Monday, December 29, 2008

Debit or Credit?

As I finished my Christmas shopping this past week, the “debit or credit” question at checkout is annoying me more than the longer-running “paper or plastic” inquiry. While I miss paper bags when it comes to carrying goods, I do not miss writing checks for payment at the cash register. Swiping my plastic check card is quicker and easier. But for some bizarre reason two alternative methods for processing the same transaction have evolved. In each case money is deducted from my checking account to pay the merchant. However, whether I say credit or debit, or more precisely whether I choose to identify myself with my signature or my PIN number makes a big difference on who pays the cost of the transaction and the risks I take as a consumer.

If I choose debit, the transaction proceeds much like taking cash from an ATM machine. A PIN number is required and after entry funds for the purchase are debited from my checking account along with an additional fee to pay for the transaction. It is not as costly as using a remote ATM, but it is not free. My bank charges me $0.50 for each transaction and that adds up quickly. If I make purchases at three or four different stores it would be cheaper for me to just go to the ATM and get the cash. It would all come out of the same checking account. After all, I’m not using actual credit.

If I choose “credit” the money also comes out of the same checking account, but a different set of rules apply. This is what I find so weird. I no longer pay the transaction fee because no electronic funds transfer takes place. Instead the Visa credit card network takes over and the merchant is hit up for the usual 2% to 3% of the purchase price even though no credit is extended. However, I have the protection of using a credit card meaning I can dispute charges and there are limits on my liability for fraud. In contrast, I have no protection for unauthorized PIN transactions. If someone obtains my PIN and check card numbers that person could drain my entire checking account and I would have little leverage for recovering the loss.

There is little reason for me to ever make a debit transaction at checkout. It is costly and risky to use my card in that mode. Naturally the store wants me to use debit because it is cheaper and safer for them. As a result all the machines are set up to prompt for a PIN number. To use credit I need to hit the nonsensical “cancel” button to move on to the credit option. No matter how many times I do this I still get confused by this step. The concept of “canceling” my purchase so that I can complete it just doesn’t sink in.

So are there ever any reasons to choose debit? Actually consumers who choose credit for gas, hotel, or rental car purchases could be in for a nasty surprise if their checking account balance is too low. The reason is that merchants selling open-ended purchases such as these typically place “holds” on the account for much more than the purchase price and these holds can last for days.

For example, suppose you intend to buy $25 of gas and swipe your visa check card. The computer doesn’t know your intention so it might automatically request an authorization for $50 to make sure you have the funds to fill up a large tank. In your checking account $50 is immediately set aside. You drive away with your $25 purchase, but the $50 set aside stays for several days. Over that time you could easily be writing bad checks because you keep account of your actual balance. Your bank has a different number—the “available balance”—that is less because of the funds set aside for the credit authorization.

You the consumer have no idea what number represents the “available balance” but you will be paying hefty bounced check fees if you overdraw on it. It’s all perfectly legal and just another excuse banks have for soaking consumers.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Monday, December 22, 2008

Good News/Bad News for Credit Card Holders

It has been a good news/bad news week for consumers who use credit cards. Labeling current credit card practices “deceptive” and “unfair,” the Federal Reserve proposed new rules for credit card issuers. What is most striking about reading the list of practices the Fed now intends to abolish is that these tactics were ever legal in the first place.

First the good news–if adopted the new rules will prohibit such practices as:

• Assessing hefty late fees if a payment arrives one or two days late. Borrowers will have a reasonable grace period of 21 days before a payment is deemed “late.”

• An interest computing practice known as “double-cycle billing.” As it stands now, a balance that is not paid in full is assessed interest beginning from the date of purchase rather than from the end of the grace period.

• Charging high fees for exceeding the credit limit solely because of a hold placed on the account. Consumers often don’t know the amount of holds when they check into hotel rooms or rent cars. I’ve had $1000 holds placed on my account just for checking into a $200 hotel room.

• Applying payments to the part of the balance with the lowest interest rate. Under the new rules, any payment above the minimum will have to be applied to the balance with the highest interest rate. It is not uncommon for consumers to have balances with multiple interest rates because cash advances and balances transfers often have different interest rates than purchases. Currently banks apply payments to balances in ways that maximize finances charges by applying all money paid to the part of the balance with the lowest interest rate.

Now the bad news: These are “proposed” regulations, not laws and they will not take effect until July 2010. As Bob Sullivan noted in his blog: “A 300-page report by the Office of Thrift Supervision described bank misbehavior in great detail, at times using stinging language.” Federal regulators “then invited card issuers to continue those unfair tactics for the next 18 months.”

A December 18 report on the NBC Nightly News stated that the rationale for allowing these practices to continue was to give banks time to adjust. A spokesperson for the American Bankers Association, Nessa Feddis, stated on camera: “The regulations, in effect, require the credit card industry in effect to completely dismantle and rebuild their credit card business model.”

This is a bizarre defense of an indefensible delay. Maybe in the future the Feds should give organized crime syndicates time to dismantle and rebuild their “business model” instead of busting them.

In the mean time, while the banks retool, all of the practices listed above are still in use. I’m not optimistic that a “rebuilt” credit card business model is going to be any better for consumers. The Federal Reserve is taking steps that should have been taken many years ago in response to the current economic crisis. I think the banks are creative enough to put together a different set of deceptive practices that will still gouge consumers. And, once the crisis is past, federal regulators and Congress will go back to looking the other way.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Tuesday, December 16, 2008

Gaming the Inflation Numbers

Is inflation good or bad? Most consumers and businesses would say inflation is bad. By distorting prices, inflation makes financial planning for the future difficult, it squeezes family budgets, wrecks business plans, and destroys savings. The government, at least in principle, agrees that inflation is bad and one of the duties of the Federal Reserve is to “fight inflation” by tinkering with interest rates.

But there’s a problem with this good versus evil story line. Inflation actually has beneficiaries with a vested financial stake in seeing it continue. For example, debtors benefit from inflation. People who borrow money during periods of inflation get to pay back cheaper dollars than the ones they spent. Homeowners benefit from inflation because no landlord raises the rent. That means as a homeowner’s income increases, the fraction of income needed for housing decreases. Most people who own homes are also in debt because of the home, so they get duals benefits from inflation.

But, the biggest beneficiary from inflation is the federal government itself. The same institution that controls the money supply and purports to fight inflation benefits from it. Actually, the government benefits most from stealth inflation. If the real rate of inflation can be hidden, the government realizes all the benefits from inflation without having to bear the same costs that everyone else does.

The federal government benefits from inflation because it is the largest debtor on the planet. No other institution measures its debt in trillions of dollars. Not only is the debt enormous, it is projected to go on forever. Vague proposals to balance the budget are lame attempts to end the growth of debt, not the debt itself. Inflation makes the national debt manageable. Without inflation it would be mathematically impossible for the federal government to meet its financial obligations.

In fact inflation is an ideal two-headed quarter for the government. Devaluing the currency is a means of taxation without the need to pass a law raising taxes. The government cheapens the dollars it owes and collects more money through the effect of tax bracket creep. At the same time, rising prices create an illusion of wealth while purchasing power falls. But much of the mathematical magic of inflation would go away if the government were honest about reporting inflation rates.

For example, the government issues inflation-indexed bonds that pay a variable interest tied to the inflation rate. Increases in entitlement spending on such a programs as Social Security are based on the inflation rate. The idea that the government can “stimulate” the economy by lowering interest rates only works if you can convince lenders that the inflation rate is low so they don’t need a high rate of return just to break even.

So how does the government pull off this deception? The problem is no one agrees upon a definition of inflation. CEOs of large corporations will say that their ever increasing, stratospheric compensation packages are necessary for a prosperous company. Of course these same executives will fight raising the minimum wage on the grounds that such an action is “inflationary.” It is rather convenient to label your rise in income as deserved and label someone else’s as delusory.

So it is with the federal government. It can tinker with economic data to underreport inflation so that it reaps the benefits but doesn’t have to pay the costs. In Jim Jubaks December 5, 2008 column: “Fake Inflation Numbers Mask Crisis” he explains some of the techniques the government has used in recent decades to disguise inflation.

For example the government started using “hedonics,” a technique that reported a $100 increase in the price of a car as $0 if in the judgment of the government the “usefulness” of the car increased by $100. An increase in the power, safety, or other features would qualify as increasing its “usefulness.” Never mind that the car does essentially the same thing—take its driver from point A to point B.

The government also started to make “substitution” adjustments to its inflation numbers. If the price of steak goes up, the government assumes consumers will substitute chicken and not pay more for food. Therefore food prices are not actually rising. Got the logic on that one? Of course some government official has to decide what substitutions consumers will make and those decisions are subject to a later change.

According to Jubak the result of fudging the inflation numbers is that the Fed should have been raising interest rates to fight inflation instead of lowering them and allowing the housing bubble to develop. Of course the Fed could accurately report the money supply figures that would give a much better insight into real inflation. While there are disagreements on what inflation is, there is common agreement that printing money to circulate without a corresponding increase in economic activity will cause inflation. But in 2006 the Fed stop publishing broad measures of the money supply focusing on more narrow measures instead.

According to the Fed, the cost of collecting the additional data outweighed the benefits the data provided–a rather convenient cost/benefit analysis to make.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Monday, December 8, 2008

Shopping our way to prosperity?

Individuals who wish to accumulate wealth and become financially secure are told to work hard, be productive, save, and invest. The advice is old fashioned and trite. Recent events have shown it doesn’t always work, but, it’s difficult to suggest a better alternative. Work hard, don’t produce, spend every dollar you make and then some will certainly not lead to financial security.

However, as the holiday season approaches and with it the annual nationwide orgy of shopping, we are told that the way out of the economic crisis is to keep up the behavior that made the mess. Black Friday sales figures are headline news. The media, politicians, and corporate executives spread a gospel of salvation through consumption. Robust consumer spending will lead us out of the financial wilderness and avert a reenactment of the 1930s great depression.

On my local NBC affiliate in Baltimore— WBAL— the general manager broadcast an editorial Saturday night pleading with people to shop. While he urged responsible use of credit, he stated: “If you can shop you should. We must each do our part to get the economy jumpstarted. The message from Washington is clear—happy shopping.”

I’m sorry but if consumption without production is not a recipe for individual success, how can it lead to prosperity for all? If Americans saved, invested and then produced what they consume the argument might have some validity. But, as a nation Americans accomplish none of the above.

Americans buy lots of stuff that people in other countries make. For the first time since the great depression our national savings rate is quantified with negative numbers. And for all the trillions of dollars our federal government and large corporations have burned through recently, there appears to be nothing with future value to show for it. Our public infrastructure is crumbling along with our manufacturing base.

Consider Dan Rodricks' column Sunday where he observed: “Look at us: We've become a nation that thrives when people spend money they don't have. This is completely upside down from the society baby boomers recall, when the economy was robust, when people made a decent wage and benefits from manufacturing jobs, and the only things they had to finance were their homes and cars.”

The lesson from the economic crash of 2008 is that unchecked consumption and debt accumulation without production and investment in the future is unsustainable. All bills come due and all debt must be paid back. Shopping is not the magic elixir that will lead us to economic salvation; it’s an ingredient in the poisonous brew that’s killing our prosperity.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Sunday, November 30, 2008

Credit Card Crisis Next?

The marketing of credit cards by banks has mystified me for years. How can banks shower the public with credit cards offers like confetti, charge usurious interest rates, tack on exorbitant fees and still have customers who are able to keep up with payments? The answer might be coming soon and it appears the answer will be—not forever. Speculation in financial news reports is that the subprime mortgage crisis will be followed by a credit card crisis.

A Reuters news story: “Looming credit card debt may be the next crisis” quotes John Whitehead, former chairman of Goldman Sachs Group, as saying that a credit card crisis is “waiting in the wings.” And a USA Today story “Why banks are boosting credit card interest rates and fees," quotes Gregory Larkin, a senior analyst at Innovest, as saying "Mortgages were simply the first storm to make landfall. Credit cards are next." According to Innovest, a research firm, by the end of 2009 banks are likely to write off 10% of credit card debt—a staggering $96 billion.

The aggressive marketing of consumer debt appears counter to the careful conservative image we generally have of loan officers and underwriters. After all, most people who loan money to friends and family members expect to be paid back. Are not banks in business to be paid back? Yet even individuals who have rung up tens of thousands of dollars in consumer debt are still inundated with new credit card offers.

So why are banks so intent on lending money to people with questionable means to pay it back? The answer in a word is—securitization. Just as they did with mortgages, banks have packaged and sold credit card debt in the form of securities to unwitting investors. The risk associated with the debt becomes some else’s problem. In the mean time if customers stay in debt, the bank can profit from hefty fees associated with managing the account.

It is actually more profitable for the banks if it customers are overloaded with debt. If a customer has too much debt to pay back in a reasonable period of time, he or she has no choice but to accept whatever additional fees and interest rate hikes the bank decides to levy. A further irony is that the inability of a customer to easily pay off the debt can be used as justification for imposing the additional fees and rate hikes.

Banks looking to make up for losses during the current financial crisis are finding that customers with outstanding credit card debt are easy targets. The USA Today story reported on consumers like Tommy Newsom who never missed a payment but had his credit card interest rate doubled to 27% for no apparent reason other than the law allowed the increase.

Banks justify sudden interest rate increases by claiming that a customer’s risk category has changed. A spokeswoman for Bank of America was quoted in the USA Today story has saying that the bank "regularly assesses the risk profile of accounts. If the bank decides to raise a customer's rate, it will notify the customer first and give him or her the chance to "opt out" and pay off the card balance at the existing rate.”

But notice the two-headed quarter in use in this statement. Customers whose “risk profile” have changed are most likely the ones identified as being unable to “opt out.” Without the means to pay off the balance the customer’s only option is to “accept” the new rate.

Banks can get away with this behavior because of loan agreements that are not agreements in the ordinary sense of the word. Credit card agreements contain language that allows the terms of the agreement to be changed by one party (the bank) at any time for any reason. The legality of such an agreement will never be tested in a court of law because consumers also sign away the right to sue. Only binding arbitration is permitted as means of resolving disputes in credit card agreements.

Of course the bank’s response to rising levels of credit card debt will accelerate the impending crisis rather than avert it. No need to worry though. More than likely customer paid tax-dollars will be sent to bailout the banks.

Thursday, October 30, 2008

The “Housing Market” - The Greatest Fraud of All

As the financial crisis has unfolded over the past few weeks, many high profile leaders have had their faith in a market driven economy shaken. Even Alan Greenspan had to admit in testimony before Congress that the assumptions behind his economic policies were wrong. He now says he made a mistake in believing that banks “operating in their own self-interest, would do what was necessary to protect their shareholders and institutions.”

Actually, I think markets work well when the conditions for them are allowed to exist. But we are seeing the unmasking of one of the greatest economic deceptions of all time—the claim that in the United States a market determined home prices. The “invisible hand” that Adam Smith envisioned setting prices in a marketplace is suppose to be just that—invisible. Smith’s economic model rested on the assumption that many buyers and sellers acting in their own self-interest and without government interference would negotiate fair prices for scare commodities.

But lets count the ways the so-called “housing market” has failed to meet these conditions.

Government subsidies for homeowners – For decades the federal government has taxed homeowners at a lower rate than renters. It accomplishes this by allowing payments for home mortgage interest to be deducted from income. Homeowners can borrow up to the entire equity in their house and spend the money on whatever they want—cars, vacations, college tuitions—and the interest paid on the loan is tax deductible. Renters are not allowed to deduct interest paid on loans. The effect of this policy is that homeowners are taxed less as long as they remain in debt. That makes owning a home intrinsically more valuable than just having a place to live.

Government-backed loans eliminate lenders’ risks-The point of Freddie Mac and Fannie Mae was to encourage banks to loan private money to purchase homes by promising public money if the loan went bad. This policy effectively privatized gains and socialized losses. The result is a moral hazard that subverts the functioning of the market. Banks can loan money under the most outlandish of circumstances because they have everything to gain and nothing to lose.

A single person sets interest rates – The Federal Reserve Chief dictates interest rates. It’s no accident that Alan Greenspan had the nickname “Maestro” when he ran the Federal Reserve. Rather than allow market processes to determine interest rates he orchestrated market movements by dictating the rates himself. Allowing the judgment of one person to determine something as fundamental as the cost of money on such a grand scale is the antithesis of a free market.

Of course the government had good reasons for these policies. Congress decided that communities benefited from widespread home ownership. In other words a social good resulted if more people owned homes rather than rented. But government manipulation of markets to achieve a social goal is the definition of socialism.

That is where the great fraud arises—the creation of a socialist system for home ownership but labeling it a “free market.” The claim that no regulation is needed for mortgages because the market will operate is absurd. Socialist systems need regulation; otherwise the moral hazards are too great. The government appears to have no plans for ending the mortgage interest deduction, ending bailouts of failed lenders, or ending Federal Reserve control of interest rates. If it continues to use these policies to manipulate home prices its needs to be intellectually honest. The government should admit that fact that the housing market has been socialist for decades and adopt appropriate regulations to protect the public.

Friday, October 24, 2008

Irony in the Financial Crisis

How much should the government pay for the bad mortgage-backed securities that the banks no longer want? I find a profound irony in that question. A problem in the current financial crisis is that no one knows what many of these securities are worth. Settling on a price that will solve the problem is tricky. If the government pays too little the bailout could fail and the banks will go under anyway. If the government pays too much banks will reap enormous profits at the expense of taxpayers and have little incentive to change the lending practices that resulted in this mess.

The reason no one knows a fair price to pay is that the securities in question are too complicated for anyone to understand. The irony is that the complexity was intentional. The securities were designed to make it difficult if not impossible for anyone to know their underlying value.

Much as been written during this current financial crisis on the question of whether free market capitalism is dead. But the mortgage industry during the past few years was anything but a free market. The idea behind a market is that fair and accurate prices will result from negotiations between buyers and sellers acting in their own best interests. But, for consumers to act in their own best interest, they need to understand the agreements they enter.

Corporations have put enormous effort into making contracts so complex the normal rules of the market do not apply. The premise behind my book, The Two Headed Quarter, is that financial companies can mislead consumers without lying by presenting numbers in such complex ways that rational decision-making becomes impossible. Bob Sullivan’s book Gotcha Capitalism exposes how companies use complex contracts to cheat consumers out of money with hidden fees and surcharges. The idea throughout corporate America is to find deceptive yet still legal methods for taking as much money as possible from consumers without them noticing.

Now there is no money left in the consumer’s pocket for the corporations to take. But, it turns out that a constant flow of money from the consumers is needed or the system falls apart. This was never a “market” in the ordinary sense of the word; it was a Ponzi scheme.

In a healthy marketplace, buyers and sellers need each other. Sellers need satisfied customers willing to come back and give referrals. A small community-based business will not survive without repeat customers. Buyers need merchants that they can trust to provide reliable goods and contribute to quality of life in their communities. A business with contempt for its customers, that exists only to acquire as much money as possible, will eventually fail.

Failure is of course what has happened. But, what I find deeply ironic is that these corporations are now victims of their own deceptions. These corporations attribute their failures to customers who did not understand agreements designed not to be understood. Now these same corporations are shocked to discover that no one understands the agreements. The executives who created the complex securities don’t understand them, Treasury Secretary Paulson doesn’t understand them, Fed Chief Bernake doesn’t understand them, would be buyers don’t understand them. A security that cannot be understood cannot be fairly priced.

A mortgage is actually a simple idea. Over the long run it benefits no one to turn package mortgages into complex, incomprehensible, financial instruments. As the government moves forward to craft better regulations to prevent a future financial catastrophe’s it should consider going back to basics. A free market will work but only if the participants understand the agreements.

Sunday, October 12, 2008

The Deceptive Math of Financial Leverage

In physics a lever is a tool for obtaining a large torque (rotational motion) with a relatively small force. Anytime you use a screwdriver, a lug wrench, a jack, a crowbar, or a doorknob, you are using a lever. In each of these circumstances the rotations achieved would be nearly impossible without the lever.

By analogy, the leverage principle in finance is intended to magnify rates of return on invested money so that relatively small amounts of money can grow much faster than the actual rate of return on the investment. But in finance the tool used to obtain leverage is debt. Borrowing against an asset to fund an investment is financial leverage.

For example, a homebuyer who takes out a mortgage is leveraging the asset—the home—to increase the rate of return on the money used for the down payment. Suppose a buyer puts $10,000 down on a $100,000 house and finances the remaining $90,000 using the house as collateral. If the value of the house rises 50% to $150,000, the homebuyer now has $60,000 of equity in the house. The $10,000 investment has multiplied 6-fold even though the asset only increased 50% in value. Had the buyer paid $100,000 cash for the house a 50% return on investment is all that would have been achieved.

Investors in the stock market can also use leverage. An investor with a normal brokerage account is allowed to borrow up to 50% of the value of stocks owned to purchase more stocks. That means $10,000 can be used to purchase up to $20,000 worth of stocks. This is called buying on margin. If the stocks double in value to $40,000 the investor now has $30,000 in equity—a tripling of the initial $10,000 investment.

Leverage seems like a kind of financial magic. For many investment banks and hedge funds it was magic because these institutions were not bound by the normal rules that limit ordinary investors and homeowners. Stockowners cannot borrow more than 50% of the value of their stocks; homeowners cannot borrow more than the value of their homes. But, in the unregulated dream world of investment banking and hedge funds, there was no limit on the amount the managers could borrow against their assets. For example, by the time Lehman Brothers went bankrupt it was leveraged more than 30 to 1. It owed $30 for $1 in assets it held. Imagine a homeowner borrowing $3 million against a $100,000 home. That might sound crazy, but that’s effectively what Lehman Brothers did.

The motivation for investment banks and hedge funds to leverage their assets to such absurd levels is that it allows them to report fantastic rates of return for modest investment gains. Suppose a $3 million cash investment returns just 5% in a year so that the value is $3.15 million. That does not sound all that impressive. But, suppose the fund managers had only $100,000 in equity in that $3 million investment. The total equity after the 5% gain is now $250,000. The fund managers can now report a “return on equity” of 150%. That is an eye-catching number to report to investors, prospective customers and stockholders. The managers can reward themselves with bonuses for the their remarkable results. At the same time the appreciation of the actual investment was nothing out of the ordinary. It is a beautiful example of a two-headed quarter—using numbers to have it both ways.

But leverage has a dark side. Not only does it magnify gains it also magnifies losses. In the example above, if the $3 million investment loses just 3.3% of its value, the $100,000 of equity is completely wiped out. In markets with normal volatility, a 3.3% downward move is not unusual for a solid investment. The problem is that many of the investments were in mortgages, which are also a leveraged investment. Many of the subprime mortgages being called assets, were for homeowners who had no equity in their houses. Leverage was piled upon leverage. No wonder the banks have no idea what the mortgage securities they hold are worth. Homeowners with no equity have every incentive to walk away when prices fall. After all, when a homeowner invests nothing, there is nothing to lose.

In the same manner, the executives and fund managers had nothing to lose by taking on such absurd levels of debt. They pocketed huge salaries and bonuses for their financial “genius.” And it was an ingenious scheme—taking home the profits and billing the taxpayers and stockholders for the losses.


Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Tuesday, September 30, 2008

The Difference Between Gambling and Investing

The crisis in the financial markets this month is a reminder of easy it is for people to convince themselves that they know far more than they actually do. The executives in charge of Lehman Brothers, Merrill Lynch and AIG were highly compensated for their years of experience in investing and finance. Their companies made billions when the investments they made appeared to be profitable.

But, the events of the past month show that the experts running these companies had no more insight into the future than anyone else. Probably even less knowledge of the future than many people because they apparently forgot all the known principles of sound investing. Instead these executives became seduced by the lure of making quick money by gambling with the enormous sums of money entrusted to them.

The problem with gambling is that winning streaks occur frequently. It is possible to place a series of bets and come out ahead. But, suppose I walk into a casino and win five hands of blackjack in row. Does that mean I know something that the other losing players do not? Should I increase my bets? Should I give up my job and become a professional gambler?

Winning five hands in row at blackjack means nothing more than that is how the cards fell for those five hands. It does not mean that I am smart or gifted or have any special insight into the future. I certainly should not be increasing my bets or plan a career change to full-time gambling.

But, the executives running these investment firms and insurance companies had a few profitable years placing high-risk bets on real estate and concluded that they knew something others did not. Instead of being thankful for coming out ahead on bets that should not have been placed, they kept increasing their exposure to risky loans.

In my book The Two Headed Quarter I draw a distinction between gambling and risk-taking. I write:

“Gambling involves betting money on a game or contest for the purpose of winning more money. Attractions of gambling include the thrill, the entertainment value, and the possibility of wealth without work. Risk-taking involves using money to achieve broader goals that have an uncertain outcome. Anyone who pays for an education, buys a house, relocates for a new job, or starts a business, is taking a risk.”

Investing should be a risk-taking activity. The basic idea is to pool and allocate capital to grow businesses and production capacity. The end result should be economic growth resulting in more jobs, more goods and services, and a higher stand of living for all. In contrast gambling simply transfers money from losers to winners. Nothing of value is created. Imagine an economy where everyone is a full-time gambler. It would be unsustainable because nothing would be created.

But somehow the executives running firms on Wall Street convinced themselves that moving money around using complicated impossible to understand formulas was creating wealth where none existed before. They rewarded themselves handsomely for creating what amounted to a shell game. Wealth creation by subtraction does not work. You cannot keep taking out money of the pot and claim that there is more in it. No matter how complicated you make the financial formulas you cannot work around the basic facts of addition and subtraction.


Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Saturday, August 30, 2008

Tips on Mortgage Math

I have been writing this month on what has gone wrong in the mortgage industry and mistakes lenders and homebuyers have made. Here are some tips about mortgage numbers that consumers should know to protect themselves.

Home Prices: Speculation abounds in the media on when the mortgage market will bottom. My research suggests that the magic number for a fair sustainable housing market is 3. That number is the ratio of the median home price to the median household income in the United States. An examination of census data shows that from 1987 to 2002 that ratio remained unchanged at 3, even though home prices and income rose steadily during that time period. In 2002 home prices began increasing much faster than household income causing the ratio to shoot up to nearly 5 at the peak of the housing market in 2006.

The fact is home prices cannot rise substantially faster than household income or soon everyone will be priced out of the housing market and there will be no more buyers. At the beginning of 2008, the U. S. median home price—$195,900—divided by the median household income—$50,233—was equal to 3.9. That means more time is needed for income to rise and/or home prices to fall for that ratio to go back to its historical average of 3.

Monthly Payments: The number 3 is important in another way. Total monthly payments for principal and interest should not exceed 1/3 of after-tax household income. Many people think that at higher income levels a greater fraction of income can be allocated toward the mortgage. My last post profiled people who were willing to allocate more than half of their take-home pay to monthly mortgage payments. I imagine they thought that their income was so large that all additional living expenses could be funded with 30% - 40% of take-home pay.

But, ownership costs scale with the price of the home. The more square footage bought, the more it costs to heat, cool, maintain, insure, furnish and pay property taxes. All of those additional costs rise with inflation. If you take out a 30-year fixed-rate mortgage and live in the house a long time, there will come a day when the monthly cost of owning the home will exceed the monthly mortgage payment. That will be true for just about any size home.

Mortgage Options: Creative financing has risks. Recent years have seen an explosion of exotic mortgages. You can choose ARMs, interest-only mortgages, 40-year mortgages, mortgages with balloon payments and many other combinations and payment structures. But, the common element in all of these financing schemes is to make the initial monthly payments as small as possible by postponing actual debt reduction. That’s not a problem in a rising market, but it can be a disaster in a falling market. When prices fall it’s easy to find yourself “upside down” meaning that you owe more than the house is worth, while payments adjust upward to level that you can’t afford. If you are considering a mortgage without a fixed rate, figure out what the monthly payment will be in a few years after the interest rate adjusts. If you can’t afford to make that higher payment now, chances are you won’t be able to afford to make it in the future.

Plan for maintenance: Set aside money equal to about 1% – 1.5 % of the value of the home each year for maintenance, repairs and improvements. It’s easy to be optimistic, but the fact is things will break on a regular basis. When you think of all the things in a house with finite lifetimes that are essential—furnace, water heater, air conditioner, refrigerator, roof, plumbing—you realize that repair and replacement will be an on going expense. It is better to budget ahead of time those expenses with money set aside in a separate bank account. Repairs should not be a financial emergency requiring borrowed money every time they happen.


Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Tuesday, August 19, 2008

Motivations Behind Bad Loans

I’ve written columns for the Baltimore Sun on the mortgage crisis and the emails I received from readers included these comments:

“It is hard to feel sorry for folks who got in over there heads, knew it and now what us to bail them out.”

“You are omitting the fact that the majority of subprime borrowers are in their current situation due to fiscal irresponsibility or carelessness.”

My response to these comments is that the goal of my writing is to educate consumers so that they are able to make better decisions. Markets do not work as intended if the consumers do not understand the contracts they sign.

But, for the people who write these comments, their underlying assumption is that homebuyers do know or at least should know what they are doing when they sign a loan agreement. The mortgage crisis is the result of character defects—greed, irresponsibility, over consumption, and so on. Pick one or several character flaws from a list and that explains the problem.

Of course, attributing misfortune and/or good fortune, on one’s character is as old as the Bible. Outcomes do depend on character, although not always. More personal failures and successes result from chance than most people would like to believe.

But the issue of character is an interesting one and I’ve been pondering it after recently reading two profiles of homebuyers facing foreclosure. In both cases the numbers involved in the loan agreements were so outrageous, it’s hard to believe any reasonable person would be party to such a contract.

A July 30, 2008 article in the Baltimore Sun profiled Veronica Peterson, a single mother of four who operates a home daycare in Columbia, Maryland. She is loosing her $545,000 home to foreclosure after the rate adjusted from 8.25% to 11.25%. The article provides few other details on her income and mortgage payments. However, if I work with the numbers provided and assume a 30-year loan, such an increase would mean monthly payments changing from $4094 to $5293 per month, an increase of $1199 per month. This does not include taxes and insurance that must add an additional $500 to each monthly payment.

I cannot image how a home daycare operator could generate the kind of income needed to support monthly payments that high; especially since the State of Maryland limits the number of children home daycare providers can care for to no more than eight. The average cost of daycare in Columbia, Maryland is about $1000 per month. That means by law she cannot gross more than $8000 per month and she must still pay income taxes. Living in a half-million dollar home while paying no taxes is sure to raise questions from the IRS. She said her mortgage broker inflated her income. I wonder what number was stated for her income on the loan application and how it compared to her tax return.

Another profile I read was in Jay Hancock’s August 8 column on Kimberly Thomas who showed up at a closing to find the interest rate on her mortgage from Wells Fargo Bank changed from 7.13% to 10.65%. The change resulted in the monthly payment going from $3000 to $4667. Her monthly take-home pay is $5000. The title company agent conducting the settlement told her to sign the documents anyway. It was 6 PM and no one else was present or available to contact. He assured her the bank would correct the “mistake” the next day.

But the next day Wells Fargo insisted that there was no mistake and that she was bound by the terms of the agreement. Because she couldn’t afford the terms, she ended up not taking possession of the house or making a single payment. The mortgage went into foreclosure immediately. She sold the house for which she paid $505,000 for a $95,000 loss and spent tens of thousands on legal fees. Eventually a jury agreed that Wells Fargo had acted fraudulently and awarded her $1.25 million in damages. Wells Fargo maintains they did nothing wrong and are appealing the verdict.

So what is it about the character of these people that results in situations where the numbers in the agreements are so ridiculous as to be unbelievable? My own take is that it is a combination of optimism bordering on wishful thinking, wanting to please others, and willingness to trust people presenting themselves as “professionals.” Homebuyers want to believe what the agents and brokers are telling them. And, the agents and brokers are very good at telling people what they want to believe. The fake friendships that develop allow the brokers and agents to take advantage of people who want to please others. Homebuyers do not want to anger people by scuttling deals at the last minute and willingly believe that everyone is acting their best interest.

Brian Paul, the lawyer for Kimberly Thomas, said: "She honestly believed there was a mistake in the terms that could be fixed after the fact."

I remember my own experiences with home buying. The real estate agent told me: “It’s impossible to overpay for a house because it has to be appraised. The bank will not allow you to pay more than the appraised price.” I’m sure all the homebuyers he works with get that same line and many believe it.

I remember a refinance of my house where the day of closing, a settlement sheet was faxed to me with a completely different set of numbers than previously agreed to. I took a hard line telling the broker the deal would not happen unless the numbers were changed back. Within an hour a new settlement sheet appeared with the original numbers. But many people are reluctant to “cause problems” at the last minute. It is also easier to walk away from a refinance than a home sale.

So, is believing the best about ourselves and others a character flaw? It can be when it allows us to be taken advantage of and enter into agreements not in our best interest. As I warn in my book The Two Headed Quarter, the lender and realtor profit from immediate sales, not the long-term financial health of the borrower. If the government, or some other investor backs the loan the lender is at no risk. That means homebuyers must look out for their own interests. Don’t believe the agent when he or she tells you that a bank would never loan you money if you couldn’t repay it.

In fact the real crux of the mortgage problem is the ability for agents, brokers, and executives to profit by gambling with money that is not their own. That is the point I made in my previous post. Wells Fargo and its agents don’t care if a loan is paid back because they will collect commissions and fees while selling the loan to other investors. The loan would become somebody else’s problem, not theirs. The homebuyers might have character flaws but the behavior of the lenders in these cases is criminal.


Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Tuesday, August 12, 2008

The Dream World of Mortgages

I dreamt the other night of being at a casino. I sat at a $5 per hand blackjack table and began playing. As the dealer flipped the cards across the felt strange events started to happen. Each time I lost a hand the other casino patrons would take up a collection to cover my loss. Then someone would rush over to add more chips to my stack. But each time I won I got to keep the money. I simply put the chips I won in my pocket. Wow, I thought; I should try this at a more expensive table.

I moved to a $10 per hand table and the same thing happened. Next I tried $50 per hand and then $100. No matter how large a bet I placed or how long a particular losing streak lasted, the lost chips would magically reappear. But, any win was mine to keep and no one seemed to care. An attractive waitress came to offer a drink. I asked for some Grand Marnier and tipped her with a $100 chip. She rushed back with the drink, a seductive smile and a food menu. I kicked back and doubled-down on a hand blackjack players call a hard-16. (Yes, I know that is a stupid play, but I might win and it doesn’t cost me when I lose.) I think I’ll just stay here. No need to go back home and return to that activity called work.

Then I awoke and regained my senses. Real life isn’t like that; or so I thought. I made some coffee and as I sipped and savored the aroma my eyes focused on the morning newspaper. I read about the government bailing out near bankrupt companies with names ending in Mae and Mac. Wait, I must still be dreaming. Is the caffeine working this morning?

Indymac, Freddie Mac and Fannie Mae were run as private companies with stockholders and highly compensated executives. The executives made a series of large questionable bets on real estate that for several years paid off handsomely. But now fortunes have changed and the bets are losing big time. Like many problem gamblers, these executives did not know how to control risk, stay within a budget, or quit before going completely broke. But it didn’t matter to them because while they got to keep their winnings for the bets that paid off, ordinary citizens are being forced to take up a collection to cover the bets that lost.

Government talk and action on the financial crisis caused by bad loans is completely disingenuous. Political leaders extol the virtues of free, unregulated, private enterprise motivated by profit seeking executives and corporations. But when these private businesses fail, our leaders tell us that taxpayers must step in to prevent the entire financial system from collapse. It turns out that the Maes and Macs performed a necessary public service, much like a utility. But Marylanders already know what happens when utilities are deregulated and run for profit. We pay extra on our electric bills every month for that improvement.

IndyMac grew rapidly during the real estate boom by specializing in so-called “Alt-A” loans. These loans did not require homebuyers to actually document the income or assets they claimed. After its failure the FBI launched an investigation of the company for possible fraud. I’m just shocked, shocked to think that without documentation, bank officials might have just made up the numbers on loan documents.

Private enterprise works well with private money. But, in the mortgage business we have a system that allows private gain to accrue from risking unlimited amounts of taxpayer money. The result is that since March authorities have indicted more than 400 people who worked in the real estate industry. We the taxpayers are now footing the bill for massive amounts of collusion and outright fraud.

In Maryland, I know of no legal blackjack games. Neither the state nor federal governments trusts its citizens to play the game responsibly. But, while casino blackjack is stacked against the player, at least it’s regulated in states where it is allowed. Many tax-paying citizens were financially ruined in the poorly regulated real estate market. But, the government says that they should have made more responsible choices. Do they think this is a dream world?


Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Thursday, July 31, 2008

Numbers Used to Quantify Writing Styles

At the end of May, Microsoft gave up in the race with Google to digitize all the world’s printed books and magazines. The motivation for these ambitious projects is to allow search engine technology to reach inside the pages of every book in print. These corporations envision a future with no need to actually thumb through a book at a store or library in search of information. Search engines will perform the task much faster and return the exact location inside of any book for any text or keyword a user is seeking.

Whether such a future is a good or bad one for writer and publishers remains to be seen. Publishers have been less than enthusiastic about these digitization projects because of fears of copyright infringement and potential loss of sales. My own view as a writer is that exposure is a good thing. Obscurity is a greater threat to a writer’s livelihood than copyright infringement.

The Microsoft explanation provided for the decision to abandon the project came in classic corporate-speak. On a Microsoft blog, Satya Nadella, Senior vice president for search portal and advertising, wrote:

“Given the evolution of the Web and our strategy, we believe the next generation of search is about the development of an underlying, sustainable business model for the search engine, consumer, and content partner. For example, this past Wednesday we announced our strategy to focus on verticals with high commercial intent, such as travel, and offer users cash back on their purchases from our advertisers.”

If I ever need to write a parody of a corporate memo these sentences are a good starting point. Just how many buzzwords—evolution, development, strategy, sustainable, verticals, model, etc—are packed into just these two sentences with 65 words of prose? Actually with digitized books, questions such as that can be answered. In fact Google and Microsoft have been playing catch up with Amazon’s “Search Inside the Book” program launched in 2004. Publishers are now encouraged to submit electronic copies of printed books for Amazon to digitize and make searchable.

But, Amazon’s “Search Inside The Book” program allows for more than just keyword searches. You can now look at statistics about the writing style of a book before you purchase it. I checked Amazon’s listing for my book—The Two Headed Quarter—and discovered all sorts of numerical facts that I did not know. My book has 672, 289 characters arranged into 99,104 words. As expected in a book about deceptive numbers, the word “number” appears frequently—567 times, but it is the second most frequently occurring word. I had no idea that the most frequently used word in my book, appearing 709 times, is “years.”

But most fascinating is the statistical summary of my writing style that Amazon provides. Potential buyers can view the “readability” and “complexity” analysis of the text. My book rates as highly readable with a Flesch-Kincaid index of 7.2, meaning that you only need a 7th grade education to read it. According to Amazon 77% of all the other books are harder to read and in the category of personal finance books, 93% are more difficult to read. The easy reading arises in large part because the complexity analysis reveals that I have a simple writing style averaging only 8.6 words per sentence.

Now that last number threw me. I opened my book to some random pages and I found myself hard pressed to find sentences as short as 8 to 9 words, let alone enough sentences less than 8 words that would allow 8.6 to be the average. Amazon’s number for my average words per sentence just didn’t seem reasonable to me. I decided to run my own check using Microsoft Word’s analysis tools on some chapters from the original manuscript. I had never done that kind of analysis on my writing before, which shows you how much I think about readability statistics when I’m writing. The results:

For Chapter 1:18.0 words per sentence, Flesch-Kincaid index —10.1
For Chapter 2: 17.2 words per sentence, Flesch-Kincaid index —10.7
For Chapter 5: 18.9 words per sentence, Flesch-Kincaid index —11.4
For Chapter 8: 19.3 words per sentence, Flesch-Kincaid index —10.8

This means the readability of my writing is consistently at a 10th to 11th grade level (not 7th grade) and about average in complexity (according to Rudolf Flesch, co-inventor of the Flesch-Kincaid scale, the average words per sentence found in reading material is 17).

So how can Amazon’s statistics be so skewed? I don’t know but I have a good idea. Again, my book is about numbers and there are many numbers in the book. There are figures and tables with numbers along with worked examples containing numbers that allow readers to figure out numerical answers to many common financial questions. Many of the numbers in the book contain decimal points. My hypothesis is that the software Amazon uses to perform readability analysis cannot tell the difference between a period and a decimal point. After all, there is no difference between the two characters. Only an actual reader who can interpret the meaning of a sentence knows that a decimal point inside a number does not terminate a sentence.

I find it ironic that a book about deceptive numbers has an Amazon listing with a bunch of deceptive numbers to characterize its readability. Another example of companies spending time and resources to compile and publish useless numerical information. By the way, according to Amazon’s site my book has 3348 words per ounce and if you buy it you will receive 4715 words for each dollar you spend.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Tuesday, July 15, 2008

Does showing up for work cost more than you earn?

The Sunday (July 13, 2008) Baltimore Sun this week had a front-page article about mothers: “Back to Work, Like it or Not” with the subtitle that “Women who left jobs for children find economy reverses the trade.” Reporter Jill Rosen writes “The soured economy—with its ever-increasing gas, food and utility prices, its sinking home values and its corporate downsizing—is forcing mothers who have traded careers for families to think about trading back.”

I can relate to the article because my wife will change from part-time to full-time work this fall. Energy and food prices have increased so much in the past year our budget no longer works as it once did. But our three children are teenagers and our current financial goal is getting them all through college. The Baltimore Sun article profiled women in much more difficult circumstances—mothers of toddlers and infants who planned on being stay-at-home moms. But, the article left me wondering if working for a paycheck outside the home is a financially viable option for many these women.

Women who can work professional salaried jobs will come out ahead financially by working outside the home. But women who work part-time or for lower wages might find that the same financial pressures forcing them outside the home might also make it impossible to realize any financial benefit.

How much money will these women have left after paying for commuting costs, daycare, work expenses, Social Security, and state and federal taxes? I’ve already seen television news reports about men with commutes so long it no longer pays to drive to work. I can imagine many common circumstances where stay-at-home moms would be hard pressed to increase the family income by working outside the home.

To assist families in figuring out how much additional income can be generated by working outside the home, I’ve teamed with my publisher to create a new calculator for the Compute Gas Savings Website. The calculator, at http://www.computegassavings.com/earningscalc.html, computes daily take home pay after subtracting all of the costs associated with showing up for work.

Consider a married mom in the suburbs with one child who finds a job in a city that pays $12 per hour. She must commute 25 miles each way in a family SUV that gets 20 miles per gallon. She manages to find daycare for $25 per day and finds herself spending an additional $5 per day on average for other work-related costs—coffee, snacks, clothes, car maintenance etc. Because she is married her additional income is not completely sheltered by deductions and exemptions. For this example we will assume a net federal tax rate of 10% and state tax rate of 3%. After entering all these numbers in the calculator it shows that she will take home just $36.17 per day out of her $96 per day net earnings or about $4.50 per hour.

Where did the money go? The combined cost of Social Security, federal, and state taxes takes one-quarter and the combined cost of daycare and gas takes one-third. That means it costs more than one half of her pay just to show up for work. This assumes she has only one child. Add the cost of daycare for a second child and daily earnings come to $11.17.

In fact it is easy to construct plausible scenarios where real earnings per day become negative. Keep the same tax rates, lower her hourly pay to $10, or $80 per day, give her two children so that daycare becomes $50 per day, make the distance to work 30 miles and the gas mileage 15 miles per gallon, and the real earnings per day becomes a negative $7.52. Going to work will cost her more than she makes.

I urge women looking to increase family income by working outside the home to test out different scenarios before deciding on a job. The hourly pay offered might not be the relevant number to compare when making a decision.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Thursday, July 3, 2008

Oil Prices Are Not Dependent on Oil Sources

A reader of my post “A Tax By Any Other Name” felt that I was na├»ve to suggest that supply and demand sets oil prices. The reader believes that oil pricing is driven more by speculation than anything else.

I agree with the reader that speculation is a large part of the reason we are paying $4 per gallon for gas at the moment. In my post I stated the supply and demand for oil is only a part of what sets the price for gas. I was mostly writing on how the increasing supply and decreasing demand for dollars is contributing to oil price increases. But in the last six months the falling dollar and increased oil consumption cannot account for the sudden 50% price rise for a barrel of oil. Speculation is clearly part of the problem.

It is no secret that the banks, investment houses, hedge funds, and oil companies now conduct most the trading in oil futures on all electronic foreign exchanges (such as the InterContinental Exchange or ICE) that are out of reach of U. S. regulators. A CBS news story quoted Michael Greenberger, a former top staffer at the Commodities Futures Trading Commission, as saying that 25% -50% of the price per barrel might be due to speculation. Greenberger believes that “If you can trade out of the sight of U.S. regulators, you can manipulate these markets."

What is especially disturbing about “foreign exchanges” like the ICE is that it is not actually foreign. Among its founding partners are Goldman Sachs and Morgan Stanley, its headquarters is in Atlanta, its primary data center is in Chicago, and it settles most trades in U. S. dollars. Despite all of its U. S. ties, the ICE claims that because its energy futures business is conducted in London—whatever that means—U. S. laws or regulations do not apply to it.

But all this supports the crux of my earlier argument that the energy independence that politicians speak of achieving is a myth because oil companies “will always sell their product to highest bidder, wherever the bidder resides.” The price of oil has no relationship to its origin.

In 2007 the U. S. imported about 10 million barrels of oil per day and produced about 5 million barrels per day. According to the Energy Information Administration, the top three countries of origin for imported oil in 2007 were Canada (1.85 million barrels per day), Mexico 1.47 million barrels per day) and Saudi Arabia (1.36 million barrels per day). Canada and Mexico actually supply more oil to the United States than Saudi Arabia.

If the U. S. decides to increase its domestic production of oil through offshore drilling or other means, it will contribute to the world supply of oil and that additional supply will be factored into the world price. Any politician who claims we can be more energy independent by drilling for more oil in the U. S. is being disingenuous. A far more relevant question to ask our political leadership is: Why are U. S. investment banks allowed to manipulate energy futures markets with no government oversight? I don’t think there is going to be a straight answer for that question.

Joseph Ganem is a physicist and author of the award-winning The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Sunday, June 22, 2008

Deceptive Numbers Used to Described Floods

Of all the deceptive numbers in circulation, the most ridiculous, expensive, and tragic are the numbers the U. S. Army Corp of Engineers use to describe the levees that they build. I saw an interview with General Michael J. Walsh on the NBC news this past week. In it he referred to the rainfall flooding Cedar Rapids as a “500-year storm.” The levees were not designed for such a rare event. According to General Walsh: “A lot of levees have over topped. We don’t consider that a failure.”

He is consistent with other officials I’ve seen interviewed, who refer to levees as having “100-year” or “500-year” designs. The terminology means that according to the statistical models used to predict floods, water should top a 100-year levee about once every 100 years and top a 500-year levee once every 500 years.

You wonder how engineers and government officials can quote these numbers with a straight face. Does the U. S. Army Corp of engineers understand anything about what they are doing along the Mississippi. Clearly once levees are constructed along the river all the flood statistics become meaningless.

Timothy Kusky, director of the Center for Environmental Sciences at St. Louis University, described in an interview on NPR how before levees were built, the Mississippi River was 4000 ft wide at St. Louis. Today the river is 1500 ft wide. As Kusky stated: “It is a simple concept; confine the river to a narrower channel and there is nowhere for the water to go but up.” The result according to Kusky is that we’ve had 15 hundred-year floods in the past hundred years, and many more 500-year floods in the past 150 years. Building structures changes all the statistics.

The other problem is that the flooding statistics are based on past events. Climate change models predict a 20% increase in rainfall in the coming decades for the Midwest. With that rainfall will come a 50% rise in the height of the rivers.

But, communities, developers, and home owners continue to invest large sums of money on the basis of the bogus statistical claims made by the Army Corp of Engineers. Chesterfield, Missouri now has the largest strip mall in the United States—3 miles long. The mall, along with 30,000 new homes, is built on land that was completely under 10 ft of water during the 1993 flood. The developer erected a “500-year” levee for protection and declared the area safe.

Robert E. Criss, Ph.D., professor of earth and planetary sciences at Washington University in St. Louis has strongly criticized such development as “ignoring geological reality.” On a Washington University news website, Criss describes as an "absurd exaggeration” the claim that a levee will withstand floods for 500 years. “If some private company were making claims that they'll sell you a car that will run for 500 years, they'd be in jail. Somehow, the government feels justified making absurd claims that have no basis."

It appears that little of substance was learned from the 1993 floods. The conclusion that higher levees need to be built ignores the reality that all of the water must have some place to go. A higher levee in one location will force water over the top in another location. The statistics that are the basis for the levee building and development become meaningless. But government officials and developers still rely on these absurd numbers and the result is heartbreaking for the people affected.

Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Wednesday, June 18, 2008

A Question About the Monty Hall Problem

A reader forwarded me a link to an excerpt from a new book—The Drunkard’s Walk: How Randomness Rules Our Lives by Leonard Mlodinow. The excerpt discusses a widely misunderstood issue in probability theory that has become known as the “Monty Hall” problem. The reader asked me: “What is going on in this one? I looked through your book [The Two Headed Quarter] for a possible answer, but no luck.”

Coincidentally I just started reading Mlodinow’s book a few days ago and at least through the first two chapters I’m enjoying it. The book’s subject has always fascinated me and the author is a fellow physicist.

My book does not discuss the Monty Hall problem explicitly, but I do in the last chapter discuss how people become deceived by events that are conditionally probable. The Monty Hall problem is an extremely subtle example of how people are fooled by conditional probabilities. It is so subtle it has fooled professional mathematicians including Paul Erdos, one of the 20th century’s most prolific mathematicians.

Here is the problem. You are a contestant on the game show Let's Make a Deal. The host, Monty Hall, asks you to pick from one of three doors. Behind one is the grand prize and behind the other two are worthless consolation prizes. You choose door number one. Monty Hall, who knows what is behind all three doors and will not reveal the grand prize, opens door number two to reveal a consolation price and asks if you want to switch your choice to door number three. Should you switch or stay with door number one?

Many people argue that at this point your chances of winning are 50-50 and switching your choice to the other door will not improve your chances. But the reality is you should switch because you will win two-thirds of the time if you do. This fact is hard to believe. In his biography of Paul Erdos, The Man Who Loved Only Numbers, Paul Hoffman describes how Erdos, did not understand why switching improved the contestant’s chances. A friend wrote a computer program that simulated the Monty Hall problem and showed that switching does win two-thirds of the time, but Erdos still did not understand the reason why.

The reason you should switch is that once the all-knowing Monty Hall opened a door, he gave away information. His choice is not random; which means that your choice now has conditional probabilities associated with it. Had Hall acted first and then presented you with a choice of two doors, your chances would be 50-50. But he acted after you did and now you have a chance to respond. These are the three possible scenarios:

Prize behind door 1 – Hall opens either door 2 or 3, you switch to the one he doesn’t open and loose.
Prize behind door 2 – Hall must open door 3, you switch to door 2 and win.
Prize behind door 3 – Hall must open door 2, you switch to door 3 and win.

Switching wins two-thirds of the time and looses one-third of the time. But if you do not switch you have ignored the critical information that Hall provided. You win only the one-third of the time your original choice was correct.

That you do not even win half the time when you do not switch is another surprise. But if you ignore the information provided, the original odds cannot change. The mere act of opening another door has no effect on your original one out of three chance. You have to change your choice based on the new information. Notice the effect of the word “must” in the last two scenarios. Hall does not have a choice in these two scenarios but you do.

Note that you only lose by switching the one-third of the time your first choice was correct. The two-thirds of the time your first choice is wrong, switching guarantees a win. To understand this it helps to imagine an extreme example. Suppose there are 100 doors and you are asked to pick one. Your chances of being correct are 1%. Monty Hall then opens 98 doors revealing consolation prizes behind each. You are faced with a choice of two un-opened doors. I’d switch immediately to the one door he avoided opening. It will win 99% of the time. Only on the 1% chance that my first choice is correct will it be possible to lose.

The Monty Hall problem is subtle but people who play poker should recognize it as the entire premise of the game. In poker, players are dealt random cards, but they do not play random cards. Once the players act and additional cards are exposed it is not correct to say that someone vying for a pot could be holding any of the possible hands. In Texas Hold’em the odds against being dealt two pocket Aces are 220-1. But, if someone is betting and acting as if he or she has a great hand, the odds are much better than 220-1 that player has pocket Aces. The deal might be random but, like Monty Hall, a player’s actions are usually deliberate.

Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Sunday, June 15, 2008

A Tax by Any Other Name

One of the most ludicrous debates of the never-ending election season is the one on tax policy. John McCain has changed his position on the Bush tax cuts and now says we should keep them. Congressional Democrats, who have argued for letting the tax cuts expire, quickly agreed to an economic stimulus package that includes mailing tax rebates to millions of American households. But it’s a sure bet that as November approaches, the “borrow and spend” Republicans will be saturating the airwaves with the “tax and spend” epithet hurled against the Democrats.

But what is lost in all in the election name-calling is that the government has two methods for taxing and it has been squeezing all of us financially while never using the word “tax.” The most familiar tax method is the one we all see with every paycheck; the method of subtraction. The government compels your employer to deduct money from your pay and send it to the U. S. Treasury. However, the government also controls the value of the currency you are paid in. Devaluing the currency is the second method of taxation.

As the U. S. government spends more and more dollars it doesn’t have, the world is being flooded with dollar-denominated IOU’s known as treasury bonds. These bonds are considered super-safe investments because the U. S. government has never defaulted on its debts. But why should it ever default? Unlike the rest of us, Uncle Sam has the power to print the dollars needed to pay its debts.

Federal debt is soaring into the trillions of dollars with no end in sight and no plan to pay it back. Foreign buyers of treasury bonds are losing confidence and the result is a steep slide in the value of the currency we are paid in. Eight years ago a Euro cost $0.82; today a Euro costs nearly twice that amount—over $1.50. The steep rise in the price of gas is only in part a change in the supply and demand equation for oil. The supply and demand equation for dollars is a significant part of the cost increase for gas, energy and food.

Politicians speak of their plans for “energy independence” or “food independence” as if the United States could wall itself off from the rest of the world and live only on its own resources. But independence is a myth. Oil is a global commodity and will always be sold on a worldwide market. Exxon-Mobil will always sell their product to highest bidder, wherever the bidder resides. The same is true for food companies.

If in the last election a politician had proposed a new substantial tax on gasoline to go towards federal debt he or she would have been voted out of office. But that has happened anyway without the word tax used as a label.

David T. King wrote in an op-ed article in the Wall Street Journal on May 23, 2008 that Oil is up because the dollar is down. A graphic that accompanied the article compared the price of oil in dollars with the price in Euros since 2002. In 2002 oil sold for $30 per barrel that at the time was equal to 30 Euros. Today oils sells for over $130 per barrel or just over 80 Euros. King concludes that we don’t need a gas tax holiday; we need an exchange rate policy.

In King's words: “Exchange rates can be managed.” But I don’t understand how exchange rates can be managed without the federal government first getting its own finances in order and wean itself away from reliance on debt.


Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Monday, May 19, 2008

Who Will Bail Out The U. S. Government?

My “stimulus” payment from the federal government arrived on the same day that a front-page article in USA Today reported that federal deficit is far greater than the government admits. While the politicians struggle to bailout the housing crisis and head off a recession, they are also rigging the budget numbers to hide the fact that there is no money to give away.

The reported deficits of hundreds of billions of dollars sound bad. But, USA Today found that federal deficits would be trillions of dollars if the government used the accounting rules that are required of corporations when issuing financial reports to shareholders. The reason for the discrepancy is that trillions of dollars in unfunded liabilities to Medicare and Social Security do not show up on the government’s balance sheet. A corporation would have to report future financial obligations as a liability unless it had the funds set aside to make the payments.

But the federal government avoids reporting unfunded liabilities. It collects Social Security and Medicare taxes to supposedly set aside in trust funds to pay for future financial obligations. That allows the government to claim its future obligations are funded. The ruse is that the money never remains in the trust funds. Instead money is “borrowed” from the trust funds to pay for present day obligations. Because the money is “borrowed” from funds the government controls, it never reports that obligation as part of the deficit.

What the practice means is that a mathematically equivalent expression for “borrowed from the trust fund” would be “spent the trust fund.” But the government never admits that it has spent the trust funds because that would undermine the entire rationale for collecting separate Social Security and Medicare taxes.

None of this is a secret. When I wrote The Two Headed Quarter I included a chart that showed that projected indebtedness to the Social Security trust fund was expected to increase from $1.5 trillion to $4.0 trillion between the years 2003 to 2014. The Congressional Budget Office (CBO) made the projection. I simply made a chart of data taken off the CBO Website. The chart makes clear that the government has no plans to every pay back the money it is “borrowing” from the trust fund.

Even though these trust funds exist on paper, the fact is money is not in them.


Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Monday, May 12, 2008

Confusing Prices at the Grocery Store

One of the frustrations with grocery shopping is the refusal by stores to post prices on many individual items. In fact, if the item costs less than a dollar the stores rarely post a single-item price. If you are not facile with division in your head or have a calculator, comparing prices is difficult and this is clearly the intention of the store. Yesterday, I was especially irritated because most of the items I bought had pricing designed to thwart rational price-comparisons.

At the produce area limes were priced 15 for $2. I’m sure the store would have liked for me to pick up 15 but I only needed 2. But, knowing the cost per lime requires dividing $2 by 15 to get 13.3 cents. That is not a simple mental division to arrive at the single item price.

With lemons the comparison problem was worse because bulk lemons were sold by weight while loose lemons were sold by quantity. The loose lemons were priced 2 for $1.38 while the same size lemons packaged in 2-pounds bags sold for $3.98. Both prices staggered me; were talking about lemons not apples or pears. It brought home how fast the prices on produce (and all other groceries) have risen in recent months.

I needed about 6 lemons; so how should I chose? I counted 7 lemons in the 2-pound bag so that is 57 cents per lemon compared to $1.38 divided by 2, or 69 cents per loose lemon. That means if I buy six lemons loose it will cost slightly more than the 7 in a bag so I bought a bag.

At the frozen meals section the quantity pricing was used to hide higher prices. In contrast to the lemons you could spend more per item buying in bulk. I reached for some meals on “special” that were priced at 2 for $6. Then I realized a competing product priced normally at $2.89 each is actually cheaper. I put the higher-priced meal back behind the large sign advertising the special price and replaced it with the less expensive product that lacked the flashy signage.

I felt like having a chocolate bar on the way out, but once again at the register I needed to perform division to know the price. My favorite Hershey chocolate with almonds bars were priced 3 for $2. I added one to my groceries because I only wanted to eat one and it rang up for 67 cents.

Of course stores intentionally post prices in this manner because it works in two ways in the store’s favor.

First, it suggests to customers that they buy quantities greater than actually needed. Most customers think they need to buy the quantity posted to get the advertised price. In fact most of the time the pro-rated price will ring up at the register, just as it did for my candy bar. But sometimes you do need the entire quantity to get the price and many customers don’t want the aggravation of finding out at the register that they needed one more of an item to get a price break.

But customers would be better off buying exactly what they need and fighting at the register when necessary if the store over charges. Why shop for special prices and clip coupons if you spend 50 cents extra on many purchases because of an artificial number the store selected for quantity? Consumers should control decisions on quantities to avoid wasting money and food.

Second, stores subvert market forces by making price comparisons difficult. The market cannot work properly if consumers cannot compare prices. It might be aggravating, but grocery shoppers should take small calculators along and do the division. Consumers should base buying decisions on single-item prices for the quantity they actually

Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Wednesday, April 30, 2008

It’s The Consumer’s Fault

Have you noticed that no matter what happens with the economy it is the consumers who are at fault? As the economy slides into recession, the reason given is that consumers are spending less. Consumer spending supposedly accounts for most of the economy and when consumers are not out buying the entire country suffers. When the media reports on the “stimulus” checks being sent out by the government this summer, the question is raised of whether consumers will actually spend the money. A repeated implication is that the “stimulus” plan will fail if people use the money to pay existing debt or worse save the money.

Of course the reason given for the recession is the subprime mortgage crisis. How did that economic disaster come about? Consumers were irresponsible. People bought houses they could not afford. Not enough money was saved for a down payment. People refinanced and took cash out of their homes to spend on frivolous consumer purchases. Banks tried to help people who were poor credit risks by extending credit anyway. Look at what happened. Those people took the money, spent it on consumer goods, and did not pay it back.

In fact consumer spending has been a problem for so long, the banks lobbied intensively for a new bankruptcy law that President Bush signed in 2005. The “Bankruptcy Abuse Prevention and Consumer Protection Act 0f 2005” made it more difficult for consumers to discharge debts through bankruptcy. The banking industry claimed that the law was needed to protect our financial system from irresponsible consumers.

So now in 2008, the health of our financial system depends on consumer spending. Actually people are spending more money than ever today. The problem is that the money is being spent on frivolities such as gasoline to commute to work, groceries to feed the family, healthcare and education for children. Those costs have risen so dramatically in the last year that most family budgets are overwhelmed. Few families ever expected that the gas to run the car would cost more per month than the payments to purchase the car.

Government leaders and the executives of financial services companies keep finding reasons to blame the consumer for any and all economic problems. Perhaps the leaders of these institutions should look more carefully at themselves. Unprecedented government debt totaling trillions of dollars is undermining the value of U. S. currency. The result is that food and energy costs more in dollars on the world markets. Lenders are quick to sell all sorts of exotic mortgages to people with questionable ability to repay. Then the lenders are just shocked to discover that people judged poor credit risks actually are.

Despite all the media hype about a recession resulting from consumers not spending, I don’t think that is the real source of our economic problems.

Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Tuesday, April 22, 2008

How Retail Stores Thwart Price Comparisons

It was a beautiful spring day in Baltimore Saturday. Time to begin the yard and porch cleanup. That required a trip to Home Depot for supplies. Having put all the local hardware stores out of business within a year after arriving, Home Depot is the only choice. The store offers what has become a typical retail shopping experience—disorder in every aisle that appears to intentionally thwart rational buying decisions.

I needed work gloves for outside and reasoned that the garden department would be the place to go. Sure enough there was an entire display rack of gloves. I selected a pair made of canvas with latex dots on the palms and fingers for a better grip. The price of $3.97 seemed substantially higher than I remembered last year. Then I saw I had picked a pair of women’s gloves. In fact the entire rack had nothing but women’s gloves. So gardening is a feminine activity? I never knew that. I must think of a masculine activity that needs gloves.

Off I trekked to the paint department in hopes of finding men’s gloves. Surely painting must be more masculine than gardening. Actually in my house, my wife does most of the painting and gardening. But, I’m trying to imagine how Home Deport marketers might stereotype men and women. Sure enough, the men’s gloves were all in painting. I found the same style and color—canvas with the black latex dots on the palms for the price I remembered—$1.94. In fact, except for the men’s gloves being larger, I could not find any difference in the make or quality compared to the women’s pair for $3.97 in the garden department.

So now I understand why men’s and women’s glove are not sold on the same rack. It would be hard to justify doubling the price for the women’s gloves in a side-by-side comparison. The sex stereotyping is just a clever ploy to avoid putting men’s and women’s gloves together.

Next I needed a new wheel for my wheelbarrow. I had two choices—an air-filled one for $14.99 and a solid never-goes-flat model with no price marked. Not needing air seemed like a good idea. How much more expensive can it be? At the self-serve register it rang up for $37.95. I could buy an entire wheelbarrow for that price. I had to disturb the attendant for the self-serve registers, who looked like he was falling asleep, to have the wheel taken off my total.

I put the items I did buy in my car, but then decided that $14.99 for an air-filled wheel seemed reasonable. I went back inside, found the wheels again in the back of the store, and waited in line at the register. The wheel rang up for $24.00.

“The price is $14.99,” I said.

“That’s not what the computer has.”

“Never mind, I’m not going to buy a wheel.”

Before leaving without a wheel, I went back to recheck the price. This time I read the fine print underneath the large $14.99 lettering. The price referred to some kind of “mat” that was nowhere to be seen. The wheels were on the shelf instead.

When I got home I showed my wife the gloves and asked her how much she usually paid for them.

“Those are about $4 to $5,” she said.

“The women’s gloves in the garden department are about $4. But men’s gloves in painting are only $2.”

“But, the men’s have more fabric.”

“It’s not about the cost of making the gloves; it’s about marketing. The stores know they can get away with charging women more for gloves, so they do.”

My wife rolled her eyes in disgust.


Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy

Tuesday, April 15, 2008

T-Mobile Rebate Run-Around: Part II

When I last wrote about my problem collecting promised rebates from T-Mobile, the company had assured me that the correct paperwork had been processed and checks would be in the mail. Despite my skepticism, the phone representative confidently stated that all was in order. But this week, a month after that conversation, I spent more time on the phone trying again to coax the promised rebates.

Progress has been made but not easily. To re-cap, on January 5, 2008 I purchased four new phones for $50 each when I upgraded my family cell phone plan. I had been promised a $50 rebate on each once I submitted the rebate form, receipt, and bar codes from the box. In February I received one $50 check and three rejection letters. When I called in February to question the rejection, they reprocessed the paperwork and said the checks would soon be sent. Three more rejection letters came instead. When I called again in March, they repeated the reprocessing of the paperwork. It was the March phone call I last wrote about.

The result was two more $50 checks and one rejection letter. I called this week to recover the remaining $50. But now the story from T-Mobile had completely changed. They refused to issue a rebate on the fourth phone. The reason given is that prior to upgrading my phone plan, I had three phone numbers. Part of my upgrade included adding a fourth phone number. Now T-Mobile claims that the additional phone needed for the new number was not part of the upgrade and not eligible for the rebate offer.

I asked to speak to a supervisor. He listened as I stated the following facts:

• I had been promised a rebate at the time of purchase and the store had issued a rebate claim form.

• I had been told when I called in February that a rebate would be sent.

• I had been assured again in March that all the paperwork had been finalized and a rebate would be sent.

• Only now in April, three months after purchase had I been told that no rebate was available for the phone.

He did not dispute those facts; he just reiterated that no rebate was available.

I asked if I could return the phone and get my money back. He said no.

I asked if I could discontinue the additional telephone line and not have to pay the $200 early termination penalty. He said no.

I said that their business practices were incredibly dishonest. He disagreed by reading to me the fine print on the rebate form I had submitted. It reads:

“No employee, dealer or agent is authorized to make, and no customer is entitled to rely upon, any representation (other than described in this rebate request form) about a rebate or change in any terms of a rebate.”

The call ended, this time, with an absolute no from the supervisor on ever receiving a rebate for the fourth phone.

I find the T-Mobile definition of honesty fascinating. The fine print on the rebate agreement absolves all of their employees and agents of legal responsibility for misrepresenting the rebate agreement. When I submit a rebate claim I agree that no promise made to me will ever be binding. Because I’ve agreed to that condition, no misrepresentation made by T-Mobile can ever violate the agreement. So it is a completely honest agreement.

Of course, this license to misrepresent is only granted to T-Mobile. I am still bound by the conditions I agreed to when I decided to purchase the phone and add the new line, even though their misrepresentation influenced my decision.

Joseph Ganem is a physicist and author of The Two Headed Quarter: How to See Through Deceptive Numbers and Save Money on Everything You Buy