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.
Sunday, November 30, 2008
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.
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.
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
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
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
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
“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
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