Don’t Feed the Alligators

A Personal Finance Blog from a Small-Scale Landlord’s Perspective

Archive for the 'Debt' Category

Bernanke, Bush, Greenspan

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Editor’s Note: Introducing guest poster Matt.  Matt and I have been close friends since our first days of college — we and our wives were in each others’ weddings.  Matt has been a bond market professional for the last ten years, and I strongly value his insight into the current economic/political crisis.  Despite the expected settlement by Congress, the American public still needs to understand and ultimately accept it.  I’ve gone back and forth on this all week, and Matt’s assessment below has certainly swayed me back the other way.

I would like to share some insights on the pending economic bailout package and perhaps clear up some confusion that seems to be circulating through political sound bites and media commentary.  To be clear upfront, as I’ve dedicated my career to them, I am a strong proponent of capital markets and believe in the model.  Also worth noting, I have never been in a role to participate directly in any mortgage lending or borrowing that is relevant to the issue at hand.

Despite my strong belief in free markets and my opposition to an RTC-like (Resolution Trust Corp as in the early 1990s Savings and Loan bailout) solution to this problem from the beginning, the recent bankruptcy of Lehman Brothers has pushed us to the breaking point and we now have no option but to pass this plan in one form or another.  This is not particularly evident by looking at the the widely tracked equity markets, but is painfully clear in the bond markets.  This is where all individuals, institutions and corporations secure loans and therefore, the economy cannot function without liquid and orderly money markets (short-term lending in the bond market).  The recent acceleration of this crisis of confidence occurred when Lehman Brothers filed for bankruptcy (as a result of a perceived weakening of financial strength leading to the loss of funding availability, the same effect that brought down Bear Stearns) and general creditors (people and institutions that loaned money to Lehman) will likely lose all of their principal.  This did not happen with Bear Stearns, Fannie Mae, Freddie Mac or AIG where only the common shareholder was wiped out.  Money markets were no longer safe and cash fled to safe haven FDIC insured bank accounts and US Treasury Bills, which briefly traded at slightly negative yields last week.  This means investors were willing to PAY the government a small amount of interest to LEND it money for one month and know their principal was safe!  The SEC ban on short-selling prevented traders from attacking the next weakest link via the equity market, but with many people unwilling to lend to banks, short-term interest rates surged and liquidity dried up.  Direct borrowing from the Fed, the lender of last resort, has exploded, and the Fed’s almost one trillion dollar balance sheet has been mostly used at this point for collateralized short-term lending to financial institutions around the world.  This is unsustainable and is a result of the inability of banks to fully fund themselves through the capital markets.  It is the combination of lack of funding, reduced equity and being saddled with illiquid assets that is preventing banks from extending credit, and the negative feedback loop that exists between these factors will ensure that the problem gets worse until something is done to turn the tide.

One important point is that this is a bailout of the economy as a whole and not just of the financial industry.  Most people do not realize how close we are to doing irreparable damage to the capital markets and how important that is to everyone in this country.  This crisis will now become worse at an accelerated pace and we haven’t seen anything yet if we continue down the current path.  This plan is the only way to restore confidence to the US banking system.

What are the reasons not to go ahead with the plan in some form?

1) Let’s not bail out a bunch of rich Wall Street people.

This is silly because they have already lost billions of dollars and over 120,000 jobs and are only one piece of the puzzle. It is an inaccurate simplification to only blame investment banks for this problem. Everyone from homeowners/spec buyers to mortgage brokers to foreign bondholders to the US government (a big part of it actually) share the blame and they have and will be punished in one way or another.

2) The taxpayer shouldn’t have to pay for this mess.

This needs to be clarified because the media is misrepresenting the facts in many ways.  The taxpayer may very well have to pay something in the end, but here are the important points:

a) The government is not “writing checks”, it is making loans and investments.  This goes for the AIG bailout as well.  Nobody “spent” $85 billion on that deal.  The government will receive LIBOR + 8.5% (London Interbank Offered Rate), which is currently more than 12% interest, on that loan and will own most of the equity upside of the future of the company.  Could it lose money?  Yes.  But it could also make a lot.

b) The government is not using taxpayer money to make these loans.  Think of the government as a giant hedge fund.  It borrows money and makes investments.  It will issue $700 billion of US treasury notes and bills and use the proceeds to buy the distressed assets.  The interest rates on the assets far exceeds the interest rates on the US govt debt so it will net receive income. As time passes, depending on default and recovery rates on the underlying mortgages, it will make or lose money on the assets, and losses, if any, may or may not be covered by the positive interest rate differential that the government will earn.  In the end, the taxpayer is on the hook for the losses, if any, and will receive the gains, if any.  Either way, the gains or losses are unlikely to be anywhere near $700 billion.  One other interesting point is that as soon as the government buys the assets, they will immediately become more valuable and private capital will most likely flow into the system again.  For example, Warren Buffet just put $5 billion into Goldman Sachs.  Would he have done that if he didn’t believe this plan would be passed?  Not a chance.
3) If we start with $700 billion, what if we need three times that much, and are we going down a dangerous road where we keep throwing good money after bad?

This is a concern and only time will tell.  It might need to expand at some point, and may or may not be approved in that event, but my feeling is the initial size will be sufficient.

This plan has more hair on it than the similar RTC-type plans in the past, but there is precedent for this.  Again, I don’t like that it has come to this, but unfortunately we have no choice.  The US economy, already effectively in recession in my opinion even though GDP growth has yet to go negative, will continue to weaken in the coming months.  However, with the passage of this bill, we have a chance to repair the banking system and enable the Fed to inject credit into the economy in levered form as it always does at this point in the cycle (i.e. the Fed cheapens lending and reduces incentive to save –> banks borrow –> banks lend ten times as much also at cheaper rates –> economic activity ultimately picks up).  Without the bill, we risk a serious disaster in the financial system and a dysfunctional banking sector will prevent the economy from operating properly.  Unemployment will rise significantly, many businesses will fail, asset prices will continue to deflate, possibly at a faster rate, capital will retrench and we risk a deflationary environment, a depression or a Japan-like scenario (also generated by collapsing asset prices and the unwillingness to write down and remove bad loans from bank balance sheets).  I think we can work out of this mess, but it’s time to take out the big bat and shock the system.  Too bad politics are involved.

Rushing to get it all done

Creative Commons License photo figure credit: booleansplit

In the original post on this subject, I outlined the almost comical amount of difficulties I faced in trying to move approximately $44,000 out of our Money Market fund at Vanguard and into our checking account so that we could pay the balance on our Chase Freedom card.  You may also recall that the reason why our balance was so high is that we were exploiting a 0% interest rate on purchases for one year — otherwise known as a form of arbitrage.

Picking up where I left off, the plot gets thicker before finally thinning out for good:

The good news is that the payment from the Vanguard check arrived at EverBank on September 8th.  The bad news is that I didn’t even consider the fact that it could take days before the check cleared.  Because of the very large amount of the check, the bank cleared it in increments: I got a $100 credit on day 1, a $5000 credit on day 4, and the total was credited on day 7.  Each day, starting on September 10th, I had to move my online bill payment from that day to the day after the final schedule payment in hopes that the check would clear the next day.

After doing this for 3 days straight, I discovered that the Chase website has an option for making payments online.  This option requires you to enter your bank’s routing number and the account number from a check.  “Great!”, I thought.  But there must be a catch to this also.  I emailed customer service and asked what the fee was for this, what the maximum amount I could pay at any time was, and how long it took to post to my account.  I was told that there was no fee, the only limit to the amount I could pay was the total of my credit card balance (in other words, I could not overpay my account), and that the payment posted on the same day as long as it was made before 4pm.

At this point, I canceled all of the scheduled billpay payments and went about setting up the payment on the Chase website.  Wouldn’t you know that I discovered another catch?  The website, contrary to the information from customer service, limited me to a payment of $25,000.  Additionally, I could not set up another payment until 3 days after the first payment.  Luckily, I still had time.  The first payment was set up for the 13th of September and the second payment was set up for the 16th.  Both payments executed properly, and I met the September 17th deadline to get the entire balance paid off by the due date.

Whew!  In total, I paid a lot for this in stress, as well as the $20.71 FedEx overnight fee to get the check from Vanguard as soon as possible.

Lessons learned and next actions:

  • We are going to fill out the form that would have allowed us to transfer the money directly from Vanguard to EverBank.
  • Never trust what a customer service person tells you — even if you get it in writing.
  • Plan ahead!
My Worst Nightmare

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In Part I one this story, I told the story of how we came to own our current home, how we financed it, and how we found ourselves upside-down on our mortgage.

The original loan on our house had a clause that said that we could not refinance or pay off the loan for at least 6 months.  Recognizing that we got a rather lousy interest rate because of our lack of documentation, as well as the fact that we would have to refinance anyway, we went ahead and refinanced as soon as we could.  Just about 6 months and a day after we signed our original home loans, we signed two more loans — one for 80% of the value, our first mortgage, and one for 10% of the value, our 2nd mortgage.  Because it was only 6 months into the original mortgage, the appraised value of the house did not change.  Both of these mortgages are 30 year fixed loans with decent interest rates.

In the time since we refinanced, rates came down considerably, and we tried to refinance again into a lower rate.  The appraisal that we got in the process was the first strong clue for us that trouble was brewing: the appraised value was about 10% lower than what we paid, despite the fact that we had undertaken substantial exterior cosmetic improvements (curb appeal).  We were unable to finance into the very low rates that we available a little over a year ago since we now owe more than the property is worth.

Having unknowingly saved ourselves from the current mortgage crisis, we also did the smart thing and consolidated the 3 credit cards that I talked about in Part I into one card.  Every few months or so, I get a set of checks from my Chase Platinum card with offers for 0% interest for a year, 3.99% for 2 years, or 4.99% for the life of the balance.  We opted for the 4.99% deal.  Since half of the improvements made with the money on this card are for a legitimate business expense, we can deduct half of the interest payments on our taxes, which further reduces the effective interest rate.  In the time since we completed this balance transfer, we have paid down 3/4 of the original balance.  Because the interest rate is so low at this point, and half tax deductible, we have slowed our aggressive pay down of this account in favor of building up some savings.

So while we are not in any trouble with respect to continuing to make our mortgage payments or servicing the debt or our improvements, we are still in a pickle.  We are looking down the road at the needs we have for housing, especially in light of our growing family, and are not all that pleased with the options we have available:

  • We can sell our house, but we would have to come up with between $30,000 and $40,000 to cover the difference between what we owe and what the house is worth.  This would wipe out our savings, and we would be just about starting over financially.  We would have to find a place to rent as well while we save money towards the down payment on a new house.
  • We can buy a single family house now, and keep our two family, renting both units.  The trouble with this option is that it would also wipe out our savings, putting us in a precarious situation if any emergencies come up.  Another problem with this plan is that the market rents for our two units is less than the combined mortgage, insurance, and utility rates we would have to pay out each month.  This is what makes the property an Alligator.  Each month we will have to feed it hundreds of dollars to keep it afloat.  This could actually be seen as a really great investment, a forced savings plan of sorts, since we will eventually get this money back when we sell the house.
  • The default option here is to keep doing what we’re doing.  That’s fine for now, but we live in a 2 bedroom apartment, and depending on the gender of our next child, may only work out for a short period of time.  The real downside to this plan is that we may miss out on some great real estate deals as the market bottoms out.  Under this plan, we can save for a new house over the next several years.  However, there is still the issue of the 2nd option above.  With any luck, rents will rise over the next several years to offset the continuous payments we will have to make into the house, but we can’t bank on that.

We made two major mistakes along the way with the purchase of this house. We bought an over-valued asset at the height of a market bubble. We failed to adequately assess the income versus expenses for a rental property. In our defense, we bought the house for the reason stated in Part I: to be able to afford to live in the area we wanted, close to other family and in a decent neighborhood. But in retrospect it was an investment that will not provide the returns that we could have achieved using other investment vehicles.

What would you do?  Do you see options that I haven’t seen?  Are you feeding an alligator? Let me know what you think in the Comments section below, or click here if you’re reading via an RSS reader or by email.

09.07.2008
Cardinals

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It’s been a few weeks since I’ve had a chance to highlight some of my favorite articles in the rest of the blogosphere, so here’s what’s been going on:

Gather Little by Little tells us what the dumbest thing on which he ever spent money is.  He asks what others’ dumbest purchases are.  The first thing that comes to mind for me is a Bowflex machine.  It really did seem like a good “investment” in our health at the time, but like many things, it was too good to be true, and in retrospect way overpriced for what you get (a lot like a certain speaker company’s products that rhyme with “nose”).  A close second is a pair of those Ionic Breeze air cleaners.  At least we bought them on Ebay and saved a lot of money off of the MSRP.

GLBL also has a great guest write up on how to start an envelope budget system.  This is not the system that we use, but the best system for you is the one that works, so if you’re still looking, give this a read.

FrugalBabe writes about missing a home owners’ association payment and getting hit with a late payment as a consequence.  Her excuse is that they don’t actually bill her.  I’m a big fan of making things automatic, and I suggested setting up an automatic bill payment with her bank.  Few people realize that they can set up a billpay payment for things other than utility, credit card, mortgage, and other “typical bills”.  Heck, you can often send your friend a payment for the dinner you split last week.

J.D. at Get Rich Slowly puts it to his readers for suggestions on how to cope with a spending addition.  I don’t think the young woman in this case has an addiction as much as a bad habit.  My advice here again would be: Make it automatic.  Set up a Debt Snowball and then set up automatic payments that take effect the day after she can be sure that her paycheck gets deposited.  Of course she has to cut up her credit cards as well for now, but once she does this, if she doesn’t have the money in her bank account, she won’t be able to spend it.

J.D. also wrote another great post on “The Idea of Having.”  I hear him on this one.  Having “stuff” is a constant struggle for us.  We’re always going through closets and bookshelves and can usually bring ourselves to part with some stuff, but not other stuff that we don’t ever use but that we can’t bring ourselves to throw or give away either.  Sometimes I wish we had to live in just one room so that it would force us to pair things down to that which is truly important.

Pinyo wrote an analysis of when to start taking social security benefits.  He argues that while the starting benefit goes up as you age, you might not live long enough to recoup the difference.  However he missed the fact that a given person’s lifespan also increases with age.  A person born today in the US can be expected to live to 75 on average.  But a person who is already 62 can be expected to live into her 80s.  A person who is already 70 is likely to live into his late 80s.  This has to be factored into a full analysis on when to begin social security benefits.

Lastly, filed under the “just for fun” category, Freakonomics published an article detailing the correlation between states that have high occurrences of Bigfoot sightings and those with high occurrences of UFO sightings.  The best explanation given for this was in the comments section:

It strongly suggests to me that the aliens are Wookies.

— Posted by Doug

PS: I have a deeply discounted Bowflex machine for sale. Seriously.

09.04.2008
Bill Payment Box

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I have written before about our experiment with credit card arbitrage.  This is where you borrow money at a very low rate (preferably 0%) and stash it in a high interest savings account.  Since we have come to the end of the 1 year period on our Chase Freedom card, I got set up to make a large payment to pay off the card — $44,061.30 to be exact.

I know that the payment is due on September 17, so I decided to play it safe and get all my ducks in a row in plenty of time.  Last Friday, August 29th, I logged into my money market fund account at Vanguard to make the transfer to my checking and billpay account at Everbank.  I got the Sell order all set up only to find that “electronic transfer” to my checking account was not one of the options for cashing out our money.  The next day, I called Vanguard to find out why.  It turns out that since this is a joint account, Vanguard needs to have a signature card on file for ScrapperMom before it can let me transfer money from a joint account.  It didn’t matter that the checking account is also a joint account.

The only option available to me was a check.  I started doing the math in my head — the market doesn’t reopen until Tuesday, September 2, they can’t sell the money market funds on my behalf until the end of trading, the earliest they could cut a check would be the 3rd.  First class mail would likely get the check to me by September 7, then I have to turn that around and mail it to Everbank, which is another 3-5 days until it hits our account.  Now we’re up to Sept. 12.  A payment sent on that day should arrive at Chase on time.

After explaining the situation to Vanguard, and not wanting to cut it too close, they offered to overnight the check to us.  This will incur some fee, of course, and I don’t know what that is yet.  I’m assuming that it will be in the $20 to $30 range, but the representative could not tell me when I set up the order.

Fast forward to last night: I logged into Everbank to set up the bill payment.  I entered the full amount in the payment box, set the payment date for Sept. 10, and clicked PAY.  The bank came back with an error saying that I could only pay $15,000 in a single payment.  Okay, I thought, I’ll just set up 3 payments to take care of it — no problem.  So I reduced payment number one to $15,000.  Then I set up payment 2.  The bank thought it was smarter than me, and decided that this was a mistake — a duplicate of a payment that I already set up.  So I tried $14,999 instead.  Then the bank told me that the daily limit on bill payments in total is $15,000.

This was starting to get frustrating!  Eventually I ended up setting up 2nd and 3rd payments for the total amount due on the 11th and 12th.  According to the bank, a payment made on the 12th will arrive by the 16th.  How’s that for calling it close?  Usually the payment gets sent on the 10th, and usually gets credited to my account on the 13th.  So this should still work out.

Today I received the check from Vanguard and we immediately turned it around and mailed it off to Everbank.  There is the off chance that the check will arrive at Everbank and be credited to our account earlier than the 10th.  That will give us a little more breathing room if true.  Another option we now have through the billpay service with Everbank is to expedite a payment by sending it electronically or by overnight check.  As you might expect, these options are not without cost: $4.95 for the expedited payment, and $14.95 for the overnight check.

What are the consequences of a late payment?  I’m not really sure, but my expectation is that since the interest rate for purchases is 14.99%, the interest for one month at that balance would likely be about $500.  So it certainly behooves us to do everything possible to make sure the payment gets made on time.  It’s not as bad as it seems, since I estimate that we made over $700 on the arbitrage over the last year.

Lessons learned:  If you have to move large sums of money from one bank to another, make sure you know in advance what the limitations of the system are.  It’s also a good idea to understand what the limits of your bank’s billpay system is also.  We’re not sure yet what this means for future credit card arbitrage… but we’ll be sure to let you know soon how the whole thing turns out!

Have you ever experienced a close call with a payment or a problem moving money from bank to bank?