Caution about Borrowing Money

In an earlier post, Why Credit Scores Should Be Ignored, I argue that credit scores are unimportant and that they encourage people to do things that benefit banks at the expense of consumers. I also suggest most borrowing by individuals is a bad idea. Most readers will agree that credit can be misused, but what about responsible use of credit? Isn't it a benefit to responsible borrowers to have a credit report containing things banks like to see?

Responsible Credit – The Math

The idea of responsible credit is to borrow money for activities that return more than the cost of interest. A worthwhile business ought to return more than the cost of borrowing money. Therefore, the reasoning goes, if you believe in your investments and businesses, you ought to borrow the most you can to fund them.

In the most common scenario, individuals borrow money on their homes and invest it. They hope to make 12% (8% after taxes) on it. The loan on their home is 6% (4% after home mortgage deduction). So they're borrowing at 4% and making 8%. This seems like a no-brainer.

But they should ask where that borrowed money's coming from. It's coming from people making deposits at an even lower rate. Why are depositors accepting a lower rate instead of investing in what you're investing in? Maybe it's because they're unsophisticated or very risk averse. Then why are the financial experts at the bank lending the money to you instead of investing at higher rates? It all comes down to risk. There is some risk in a portfolio that provides higher returns. Individuals borrowing from the bank to invest (or keeping investments while they're making payments on a home loan) need to be aware that they have chosen to accept risk in exchange for more money. There's nothing wrong with doing that. But they should not be surprised if at some point in their life they have to make quick changes when their portfolio goes down at the same time they lose their job.

A similar argument applies to business debt. If the businesses does not work, the borrowers will have to sell whatever they must to repay the debt.

Consumer debt is the worst because it's used to buy things that are not expected to return any money. Oddly though, the line of reasoning that leads people into mortgage debt and business debt can be used to rationalize consumer debt. People think their investments or business are so good that they should maximize all borrowing so they can maintain their consumption while investing all possible money. Even if their investments do return more than the cost of the debt, there is a hidden cost of consumer debt: It makes it very difficult to track income vs. expenses. Having all this money flying around to and from loans complicates basic budgeting. It also makes people vulnerable to liquidity problems if there are unforeseen expenses or income interruptions.

Should We Never Borrow Money?

Everyone needs to look at the risk and answer the question for himself. IMHO, if people do not have the money to buy a house but could borrow the money at roughly the same payment as renting the space, they should do it. They are taking the risk of a problem with the home or a decline in prices, but they get the benefit of the potential profits their landlord would have made.

If someone with no money needs tools or a vehicle to get a job, borrowing money could make sense for them. IMHO, they should explore all other avenues, e.g. a job that provides tools and does not require a vehicle.

Caution

The point of this post is to urge caution. Many people borrow money on cars assuming that their income will remain steady. They borrow money on houses without even considering that they could lose money. Even people with jobs that they know are unstable continue to ignore the reality. When one of life's hiccups eventually occurs, they are shocked. After the fact they call on politicians to subsidize their mortgages or to try to bring back post-WWII era job security. I am not commenting here on whether politicians should do those things. I'm simply saying that until they do, intelligent people should see the risks of the financial products they buy and take caution.

When a salesmaker approaches people on a car lot, they are rightly cautious. They may preface questions with, "I'm just browsing." They know that the salesperson may want to sell them products that are not right for them. They know they need an independent opinion.

In the case of financial products, however, much education comes from financial institutions themselves. They teach people to "protect their credit score". They produce educational materials for children explaining why financial products are part of the path to responsible adulthood. They train so-called "financial planners" to sell financial products to people who are seeking financial advice. Most of the financial education the average person comes across is aimed at benefiting financial institutions, not consumers.

Many financial products are worthwhile. It's important to take the time go over each of them, as we would with any purchase, and ask if we really need them and if we're getting a fair deal.

Caveat emptor.

Share the Roads

Winter started in full force in the Upper Midwest without giving us time to ease into the driving difficulties. Everyone I have encountered on the roads on my seven-mile commute so far this year has been cautious and understanding of other people using the road. Twice someone going slow has beeped and gestured to communicate that they were going to continue going slow and that I had time to get across the road. I see people out helping their neighbors shovel their walks. It's so nice to see people come together in the face of winter's inconveniences.

There are a few crotchety fellows out there, who I have not seen on the roads but who make their frustrations known on blogs and at gatherings. There is a natural tendency to want to blame our frustrations on some one or some group, say the snow removal crews or SUV drivers. That's when we have to step back and remember this is Wisconsin and tough winters are part of the deal.

When we start feeling like we own the road, it goes something like this:

• Bicyclists: I am out here doing my part to save the environment while these nitwits in cars are putting everyone at risk with their 3,000 lbs of metal. They don't use studded ties or chains and they can't drag their feet to stop in an emergency. Since they can't stop and they're a lethal threat, it's just common sense that motor vehicles should not be on the roads.
• Cars: I can't stand these SUV drivers. It's easier for them to get going in the snow, and they don't worry about having to stop because if they hit my Honda it's me not them who gets hurt. What's worse is the bicycles, who I have to avoid because if I hit them it's me not them who will have to pay damages. It's just common sense that only cars should use the roads.
• SUVs: It seems like I am the only one responsible enough to drive a vehicle appropriate for bad weather. They blame me for global warming, even though my car is only a small percentage worse than the average car. If I smash one of those cars or bikes, I'm going to be liable for major damages. It's just common sense to stay off the roads unless you vehicle can handle the conditions.
• Professional Drivers: I'm trying to make a living, and all these inexperienced drivers who only drive maybe an hour a day get in my way. If I hit some car or bicyclist, they'll throw the book at me because people demonize semis and buses. It's just common sense that if you don't have a CDL, don't have experience driving all day long, and are not in a large truck or bus you should stay off the roads.

The authorities have not restricted the roads to any of these groups. So, as the signs say, we must share the road.

It hard to reason with curmudgeons. At best they'll hear a two-word response. At least for the holiday season, I will do my best to keep Happy Holidays as my two-word response of choice to the winter weather bellyachers, even when they're not always the first two words to come to mind.

Demographic Trends Drove the Real Estaet Bubble, But Not so Much as Speculative Mania Did.

My father sent me an interesting article from last year about the demographic aspect of real estate prices. It says people have different property needs at different ages, so as a large age concentration like the baby boomers pass through an age, there is more demand for the types of real estate they use. I have never thought of land use as generational, but it completely makes sense. The article predicts housing price declines in 2010s due to changing needs of the baby boomers.

I agree with the article, EXCEPT I think liberal financing vehicles and speculative mania drove the bubble more than actual need for housing by any demographic group. If the bubble were caused by increased demand for housing, rents would have risen too. Inflation-adjusted rents stayed constant. I predict more declines in this decade because financing vehicles and speculative mania are drying up, and I predict that factor will predominate over all others.

When you look at the long-run, real housing prices take large (sometimes 30% or more) swings up and down around the same value. They've been doing that since the Civil War. Demographic shifts are one cause of the up-and-down swings. The latest upswing is almost 100% above the average, but it's the same idea. If people planned for reversion to the mean, large price swings over a period of a few years would not be a cause for celebration or panic.

Is What's Good for Realtors Good for Everyone?

According to the Wisconsin Realtor's Association, the median sale price for existing homes in Wisconsin rose 2.4% from Q3 2006 to Q3 2007. This is surprising because
a) Real estate prices compared to rent prices are far above historical norms.
b) The subprime meltdown (March 2007) and mortgage liquidity trouble (Aug 2007) happened during that period.

I cannot explain why the bubble persists in Wisconsin, at least for existing homes, now that the easy money has been shut off. It is clear, though, that a lot of people have an interest in seeing the bubble continue or at least deflate as slow as possible.

Look at the implicit assumptions in a recent WI State Journal article on the topic: (emphasis added)

Stephen Malpezzi, real estate department chairman at the UW-Madison School of Business, said he expects most Wisconsin cities to fare better than areas with shaky economies.
[snip]
"I don't see any steep (price) declines or huge problems," he said. Wisconsin home sales were better than the nation.
[snip]
So far Wisconsin has weathered the foreclosure and subprime mortgage crises better than more speculative housing markets.

A lot of things are going "better" for Wisconsin. But what is "better"? The article doesn't make it clear. It seems that part of "better" is a) people spending more money on housing and b) people moving more frequently instead of staying in one place. If inflation-adjusted home prices and rate of sales went back to their year 2000 levels, these people would call it an absolute crisis. But somehow life went on in the year 2000. On the other hand, the "best" situation would be for everyone to be spending over 50% of their income on housing and to move every year.

This is all about what's best for the FIRE industries (Finance, Insurance, and Real Estate). What does it mean for other people? We are working similar jobs to what our parents did 30 years ago and living in similar houses. The difference is if we buy a house we need to liquidate more of our other investments and/or borrow more money than they did. Because of all that money being borrowed, though, money market funds that invest in mortgage-backed securities provide good returns, safety, and liquidity. People borrow a lot more money to buy a house, pay more to insure it, and receive more money when they sell it. There is definitely a lot more money sloshing around through the banking system, but unless you work in one of the FIRE industries, you're none the better for it.

Because the bubble was so beneficial to the FIRE industries, they will hold on to it as long as they can. They infect the language so that news paper articles unapologetically write as if the more money people have tied up in houses the better. They are not powerful enough, however, to stop the forces of supply and demand. If year after year there are no investment properties that generate enough income to cash flow, investors will not be there to buy the properties. If the families are making more interest on the amount of money required to buy a house than they pay on rent, they will not forgo that interest to own property. In short, real estate prices and rent prices will return to parity.

It is not my intention to condemn the FIRE industries. I condemn newspaper articles that imply that what's good for the FIRE industries is good everyone else.

Why Credit Scores Should Be Ignored

I heard a news report from a mainstream news outlet putting forth the claim that protecting your credit score is an important part of good money management. This is a lie promulgated by the financial services industry and repeated by most everyone.

The three credit bureaus are private organizations that keep track of how well people pay their bills. They also summarize this information into a single numerical value, so that lenders can quickly work out the risk of lending to a consumer.

People who want to "establish a good credit score" do something like this:

• Open a few accounts to increase their unused credit line but not so much that they are penalized for requesting credit too often.
  
• Borrow some money and pay it back on time, while not borrowing so much that they are penalized for lack of available credit.
• Take great care with anyone who has the ability to put a negative market on their credit reports.
• Monitor their credit reports frequently for erroneous information.
• Pay the credit bureaus extra (beyond the cost of a credit report) to compute their score for them so they can get feedback on to what extent their financial lives match what the bureaus want to see.
  

What do they get for jumping through these hoops? They get the ability borrow money at a lower interest rate and to borrow money for things that lenders think are risky.

If you want to borrow money for a house and have a good down payment and enough income to make the payments, you do not need good credit. The underwriting guidelines are not that strict. A person without a long credit record or a high credit score can get the same interest rates available to someone with a high credit score. The person with the high credit score, however, will be able to buy a more expensive home with no down payment, borrow to buy a car, borrow money unsecured, and so on. In short, having a high credit score allows you to do things that are costly and risky for the consumer and profitable for lenders.

This situation really bothers me when I hear someone suggest a financial move for the purposes of "building credit", especially if the financial move profits a bank at the expense of a consumer. It also bothers me to hear people considering settling a dispute with someone because they're scared that the other party will put a negative mark on their credit bureau. It goes like this: I got this letter saying I owe money. I don't think I do, but instead of refusing until I see proof that I owe the money, maybe I should just pay it to protect my credit report. We have courts to resolve disputes like this. The credit bureaus' opinion on a dispute should be irrelevant.

The bureaus make a clear distinction between their customers and consumers. Customers are banks and anyone else who pays for a credit report on someone. Consumers are the people who want to borrow money from banks. The bureaus get their money from their customers, so that's who they're accountable to.

It's wise for people to avoid borrowing money and to ignore the opinions of banks and credit bureaus.

Revisiting Optimistic Predictions for the Occupation of Iraq

Here are some excerpts from a March 29, 2003 article in the Washington Post, written just as the US-led invasion of Iraq began.

Cheney said, "I think things have gotten so bad inside Iraq, from the standpoint of the Iraqi people, my belief is we will, in fact, be greeted as liberators." It was then he predicted that the regular Iraqi soldiers would not "put up such a struggle," and that even "significant elements of the Republican Guard . . . are likely to step aside." Asked if Americans are prepared for a "long, costly and bloody battle," Cheney replied: "Well, I don't think it's likely to unfold that way. . . . The read we get on the people of Iraq is there is no question but what they want to the get rid of Saddam Hussein, and they will welcome as liberators the United States when we come to do that." Cheney has spoken that way for months.

In September 2002, he said that "you always plan for the worst," but he also said, "I don't think it would be that tough a fight; that is, I don't think there's any question that we would prevail." In a speech in August, he cited a scholar's view that "the streets in Basra and Baghdad are sure to erupt in joy in the same way the throngs in Kabul greeted the Americans."

In an interview on PBS, Perle said he "would be surprised if we need anything like" 200,000 troops, and predicted only 10 percent of Hussein's troops would be loyal. Though warning of "contingencies," he predicted an internal revolt against Hussein, adding: "It will be quicker and easier than many people think. He is far weaker than many people realize."

I'm glad my mistakes aren't this public. I've certainly made my share of mistakes. I'm fortunate that my job doesn't require me to go on record selling people on the outcome of my plans and that my job does not involve life-and-death decisions.

I suspect the architects of the invasion and occupation of Iraq believed their own propaganda. Their training was in military, and they really wanted to believe that war could solve problems like Iraq and the sanctions; just as I would like to believe that information technology will bring about world piece by acting as a force for equality and democracy like the printing press, only more so.

I certainly hope the Vietnam syndrome (i.e. reluctance to get involved in military conflicts) is back for good. Reluctance to getting involved in wars goes back to the founders of the US. I hope what hawks called the Vietnam syndrome will from now on be recognized as basic American values.

Is the US Federal Reserve Worthwile?

My wife asked yesterday if I agree with US presidential candidate Ron Paul's call for eliminating the Federal Reserve. I do not agree with Paul on this, however, I think it's very good for Paul to be putting the question out there for discussion.

We've had the Fed for so long most people never ask whether it's a good idea to have federal officials setting our monetary policy. The Federal government should be constantly evaluated on how good of a job it does on everything it's involved with.

The criticisms of the Fed

• The Fed has made bad decisions: Overly tight policy led to the Great Depression. Overly loose policy led to the stagflation of the 1970s. Critics have blamed Fed policy for the tech stock bubble.
  
• Unexpected inflation: Poor Fed policy could result in unexpected inflation. People making economic transactions have to factor this risk into their business deals. People making a long term lease contract need to be mindful that they don't know what the value of the dollar will be at the end of the year. People lending fixed-rate money need to charge extra (and consider protecting themselves with rate derivatives) to handle the risk of rising rates.
• Expected Inflation: Good Fed policy results in a normal condition of a few percent inflation. This costs people "menu costs" to update their price lists, "shoe leather costs" to take their money to the bank. It also discourages people from saving because when investments go up with inflation, it's taxable.
  

Why the Fed is a good idea

The Fed evens out the economic cycle by smoothing out the expansions and recessions. Even if the Fed has not done a perfect job, it's better than just leaving it to chance. The alternative Paul suggests is to peg the dollar to gold. Gold is used in products and is still being extracted. Its value could change with supply and demand for gold. We would be turning our monetary policy over to something random.

We see Fed critics on both sides.

• The Fed should provide more liquidity to help with the housing bust.
• The Fed created the tech and house bubbles and is risking creating inflation with too loose monetary policy.

It makes me suspect that Fed is doing a decent job balancing the pressures for tight and loose policy.

It does such a good job that I would like to see a similar board set up to set fiscal policy. (More on fiscal policy in a future post)

The Decline of the Nation State

Earlier this year I talked to two people who told me that globalization is shaking up US society because corrupt politicians just look the other way. All of the negative affects of liberalized trade, they said, could be prevented by the government acting in the interests of ordinary citizens rather than those of corporations.

While it's true that large special interests must get something for their political contributions, I don't think poor policy making explains the negative effects of globalization.

Technology has shaken up everything, and there's nothing that can turn it back, at least not if we're interested in continuing to have heaps of consumer products. We're falling into history. A future history book might have a chapter titled, "The 21st Century: The Decline of the Nation State". That's bigger than any crooked politicians. After 30 centuries, the nation state is the devil we know. Thanks to cheap energy and telecommunications, we're just starting to try something new.