Subprime Mortgage Revisited

Recently, Bloomberg News reported (8/31/11) that Standard & Poor's, the New York based rating agency, was "poised" to provide a AAA grade (it's highest) to a mortgage trust comprising bonds totaling $497 million dollars lent to homeowners with "below average credit scores and almost no equity in their properties." The mortgage trust was put together by a lender who specializes in lending to borrowers with risky credit, and who also pays S&P to evaluate the deal for creditworthiness. This is the same S&P rating agency that recently downgraded the United States to AA+ (its second highest rating) because US politicians are becoming "less stable, less effective, and less predictable." As the Bloomberg article pointed out, debt issued by the United States is now comparable in risk of default to that of Belgium.

Deven Sharma, who has been S&P's president since 2007 and who is reportedly stepping down this month, defended the company's practice. He suggested its methodologies are "completely comparable" and consistent across all assets it reviews. These attempts to be consistent have seemingly met some snags. S&P apparently continues to assign its top grades to pieces of home-loan bonds which are packaged into securities called re-remics. Bloomberg reports that in May 2010, S&P was forced to lower the ratings on 308 classes of such deals. One deal worth a reported $10 million, created only nine months prior to the downgrade, went from a AAA rating to CCC, a slide of six ratings in one day! The reason was a higher-than-forecast number of mortgage defaults. In December 2010, S&P said it would need to review 1196 such re-remic securities because it had apparently "incorrectly analyzed" the debt structure of the underlying deals. Bloomberg also cited S&P's admission of mistakes in structured finance, ranging from misunderstanding of cash flows to inconsistent and sometimes conflicting methods of analysis.

Is S&P in this alone? Apparently not. According to Bloomberg, a former analyst from Moody's Investors Service, in a letter to the SEC, said that his group faced management pressure to issue higher grades in an effort to win business for the firm by implementing "a market friendly methodology." You might be tempted, as we are, to ask "Friendly to whom?" Enough people are asking that question to prompt the Justice Department, the Senate Banking Committee, and the Securities and Exchange Commission to investigate the role of the rating agencies in the original crisis of 2008 and in the downgrade of US Treasury debt last month. I would submit that you don't get that kind of broad-based attention unless things are seriously out of alignment.

Credibility for Sale?

The credibility of S&P and its brethren is clearly on the wane. The Bloomberg article cites a number of money managers with significant doubts on rating agency reporting. This is quite understandable, given the capital they have at risk and the experience they have been through in the last three years. More importantly, the markets seem to be the ultimate voice of sanity. Rates on 10-year US treasuries have been consistently far lower than on comparable mortgage-backed offerings of similar maturity, even after the August 5 downgrade. This suggests that investors demand a far higher yield on the mortgage offerings, given the perceived risk involved. And the risk is considerable. It only takes a slight downturn in the economy to further depress home prices, which will encourage another wave of borrowers to walk away from their underwater homes and leave investors with a sea of worthless debt. Treasuries are still the safe haven for capital, no matter what S&P says. And why shouldn't it be? Unlike the mortgage deals mentioned, the US Government has the authority to adjust tax rates (and thus its income to repay the debt) as well as to print more money (despite the accompanying inflation). Just who is S&P trying to kid?

The casualty in all this, once again, is the individual investor who at one time came to rely on the three major credit rating agencies (S&P, Moody's, and Fitch) for reliable credit reporting. Their reliability has seemingly been sold to the highest bidder in the name of corporate profits. In order to please Wall Street securities firms, the reporting agencies are slathering lipstick on so many pigs and selling them off as stallions. And apparently it is working. That $497 million in bonds for sale in the mortgage trust? According to the Bloomberg article, roughly half had been sold. Some lessons are just too difficult to learn, and some people never get it.

Market Upheavals: Summer of Our Discontent

Over the last two months, equity markets have once again delivered record-breaking volatility along with jaw-dropping declines. The down grade in US Treasury debt by Standard & Poor's and the turmoil in Europe surrounding Greek credit challenges are the primary culprits. Regardless of reason, fear seems to rule the day. At one point in early August, despite any real signs of recession, selling pressure resulted in a ratio of declining stocks to advancing over a day's trading of 77 to 1, a level not reached in the last 80 years! The result was a blood bath of short-term losses that rocked the investment world and shortened the vacations of nervous hedge fund managers and short term traders. The press, of course played its part suggesting comparisons with the 2008 debacle, creating the impression that the sky was indeed falling, and opening the door for emotions to overwhelm rational reason.

What, me worry?

While we at Dowley & Company have been known to be optimists, I think we are well within the bounds of credibility and we seem to have lots of company. Yes, the economy is not exactly firing on all cylinders, while unemployment remains stubbornly fixed and seems content to remain so. And the EU? Well they seem to despair at the tough choices around Greece and how to handle it all. When you look at it, it does seem pretty ugly, doesn't it?

Not so fast

There is a big difference between economies and markets. Economies grow (or not) and change with the pace of a tortoise while markets leap about like so many hares on amphetamines. The US Economy is growing, despite all the evidence in the press to the contrary. One percent seems to be the annual estimate at last look. Growing slowly, but growing nonetheless. Consumer debt is shrinking, as indicated by the numbers of defaults on revolving credit. As of the end of the second quarter of this year, over 75% of the S&P 500 companies reported earnings that beat Wall Street estimates. They posted earnings growth of 18% and revenue growth of 13%. They also happen to be harboring a record amount of cash. If you exclude financial stocks from the mix, it is estimated they have approximately $1.75 trillion on the balance sheets. Even if they need to borrow the money for their expansion ideas, interest rates are at record lows and it costs them very little to do so. Access to capital does not seem to be a problem. In case they want to hire new employees, they have what appears to be the largest supply in half a century available at competitive wages given that most of the potential hires would be glad to take a pay cut just to get a job. Wage inflation doesn't seem to be a problem (or any inflation for that matter) nor does the supply of eligible hires.

So why aren't these businesses investing and spending and hiring? Businesses are concerned with return on equity. They want to know if they put their capital to work; it will give them a return that will accrete to the bottom line. The only reason they don't invest in new capital and hire employees is fear of not getting that return. So they do things like increase dividends and share buy backs to improve their stock's market price. Yes the economy may be slow, or slower than we would like. While markets may be depressed on the back of uncertainty in the news, they look like they have earned our optimism.

That leaves only one major unknown: government. I would like to think even politicians couldn't mess this one up. Yet they are so desperate to save their elected hides that they will do almost anything, which is where the problem comes in. I would like to think the legislative environment is accommodative to business, and it probably is right up to next year's election. After that, all bets are off.

So what do we like?

Taking into account that volatility will be the order of the day, our investment team continues to favor equities over fixed income and large cap stocks over small. We like the emerging international markets and continue to allocate assets to that area. We have taken gains earlier this quarter and used the proceeds to reinvest opportunistically where we have found price declines have created value. While we still allocate assets to fixed income asset classes, our managers have tended towards a defensive posture in our core holdings and increased security selection at the fringe. Overall duration is shortened given concerns over rising interest rates. After all, we know they cannot go down forever. The question remains, when they do go up, how fast will it happen? The Federal Reserve may like to broadcast its intentions, but bond markets are not so generous.

A final thought

One investment strategist was quoted recently saying, "When we're getting close to a market bottom, the phone starts ringing off the hook and our clients want us to sell everything. Market bottoms are less about an improvement in the fundamental situation and a lot more about getting rid of all the anxious investors"

No doubt the media will continue to translate the current volatile market conditions into dramatic headlines. No doubt this will continue to feed investors' fears. No doubt some of them will sell everything. Our job is to prevent the market swings from getting rid of the anxious investors, instead helping the investors get rid of their anxiety.

How to Start a Financial Planning Relationship

Financial planning has come a long way in the last 25 years and can even be described as a “mature industry”. Despite this, there is still plenty of confusion concerning when, why and how to get started working with a financial advisor. I was encouraged recently to describe how potential clients can get involved in the financial planning process. Is there are right time? How much money do I need to have to consider doing it? Is it expensive? What can an advisor do for me?

Engaging in a casual conversation, as I frequently do, with someone who has enquired as to what I do for a living, I receive all sorts of apologies for why he/she has not started on a financial plan. “My situation is really quite simple” or “I don’t really have any money to plan with”, are common responses. Some folks say their accountant takes care of “all that stuff”. It seems like people will fall all over themselves trying to convince me that they are not appropriate candidates for it. It tends to stir the imagination as to what they think might happen to them if they actually sit down and talk about money. For some, it would be more comfortable to talk to their teenagers about sex, or go to the dentist.

Truth and More Truth

The truth is that there are very few people out there who cannot benefit from a financial plan. Done well, the results are life altering. More truth: most people feel all sorts of emotions around money including shame, guilt, anger, fear and a host of other emotions they would just as soon bury in their sock drawer which is where most of them have left these things. One suggestion is to seek out those who engage in financial life planning to find a non-judgmental method of coming to grips with these issues. I can’t imagine any accountant I know wanting to handle this. As for the, “not enough money” argument, there is never enough money. Not having enough money is the best argument for getting started that there ever was. The question is, if there isn’t enough now, what needs to happen to change that? Or are you willing to live a life of “never enough”? Look around and you will see lots of folks living a life of complacency and “never enough”. For those who would rather chose abundance, financial life planning is a great place to start. As for the “my situation is really simple”, this is a confession that reveals how little people know about their finances. I translate this into, “I only understand a small portion of my finances and I dare not go any further”, another self-imposed limiting belief that will keep the believer from achieving. Think small and you will get small.

Dress Rehearsal?

One of the most consistently asked questions about doing any financial planning is “when is it a good time to get started”? Life events such as forced retirement, death, divorce, and marriage are common motivators to initiate planning. While these frequently bring people into the office, I cannot think of any life process or financial decision one could go through that wouldn’t be enhanced by the presence of a knowledgeable and trusted advisor. In 25 years of practice, I have heard the expression, “I wished I got started 10 years ago!” more times than I can remember. When to start? How about yesterday! Life is not a dress rehearsal. This is the big show! The real deal. There are no do overs, no gimme puts. Why would anyone want to go through it with anything less than full potential being realized? I will also suggest that it is not nearly as painful as say…going to the dentist. The results are certainly a lot more fun.

Trustworthy Inspiration

There are dozens of articles written in the popular press about how to pick a financial advisor. I won’t take up time and space regenerating those author’s ideas accept to say that most of them have it all wrong! They start with the idea of advisor compensation and services they can render and ask the reader to evaluate them and compare advisors based on what they think they need as if they were purchasing tomatoes. What a load of rubbish! Most of their readers have no idea what they need. They only know what the press tells them they should think. If people knew exactly what they needed and how to get it, they wouldn’t be sitting in an advisors office to begin with! Knowing how someone is paid is important, but is an afterthought compared to the idea of finding someone who is worthy of your trust and who can inspire you to do great things! Therefore, the question is not, “What can this advisor do for me?”, but rather “What can this person inspire me to do?” After all, the advisor is there to do the planning by facilitating a process with energy and passion. The implementation of that plan helps you to a life worthy of living but it is for the client to do, and the advisor to coach.

What should this cost to do?

The popular press would have you believe that you should never work with an advisor who works on commission as their biases are always towards selling products that earn the highest rewards. The truth is that many of the best and brightest advisors I know work on commissions. I worked almost exclusively, for the first 11 years of my professional life, on commissions. While I prefer working in a fee based practice, it does not define ones ethics as to how we earn a living. Many people who can’t afford a fee model and who want to get started in the financial planning process can best do so in a commission compensation environment. There is nothing inherently bad or wrong with this. The bottom line is, if you follow your instincts and hire an advisor you can trust and who inspires you, how they get paid does not, and should not matter. Understand the compensation system, and then forget it. If they are going to have the dramatic impact on your life, to inspire you to do things you could not accomplish on your own, it is probably worth many times what they will actually charge.

Rearrange the Sock Drawer

Some 24 years ago, I shared an office with a colleague who had an appointment with a gentleman he had not met before. It was common for us to suggest that people bring with them information to judge how we can help them to that first appointment. At the hour of the appointment, my colleague greeted the man in our office and ushered him into his office. The man was holding a good size box in his arms which he placed on the table, turned and started to leave the office. My colleague asked him where he was going. He said, “I’m going to my car. I have two more boxes to bring in (!)”. Over the next week, delving through his client’s life (in the form of boxed paperwork), my colleague found thousands of dollars of assets that his client never knew about. He was a single man who worked long hours and didn’t have much time for things like benefit plans and investments. His mother had died a few years back and had left him as her heir. He had not paid much attention to much of what she had left him. The box with her things just got pushed to the side while he went on with life. My colleague pulled out of those boxes things like a passbook savings account book with $70,000 in it and three life insurance policies on the mother on which no claims had been filed! This is an example of what we call “found money”. While this example may seem extreme, I can recall many similar instances where, through ignorance or just “to busy rearranging my sock drawer”, people are leaving money on the table. Even if you don’t understand all that you are presented with in this complicated and busy world, empowering someone knowledgable who can advocate on your behalf can pay big dividends. Bring in the shopping bag full of stuff and let your advisor dig around in it. You will be surprised at what they might find.

Change

Lastly, when you go into this process, expect to make changes. I know this is potentially the scariest part of the whole thing but it is also where all the value is found. Any good advisor is going to suggest, sooner or later, that you consider a fundamental change in either behavior or thinking, or both. Expect it to come. Remind yourself that it is coming and measure how you feel when you get nervous about these changes. Prepare yourself ahead of time and think about what changes you would be willing to make. I don’t know who said it but please remember the following:

“You always get what you’ve always got if you always do what you’ve always done.”

The Reverse Mortgage

From time to time, I indulge myself with what the popular press has to say on various financial matters. Given the downturn in financial markets over the last few years and its affect on retirement portfolios, attention has turned to the reverse mortgage as a way to provide some measure of financial security to retirees. The press has taken the almost universal stance that the reverse mortgage is "too expensive". I would like to take the contrary view and suggest it is one of the best financial deals going. But first, a little background for the reader.

The foremost authority on the reverse mortgage is The US Department of Housing and Urban Development (HUD). To understand this mortgage, one needs to consult their website (www.hud.gov) and search for "reverse mortgage" or as they refer to them as a home equity conversion mortgage (HECM). The website contains all the requirements both for the homeowner and the home itself.

What is it?

The HECM is FHA's (Federal Housing Administration) reverse mortgage program which enables a home owner age 62 or older to withdraw some or all of the equity in a home. The funds can be withdrawn in a lump sum or as a fixed monthly amount or a combination of both. Either way, there is a line of credit established with a maximum amount based on the home value and in line with FHA guidelines. The program has a number of stipulations such as the home must be owner occupied and be a principle residence but is available to multi unit properties and even condominiums. If the home has current debt outstanding, the proceeds of the HECM are used first to pay off this debt before the balance (if any) is paid to the homeowner. This means if you have an outstanding mortgage of any kind already, you may still use the HECM.

How much can I borrow?

The amount loaned is based on a number of factors such as the age of the youngest borrower, the current interest rate, the lesser of the value of the property or the FHA mortgage limit for the area, and finally the initial Mortgage Insurance Premium (MIP) option chosen (2% standard option or .01% Saver Option). The older the borrower(s), the more valuable the home and the lower the interest rate, the more can be borrowed. Appraisals are usually required and the HUD website says that $625,000 is the current maximum that can be loaned.

How do I pay it back?

You don't. I'm kidding right? No, I am not. You may never have to pay it back. As long as the home is your principal residence and one of the borrowers remains living in it, no payments are required. The home must meet the terms of the mortgage such as keeping it insured, paying any property taxes, and doing routine maintenance. Otherwise, the homeowner gets to spend the money in whatever way he chooses. When the last of the borrowers stops being a resident of the home, either due to death, a nursing home stay likely to be permanent, or just because he or she wants to move, the home is sold and the sale proceeds pay off the mortgage. If the sale proceeds are more than the amount owed, the homeowner gets the balance of the proceeds. If the sale proceeds are insufficient to pay the loan, FHA picks up the balance. That is what MIP is for and why it is charged. So even if the home declines in value, the borrower is not left with the problem.

So what is the catch?

The catch is the costs are higher than a typical mortgage which is why the press has such a problem with them. They include an origination fee than can be as high as $6000 (current cap). The closing costs include an appraisal, title search, surveys, inspections, recording fees, credit checks, and mortgage taxes. There is the MIP mentioned above as well as a monthly servicing fee that is deducted from the loan proceeds or added to the loan balance each month. These are in the $30-$35 range. There is of course interest charged each month on the outstanding balance. The total on these loans can amount to $12,000 or more to close the deal. Sounds like a lot of fees, right?

What is the problem?

Other than the origination fee, the monthly servicing fee and sometimes MIP, all the fees listed above are quite normal in a standard home mortgage. Yes, sometimes a conventional mortgage broker will cover some of the fees out of commissions they receive giving the illusion of a "no points/no closing costs" mortgage. They are still there and must be paid.

On most of the HECM fees, the borrower can fold the costs into the amount borrowed. Typically, very little needs to be put up front in cash. Given that HECM loan proceeds are allowing retirees to live out their remaining years enjoying a life they would otherwise never have, are the cost really that big an issue? Assuming the families of these retirees don't intend to keep the home being used for collateral, why would we worry about the fees charged? The lender (FHA) is taking all the risk and being paid to do so. The issue seems to be that the costs are high compared to conventional mortgages. But as we can see, with no payments to be made on the loan, it is a very different type of mortgage. The advantages to the borrower are the lack of any payment and the lack of worry about the valuation of the house after the loan is closed. There is no "upside down" loan for these borrowers. Used for the right reasons, this is a great product and can bring a real change to the lives of cash strapped retirees!


Chris Dowley

February 2011