Belligerati

Something new to consider:

Second mortgages, which in the case of default only get paid after the first mortgages are paid off were more likely than first mortgages to be held on the banking books.  This challenges the idea that the securitization of mortgages was what caused the problem because even though these securities had more risk than first mortgages the banks held on to them. If banks knew mortgages were risky then why did they hold on to the riskiest ones? This isn’t like the the super senior tranches of CDOs that the banks lost billions on. Those losses were tail risk (that a lot of them could go belly up at once). That is, those structures lost money in the event of huge falls in many home prices which could have been a low probability even but unfortunately which happened. But second mortgages were held outside of CDO and ABS structures. As such, banks lost money on the first dollar of housing losses and would lose money dollar for dollar as people defaulted on their second mortgages. The trillion dollar question is why did do it?

HT: The second-mortgage underwriting failure

Maybe this is why:

When mortgage modifications like Hamp [Home Affordable Modification Plan] come into play, that traditional priority order is reversed. The borrower is paying the Hamp-modified (i.e. lower) first lien amount, and the full second lien amount, so the second lien effectively becomes senior to the first.

The second lien sticking-point

If banks were getting a higher rate of interest and knew in the event of any mortgage modification that they would be made whole, maybe they’d get paid enough to take that extra risk. But given that almost no mortgages have been successfully modified, and the HAMP rules were put in place afterwords, how could banks have expected that to bail them out? And if secondary lien banks are getting such a great deal out of HAMP, why are so many seen as an obstacle to putting in place modification plans?

This leaves us with many new questions and no new answers. It could well be a generation or longer before we really understand what caused this financial crisis.

Many of you know that one of the classes that I TA is a portfolio theory and practice class, where students learn the how and why of constructing mean-variance efficient portfolios for investors. As part of the class students are expected to put together a final project that involves constructing an investment plan for a client that is mean-variance efficient. I’ve taught the class a number of times now. My experience is that  students seem to come to believe the core lessons of the class, to keep expenses low, diversify,  invest in asset classes rather than picking individual assets, and to distrust alpha (investment managers who claim to have the ability to outperform markets without taking exotic risks).

One place where students often end up taking a different position than I do is exchange traded funds (ETF). They like them because they see them as having ultra-low fees. ETFs performs similar to a mutual fund but you buy and sell it on the stock market rather than from a mutual fund company. As such, you generally pay a a brokerage fee to buy it and again to sell it.  Many people don’t know that you also pay annual fund operating expenses, just like a mutual fund.

For example, SPDRs perhaps the most liquid and popular exchange traded fund in the world have an .09% annual operating expenses. That’s 9 cents on each $1000 invested per year.  In contrast, the Vanguard 500 Index charges 0.18%, Fidelity Spartan 500 Index charges 0.10%, and the Schwab S&P 500 Index charges the same 0.09%. Yet all three of these funds track the same underlying portfolio, a market weighted portfolio of the 500 largest publicly traded US corporations with little tracking error. So even you didn’t have to pay to trade ETFs, it would take a long time to make an economic difference. Say after fees and inflation you can get 7% on the SPDR and 6.99% on the Fidelity Spartan. To make things simple we’ll ignore reinvestment issues (which advantages mutual funds, more on this later) and just assume we can annually compound your investment of $10,000 at the two rates. After 30 years you’ll have (on average)    $75,909 with Fidelity and $76,122 with the SPDR ETF. That’s $213 extra for your troubles.

What troubles? Mutual funds typically allow you buy and sell them without and fees (if has  fees for this  you probably should get one that doesn’t) where as ETFs have fees to pay in both directions, plus bid ask spreads (which are small but still count). Call that $8 on each side (buying and selling). Now the ETF advantage over $30 years is down to $144.65 per $10,000 initial investment even without the reinvestment issues.

Also, unlike the stock market you can buy fractional shares.  As of right now, SPDRs trade for $109.82 each. So if you have $439.28 to invest you are all set. On the other hand, if you have say $500 to invest, you can buy $439.28 worth and then save the remainder until you have enough to buy another share. In a mutual fund they’d happily sell you 4.55 shares. Similarly, this is a problem for reinvestment. when you get a bunch of dividends in a mutual fund you can buy .25 more shares, which in the ETF you have to wait in some way until you have enough to buy a share. Which means that you are not fully invested in the stock market as you intend to be and over the long haul you get a lower return. Obviously if you have a lot to invest this isn’t a huge deal. You’ll get approximately one share in quarterly dividends for each $22,000 you invest. Fractional investments  mean uninvested money. But, you have to pay that trading fee on reinvesting those dividends (unless your have a decent drip program which you can’t always get and I believe generally can’t with ETFs) , so you end up with much higher total expenses because you end up paying $8 every time you have dividend. At $32 in reinvestment fees a year it only takes a few years to eat up that lower fee. Over that 30 year investment from before, the break even is now about $70k.  Any less than that and you make out better with the mutual fund even ignoring univested capital.

Finally, if you ever work for a bank or financial firm they are going to want you to put your money into their brokerage system. Chances are when they do it will be a full fee brokerage, charging a great deal more than $8 a trade. So the economics get even worse if you work in finance or consider a full fee broker over a discount one.

My closing advice is that in general one should invest in a series of index funds that expose you to your desired asset classes, and reinvest the dividends and interest.  This is a relatively low cost, liquid, and simple financial plan that mostly takes care of itself except for the occasional re-balancing issues that also exist for an ETF strategy except that they are more expensive in that case.

As I understand it, you can use non-retirement income to convert the balance in your non-Roth (pre-tax contributions)  into a Roth balance (after-tax contributions). I’ve ended up with a non-Roth IRA from rollign over my 401k after I left to go back to school.

There are several factors. For one, I’m currently in a lower tax rate than I expect to be soon or at retirement. After the conversion I’d have to pay taxes on the entire balance I’d convert, but it wouldn’t be at too high a tax bracket. Second, I expect tax brackets are going up, so better to convert now while tax brackets are lower.

On the other hand, I’m not so sure that the government will really keep its mitts off my cash once I pay my taxes on it. If the government switches to a consumption tax (VAT style) or just decides to tax Roth IRA withdrawals directly than I’ll be taxed twice and this will be a loser.  Also, conversions are tricky and I could mess it up.

Any thoughts?

A reader suggests:

Re: para. (3), I wouldn’t have any concern about the imposition of taxes on previously taxed income.  any change will surely have a grandfather clause.  This is a nil probability event to me.  The consumption tax is more plausible, but still a long ways (politically) off.  I wouldn’t plan with that uncertainty in mind; disregard it safely.

Another reader suggests:

Assuming a 3~4% growth rate in investment you should always make out with the Roth. If you investment return is not so good… like the past 15 years… then maybe its not.

Certainly, I would have made post tax (Roth style) contributions if I had the chance  while working and I was at a higher tax rate then, which suggests that I should do it now that I have a lower one. However, I might not have invested as much. To make up some numbers, if you have 20 grand in a non-Roth IRA and you convert it paying $10k in taxes to end up with $20k in a Roth IRA then you’ve put 40 grand in pretax income (20k initial non-roth and 20k to earn the 10k to pay the taxes).  So the after the tax paying contribution I might just end up with with putting too much of my wealth into retirement savings.

Back in December I wrote a post on the possibility of Greece defaulting on its debts because no one seemed to want to lend them any more money (What would a bankruptcy by Greece mean for the Euro?). This is happening because they are unwilling to cut spending to match their national income and have now borrowed so much money that creditors are starting to doubt that they will be repaid.

Now much of the English language press is jumping into the discussion  with the Economist (A Greek bailout, and soon?) and the NY Times (The Not-So-Safe Euro Zone) discussing it.

The argument is effectively summarized by the Times:

The economic fortunes of all the euro-using countries are too tightly linked to contain the crisis to one of them. And Greece may not be alone for long. Similar financing crises could soon hit Ireland, Spain and Portugal. Market anxieties threaten the currencies of Poland, Hungary and the Czech Republic.

This contagion worry is only a real threat if Greece’s problems are problems of liquidity rather than solvency. If Greece is good for the money but having temporary borrowing problems then this liquidity crisis could actually cause the very problem that individual borrowers are seeking to avoid when refusing to lend. But if Greece has deep problems repaying what it has borrowed already, lending them more money is unlikely to make things better.

But what if markets are confused. What if they cannot tell the difference between failing for liquidity and solvency issues. Then markets see a failure for Greece (even though their problems are structural) as a problem for everyone and they cut off the poor and small European countries for debt markets. Is it possible that the best policy is to just bail out Greece to prevent the contagion?

I doubt it. For one, the expectation of just such a bailout may well be why Greece hasn’t sorted out its financial troubles. So how can we provide poor and small Euro countries with an incentive for live within their means while simultaneously using the superior financial strength of larger and richer countries to protect those less stable  countries from panics? One way would be to say that they won’t bail out Greece but they will bail out any other countries that get into trouble.

But then once (if) Greece goes belly up other countries lose the incentive to maintain financial discipline. So one thing we could add to this is that bailouts will be larger in the future (for the third failure and later).  That way countries have every incentive to secure private financing, sell off gold, art, and land, pass austerity budgets and otherwise manage to fail later. High profile assets like these could easily be used as collateral for repos as well.

Update:

The Greek government has just unveiled a new fiscal austerity plan