Navigating Treacherous Waters, Part III

This is the third part of a three-part series. Part I can be found here, and Part II can be found here.

*As usual, please remember that I am not a financial advisor and that these posts of mine are not advice for you to take without talking to your own financial advisor and giving serious thought to your own finances. Seriously.

So we have good guesses as to the origins of the present crisis and have some good practical tips for the kinds of short-term things we ought to be doing. What next?

First let me say, somewhat tangentially, that President Bush’s speech last night was, in my opinion, a fairly clear and concise summary of the recent crisis, and it did a good job of conveying the urgency behind finding a solution. Some may decry him as being too much the Chicken Little, but I suspect the urgency is warranted. As the President said, the first priority is freeing up the financial markets and stemming the risks of further market degradation; then we will be able to turn to issues of market regulation and enact policies that make sense more than mere knee-jerk reactions that stifle us all.

Anyways, here’s my quickly-scribbled wishlist for some policy changes, both near and far-term. None of this is particularly noteworthy.

–Better regulation of the credit rating agencies, particularly with regards to securitized assets. It is clear that a AAA rating on a CDO is not the gold star of secure investment that such a rating ought to be.

–Vetting of prospective borrowers and lenders. This is a hard one. I don’t like the idea of telling young couples that they cannot buy their dream house — and I also don’t like the idea of telling a bank that they cannot loan money to such young couples because it would be too risky. But it is obvious that somehow we all started thinking that home ownership is a right, and lenders were eager to use predatory lending practices and foist balloon loans on unsophisticated borrowers. The weak need to be protected here, and we all need to be protected from the marketwide damage that can occur when poor loans are granted on a massive scale.

–Limits on CEO pay. I believe Warren Buffett when he says that CEO pay is the barometer of our willingness to regulate markets.

–Higher taxes for the top 0.05% earners. Yes, I know Mormons hate taxation (as Satan’s corrupted form of the United Order). If any of you are top 0.05% earners and don’t like my proposal, email me and we can talk about it. Better still, hire me and I’ll revise my post.

–Fewer foreign wars. Wars are EXPENSIVE.

–It seems to me we need a better market clearing mechanism so that the downfall of any single entity is not capable of generating marketwide instability as it has.

–Freddie Mac/Fannie Mae need to be spanked. I would seek some serious investigation of their former executives.

–Executives of failed institutions (or those who stand to survive only via the bailout) should forfeit their bonuses (and possibly their salaries for a limited period). They have failed in their jobs.

Now, some general thoughts on long-term investing.

First, I believe the Church’s general financial advice is immensely valuable in this respect. Provident Living has a number of articles and thoughts on investing and managing your money, and I believe it’s good advice. The epic pamphlet One for the Money is worth printing out and reviewing. Elder Marvin J. Ashton wrote that sucker in 1975 and it’s still great today.

Second, I think the most important thing is to keep going. Keep working, keep saving on a regular basis, keep on spending less than you make. Keep maxing out your 401(k), keep contributing to your Roth IRA. Keep using a flexible spending account for medical expenses. Keep using an FDIC insured online savings to make sure your basic accounts are earning interest. Don’t make rash financial decisions, don’t needlessly second-guess yourself and micromanage your investments. Similarly, don’t get overconfident — just because there’s a bailout for Wall Street today doesn’t mean that there will be another one, or that anyone will be there to pick up the pieces if you make bad investment choices today.

Third, I would get educated. Basic self-help books like The Millionaire Next Door or Rich Dad, Poor Dad are a decent starting point. The Wall Street Journal puts out a small book on personal finance that is pretty helpful. More important than book-learnin’, learn your financial state. You should have a pretty darned good idea all the time of what you are worth. That short-term list of assets and liabilities should be constantly updated.

Fourth, I would get organized. Organize your taxes, receipts, etc. But put your house in order generally. Get term life insurance. Get a living will and trust set up. Organize your assets so that they will pass efficiently should anything happen to you. Make sure your spouse knows where the keys to safe deposit boxes (and passwords to bank accounts!) are to be found.

I welcome your thoughts.

Comments

  1. PS – Ardis, I hope you can breathe easy now!

  2. Whew! I was turning purple!

  3. Aaron Brown says:

    I’d be interested in hearing you say more on the pros and cons of limiting executive compensation. I mean generally, and not with specific reference to the heads of failed institutions (where the correctness of your recommendation seems more intuitive to me).

    AB

  4. AB, I hate to say too much about it, because I don’t like to pee upstream. But it is clear to all, I think, that executive pay has far outstripped the risks and added value of such positions, SOX notwithstanding.

  5. I don’t like the idea of telling young couples that they cannot buy their dream house — and I also don’t like the idea of telling a bank that they cannot loan money to such young couples because it would be too risky.

    But I think this has to start happening more… If the couple truly isn’t financially ready for home ownership, then they should wait…

  6. Steve Evans says:

    Queuno, I agree — and traditionally banks would be smart enough to evaluate risk and turn people down, but they haven’t done so for 10 years now. If we are talking about top-down regulation limiting banks, that is something different.

  7. Executive salaries tied to the total salaries of the non-executive employees? Perhaps X% of the net revenue? Or maybe it can be a function of the federal taxes actually paid by the corporation? :)

  8. Mark Cuban had a comment that the CEO of any company bailed out should not be paid more than the Treasury Secretary or the President… Not a bad idea.

  9. IMHO, I think crazy loans like the ones Clinton authorized under Freddie and Fannie could be ok, if the number of these loans available was regulated.
    It is common for cities and counties to have non-prof organizations that offer money down for lower income families to get into a house. However, they only have so much money available every year to do this, when it is gone, it’s gone. Something similar could be done with banks when handing out higher risk mortgages.
    Supposing banks would have to have a risk balance regulation–they could allow their portfolio to contain 80% low risk mortgages and 20% (easy numbers for the sake of argument) higher risk. If they could not go over that limit, then even if the high risk group failed, they would not forced the economy to into recession. Regulations by Freddie and Fanny could force the risky mortgages to be offered to only low income people.
    We’re still not talking dream house, but house.

  10. Steve Evans says:

    Read Page 20, here (I really like Warren Buffett, in case you couldn’t tell).

  11. In addition to page 20, pages 2 and 6 are great.

  12. Please don’t perpetuate the idea the Rich Dad Poor Dad is a good book for financial newbies. Haven’t read the Millionaire Next Door but I’m deeply suspicious of any book that confuses correlation with causation and completely ignores survivorship bias.

    The WSJ guide you recommend is rock solid. As I wrote elsewhere some time ago, some good books for beginners are:

    “Smart Women Finish Rich” and “Smart Couples Finish Rich,” both by David Bach, are easy to understand starting places. Bach makes a fetish out of brewing your coffee instead of buying it at Starbucks, but his advice is sound.

    “The Wall Street Journal Guide to Understanding Money and Investing,” by Morris and Morris covers market basics. If you don’t know the difference between a stock and a bond or understand the significance of the federal funds rate you should read this book.

    I like the “Wall Street Journal Guide to Understanding Personal Finance,” again by Morris and Morris, because it covers a wider range of considerations than the other books I mentioned–getting into thinks such as life insurance, taxes, mortgages etc.

    Finally, “Against the Gods” by Peter Bernstein is a fun book on risk that helps investors think about the difference between “skill” and “luck”

  13. Also Rich Dad Poor Dad is not a good book for the financially sophisticated–but they already know that. It is dreck.

  14. Thanks for doing this series–it’s been very helpful for me!

  15. Steve Evans says:

    Mat, Rich Dad Poor Dad is a bit odd, but the idea of focusing on cash-generating assets is a great great concept. Also Kiyosaki does a good job emphasizing financial knowledge generally.

    Re: Millionaire Next Door, you should read it — it doesn’t have the confusions you describe and is pretty clear as to its limitations.

  16. Steve Evans says:

    And yes, I know that RDPD is the nuskin of financial advice. But it’s accessible and better than nothing, if it came to that.

  17. Sumer Evans says:

    I somewhat agree with Mat on Rich Dad Poor Dad. Instead, a good book with some solid financial advice for beginners would be The Total Money Makeover by Dave Ramsey. It emphasizes organization and financial responsibility.

  18. Steve Evans says:

    Jezebel! Our house is a RDPD house!

  19. Steve,

    Kiyosaki (with Sharon L. Lechter C.P.A.)’s book is good for getting people excited about investing, but it has way too much fundamentally unsound advice along the way. Besides, how can you trust a book that became a best-seller thanks to Amway distributors?

    I understand the premise of Millionaire Next Door to be that an explanation of how you can make millions by looking at how a bunch of millionaires made millions. No?

    I whole-heartedly agree, however, that the church’s pamphlets on money are good advice.

    You know a lot of people on Wall Street did fail in their jobs–but I’m betting when the dust clears we’ll find the larger failure was on Main Street. I can think off-hand of 10 friends or acquaintances who treated their home like a credit card and couldn’t wait to trade up to a two car gargage. And they didn’t go to Wall Street for that loan either–they went to a mortgage broker or their local bank. Wall Street was definitely an enabler, but the blame must ultimately fall on an irresponsible public.

  20. Yeah, Mathew; it was the guy next door that made Lehman leverage their debt to 40X holdings. We all now know how long such a wind-down takes.

    It’s not the man on the street’s bankruptcy that’s causing havoc in the financial markets; it’s large scale shenanegins like that above.

  21. Steve Evans says:

    Mat, I agree with you re: Main Street. Reckless consumer spending and mortgages were a real problem.

    RE: Millionaire Next Door, it tries to arrive at general conclusions about spending and investing habits by looking at millionaires. I don’t see how that’s inherently bad, depending upon your methodology. Check out the wiki on the book; I have a hard time disagreeing with their approach.

  22. Last Lemming says:

    You have to go after executive compensation indirectly–by empowering shareholders. It is certainly not in the shareholders’ interest to reward executives for running their company into the ground, but shareholders are severely limited in their ability to influence executive compensation. The board chooses the compensation committee, so for shareholders to influence compensation, they need to be able to shape the board. But the SEC has made that nearly impossible. (See this Washington Post article).

    Direct government attempts to limit executive compensation not only short-circuit the market, they typically fail to accomplish their basic objective. (See this Time magazine article).

  23. djinn,

    Lehman and the guy next door suffer from the same fundamental problem. Lots of leverage and insufficient cash flow/reserves. But actually it is the man on the street’s bankruptcy that’s causing havoc in the financial markets. I’m sorry to see people lose their homes–heck I sold my own house last week for less money than I bought it for–but financial speculation by the general public, is at the root of the market disruptions.

  24. LL, the SEC hasn’t made it nearly impossible; that’s a mischaracterization. It would be more accurate to say that the SEC has limited the extent to which minority shareholders can force their way onto a ballot. I don’t think the Post article is a very accurate description.

    Couldn’t agree more, however, with empowering shareholders generally as the right way to go about this, and I agree with you that that the SEC can greatly improve in this respect.

  25. I don’t like the idea of telling young couples that they cannot buy their dream house — and I also don’t like the idea of telling a bank that they cannot loan money to such young couples because it would be too risky.

    But I think this has to start happening more… If the couple truly isn’t financially ready for home ownership, then they should wait…

    A fascinating read on this topic is “The Two Income Trap” by Warren and Tyagi. They draw a great analogy on the sub-prime and/or ARM loans loans to household appliances. Imagine that Toaster X came with no instructions, safety warnings and 15% of them spontaneously combusted several years after being purchased.

    Imagine the class action lawsuits, recalls, the whole nine yards if such faulty products were something as trivial as a toaster. While we have REGULATIONS in place to protect people from themselves in such situations, when it comes to home loans, all reason flies out the window over “dream homes” for families desperate to overextend themselves for a “safe neighborhood with a good school district, plus some growing room in the house.” The lenders knew some similar percentage of these loans would “blow up” before even issuing them.

    While Wall Street screwed up big time in managing their short-term liquidity (and needs fixing in its own right), the lack of regulation, coupled with emotional homebuyers and lenders all too eager to exploit the situation to their advantage is the root of the problem (and has been known well before now).

    Count me among those who would love to see the regulators tell these “young couples” to get real and opportunist lenders “PARTY’S OVER!” for GOOD. As we are now seeing, it would have been in everyone’s best interest.

  26. James,

    Just a few years ago someone posted a brilliant review of that book on this very site: http://www.bycommonconsent.com/2005/01/can-you-support-families-and-sub-prime-lending/

    Well worth a read.

  27. Steve Evans says:

    We should have fought harder to retain that masterful genius blogger!

  28. I dunno about the whole CEO thing. Maybe I don’t understand it all clearly, but a minimum wage is bad enough, I’m not sure a maximum wage would be very good. I guess I just don’t see the good way to do this.

  29. CEO compensation and the current problem are completely unrelated but are both symptoms of the same problem–risk transferance to disparate investors such that no one has an incentive to monitor bad behavior. And the moral hazard which leads to CEOs plundering their companies banks/borrowers engaging in irresponsible lending/borrowing practices is born. We do need controls but that is easier said than done.

    We’ve been working on the problems that were spawned when ownership and management became separate in the corporate context for at least 80 years and haven’t been entirely successful. Disclosure based rules are still probably the best solution.

  30. About ten years ago, I helped my daughter buy a house. She was single, two young boys, living in an apt. Her the payments would be less than the apt. and a much better place to live. But the down payment of 20% or PMI, were deal breakers. I was unwilling to come up with the down payment. But the Bank let me post a $30,000 CD at 6 1/2%. I would get the CD back, when she had 20% equity in the house. This took 18 months. She is still in the house, and I have my CD back.

  31. She got 20% equity in the house in 18 months?!?!

  32. You could reach 20% equity in 18 months if you just made the regular monthly payment . . . and the loan term was 7 years.

  33. #27,

    As I recall, that blogger was booted from the site (the first time) for neglecting his posting duties.:)

  34. All the advice in the world won’t stop someone making a foolish investment if he’s got his mind set on it. I’ve had clients who bought properties were the numbers just didn’t add up, and they’ve plunged on in, confident that a rising market would float their boat.

    Unfortunately, their boat had a hole in it, and they were in denial, and the Nile rose and they foundered.

  35. somehow we all started thinking that home ownership is a right

    Or at least something bordering on necessity given the abuse non-mortgage holders otherwise suffer at the hands of those that believe one must own a piece of the land in order to stand up and be counted as a true stakeholder in the community.

  36. #31,#32:I paid $160,000, below the market value. I only needed to wait 18 months for an appraiser (picked by me), to give me a $190,000 evaluation to get my money back.

  37. Mathew-

    Great review of the book indeed! While personal bankruptcy is obviously not the central issue I was referring to, as your post primarily focused on, it is an ever-present threat for too many families these days, it seems.

    I am fascinated with the implications of the book’s conclusions as they relate to LDS families who strive for the dad at work, mom at home household. There are some insidious dynamics at play for those who hope to live this way. If safe communities with good schools are only in reach the wealthiest 1-wage families or moderate wage 2-income families, moderate wage 1-income LDS families will increasingly find themselves in a lose-lose situation. I believe the spiritual implications relating to these issues are also critical, though often overlooked.

  38. Steve:

    This is a great post/series. While there really isn’t any overt hammering on a correlation between Church History/ spirituality and personal finance, just the fact that this is here makes an interesting point. Whether we tie the gospel into this topic directly or not, there is a correlation between spiritual health and financial health in the context of consumer behavior.

    While I generally don’t agree with Pres. Bush, I do agree that last night he was right on cue – and yes we must act quick.

  39. #38:Yes, there is a correlation: less spiritual usually means you have more money. 2) We should do nothing as a government, other than start some real oversight on our finance community.

  40. Cowboy,

    Just a few years ago someone posted some brilliant thoughts on prophets, spirituality and personal finance: http://www.bycommonconsent.com/2005/01/can-you-support-families-and-sub-prime-lending/

    Well worth a read–especially in today’s troubled environment.

  41. Cowboy,

    Sorry–the correct link is http://www.bycommonconsent.com/2004/04/apostles-prophets-and-personal-finance/

    This is actually one of the few things I ever wrote here I thought was actually useful.

  42. It is common for cities and counties to have non-prof organizations that offer money down for lower income families to get into a house.

    Ouch, those organizations are generally nothing but shell games to allow a bypass of regulations involving mortgage insurance and downpayments.

    It was especially egregious in the mobile home industry. Home is worth 10k. Listed for 12k. Charity puts up 2k (which, of course, it gets from the manufacturer). As a result, buyer has 20% down and qualifies for a loan.

    It was pressure to allow that practice, and variants (e.g. a second mortgage for the 20% down to avoid mortgage insurance) that created the mess we are in — all in the name of “affordable” housing.

    As for Freddie and Fannie, there was a nasty confluence. Pressure from congress to have them buy the resulting paper and the people at the top on short horizon bonus programs where giving in netted them huge bonuses and resisting political pressure had no benefit at all.

    The bi-partisan creation of this huge mess … argh ….

    What you need is some recapture mechanism in the market, right now the horizon on commissions and bonuses is much shorter than the fall-out horizon, so that it is possible to sell a lot of drek, make millions (or, in the case of the ex-CEO of AIG, a billion) and then be out of town before the mess hits (though the AIG ex-CEO did settle the law suit against him for 115 million — right before AIG collapsed).

    A better recapture model would make people think twice.

  43. Steve,

    Just curious about your feelings on the WAMU failure and forced sale. It would appear that from what I heard on NPR and elsewhere that some $1.6 Billion in deposits were withdrawn since September 16th, which has all the signs of a “run on the bank”. That figure represented, by my calculations, 5% of total assets, and probably more than half their liquid assets. The withdrawals exacerbated the cash/credit shortage for WAMU, which in turn caused them to be downgraded by the ratings agencies, ultimately forcing the FDIC to intervene.

    Had the depositors sat tight, do you still think WAMU would have failed? You seemed to intimate that in Part 1 or 2 of this series. I’m just trying to understand some fo the dynamics here. We certainly are in a crisis, but how much of this is fear and emotion undermining institutions that had a chance for survival, versus the ones so out of balance and highly leveraged as to be truly a basket of broken eggs?

  44. “Had the depositors sat tight, do you still think WAMU would have failed?”

    Yes, I believe it would have. WaMu didn’t fail because of a garden variety run.

  45. Hardly anything these days in the financial markets is “garden variety”. This series has been helpful, along with a lot of other reading I have been doing. Thanks.

    I read in Business Week this week that even prime mortgage foreclosures are up 40% over last year, an indication that hard times breed more hard times. I’m getting more convinced that were still a bounce or three from the bottom of this whole mess.

  46. kevin, in terms of how Joe Consumer will feel the impact, I couldn’t agree more.

  47. Back in 1993 the government first attempted to limit executive pay by making only the the first $1M in cash compensation tax deductible. Businesses responded by issuing executives non-cash compensation above that $1M threshold in the form of slowly-vesting equity stakes in the businesses they managed. The decade and a half since that policy went into effect has demonstrated the folly of that idea.

  48. The writing was on the wall for WaMu months if not years ago. nothing could have stopped it from failing.

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