Expect consumer retrenchment to worsen

October 18, 2008 at 10:14 am | Posted in credit, economics, Uncategorized | Leave a comment
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With Wall Street volatility increasing day by day, and -at the very least – delays to the bailout plan, I believe the consumer retrenchment we have seen so far this year will only deepen. Consumer spending has been under pressure from a variety of factors, from high gas prices to increasing food inflation to weakening job prospects.

Since about September 2007, I’ve been expecting consumer sentiment and spending to both weaken significantly. While the latest data points are weak, I still believe the bottom is still some way away – At the very least 2Q 2009 – with a very slow recovery after that, but I am increasingly inclined to believe that the bottom may be in 2010.

What should we rescue? And what can we rescue?

October 5, 2008 at 5:06 am | Posted in economics, Housing, regulations, Uncategorized | Leave a comment
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The housing and related market has several layers to it. There are a whole lot of individual mortgages. Many of these are sensible mortgages on affordable terms made to people who have been reasonably prudent. Some of them were risky, for a variety of reasons, including individuals who got greedy for more house than they could afford, or lenders / brokers who put buyers into unaffordably large mortgages or with onerous terms. Some of the risky mortgages have defaulted or are otherwise in trouble, and things will continue to worsen for some time.

Tightening credit norms are making it difficult for buyers to buy homes now, even as prices are slipping and inventory is rising, further causing prices to spiral downward.

Most of these individual mortgages were put together into pools of mortgages, and investors bought securities created out of these pools. The idea is that each mortgage-backed bond represents tiny fractions of thousands of mortgages, and so should be safe even if a few of those mortgages go bad. These securities are then broken up into tranches, with the worst tranches the first to absorb any losses from defaults, and the best tranches only taking a loss if the lower-ranked tranches were wiped out.

So far, so good. The value of these mortgage backed securities is similar to the value of the mortgages underlying these securities. But then, we add derivatives on these MBS’s. There is no real limit to the number or value or complexity of derivatives. We can bet that one security will be worth more than another, or that the defaults in one security will exceed (or be below) a certain level, or a host of other such bets. And we can then create securities that pay off based on the outcome of other bets. The size of the derivatives market has been estimated at nearly $700 trillion – A thousand times the size of the proposed bailout, and ten times the size of the global economy.

I guess thats a bit like horse racing – The amount of money that changes hands based on the outcome of a single race is many times the amount of money spent by the breeders, or the prize money they may win.

I think that if the bailout money was used to buy mortgages, the price support is more likely to buoy the prices of the derivatives, than if the attempt was to either support the derivatives directly, or to rescue the bank after the derivatives caused big losses. After all, with the money, one could buy up over 5% of mortgages, and thus support the value of derivatives that depend on the value of the underlying mortgage for their own value, or make the tiniest dent in the derivatives market. If the derivatives got support from underlying values, there wouldn’t need to be as much of a writedown.

Obviously, every trade has a counterparty. For everyone who bought a derivative, someone sold it. If the value of the derivative tanks, someone loses big, and someone makes a killing. Supporting the derivatives market via underlying mortgage action will reduce the change in the derivative value. People won’t lose as much, or make as much.

Clearly, this is distortionary – If the investors believed the government would rescue the derivatives, they would not have made the same trades. But I think that the only area where a rescue could work is at the underlying mortgage level – and if derivative investors see bets they called correctly going against them because of the rescue, I feel for them, but still think the economy is better off than if the bailout money was used to rescue the financial sector from the results of mortgage defaults.

Just checking in

September 29, 2008 at 8:56 am | Posted in Uncategorized | Leave a comment

Hi, we haven’t had internet access the past couple of days, and we may have only spotty access the next three weeks as we backpack across north eastern India. I will post when I can, and as often as I can.

Retirement planners overestimate returns

September 16, 2008 at 9:56 am | Posted in retirement, saving, Uncategorized | Leave a comment
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I think there is a risk that retirement advice tends to underestimate what we need in retirement, and how to get there. In particular, I think there is a tendency to be too optimistic about the long-term returns on our investments, and thus save too little. And I think the main problem is that they use an inherently risky assumption about how much our investments can earn to forecast our savings goals, which I think should be fundamentally low-risk. I don’t want the risk that I do all I set out to do to be able to retire comfortably, but fall far short. It is ok to fall short of stretch goals, or luxury, but I must ensure that the necessities are taken of, and there isn’t much risk that my nest egg falls short of that basic level.

So here’s how I would aim for a risk-free retirement.

The risk free rate in the US is basically the 10-year treasury, which currently returns 3.4%, but lets assume it is 4% over the next few decades (If it averages too much more, we are all in trouble on the economy). A look at the markets today basically tells us that anything above this is risky – either there is some default risk (mortgages are just one example, there are plenty of others) or there is uncertainty of returns (the equity markets) or something else.

This is not surprising at all – If any investment, equity, or otherwise, returned a 8% return with the same risk as a US government treasury, the market would sell out of US treasuries and buy that investment – whether it is an S&P 500 index fund or the Orange County, CA residential REIT or Vallejo, CA muni bonds or a silver fund or whatever it may be. In the process, the two returns would begin to converge. In practice they don’t. So the market is telling us that this alternative investment or basket of investments (lets call it X) are riskier than treasuries – risky enough that the market demands a 4% higher return than treasuries.

Now – I want to have a nearly 100% chance of not running out money. Maybe that means 90% for some, 99% for others. But its not 50%. That means that whatever my target retirement date is – 25 or 30 years from now – I want to be just about sure that I have saved the amount I needed to save (more on how much that is later).

Say I want to save $1 million at the very least – 99%+ sure… I could buy US treasuries, or some other “safe” asset. If I assume a 4% return, I can figure out how much I need to save over a 40 year career to get to $1 million – $7560 in year 1, growing at 2% a year. But lets say I actually invest in equities, which have a higher potential. And to put that in context, if the family is making $75000 a year, you need to save just 10% of your income to make it to that $1 millionĀ  mark.

If I actually get an 8% compound return, when I was planning for 4%, I have $2.5 million in the bank when I retire. Wow! What a windfall! Maybe I retire early. Maybe I travel a lot or buy a vacation home somewhere. I can live up the good life. But if I really got 4% (remember, that is all that is considered risk free, anything above that – well, lets hope for it, but lets not depend on it), I have $1 million. With whatever is left of social security or other sources, I have enough to pay the bills, and pay for all my medications and maybe assisted living at the end of my life, and a nice vacation every now and then.

So if I assume a 4% return, I end up with something between a comfortable retirement and a luxurious, windfall retirement.

What if I assumed an 8% return like the financial planner suggested? My financial planner would tell me to save $3000 a year instead to get to $1 million. Easier? Yes, so this is what I want to hear – $3000 does it, why bother with $7500??

But – If I do get an 8% return, I have a comfortable retirement. What if I only got 4%? That is equal to the risk free rate, but remember, the market returns could be lower than the risk free rate – just not very likely over a 40 year period. Well, if I got 4%, my nest egg would be only $390,00! I’ll have to work longer, maybe my retirement travels would few and near home, and maybe I might have to think about which of my diabetes or cholesterol medication I could afford to skip this month!

The financial planner knows that saving $3000 is easier than saving $7500. She’d rather get the commission on the $3k than hope you agree to save $7.5k (rather than just go to another guy who tells you $3k is more than enough.

Don’t worry about your assets outliving you – if they do, it means you had fewer caramel lattes than you could have had, or ate out less often than you could afford. Assess the situation when you retire, and decide if you can now try the fancy French restaurant and the holiday cruises.

But if you outlive your assets, you had better have really nice kids with good jobs.

I’d rather plan for my nest egg to be a regular egg and end up with an ostrich egg, than plan for it to be a regular egg and pray it doesn’t end up being a pigeon egg! Its hard to save more, but the next time a planner says you can make 8%, just say, no thanks, lets plan with 4%.

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