Handling Finances

On the radio a few days ago, I heard an interview with New York Times economy columnist David Leonhardt on the state of the economy. The interview centered on his column from March 19, 2008 called “Can’t Grasp Credit Crisis? Join the Club.” The first line of the column grabbed my attention: “Raise your hand if you don’t quite understand this whole financial crisis.”

In short, the stock market is jumping around like a caffeinated jackrabbit on a hotplate because nobody really knows what’s wrong. Subprime mortgages and other subprime loans got sliced up, packaged together and sold in so many different ways that it’s been nearly impossible to figure out which investments are losing how much. And when people don’t know how bad it is, they tend to panic. That’s what happened to Bear Sterns — the major investment banker that is being sold for a small fraction of what it was worth a year ago… or even a month ago! They didn’t just lose all their money investing in risky subprime loans, but when the market panicked, people started pulling millions of dollars out of Bear Sterns (and other investments like mutual funds) to protect their money from further losses. The more people sold, the more Bear Sterns was forced to sell more and more failing investments — right when they were at their lowest. After a few weeks and months of selling more and more of their assets at lower and lower prices (desperate to repay those who asked for their money back) they were finally forced to admit that they didn’t have enough assets left to cover all their obligations. It’s really similar to a run on a bank where too many people ask for their money back, but since the bank has loaned most of it out, they can’t repay it right away and end up in big trouble with it’s patrons (though in the US, there are protections to keep this from happening).

So what caused the credit crisis?

So some of the trouble — and certainly the speed and magnitude of recent market declines has been caused by fear and panic among investors. To understand what set it off requires a bit more understanding of recent economic history.

After the real-estate slump in the early 1990’s, mortgage lenders were becoming increasingly national and international in scale rather than simply local. Instead of developing long-term relationships with their borrowers, they competed for loans nationwide and lowered fees while creating new types of mortgages like ARMs — perfect for people who aren’t planning to stay in their house for more than a couple of years and want to save on interest.

Everybody was sure that home values could never drop nationwide, and with the federal funds rate held very low to ward off a second recession in the early 2000’s, everybody from homeowners who took out mortgages with little or no down payment, to big-time investing firms were increasing their returns by heavily borrowing at a low rate and investing in the high interest-rate subprime loans. When betting with borrowed money, even a relatively small drop in investment value can wipe out the investor which explains why so many groups went bankrupt all of a sudden. To make it worse, since the investing firms don’t always know how much exposure they have to the subprime loans (since they’re all sliced up and packaged in many different ways), they’re now holding onto cash to avoid the same fate as Bear Sterns by running out of money as investors ask for their money back. More cash means less investing which just compounds the problem as those trying to sell have an even harder time finding buyers and are forced to drop prices even further.

It’s a highly complex issue with all sorts of ripples affecting what would normally seem like barely-related investments. My main goal through this whole mess is to follow it closely and learn as much as I can — this kind of perfect storm doesn’t come often, but it’s always a potential danger and understanding how bubbles grow and burst is the first step to recognizing them in the future.

In many countries, and even in America at one time, people saved to purchase their home. A home would often stay in the family for many generations, and as funds became available, the family would simply add to the house as needed.

In contrast, we’ve been raised culturally to expect a mortgage. Mortgages are called “good debt” and treated as the default way to purchase a house. The banks that profit from this naturally encourage mortgage lending — earning interest for 30 years is a pretty sweet deal, as long as people honor the loans.  Now that it’s become apparent we’re borrowing more than we can handle, many are calling for our government to make borrowing money even cheaper to help people keep their homes.

What would happen if mortgages didn’t exist?

First of all, houses would cost about half what they do now. That’s not to say that if mortgages suddenly disappeared, house prices would drop by half but at 5-6% interest over 30 years, we end up paying twice for the house — once up front to the seller and once over the life of the loan to the bank. This is a somewhat simplistic view of house prices and in fact, house prices would drop even further when you factor in the detail that without mortgages, people would be willing to pay much less for houses than they do now.

Of coure mortgages aren’t going anywhere, they’re just becoming more difficult to qualify for, but it’s interesting to me how universal mortgages have become. Many people are absolutely certain that the stock market will continue to rise at around 10% per year long-term so they see a 5% mortgage as a really good deal. Others can’t imagine saving for a decade or two while renting until they could afford their house.

What I find so fascinating, is that we’ve twisted the American dream of homeownership from the reward for hard work it once was to an item we all deserve. We call it “home ownership” even when we never own more than 20% to 40% of the house, and are totally content to throw hundreds of thousands of dollars to banks for the “privilege” of living in a home we never intend to own.

I’m a big fan of mortgages to be sure, but the same feeling of entitlement that makes us think we deserve a bank’s money to buy a house has lead to a great deal of inflation in housing markets. The “real estate bubble” may have burst with real estate prices dropping nation-wide, but many Americans still treat homes as an investment — hoping that when they want to sell, mortgages will be even easier to get in even higher amounts so that they can end up with a positive return. I wonder how many people compare their “earnings” with the interest they paid over the years.

I wonder how many people simply get the largest mortgage the bank will allow because the banks told them that was the American Dream and because nobody bothered to tell them that the American Dream comes with limits and consequences.

No, this isn’t yet another ‘bash P2P lending’ writeup, I’m actually quite impressed with both the idea and the execution of Prosper.com and LendingClub.com. There are issues surrounding default rates that are really important, but in my opinion, it would be hard to do due diligence regarding the P2P lending and not have a reasonable understanding of default rates and how they’re affected.

The problem with P2P lending in my opinion is that the interest rates don’t quite work the same way as with money market accounts and as the lending sites don’t point it out, it’s very easy to miss. Quite simply, you only earn interest on the money that’s actually loaned out — as the loan is slowly repaid, you earn less and less unless you reinvest the money you receive in another loan.

For example, if you lend out $50 at Prosper and earn 8% interest on the loan, you’ll end up with $56.40 at the end of the three-year period.  Due to the magic of compound interest, you’d earn the same amount in a money-market account at 4.0%.  Why the big difference?  You’re not earning interest on any interest paid and you’re not earning interest on any principal paid.  In short, in a money market account, each interest payment immediately starts earning interest itself.  At Prosper, you have to reinvest — or make another loan to earn interest on the money that’s paid back to you.

It’s a simple concept, but something that often gets overlooked when people get into P2P lending.  Of course, if you reinvest the payments you get back every time you accumulate $50, your ‘losses’ are much lower.  In fact, if you have around $1600 invested, you’ll accumulate about $50 in payments each month, so on average, you’ll only lose about 0.1% due to money sitting around waiting for your next loan.

It’s not a problem that makes P2P lending worthless for lenders, but you should carefully consider the cost if you plan to invest less than a thousand dollars in P2P loans.  Not only will your returns be significantly slashed as a large percentage of your money sits doing nothing, you’ll have so few loans that even one default could easily wipe out your potential profits altogether.