Simple Plan to Tackle the Home Mortgage Crisis

Houses Up
5&7 Plan

The idea is so simple, it is surprising that no one (that I have heard about) has proposed it.  One big problem the US government faces is the enormous pile of mortgage-backed debt held by Fannie Mae and Freddie Mac.  Another problem is that many “home owners” are underwater with their mortgages.  [How can you be a home owner if you have negative equity?]  Finally, the popping of the housing bubble continues to be a drain on the US economy.

The solution I propose is making interest on mortgage-backed securities tax free for five years.  This plan would immediately drive up the value of these “toxic” assets and drive down mortgage interest rates below historic lows.  This would provide a tremendous boost to Fannie and Freddie and even the Federal Reserve.  Increased demand for tax-free MBS would spur banks to issue more mortgages under easier terms, which would help prop up home prices.  Naturally, fewer home owners would be under water.

This would also be a boon for investors, giving them access to another tax-free asset class.  The incentive of tax-free MBS would be so powerful, it would threaten to take money away from tax-free municipal bonds.  To help offset this risk, part II of my plan would make long-term capital gains on municipal bonds tax free for seven years.  Like Cain’s 9-9-9 Plan, my plan would have a numeric title, the “5&7 Plan”.  (To avoid confusion with the 5-7 Pistol, the “&” symbol is used rather than a dash.)

The long-term capital gains provision gives investors an incentive to hold municipal bonds for at least one year.  The extra two years for municipal bond gains gives investors an added incentive to hold long-maturity municipal bonds.

The 5&7 Plan would expand the tax-free bond universe and introduce the concept of tax-free interest investing to a new group of investors… the middle class.  Typically only high-income earners benefit from tax-exempt bonds because they offer lower interest rates than taxable bonds.  Because high-income taxpayers face higher marginal tax rates, tax-free municipal bonds make sense despite lower interest rates.  If the 5&7 Plan becomes law, higher-yielding MBS will become lucrative to savvy middle-class investors.

I encourage the 2012 presidential candidates to consider adopting the 5&7 Plan.  I could see Romney offering the 5&7 Plan as a way of “cleaning up Newt’s Fannie and Freddie mess.”  Similarly I could see Gingrich pitching the 5&7 Plan as a way of “fixing the Democrat’s Fannie and Freddie problems.”  Finally, I could see Obama selling the 5&7 Plan as “an innovative way to clean up America’s mortgage crisis”.

If the 5&7 Plan gets enough press, it will revitalize the mortgage debate.  It will help turn the debate towards real solutions and away from political blame games.  And, if passed, 5&7 will energize the mortgage and housing markets in explosive ways compared to the tepid response all the other failed legislation of the past 3 years.  If you like the 5&7 Plan, share this link.  If you don’t, please share why.  I will publish all non-spam replies.  Let’s get the 5&7 debate started!

5 Ways to “Show Me the Money”

Ask whether these people are showing you the money. Hold them accountable for your money.

1. Your boss/company. Ask yourself first if you had a good year. If so, do some research on at you should expect to be earning.  Try starting with Glassdoor.  If you are not making what you want and are not moving in the right direction, consider moving to another company.  But, be sure to do through research and then line up a job (in writing) before giving your notice.

2. Politicians.  Are you getting reasonable benefit for your taxes?  Grade by region.  Here’s my grading:  City C, County B, State B+, Federal D.   If your grade is C or less, consider voting the bums out!

3. Social Security.  Ever work out the rate of return on your projected Social Security payments versus the amount you have and will put in.  Mine is about 0% return.  And that is *if* I ever get *any*.  Not much you can do about it, but something to consider when planning your own retirement…. What if I get nothing from Social Security when I retire?

4.  Investment Adviser.  How does my return stack up to A) The S&P500 total return (including dividends)?  B) A 100% bond profile such as Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX)?  If, overall, it is under-performing both, fire your adviser.  If it beats one… ask questions like why it didn’t do better.   If it beats both, ask “what risks are you taking with my money!”?  If you are your own investment adviser ask yourself the same questions.  And, if you decide to fire yourself, consider getting advice from someone reputable and sane like Vanguard.

5.  Your credit score.  Know your credit score (FICO score).  Guess what?  If it’s below 711, it’s below average! [Technically below “median”, but let’s not split hairs.]  720 used to be golden, but today 750 is the new golden score.  In some cases 770.  If your score is below where you’d like it to be, start getting financially fit.  And remember, success doesn’t happen overnight.  Success takes time.

What Baseball and Finance Share

A Litte Baseball
Baseball before Moneyball

In a word: stats.  Baseball has statics for almost anything of relevance that happens on the field.  Finance has statics like expense ratio, yield, price-to-earnings ratio, total return, alpha, beta, R-squared, Sharpe ratios, and the Greeks (delta, vega, theta, rho)… just to name a few.  I  suspect most of my readers are more familiar with baseball stats like batting average, on-base percentage, slugging percentage, OPS, ERA, K%, BB%, GB, and the like.

Today’s blog will start with the simple concept of batting average.  In baseball batting average is the number of hits divided by the number of official at bats.  Since a typical baseball player can have 400 at bats per baseball season, there is a lot of statistical significance to his batting average for one year.

In contrast, a fund manager could be said to have about 4 at bats per season — one per quarter.  It would take a 100-year career to have as many “at bats” as baseball player has in one.  Even if you decided to count fund performance on a monthly basis, it would take 25 years to match a baseball season’s worth of data.

The most common financial definition of batting average counts a hit as outperforming the market (say the S&P 500) over a given time period, say 3 months.   An out is under-performing the market.  Generally a .500 batting average is analogous to the the Mendoza line in baseball.  Sadly, many fund managers and financial planners bat below .500.   And often those that do exceed .500 get there by early luck… luck which generally fades (back below .500) with time.

Just like in baseball batting average is not the most useful static in finance.  OPS (on base plus slugging percentage) is probably a better financial stat… if it existed.  Instead financial stats like Sharpe Ratio and alpha fulfill a similar role of financial performance measurement.  The problem with all these financial stats for measuring fund managers is there are simply not enough “plate appearances” to reliably measure a fund manager’s performance until his or her career is almost over!   It is only after a long financial career that the difference between skill and luck can be accurately sorted out… a bit late I’d say for investors looking to pick fund or fund managers.

There is a factor other than stats that financial and baseball matter share.  In a recent conversation someone mentioned that baseball is the only major sport where the player scores [directly].  In other words the runner himself (herself) scores by getting safely to home plate.   Basketball, football, and hockey require an object (ball or puck) to cross a threshold.  Football requires a ball + a player to score a touchdown, but a field goal does not directly require a player to fly through the uprights!  Only in baseball does the player himself score a run.

This analogy can be extended to the idea that the investor herself can be the only thing that matters (that scores).  At the end of the day it the investor who determines how successful she is at meeting her financial goals.  The Sabermetrics of finance may help her get there, but ultimately it is the investor herself who has a winning, losing, or World-Series-Championship financial season.

Financial Toolkit: The Rule of 72

The rule of 72 is an easy way to make fast financial calculations in your head (or on a sheet of paper)… no calculator is necessary.  The idea is that you can determine how fast money will double based on an interest rate or rate of return.  Divide 72 by the interest rate and that is the number of years it will take for the investment to double.

For example if a CD (Certificate of Deposit) is paying 6% it will double in 12 years because 72/6 = 12.

The rule of 72 can be used for decreases in value, such as inflation.  If inflation is 4%, money under a mattress loses 4% per year in value.  Because 72/4 = 18, that money’s value will be cut in half in 18 years.   So positive returns divided into 72 tell how long it will take your investment to double and negative returns how long to lose half its value.

The rule of 72 provides convenient illustration of how fees can effect an investment.  Let’s say you are considering two investments in your IRA managed by your brother-in-law Sam.  Option A is to buy and hold SPY, an index fund that has an expense ratio of virtually 0% (0.09% actually) or option B tracking the same index  but managed by the Sam’s company with a 2% expense ratio.  Sam says “Hey buy my index and I get a commission and a chance to win a boat.” Using the rule of 72 you see that 72/2 is 36, meaning Sam’s index will only be worth half of SPY in 36 years.  If you are 29 years old and want to retire at 65 (in 36 years) that’s half of your retirement money!  Tell Sam to find some other sucker to win his stupid boat.

Rule of 72
Cost of 2% based on the Rule of 72

Finally you can use the rule of 72 together with inflation and expected return to plan your financial future.  If you expect a 7% (nominal) return on your retirement portfolio and 3% inflation, that’s a 4% annual return, so your money will double — in inflation-adjusted terms — in 18 years.  Now if inflation is 4% your real return is 3% and your real investment value will double in 24 years; that’s a whole 6 years longer.  Possibly 6 more years until you retire.  Add a 1% management fee and your real return drops to 2% and doubling time is now a whopping 36 years.  Yes, even a 1% fee can cost you 12 more years until you retire!

The example above shows the destructive power of inflation and why even a 1% annual inflation underestimation can be a big deal.  For tax payers that means tax brackets (based on the government’s CPI-U) gradually form an increasingly tight straight-jacket around your take-home pay.  For Social Security recipients this means cost of living adjustments that simply don’t keep up with real world expenses.

The rule of 72 is a powerful tool for financial estimation.  The rule of 72 is not perfectly accurate, but it is generally pretty close to the target.  It is, however, easy to use and can be used to explain financial concepts to people that aren’t that “mathy”.  It is a great way to start explaining finance to kids; while being a tool powerful enough that is also used by Wall Street pros.