Regulators – absentee parents

September 20, 2008 at 7:03 pm | Posted in credit, economics, Housing, regulations | Leave a comment
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I think regulations and regulatory agencies failed to create an adequate framework for the credit markets.

In essence, while lenders invented 5% down, even the 0% down, no documentation, stated-income loans with down payment assistance, regulations allowed lenders and investors to get away with similar low equity / high leverage balance sheets. Lehman, for example, had a debt-equity of 30-40x (admittedly boosted by prior write-downs of its assets).

This is just like parents raising kids – Some parents regulate kids more than others (I think less- but not too much less- is better, generally), but if you fail to regulate them, sooner or later, they are going to need rescuing – whether you rescue them or want to teach the kids a lesson.

Crisis of risk aversion

September 20, 2008 at 6:55 pm | Posted in credit, economics, Housing | Leave a comment
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I think, and some people wiser than me think, that this whole crisis was created, not by too much risk taking, but by too little. Investors had money to invest, and tons of potential investments. They could invest in startups, or corporate debt, or in biotech R&D ventures, or in retail – They had the option of investing in just about any area of our economy.

But they invested disproportionately in two areas – First, in treasuries – safe paper. The other area they invested in was also supposed to be just as safe, but could let them eke out a few extra points of interest – mortgage securities of all stripes. They were very complex, and a single security contained as many as tens of thousands of underlying mortgages. This was too much data to handle, in terms of the quality of each underlying mortgage, and the derivatives on this became ever more complex. The investors did not have the time, the data or the ability to understand them fully.

But the credit rating agencies said that they had studied these mortgages, and their models predicted that the losses in the portfolio would be modest, so the investors piled in. The problem was, the models were wrong. The models assumed that house prices would always keep going up, and thus, that refinancing would never be a problem. Wrong on both counts.

All it takes is a close look at the economy – where have all the record profits of the past 5 years gone? Where is the big spending? Where is the corporate expansion? Where is the massive R&D? The investments?

It all got crowded out by the least risky option – Not by someone swinging for the fences with their investments, but by someone hoping to approximate the safety of a treasury with 27 extra basis points of return.

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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