Economy | Control Your Cash: Making Money Make Sense

We Learn Nothing

January 13, 2012 4 Comments

We're going to need more chairs

Not that many years ago, real estate was regarded as a safe investment. Now it’s the butt of jokes. What happened?

Fannie Mae (formerly the Federal National Mortgage Association) is one of the government-sponsored enterprises entrusted with making it easier for people to afford homes. Its sibling, Freddie Mac (né Federal Home Loan Mortgage Corporation), is another. A cousin, Ginnie Mae (Government National Mortgage Association) does pretty much the same thing, the big difference being that Ginnie Mae doesn’t pretend to be a private company.

One-paragraph summary:

You borrow money from ABC Bank to buy a house. Now you have a house, and ABC has your promise that you’ll pay them, say, $250,000 (with interest) over the next 30 years.

(On second thought, there’s no way in hell we can do this in one paragraph.)

That promise, from ABC’s perspective, is an asset. Of course it is, it’s money coming in. An annuity, if you will. ABC can then sell that asset to a secondary lender (ABC is the primary lender, duh) such as Fannie Mae.

ABC now has cash from Fannie Mae, cash that ABC can loan out. Loaning out money is the very purpose for a bank’s existence, thus ABC is happy with this situation. If ABC loans that money out to someone else for a mortgage, then if all goes according to plan, now you and that other person will own houses, instead of just you.

Fannie Mae was founded by the federal government in the 1930s, under the principle that having as many people as possible owning houses (and, by extension, owing banks money) was a goal worth pursuing. The logic went that with more liquidity – i.e., more money to be loaned out – not only would more people be able to afford homes, but mortgage interest rates should lower, too. A self-perpetuating cycle of easy loans for everyone!

I don’t understand what Fannie Mae is getting out of this. Wouldn’t they have to pay a premium to ABC for the transaction to be worth ABC’s while?

Yes. Fannie Mae pays the bank a ¼% servicing fee for the life of the loan.

Oh, I see. So Fannie Mae loses money on every loan. Sounds like a great way to do business.

Fannie Mae gets to borrow from the U.S. Treasury at extremely favorable rates. Currently ¾%. So with the average 30-year mortgage going for about 3.96%, Fannie Mae comes out way ahead.

So it’s the U.S. Treasury that’s losing money on every loan.

Yes! Isn’t “capitalism” great?

Now, Fannie Mae doesn’t just hold onto that money. It assembles your $250,000, your neighbor’s $281,384.34, and several other mortgagors’ loans into a multimillion-dollar mortgage-backed security. Then it sells that mortgage-backed security to an underwriter. The underwriter pays a higher interest rate to Fannie Mae than the ¾% at which Fannie Mae borrows from the U.S. Treasury, so Fannie Mae is happy. The underwriter is happy, because it has cash on hand (again, to loan out) and is paying a fairly favorable interest rate. But that rate is artificially low, because it’s based on the artificially low rate that Fannie Mae borrows from the U.S. Treasury at.

Isn’t this creating money out of thin air?

It’s creating “liquidity” out of thin air, which is almost the same thing.

With the creation of Fannie Mae and its relatives, the federal government effectively lowered the requirements for a prospective homeowner to get a mortgage. To the point where people who weren’t yet ready to own houses were owning houses. Some of whom were never going to be able to pay their mortgages back, and who got foreclosed upon.

Well, couldn’t lenders just charge those people sufficiently high interest rates that it’d be worth the increased risk to lend to them?

Of course not, this is America.

In the ‘90s, the government ordered Fannie Mae to keep a minimum percentage of its loans in mortgages for “low- and moderate-income” borrowers. By 2007, fully 55% of Fannie Mae’s loan originations were with such borrowers. The government then prohibited Fannie Mae – which is to say, the primary lenders who sold loans to Fannie Mae – from charging “predatory” rates.

So lenders were left with two choices: continue doing business with Fannie Mae, and risk losing money on bad clients; or don’t do business with Fannie Mae, and set their own high rates for borrowers with poor credit histories who didn’t deserve to borrow money at prime rates (the infamous “subprime market”.)

If lenders went with option B, they could create their own mortgage-backed securities, with higher interest rates and higher volatility. Those privately fostered mortgage-backed securities then hit the market, at which point people stopped buying Fannie Mae’s mortgage-backed securities (at their comparatively low interest rates.)

So Fannie Mae started offering higher, more competitive interest rates. The free market at work, right?

Sure, except Fannie Mae and Freddie Mac only pretend to be private corporations with stockholders and everything. The federal government goes to great lengths to explain that Fannie and Freddie are not branches of itself. Functionaries can quote you the 1968 act that led to Fannie Mae being named an “independent” company. In reality, the government wanted to remove Fannie Mae’s obscene levels of debt off the national balance sheet (cf. Abraham Lincoln, a tail ≠ a leg). Investors and customers alike continue to treat Fannie Mae as a branch of the government, with an implicit government guarantee if not an explicit one. Put it this way: if your elected representatives committed billions of dollars of your tax money to AIG, General Motors and Chrysler, they’ll do it for Fannie and Freddie. Again.

Which would you rather invest in, assuming each had the same credit rating: private or Fannie Mae mortgage-backed securities?

The latter offered returns similar to the former, only with that implicit guarantee. Therefore people bought more of them. To create more mortgage-backed securities, Fannie Mae made more and more low-interest, sketchily underwritten loans. A private bank like Lehman Brothers can die a quick death and leave the remaining banks healthier. But there’s no concept of culling the herd when it comes to Fannie Mae.

(There is nothing government can’t ruin. Vote Ron Paul.)

Meanwhile, because of the low mortgage rates Fannie Mae was responsible for spawning in the first place, millions more people bought houses than otherwise would have. Too many people chasing too few houses means prices rose. A “bubble”, if you will. Then borrowers started defaulting, and lenders realized that they didn’t have enough collateral to cover debts.

When there’s downward pressure on primary mortgage loans, and upward pressure on secondary mortgage loans, something has to give. Add to that the underqualified people who couldn’t make their mortgage payments, and thus got foreclosed on, and the result was even more houses sitting empty. By 2008:

-Fannie Mae and Freddie Mac either owned or guaranteed half the residential mortgages in the country.
-As “independent businesses”, “free of governmental control”, and publicly traded, their stocks began to drop. In the case of Fannie Mae, 99.66%:

It’s almost impossible to lose a higher percentage than that, yet Freddie Mac managed:

-As investments, Fannie Mae and Freddie Mac were effectively worthless.
-The Secretary of the Treasury, operating under the orders of his boss, lied through his teeth and told the public that Fannie Mae and Freddie Mac were financially sound. No one who’d examined the issue could possibly believe this, but the public at large might have.
-Someone owned Fannie Mae’s and Freddie Mac’s mortgage-backed securities. Actually, lots of people. Foreign governments, retirees’ pension funds, etc. The argument went that if Fannie Mae and Freddie Mac were officially deemed worthless, disaster would occur. As if requiring half a trillion dollars from American taxpayers didn’t qualify as a disaster.

So the federal government did exactly that, putting you on the hook for every horrible decision made by entities that created no value in the first place, and distorted the market by their very existence. It would have been less damaging to have simply cut a five-digit check to each family that wanted a house and didn’t have the money for it.

Fannie Mae and Freddie Mac aren’t subject to the same capital and diversification requirements that private banks are. Nor do Fannie and Freddie ever have to worry about having their loan portfolios reviewed by regulators, nor rely on those same regulators to give them a safety and soundness rating.

Today, Fannie and Freddie continue to have a hand in most residential mortgages. They still lose staggering amounts of money – $14 billion and $22 billion last year, respectively. And as we’ve seen, their stocks now trade on the over-the-counter bulletin board, the Canadian Football League of securities trading.

Fannie Mae’s chairman made $6 million (of your money) last year, Freddie Mac’s $4 million. Yet none of those Occupy Wall Street vermin protested outside their respective headquarters. Merry Freaking Christmas.

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Filed Under: Bad Examples, Consumer Debt, Economy, Education, Newsflash

Warren Buffett is a Hypocrite, Part I

September 23, 2011 5 Comments

Amass an 11-digit fortune, and you should probably forgo a name tag

We’ve never done a post on The Oracle of Omaha, which makes us unique among personal finance blogs. We also didn’t misspell his name as “Buffet”, which also makes us unique among personal finance blogs.

Yes, he’s the greatest investor of all time. No one disputes this. The problem is when he starts talking about topics he either knows nothing about, or is being deliberately obtuse about. Amassing wealth doesn’t make you an authority of every subject. Case in point, his recent lament about taxes.

Buffett wrote in The New York Times that the current progressive tax system in this country, in which rich people bankroll most everything, just isn’t progressive enough. He pointed out, yet again, the absurdity of his secretary paying a higher percentage of her salary in taxes than he does.

Summarizing, Buffett claims that at least one of his employees allegedly pays an effective tax rate of around 41% on income, while Buffett himself pays 17%.

First, the former claim is a lie. The highest marginal tax rate in this country isn’t even 41%, let alone the highest average tax rate. The highest marginal tax rate is 35%, and given the income level at which the IRS administers it, to pay an effective tax rate of 35% you’d have to make $6 million a year.

So Buffett’s not comparing himself to the woman who answers phones at Berkshire Hathaway. He’s comparing himself to a manager who makes a higher salary than almost everyone in America, even more than your average NBA or major league baseball player.

We’re giving Buffett the benefit of the doubt here, assuming that he meant 35% instead of 41% even though those numbers are easy to distinguish. No one knows where he got the 41% figure from.

Furthermore, that 35% maximum rate is on taxable income. Anyone who’s ever filled out a 1040, or had someone else do it, knows that taxable income is considerably less than total income. There are these things called deductions and credits, which Buffett is presumably familiar with (and which any manager who makes $6 million a year must be familiar with, too.)

It makes for a great class warfare talking point: every dollar that I fail to make is somehow some richer person’s doing. And who better to inspire envy among the poor salaried millions than a tycoon who’s finally seen the error of his ways?

Buffett – and we salute him for this – has spent a lifetime earning money via capital gains, rather than salary. Do we think this is a good idea? Hell, we wrote a book about it.

Capital gains are taxed at lower rates than salaries are. The people who write the tax code, and make it the most cumbersome and impenetrable thing on the planet, ensure this. Of course they do. Legislators write the code to accommodate and exploit this, because they derive most of their income through capital gains.

Let’s assume that Buffett indeed has employees who are paying twice the proportion of their income in taxes as he is. What’s the fairest way to make things fair? Again, multiple-choice.

Further soak the rich.
Get government’s foot off the throat of the poor.

Raise the rich people’s taxes to make things even, or lower the poor’s? Rich people seem to enjoy being rich. Why not reduce rates on the salaried masses to put them in line with whatever Buffett’s definition of “rich” is, instead of the other way around? Instead of creating prosthetic limbs for amputees, Buffett wants to break the right arms of the able-bodied.

The reactionary answer is “Because it’ll reduce much-needed tax revenue.” It wouldn’t. People respond to incentives, and will have incentive to work harder, longer hours if they get to keep more of what they make. When I can keep 84¢ of my next marginal dollar, there’s a better chance I’ll work for that dollar than if I only get to keep 67¢.

It’s the height of arrogance to complain about the tax system not because it hurts you, but because it benefits you. Especially when there are so many ways for Buffett to fix this perceived injustice. Sure, he could cut Washington a check for whatever amount he feels he should be paying. He could increase his employees’ pay enough to offset any tax advantage.

Or, and this is the least likely of the three, he could rework the dividends that flow through his corporations so that he could receive all his income as salary, rather than capital gains. The chance of this happening is roughly equivalent to the likelihood of Buffett running a 4-minute mile.

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We’ve been pushing the concept of a diagonal tax since we were old enough to understand the concept. Everyone gets a basic personal deduction – say $20,000 – and pays some percentage – say 17 – on the rest.

The guy making $6 million would thus pay 16.94% of his income in taxes. The guy making $30,000 would pay 6% of his income in taxes. The guy whose net worth increases $10 billion in a year would pay 16.99997% of his income in taxes.

People who want to soak the rich should love this system. It treats the rich and the hyper-rich almost identically, biting them almost 3 times as hard as the working stiff, relative to what all three make. If that’s not enough, just manipulate the deduction and percentage numbers until it all makes sense.

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Filed Under: Bad Examples, Economy, Education, Estate Planning Tagged With: IRS, liar, marginal tax, tax rates, warren buffett

Au M G!

September 2, 2011 3 Comments

This bears revisiting, yet again. 88 weeks ago we encouraged you to look at the “rising” price of gold from a different, opposite perspective.

Why is “rising” in quotes? Because it implies that gold is getting more expensive, when technically all it means is that it takes more dollars to buy the same amount of gold than it did previously.

No, that’s not splitting hairs. It’s a distinction with a gigantic difference. Again, it takes more dollars to buy the same amount of gold than it did previously. In other words, each dollar now buys less gold.

Why do we assume that it’s the dollar that’s the consistent source of value and the gold whose price is deviating from some norm, rather than the other way around? Especially since the supply and inherent value of gold are far less subject to political pressure and artificial maneuvering than are the supply (and inherent value) of the dollar?

We proposed that instead of quoting the price of a fixed quantity of gold in dollars, we quote the price of a dollar in the corresponding amount of gold. Hence a new makeshift currency, the Aumg (milligram of gold.)

For instance, as of this writing the price of gold is listed as $1830 per ounce. Using the reciprocal of that, a dollar is thus worth .00056 ounces of gold. Clearly ounces are unwieldy units to use here, so instead we use milligrams. There are 31,103 milligrams in a troy ounce*, therefore a dollar is worth 17 Aumg.

Which means nothing on its own. Instead me have to look at comparisons over time and across currencies.

When we first devised this idea, the dollar was trading at 30 Aumg.

Last November, it was down to 22 Aumg.

And in 1968, it was worth 883 Aumg.

It’s not as if gold suddenly got less plentiful over the last 43 years, or even the last 43 weeks. The world’s gold reserves didn’t exit the atmosphere and head for Venus. It still takes unbelievably long man-hours and prohibitively expensive capital investments for mining companies to dig gold out of the ground and turn it into something shiny and marketable. That’s part of the reason gold has been such a constant source of value throughout human history: unlike oil, natural gas, pork bellies or other commodities, the annual output of gold stays consistent (and low, especially relative to what’s already been mined.)

Dollars are a different story. First off, they’re artificial. They’re an arbitrary representation of value, created and put into circulation by a government that controls all the printing presses. Not to go Montana Freeman on you, but even the most ardent monetarist in the world would have to concede that. It’s a fact, not an opinion. And because dollars are imaginary, there’s no limit to the number of dollars the government can create. If Federal Reserve Chairman Ben Bernanke orders the Fed to create $38 octillion, it can and will. The number isn’t even limited by the amount of paper and ink available: all the Fed would have to do is increase the denominations.

Dollars are imaginary, but that doesn’t mean they’re worthless. (You can place an ad on the ControlYourCash.com sidebar, and we’ll take dollars as payment. At least for now.) But look at the numbers above if you don’t believe they’re a declining source of value.

So who cares? Prices rise, wages rise correspondingly. They’re just numbers, right? My grandparents bought a house for $40,000, but it still represented 4 years’ wages like a similar house would today. What’s the problem?

The problem is that the government owes money. Lots of it. To future retirees, to foreign governments, etc. The federal debt is the largest dollar figure regularly quoted in the media. Either those bills need to be paid, or the government must default.

Government “of, by and for the people” means that 1/300,000,000 of that debt is yours. If that sounds overwhelming, you can thank the representatives and executives you chose to represent you.

Those payments are quoted in dollars. An insolvent government has every incentive to weaken the value of each dollar it owes. It does that my printing more of them, making each dollar worth fewer and fewer Aumg.

Here’s all the proof you need that the number of dollars in circulation isn’t close to keeping pace with the gold in circulation. Those annual increases in the money supply far exceed any increases in population.

What does this mean for you? Relative to the pound, the euro, and the Canadian dollar, the U.S. dollar might stabilize. It might even increase in value. But relative to gold, wagering on the dollar is a losing bet.

Unless that federal debt gets any smaller.
(Try to contain your laughter.)

*You know that childhood brainteaser, “What weighs more, a pound of feathers or a pound of gold?” The answer is the feathers. Metals are measured in troy weight, just about everything else is measured in avoirdupois weight. An “everyday” ounce is larger than a troy ounce, and besides, there are 16 avoirdupois ounces to an avoirdupois pound as opposed to 12 troy ounces to a troy pound.

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