Monday, June 27, 2011

Why the government needs to spend more money

This will be the first post of a series on issues facing the country (some financial, some not), as we start the long slog toward the 2012 election. As the truth about many issues is obfuscated by one's political slant and particular media choices, we'll try to explain these topics from first principles. This will be done as part of an overall general policy goal of simply maximizing the country's wealth and the well-being of its citizens, without neglecting the poorest among us. We'll try and throw and preconceived notions out the door. As always, we'll have links a-plenty, and comments are welcome.

We'll start with the state of the economy. As negotiations continue on raising the debt ceiling, I'm afraid the real problems have been brushed aside. There are two major points that people have lost track of. The first is the fact that unemployment in the country as still a major problem. Take a look at this figure. It shows the civilian employment rate (as a percentage), since 1990. You'll notice the drops in employment during the '90-'91 recession and after the tech bubble burst in 2000. With the most recent recession, not only has the drop in employment been much steeper, but there is effectively no sign of recovery in terms of job creation. Compare this lack of recovery with that of previous recessions here. While the general economic malaise is in the news, the dire jobs situation isn't making any headlines. While this is stunning in and of itself, it also ties closely into my second point on the campaign issues and the national agenda.

What seems to be making all the headlines these days is the fact that the country has a debt problem. It does, and that's not really in dispute. The problem lies in the fact that people feel that we should address the issue RIGHT NOW. Politicians and common citizens alike are calling for spending cuts. Everyone has noticed Greece in the headlines; they may have heard of Portugal or Ireland's debt and financing issues. But it is wrong to look over to Europe and decide that we'll soon be sharing their fate. Let's first look at what interest the market is charging Greece, Portugal, and Ireland on their debt. When borrowing for 10 years, Greece is currently paying 16.8%, Ireland 12.1%, and Portugal 11.7%. This is roughly the rate Joe Shmoe would pay on his credit cards... and these are sovereign nations. The US? 2.93% (look at 'bonds' on the right side). It doesn't appear as if the market is sending us any worrying signals. In fact, as this chart shows, 10 year treasury interest rates (i.e., the rate at which people lend to the govt) never dipped below 3% at any point during the Johnson, Nixon, Ford, Carter, Reagan, Bush, Clinton, or W. Bush administrations. Matt Yglesias cites these facts, and justly asks "So why is this on the agenda now?" Robert Frank connects this issue with my first point:

Almost 14 million people — 9.1 percent of the labor force — were officially counted as unemployed last month. But that’s just the tip of the iceberg. There were almost 9 million part-time workers who wanted, but couldn’t find, full-time jobs; 28 million in jobs they would have quit under normal conditions; and an additional 2.2 million who wanted work but couldn’t find any and dropped out of the labor force.

If the economy could generate jobs at the median wage for even half of these people, national income would grow by more than 10 times the total interest cost of the 2011 deficit (which was less than $40 billion). So anyone who says that reducing the deficit is more urgent than reducing unemployment is saying, in effect, that we should burn hundreds of billions of dollars worth of goods and services in a national bonfire.

What has happened is that people are now in the debt-binge hangover stage. While loading up on debt while the bubble inflated, consumers are now paying down the debt and have reduced their current consumption. As roughly 2/3 of the economy relies on personal spending, when everyone reduces it at ones the result is reduced economic output and fewer jobs. However, as we've seen, the US can currently borrow money extremely cheaply. People recently were actually paying the US government to borrow their money. As we have a lot of infrastructure that needs to be built or improved around the country, it would be wise to borrow at these cheap rates and spend the money on the projects (which will have to be done eventually), WPA style; in this manner the government would step in and create the demand, since consumers haven't been able to. Considering the fact that it was a recession-related decline in tax receipts, and not runaway spending, which has exacerbated the budget problem, focusing on the economy to solve the issue makes sense.

With what's going on in Greece, I understand why there would be some concern over our budget. But it would be wise to wait a few years for action, at least until the economy has recovered. For now, the government can borrow cheap, spend the money that consumers cannot, help the economy, and perhaps relieve the unbelievable jobs situation. It's easier to pay down debt when your economy is not convulsing.

Postscript: Bill Clinton and Bill Gross recently talked of (related) ways congress could help stimulate the economy. See here for how the economy has recently (and repeatedly) failed to meet expectations.

Have grown kids? Stop throwing your money away!

I talk to a lot of young adults who tell me that they don’t need auto insurance because they are covered on their parent’s insurance plan. I ask them if they still live at home, and they say ‘no, but I’m paying my parents for my part of the insurance,’ or ‘no, my parents list me as a driver on their policy and cover it.’ It’s important for everyone out there to understand how insurance works, because in a situation like this, you’re probably paying for nothing.

When you actually read through your insurance contract, you’ll find that the only people who are actually covered on the policy are the two named insured’s, and their “resident relatives that are living in the household.” Also covered are people who borrow the named insured’s vehicles, but not if the vehicles are “readily available for their use.”

Basically, this means that your kids who don’t live with you aren’t covered because they are not ‘resident relatives that are living in your household,’ and your vehicles are ‘readily available for their use’ because they are driving them every day.

Most people think that if they list their kids on their policies as drivers that they will be covered, but this is not the case. Listing drivers has nothing to do with coverages on the policy; it is strictly an underwriting measure by the company. They want you to list all members of your household on the application so they can charge you more money. In fact, you have to list all members of your household or show proof that they have coverage elsewhere, or you’ll risk cancellation or a premium increase. However, this again is an underwriting measure by the company to ensure that you are being properly rated by the company for all household drivers. Listing someone as a driver on your policy does not guarantee coverage for that driver.

So, you must list all your kids that are living with you as drivers on the policy, but if a child moves out, they are no longer covered under the insurance contract even if they are still listed as a driver and you’re paying extra premium for them. You are basically throwing your money away in this situation.

Now, when your kid causes an accident or incurs damage to a vehicle and they have to file a claim, how will the insurance company know that your child has moved out of your house? The answer is that it depends on the size of the claim. If it’s a small claim, the company will likely pay for the damages without too many questions. However, if it’s a large liability claim (for example, your child causes a car accident that injures someone, who then sues you and your child for thousands of dollars), the company is going to send a claims adjuster out, who is going to ask a lot of questions and will most likely discover that your kid moved to a new place.

Your insurance agent can’t possibly explain everything on your policy to you. You’re not interested in sitting there for hours discussing it, and there is so much to go through that your agent doesn’t know exactly what is most important to your situation. So it’s important that you make sure to ask your agent a lot of questions about anything that concerns you. Don’t be afraid to call and ask. If you have a good agent, he or she will be more then happy to talk to you, and will probably be grateful that you called. It would also be a good idea for you to read over your insurance contracts and mark any areas that you don’t understand or have questions about. Talk to your agent and go over them together.

The last thing you want is to have disaster strike and be denied a claim by your insurance company, especially when you could have been covered if you’d only thought to ask your agent about it beforehand.

Saturday, June 18, 2011

Movie Review: "Super 8"

“Super 8” was directed by J.J. Abrams, the man behind the recent “Star Trek” revival, and creator of such television shows as “Alias” and “Lost.” Abrams grew up watching such Spielberg classics as “E.T.,” “Jaws,” and “Close Encounters of the Third Kind,” and “Super 8” is his attempt to replicate those films and bring back some of their magic to the big screen.

Let’s first start with what’s good about the movie, which are the performances. The movie is perfectly cast with some great young actors, particularly the lead characters of Joe and Alice, played by Joel Courtney and Elle Fanning. Joe recently lost his mother in a factory accident, and Alice is a sympathetic new friend. They are perfect as two young kids who are both dealing with difficult family situations.

Joe and his friends are in the process of making a zombie movie for a local film contest, and they recruit Alice to play the main character’s wife. The rest of the kids are also great, and provide many of the funniest moments in the film. The town is populated with very likable, real characters, and I found myself thinking that this would be a fun place to grow up. The emotional moments between the main character, Joe, and his father are very well done, as are some of the moments between Joe and Alice.

A train accident nearby occurs while the kids are shooting one of the key moments in the film, and there are some mysterious circumstances surrounding it. Something aboard the train could be potentially dangerous, and soon the town is overrun by military personnel as the town is kept in the dark about what really happened. The kids were lucky enough to capture some of the wreck on film.

“Super 8” is shrouded in secrecy, so I won’t give any more details on the plot. I will say that one of the problems with the movie is that it tries so hard to replicate the classic Spielberg movies that it fails to develop its own personality. It tries to be too many things, and ultimately, fails in some key areas. The movie ends up being too much like “E.T.,” but without the heart. While I did like the characters and was rooting for them, I didn’t have the same sympathy for them that I probably should have, and the end of the movie felt kind of hollow.

While Spielberg flouted his alien throughout “E.T.,” we don’t know who or what the monster/alien is “Super 8” is all about until the movie’s almost over. We care about the kids, their relationships and well-being, but we’re pretty certain that everything’s going to work out fine for them in the end.

Ultimately, “Super 8” is a watchable, fun movie that has some very nice moments, but fails to reach the emotional heights of the movies it’s trying to replicate. Perhaps if it had more of its own ideas, and relied less on throwbacks to older movies, it would have been more touching. Maybe “Super 8” is just proof that you can’t move backward in history, and in order to keep an audience engaged and entertained, you have to show them something new, or at least do something in a different way. “Super 8” is a nice homage, but that’s about it. The tragedy is that it could have been so much more.

Tuesday, June 14, 2011

Homeownership--what can and can't be measured

This'll be the last post in the series on homeownership, wherein we'll delve into both valuations and the non-financial benefits of owning a house. While some people (myself often included) attempt to determine, generally, whether buying a home is a better financial strategy than renting, the issue is too complex for such broad conclusions. This is somewhat unfortunate, as I often like to settle and wrap up matters into neat little boxes and file them away. The rent vs buy question, however, is situation dependent. The good news is that determining the best route for a particular situation isn't that complicated.

After once criticizing a mutual acquaintance for buying a house at the top of the housing bubble, a good friend defended the buyer, saying that she couldn't know at the time what house prices were going to do. While house stock prices cannot be accurately predicted from one month to the next, we can use logical valuations to determine if these assets are under or overvalued. Unlike gold (which you shouldn't invest in), stocks and houses provide a non-speculative financial benefit. Stocks are pieces of a company's earnings and a house provides what Jonathan Clements calls "imputed rent." Just as stocks and bonds pay dividends, so does your house through this imputed rent. He explains:
Consider how much you might earn if you rented out your house. Conceivably, you could receive a sum each year equal to 7 or 8 percent of your home's current market price. That is an indication of how much value you get from your house, as you live there rent-free.
So, this gives us an anchor for home prices. Could we get 7 or 8 percent of our current home price if we rented it out? William Bernstein approaches a home purchase through a similar lens:
A good rule of thumb is to never, ever pay more than 15 years fair rental value for any residence. This computes out to a 6.7 percent (1/15th) gross rental dividend, or 3.7 percent after taxes, insurance, and maintenance, which is about what you might expect from a mixed portfolio of stocks and bonds. (Imputed rent does have one real advantage over the return from stocks and bonds, which is that it is tax-free).
He goes on to say that the figure he keeps in mind whenever he's looking at a house is 150 (the number of months in 12.5 years). After hearing a broker's pitch, ask them what the place would rent for. Times that figure by 150, and if the house costs more than that, walk away. To add one more "rule" to the equation, due to transaction costs, Clements says that if you're not staying put for at least 5 years then renting is the better move.

Of course, there are other important features of the equation that are more difficult to assess. One is the fact that with purchasing a home, you are tying your family to the fate of the local economy. As mentioned previously, if the local economy is suffering, you may lose your job and want to move to find better prospects. The trouble is that your house price is probably also declining and your place will be that much harder to sell. This aspect is often over-looked, as people generally don't realize how much the economies of the various regions of the US can decouple. For example, if you've been living in Nevada for the last year you're experiencing an unemployment rate of 12.5%. This is bad enough under any situation, but if you're like more than 63% of Nevadans with mortgages that are underwater, you're not going to be able to easily move to equally deserted places, such as North Dakota, which has an unemployment rate of just 3.3%. Doubting how much unemployment negatively affects people? See here and here.

Finally, the main (non-financial) benefit of owning your own plot of land, free and clear, is something that everyone easily understands. You can't get kicked out. You can change the place as you see fit. And there's more that I'll simply leave to this boglehead:
Your land is not only part of your "net worth," it is also part of your total worth as a being traveling on this planet we call earth. From the dawn of time, for all living creatures, the land has been our mother, our father, our sustainer, that from which we arose and that to which we will return. Land can provide us with food, water, shelter, clothing, a place to mate and a place to call home. It can satisfy our physical needs, our emotional needs and provide a spiritual connection to all that is.

Put more concretely... you can build and live on your land, grow crops and raise animals there and have the space to provide for those of your clan.

The land you own has far more value than any bank account, 401 K, mutual fund or electronic entry next to your name.

They say that value lies in the eye of the beholder, but in the case of land the value will be there long after the beholder is gone.

Wednesday, June 8, 2011

The calculus of buy vs rent

First off, thanks for reading and for the comments. The last post wasn't meant to be a full treatment on the rent vs buy argument, but rather some seldom heard facts about homeownership. BUT, I feel compelled to more evenly state the case to avoid looking as if I suffer from cognitive dissonance or some such. These posts are meant to look at homeownership as an investment; while there are many non-financial benefits to owning a home that I'm fully aware of, we'll save those for future posts. To be clear, I don't begrudge people for buying homes. My issue is with the societal belief that one is setting themselves up for a golden future by borrowing $200k from a bank and sinking it into land and a pile of bricks. If the public generally thought of their homes simply as places to live then I wouldn't be writing this.

To begin, as stated in the comments, buying a home with a fixed mortgage payment is a great inflation hedge. While rents will generally increase with inflation over time, the house payment you have today could be the same 25 years from now when your income is much higher (given you don't take out home equity loans or refinance). I remember my parents house payment as being nearly the same as current, typical car payments. This will especially help if we return to the inflation of the 1970s. This doesn't look to happen soon (current 10-year expectations are ~2%/year), but, either way, it's a great feature of the fixed rate mortgage.

The second positive feature of the mortgage is the fact that you can write off part of the mortgage interest. This is one of the only types of debt that the government gives you a tax break on. While many economists rail against it, politicians hold it as somewhat sacred, so it'll be here for a while yet. Granted, it's a deduction and not a tax credit. So if you're in the 25% tax bracket it will lower your taxable income and save you a quarter for every dollar spent on mortgage interest. It's not as great a deal as some make it out to be, and definitely not a reason to spring for a bigger loan, but for those who itemize it's a bonus.

The third major feature of the mortgage is that it forces you to save and thus one day allows you to live without paying monthly for shelter. This obviously best for those who have a hard time saving otherwise. Many such people who would pay a little less each month by renting would likely fritter away the difference and end up renting (and paying for shelter) for life. It's a little easier to avoid the newest iphone or new pair of shoes when the bank can kick you to the curb after too many indulgences.

That last one, though, is where renting can be a decided benefit for those who are able to systematically save and invest the extra each month. While landlords are able to pass on some costs of insurance, property taxes, and repairs, they can only charge renters what the market will bear. Also, their maintenance and repair costs per unit are often lower because of scale on which they operate. Thus, while it's not a ton, often a rental will cost a bit less than an equivalent home. Avoiding having to plunk down ~$40,000 for a downpayment and instead being able to invest it is another benefit to the savvy renter. If you take this $40k (20% down on a $200k home) and instead have it in a 401k or IRA invested in stocks, the results after 30 years can be surprising. Stocks are often said to have a real return of 7% per year, whereas we've seen houses return around 1%. If you take the difference (6%), and compound the would-be downpayment over 30 years, one ends up with 40000 * (1 + .06)^30 = $229,000 which is enough to buy a slightly nicer house, without any debt. And remember, we accounted for inflation. If one is able to save $200/month from renting (not an unreasonable assumption), one ends up with $419,000. It's tough for a lot of people to save, however, so for a large portion of the population this wouldn't happen.

While we sadly can't shoe-horn this issue into a small, neat box, it was (reasonably) mentioned on that there seem to be almost three tiers of suitability: good savers may be best renting, people relatively bad at saving are probably best in a house, and for those with fragile finances, just avoiding the mortgage and leverage altogether would be a boon (whether or not they save the extra). Ryan Avent cogently details some of the downside risks of ownership:

Like a home, a small business is an illiquid, undiversified, highly leveraged investment, the performance of which is likely to be highly correlated with the owner's personal economic welfare. And we encourage small business investments, do we not? With good reason!

But the risk inherent in entrepreneurialism is widely understood. Everyone knows the factoid that half of all businesses fail within the first four years (this statistic is not necessarily accurate, but people understand the risk involved). Starting a small business—even just buying an investment property to operate as a landlord—is not part of the standard advice given to people looking to save for retirement. No one is looking to make three-fourths of the American population small business owners. Why? Because illiquid, undiversified, leveraged investments are dangerous! And while there are nice potential returns to be had by those able to make such investments, it's not the kind of thing we urge on typical working families with barely enough in savings to cover the initial downpayment.

So sure, it's fine to think of homes as investments, so long as the kind of investment you have in mind is the highly risky sort you wouldn't recommend to anyone who didn't have the ample knowledge and financial cushion you'd expect to see in a successful entrepreneur. And that does not describe most potential homeowners.

Things can go terribly wrong. House prices can drop 60% (see Nevada), the house perhaps won't sell for a year when you're looking to relocate for job propsects. Even when it does sell, it you may end up owing tens of thousands in cash to the mortgage company cause you're underwater. Felix Salmon adds another dimension:

Avent is right that buying a home is a bit like starting a small business, but the big difference is that the value of a small business comes in large part down to the owner. Whereas in the property market, the owner can only affect value at the margin.

If you have essentially no control over the outcome of your investment, and you have no way to exit that investment if it starts to go bad, then you’re a gambler. And as Avent says, that does not describe most potential homeowners.

While your prudent home purchase likely will end well, as with all aspects of life, don't treat the unlikely as impossible. To help reduce the risk, put 20% down, don't buy a place bigger than you need, and keep 3-6 months living expenses in reserve for emergencies. There's no downside to being conservative here.

Sunday, June 5, 2011

The siren song of homeownership

Despite the recent financial crisis, largely caused by people taking on too much housing debt, it again appears to be all the rage to be a homeowner. In contrast to other American idiosyncratic views or fashions, this one differs in that the people who ride the wave are thinking they are doing something beneficial for their long-term wealth. The truth is that they probably aren't.

You'll invariably hear that renting is throwing your money away, or that you're making the land lord rich, but people are often quick to ignore all the costs involved with homeownership. Proponents say that the tax break* is a real bargain or that house prices always go up and that you should get in while the gettin's good. The reality of it isn't so clear-cut. First, when buying a house one doesn't simply pay for the price of the house, but they pay what's called PITI (or, principle, interest, taxes, and insurance). This doesn't come cheap. Depending on the rate, interest can easily more than double the cost of your home. See this calculator for details on your situation (and hit the amortization button). Property taxes are usually a couple thousand per year (more if the house is large), and homeowners insurance often runs above $600 per year. This quickly looks onerous when compared to cutting a simple rent check each month (as renters insurance is often a nominal amount and the other fees mentioned are nonexistent). As a homeowner the ongoing costs quickly mount, as every extra square foot of the home has to be heated, cooled, maintained, repaired, insured, and taxed. Lately, we've added a few square feet. According to Robert Shiller, the "average size of new houses increased from 1100 square feet in the 1940s to 2150 square feet in 1997," just as family size has shrunk. With respect to these types of trends, Ben Franklin appropriately repeated the aphorism that "it is easier to build two chimneys than to keep one in fuel." After examining similar similar issues, Bill Bernstein, a respected financial theorist, concluded that "after taking into consideration maintenance costs and taxes, you are often better off renting." If you do buy, purchase the smallest house your family can stand.

Well, what gives? Just about everyone says buying a house is a wise move. In our culture whenever a young adult, fresh out of college, is at a family reunion, the older people perpetually encourage the youngin' to buy a house. They always say it's a great investment. But is it really an investment? Remember, investing is what we do after we've deferred consumption. As Bernstein avers, "Home ownership is not an investment; it is exactly the opposite, a consumption item." Do any recent homeowners out there feel as if they've actually been reducing their consumption?

If one does go ahead and considers it an investment, it is truly a poor one when assessed in light of three common characteristics which all good investments possess. First, for the vast majority, the home is often bought with a ton of borrowed money, which makes it a highly leveraged investment; this is bad. The gist: if you put 10% down on your house, your investment returns are magnified by 10 times (at 20% down they're magnified 5 times) This is how many people's equity was completely wiped out recently with price declines greater than 20% nationwide. - 20% X 5 or 10 quickly gets you to a 100% loss on your investment (i.e., you're underwater). A recent estimate states that over 28% of homeowners are underwater on their mortgages. Basically, these people have no skin in the game and their down payment (whatever it was) has been completely wiped out. The second negative characteristic is that your house is illiquid (i.e., you cannot get cash for it in a hurry). During a crisis people need quick access to cash. And it is exactly during crises that it's most difficult to sell your house or get a home equity loan. By contrast, the stock market is quite willing to buy your stocks from you at your leisure. Third, the purchase of a single home is undiversified. You're not investing in real estate in general, you're investing in a type of real estate (residential) in a very specific location. Again, the correlations here aren't helpful. Cities with the worst job situations will be the places where it's hardest to sell your house. Wanna uproots quickly and go to where the jobs are? Good luck. As Ryan Avent said, "homeownership, let's recall, is in most cases a highly leveraged, undiversified, relatively illiquid bet, with a return that is highly correlated to local labour market conditions."

What about those high returns from price appreciation? They are largely illusory. Three studies of prices in the US, Norway, and Amsterdam show that our homes likely won't fund our retirement. First, Rober Shiller examined home prices back to 1890 and determined that, "until the recent explosion in home prices, real home prices in the United States were virtually unchanged from 1890 to the late 1990s." Note that this was written in 2006 and that real prices means that inflation is considered. Similarly, two bankers studied Norwegian house prices from 1819 to 1989 and found that their average real increase was 1.3% per year. Analogously, a Dutch finance professor analyzed transactions of buildings on one of the canals in Amsterdam from 1628-1974 and found that real prices there increased by 0.5% per year. Not exactly heady figures. Considering the price volatility, your money is probably better off invested elsewhere. Despite this, my (future) wife will probably want a house for the (future) kids and I'll likely be in the market for a place one day. But I won't consider it a wise financial move. Please comment and point me to views/articles that refute the above.

*If one itemizes their taxes, they are able to deduct mortgage interest from their income. The benefits of this are debatable as most people don't itemize. Also, if you think it's a good deal to spend a dollar in order to get a quarter in return (how to think about the interest deduction), then message me cause maybe I'm missing something. The post above neglected to mention closing costs which often run at 6%. On a $200,000 home this is $12,000; this pain is often not felt as it's wrapped into the monthly payment.

** See here for a buy vs. rent calculator, here for what assumptions to use in the calculator, and here for a balanced view of this issue from the bogleheads, an online investing forum.