from collecting. Finally, there's no guarantee that long-term-care insurers, some of which have weak balance sheets, will be around 20, 30, or 40 years from now when you need them to pay.
Hopefully, better products emerge.

Thanks to aging boomers, the word retirement seems synonymous with disaster. Almost every week some survey or another crosses my desk (usually paid for by a financial services company) demonstrating yet once again that boomers aren't saving enough for their old age. They're spendthrifts, unable to resist the lure of the shopping mall and the latest high-tech gadget, satiating their desires with heaps of debt.

I don't buy it. Over the years, an impressive and underappreciated body of scholarly research has shown that the typical boomer has accumulated more wealth and earns more income than their parents did at a comparable age; that boomers are saving at roughly the same rate as their parents; and that working even a few years past the traditional retirement age does wonders for boosting the personal bottom line. And we can always cut back on spending.

And then there is the issue that I think is underappreciated: inheritance. No, not the receiving of an inheritance but leaving one to your kids. I'm struck that in many cases where money is tight the parents are setting aside money for their children. But why? You've educated them. You've given them values. A leg up in the world. They're fine without your money.

This is another example why it is so hard to figure out if people are saving enough for their old age.

Nevertheless, we all worry if we're saving enough. It's not just the financial side of the equation. There are also measures of psychological well-being. What if we are forced to move to a smaller home, and shop at cheaper stores? We still own a home and decent clothes, but it isn't what we're used to.

Jonathan Skinner, economist at Dartmouth College, has written a thoughtful paper on retirement savings. It's at the website of the National Bureau of Economic Research (paid subscription). He uses a classic economist's point of view, which assumes that consumption spending remains flat or the same throughout a lifetime. For instance, we save while working so that our standard of living stays the same when we're retired. So, we smooth out our consumption. He makes a number of other assumptions, and comes up with some numbers that we may be doing okay, certainly better than the doomsayers suggest. Yet life intervenes: divorce, a disabling disease, a stock market crash. For example, in a ten year period, he notes that seven out of 10 adults aged 51 to 61 developed health problems, lost their jobs, or lost their partner from death or divorce. Among couples, a new medical condition caused a 17% decline in wealth; divorce a 44%.

But the real worry is growing out-of-pocket health care costs in retirement. Here's just one of many ominous figures: One study suggests that median out-of-pocket health care expenditures for retiree couples will rise from $5,760 in 2000 to $16,400 in 2030. That's 35% their future after tax income in 2030.

This is yet just another example why health care reform is coming. The pressure for universal coverage will only grow with time.

Dimensional Fund Advisors (DFA) is hardly a household name, Which isn't surprising since until recently it focused on institutional investors (like pension funds) and not individual investors. That is changing, although you and I can't buy a DFA fund on our own. We have to go through a financial advisor. Still, it is good that DFA is branching out, since its top flight outfit offering a variety of broad-based index funds. The firm is best known for its small cap indexes (indexes based on smaller publicly traded companies). Bloomberg has a good story on DFA.

Now, I am a big believer in indexing, but I don't like the drinking-the-Kool-Aid aspect of DFA's approach. From the story:

"Once they've survived the hazing, the financial advisors are policed by other advisors to ensure they don't dabble in active investing. DFA converts keep tabs on other advisors to make sure they toe the line.

'Eyes and ears are out there,' Wheeler says. [Wheeler is a DFA vice president] 'We'll give that advisor a call and say, 'You can't do that.'

What is this? The Politburo School of Investing?

You can't beat indexing as an overall investment approach. Broadbased equity and bond index funds should make up the core of any long-term portfolio. But that insight doesn't mean there still isn't a role for active investing.

It's a question we get all the time on Marketplace Money: Should I save for my retirement or accelerate payments on my mortgage? The way the question is usually asked, most people want to pay down their mortgage fast. It's understandable--who doesn't want to say goodbye to the bank for the last time?

But that decision can come with a steep financial price. In "The Tradeoff Between Mortgage Prepayments and Tax-Deferred Retirement Savings" (NBER Working Paper No. 12502), scholars Gene Amromin, Jennifer Huang, and Clemens Sialm argue that the costs of using this approach can be significant. They find that nearly 4 in 10 (38%) of them would save money by redirecting those extra mortgage payments into a tax-deferred retirement account. The authors believe "To the best of our knowledge, this is the first paper to . . . [consider] retirement contributions and mortgage payments as two alternative forms of household savings decisions." You can read a summary of their report on their website.

I'm a Henry "Bud" Hebeler fan. A former top executive at Boeing, he offers up financially conservative thoughts on planning for and living in retirement. You can look at his calculators and articles at his website www.analyzenow.com.

He sent me one of his articles the other day: "Should I Take Social Security at 62?" Or should you wait until your full retirement age (it's between 65 and 67 depending on your date of birth) or 70? At 70 you get the maximum benefit.

Seems like it should be a simple calculation. It isn't.

The answer is.... it all depends....

For instance, Hebeler recommends electing for early Social Security payments if you have health problems or can't work or have good reason to believe you won't make it past 80.

But for most couples that will live into their 80s, the numbers suggest that the higher income spouse wait until age 70 to get the maximum benefit, and the lower income spouse wait until 65-67, whichever is the full retirement age..

If only we knew when we were going to die...

You can play with the numbers at www.analyzenow.com.

Anyway, this article is an aid toward thinking through the right answer for you when the time comes.

Here's a profile that Robert Barker, a former colleague of mine, wrote on Hebeler. It's from 2000, so it's out of date. But it gives you a good sense of the man. Go to article.