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A Simplified Guide to a Financial Apocalypse

In an effort to distract me from my card play, someone at our home poker game asked me what I thought about the "bailout" that passed last week.  After the 2nd sentence of explanation, it was obvious that they either didn't really care or just enjoyed taking my chips while I tried to explain how we got here and why I felt something, "bailout" or something else had to be done.  It was also obvious to me that I don't have an easy answer that connects.  So for those interested in why it seems all hell has broken loose economically, I will try to give the old college try.

Everything starts  during the real estate bubble.  Remember that?  Real estate was suppose to be where the money was to be made.  You turn on a cable channel and watch, "Flip my house" or "What's my house worth?"  That these shows were even green lighted, much less popular should have been symptom number one that something was going awry.  When you watch a "realtor" show a house for entertainment, there is a problem..

The fact is everyone wanted part of the action.  After all, you would hear of people making eye popping profits and with interest rates low, real estate going up (after all they don't make any more of it, you know), people of all financial levels were catching the American dream. 

With so many people buying houses they really couldn't afford and the mortgage business being an extremely profitable venture, there was fierce competition to originate loans despite the ability of the borrower to be able to repay.  That coupled with the fact that most mortgages could be sold off, there was little reason to be concerned about the risk because the agent could get his fat commission, sell the loan off for someone else to worry about.  These loans were then bundled together with other loans in instruments called CMO (Collaterialized Mortgage Obligations) or CDO (Collaterized Debt Obligations).  The higher the average risk of the loan in those instrument the higher the yield.  Which leads us to what should have been a second harbinger of things to come.  When you are getting 10-12% returns on securites that are considered "fixed income" you should know something isn't right. You don't buy fixed income securities for "return" but rather for security and income, not growth.

Okay, back to the borrower.  Here is what a conversation may have sounded like in a typical mortgage office.

AGENT-  "How can I help you?"

BORROWER- "Um,  I want to move into a house with a better school for my kids (notice we always justify our greed with our kids."

AGENT- "Great! How's your credit?"

BORROWER- "Well, that's the thing, it isn't that great, but I think this home will be a great investment and, you know, my kids can go to this great school.  I may even sell this home to fund my retirement.  Can you help people with crappy credit?"

AGENT-  "Oh sure, that's why we are here, to help people...."

BORROWER-  "Well, I make....

AGENT-  "No, no, no, don't worry about that, we can get a loan that you can afford.  How much a month could you pay?"

BORROWER- "Uhhh, I don't know, maybe $800 per month, but my credit.....

AGENT- "Hey, like I said, don't worry about. I am here for you.  Here's what you do.  We will put you in an Adjustable Rate Mortgage, you will only pay like 4% interest for 2 years.  That will keep you monthly payment at $800.  By paying it, you will improve your credit, and with this great investment going up, you will be able to use the equity to refinance into a fixed rate loan and get a good interest rate because your credit will be all fixed."

BORROWER- "Wow! That's sounds great, but you said something about 2 years, what happen when...."

AGENT- "You come back to me and we will refinance! It's a win-win for everyone."

BORROWER-  "Oh, thank you, thank you.  This is a dream come true."

The agent gets a huge commission, the borrower get's his kid into THE school system, and some investment bank gets another mortgage to bundle up to sell to pensions, institutions, and individual investors.  All is good.

The poor insurance industry however was missing out on this orgy of money, so they decided to get in on the action.  They recognized that many of these bundled securities are being sold to people who like safety.  So they decided to sell an insurance equivalent on those securities.  The idea being that they would insure these investments should they blow up.  They called these "credit default swaps."  Notice the name.  They will swap the risk should the credit represented in those loans default.  These proved to be extremely popular (and profitable).  It has been estimated that there were about 62 trillion in credit default swaps issued.  That is trillion!   

You will also notice that I said estimated, because no one really knows.  Why? Because, notice that credit default swaps are not called what they are, insurance.  Insurance in not in the name.  Why?  Because insurance is regulated by the states and we know that regulation is ultimate evil. If you deregulate, the free markets can rule and we do love the free market (as if it really existed).

So what you have is billions if not trillions of dollars in risky loans made with the belief that real estate would increase forever, insurance on those loan, predicated on the fact they would never have to pay a claim. 

Then the bubble burst.  Real Estate values fell, that home equity the borrower was planning on using to refinance was nowhere to be found.  His mortgage payments went up after two years and all of a sudden his home was facing foreclosure.  Again and again this happened.  Which means all those CMOs and CDOs were blowing up, which meant that all those credit default swaps were being called to pay out.  Since the insurance companies weren't regulated, there weren't required to keep any capital liquid to payout on the claims. Instead those used those huge profits to pay extraordinary bonuses and commissions to executives.

Hence, what we know as a credit crunch.  That simply means that institutions no longer trusted other institutions to lend them money because they didn't know if they would be able to pay back those loans.  Why no trust?  Because no one could determine how much bad investments, or bad swaps a company held.  All of sudden risk mattered again and the pipeline of credit ceased. No credit, meant that businesses couldn't continue their business, which meant, a collapse.  

Hence the so called "bailout."  Which essentially is the government, using taxpayer money, to buy these endangered investments, to get them off their book, so that banks and institutions will feel better about lending them money again.  The idea is that this will free up the offering of credit and business can continue. 

If it doesn't work, or if nothing was done, the mom and pop store on main street wouldn't be able to keep their inventory up to date, couldn't make their payroll, couldn't pay their bills.  That would lead to layoffs, and layoffs would lead to rapid decrease in consumer spending which makes up 2/3rds of the the American economy.  That my friends would  be a depression, not a recession.  It is a perfect financial storm.  And that is as simply as I know how to put it. 

To Catch an (insurance) Predator

Southern Sojourner (SS) is a personal blog.  I place where I can be juvenile or mature, a spot in the worldwide web where I can spout off or write out my reflective contemplations. It is my space where I can share what is on my mind, pissing me off, or stirring my soul.  I enjoy it, need it and have made some great friends because of it.  I met my friend Michael, with whom I play poker every month, who lives in my own neighborhood, due to this little dot in the vast technological universe. But it is a personal blog.

I have two other blogs that I could start with my Typepad account and I have often thought of using one of them for my business and one for my faith community should I ever get around to starting it. (BTW, if anybody that reads this that lives in McCalla/Bessemer area and wants to help start a progressive faith community let me know.)  I just didn't know if I would have the time to maintain them.  This blog sucks enough as it is, do we really need two other under attended blogs out there.  I doubt it. 

Anyhow, since I can not separate my business from who I am, I periodically share financial stuff here at SS. My friend Jack put me onto the Dateline NBC special that aired last Friday night.  Turns out that pedophile busting Chris Hansen put on a different type of sting operation here in good old Birmingham. The predator he was looking for this time were insurance salesmen who prey (on anybody) primarily on seniors touting the "risk free" investments that are known as Equity Indexed Annuities.  Boy howdy, it was spot on.  I have sat in training sessions where the insurance companies taught agents how to sale these crappy products and I can tell you first hand that the "undercover training school" that was represented here is how it is.   Check out this segment from the special.

If you are considering or more probably being sold an annuity, you might want to check out the whole episode. I will give you a couple of rules of thumb to help you sort through the decision.  Most people, not all, mind you, but most, people do not need an annuity.  They are ridiculously expensive.  Second, if an advisor is trying to get you to put an annuity in an IRA, you can be sure he/she is not working in your best interest. There is no reason to have an annuity inside an IRA, it is just an sales tactic.  Finally, you will be better served in both the short term and the long term to work with an planner/advisor that doesn't receive compensation from any source other than you.  You work for whomever pays you and if you are the sole source of compensation for your planner then that planner will work for you or else you will fire him. And you can fire him with no surrender charges.

All I can say is beware the sale of financial products and cautious around those that sell them.  Many are indeed predators. 

On Suburban living, taxation and the sacrifice of following Christ

The power of blogosphere has once again become evident.  I came across this list from Josh, who found it via Steve, who posted it from Will, who received the thoughts from Chris.  I found these suggestions for suburbanites to be interesting, thoughtful and provocative.  If you live in a suburb and struggle with feeling apart of a community (particularly difficult if you don't have children in the local schools system) you may want to consider some or all of these suggestions.  If you are interested in living out your faith in the suburbs you might want to check out Will's book, Justice in the Burbs. I haven't finished it yet, but it is worth contemplation.

On another note, my new friend Steve Craven, after a discussion of tax policy one night at the poker table, reminded me of one of the macroeconomic principles that served as a foundation of Reagan's "supply-side" economics, call the Laffer Curve, or you might want to call it the Laugher Curve.

Reagan bought into the curve citing his own personal experience.  Saying that if he has the choice between making one movie or a second movie and being taxes at a higher rate, he would only make one movie (thus, in his mind, progressive taxes hurt productivity, since he, himself was less productive if it meant paying more tax). So much for making art for art's sake.  The reality of Reagan's own example is that it underscored his own greed and economic self-interest. Some people do things for something more than mere economic purposes.

Which brings me to the fascinating insight of Susan Pace Hamill.  She had a "conversion experience" while studying theology on sabbatical from her taxation professorship at the University of Alabama.  She began to truly explore and develop theology of taxation if you will.  You can read her ideas here.

I have heard Professor Hamill speak on a number of occasions, most recently at the screening of Golden Rule Politics. I have fallen in love with her distinction of "High sacrifice" theology vs. the prevalent "low sacrifice" theology.  This not only applies to how we should think about taxation inequities, but a host of other issues as well.  For example, citing common "pro-life" stances by the religious right,  she points out that they usually only focus on abortion, which is a low sacrifice issue, but focusing on infant mortality, pre-natal care for the poor, providing contraceptives that would actually lower the need for abortions, etc, is a high sacrifice stance. 

The same would hold true with regard to environmental issues.  Too many want to deny the affects of climate change and question the science because that is low sacrifice, but actually having to look beyond one's own economic self-interest for benefit of the environment is a high sacrifice issue.  Ultimately, she rightly asserts that the gospel of Christ is a high sacrifice position and woe to those who want the benefits of an eternal heaven without wanting to pay the sacrifice. As she would say, those of us who have the most have to sacrifice the most to help those with the least.  Perhaps, as  Reagan, Christians are motivated by their own economics rather than a firm commitment to the gospel as lived and preached by Christ.

Equally compelling was Dr. Jim Evan's analysis of the Republican triumph over the South in the last thirty years, but I don't have time to address that, perhaps in a future entry. Lot's of links in this blog, but worth the exploration if you have time.

I may have been wrong

I have protested the assessment of the "world going to hell in a hand basket" for some time now, but the evidence is mounting up against me. (ht. Buz)

Maranatha, please!

De-"fault" finances

I have always contended that that everyone has a financial plan, call it a default plan. The problem is that most have never thought about those default settings.  Some however do think about their plan and then make decisions accordingly.  If you need proof that perhaps an objective professional might can help, check out Timothy Bowers financial plan.

COLUMBUS, Ohio (AP) -- A man who couldn't find steady work came up with a plan to make it through the next few years until he could collect Social Security: He robbed a bank, then handed the money to a guard and waited for police.

On Wednesday, Timothy J. Bowers told a judge a three-year prison sentence would suit him, and the judge obliged.

"At my age, the jobs available to me are minimum-wage jobs. There is age discrimination out there," Bowers, who turns 63 in a few weeks, told Judge Angela White.

The judge told him: "It's unfortunate you feel this is the only way to deal with the situation."

Bowers said he had been able to find only odd jobs after the drug wholesaler he made deliveries for closed in 2003. He walked to a bank and handed a teller a note demanding cash in an envelope. The teller gave him four $20 bills and pushed a silent alarm.

Bowers handed the money to a security guard standing in the lobby and told him it was his day to be a hero.

He pleaded guilty to robbery, and a court-ordered psychological exam found him competent.

"It's a pretty sad story when someone feels that's their only alternative," said defense attorney Jeremy W. Dodgion, who described Bowers as "a charming old man."

Prosecutors had considered arguing against putting Bowers in prison at taxpayer expense, but they worried he would do something more reckless to be put behind bars.

"It's not the financial plan I would choose, but it's a financial plan," prosecutor Dan Cable said.

Copyright 2006 The Associated Press. All rights reserved.

Losing Money

I spoke to a local rotary chapter last week, in rural Alabama. The folks were great and welcoming and I got to visit an area that I had not been before. I spoke on "How to get behind: Guaranteed ways to lose your money." The presentation went okay, but I have been thinking about stupid things people do with their money. Here is a list of a few:

• Buying New Cars
• Buying Any Car often (if you buy a car more than every 5-7 years, you are being stupid with your money)
• High Expense Ratio Investments
• Load funds
• Cash Value Insurance
• Annuities- Stay away from annuities unless you have an objective source tell you that you need one
• Starbucks
• Liquor- I love a good wine, but great day, the price of scotch!
• Living in a neighbhorhood you can't afford
• Not saving for retirement when they are in their 20's
• Not saving for retirement in their 30's
• Saving for College before saving for retirement
• High Priced Clothes
• Fishing
• Toys

Is Dave Ramsey Right?

I often get asked about what I think about Dave Ramsey.  If you don't know who Dave Ramsey is, he is the evangelical, bombastic, personal finance radio celebrity.  His show has become widely popular, even appearing on the famed CBS news show Sixty Minutes. His show is taped delayed in Birmingham on a popular AM station. 

Clearly people are listening and he is known to take his show on the road, often meeting in large churches, charging admission to hear his rant against credit cards, debt, and ridiculous financial behavior.  He also sells his books, CDs, subscription services and church programs like Financial Peace University.

So what do I think? 

First, what is right about Ramsey.  When talking about basics, he entertainingly speaks about what should be common sense.  Stuff like, you can't spend more than you make.  Wow, now that is novel!  I also find some of his counsel regarding debt management to be helpful.  I don't subscribe to his "All debt is evil" philosophy and his biblical proof texting is disconcerting, but clearly many American's have some real debt issues and he does have something to say to that issue. I often agree with his assessment of the American fascination with the automobile.  My opinion is that automobile purchasing can be one of the most detrimental obstacles to achieving financial independent for middle income folk. So while, he is over the top, there are some snippets of truth in his advice. 

But beyond that, I have some real problems with Ramsey, including, what I consider to be a hypocritical, inconsistent philosophy with regards to many other things regarding personal finance.  After all there are other financial concerns beyond debt ratios and savings rates. 

The thing to remember is that Dave Ramsey is all about DAVE RAMSEY. You don't have to listen through more than one segment of the show to realize that this joker is a salesman, not a financial professional, which his is discreetly disclosed in an obligatory statement concluding his show. He is a marketing extradionairre and is willing, in my opinion, to compromise consistent financial practice in order to increase his network of advertisers and ELPs (endorsed local providers).  By the way, in case you are wondering, his endorsements are for sale, and it is not cheap. 

His investment philosophy is goofy at best and harmful at worst.  Ask him and he will tell you to just go out and buy growth stock mutual funds, but he rarely says more. Is he speaking of growth as an asset class? Large Cap or Small Cap?  What about value funds, which outperform growth historically? And how do you choose which fund of 17,000+ funds that are out there. He doesn't elaborate, but he doesn't mind telling  you over and over that his funds (which he never names) average 17-18%!  This is just irresponsible, particularly considering that his audience is often desperate and take his words as gospel.  A year to year expected return of 17-18% is not realistic over a time horizon of any length. 

His asset allocation of 25% aggressive growth, 25% growth, 25% small cap and 25% international that he often lauds, is not good advice either.  He has no concept of risk tolerance and if he thinks that the above mentioned asset allocation classifies as diversification, well he is wrong.  Folks, risk is real and is as important as return.  To chase return with no regard for risk is irresponsible and would get any real investment adviser sued in a heartbeat. 

Another real concern is his unwillingness to speak to the inherent conflicts of interests that exist with commissioned and/or fee-based financial advisers.  This does not seem to match his persona of being a champion of the people.  I have looked at some of his ELPs and I can tell you that I would not get close to some of them with my money.  He wants to bash the insurance agent, but those same problematic practices exist in commissioned/ sales based investment products.  But guess what, to speak about to those issues would cost him money.  It is a double standard, wrong, and borders on the unethical. 

Finally, the fact that he markets heavily in the church is a problem for me.  Many adherents of faith communities will indiscriminately accept his advice because for them it has become legitimized  because they heard it in their church house or faith community. 

Does Dave do some good?  Yes.   But  I would advise you not to stand too close to the sheep, because there are some wolves nearby.