Archives for June 2007

Subprime Mortgage Troubles Caused By Both Bad Lenders, and Bad Borrowers

I’ve been seeing a lot of media coverage on the increase in foreclosures recently. It’s clear that there have been examples of predatory and misleading lending practices, as well as examples of people showing poor financial judgment, although most articles seem to focus on the former. But I couldn’t help finding this Wall Street Journal article ‘Subprime’ Aftermath: Losing the Family Home to be almost amusing. If it was trying to illustrate how sub-prime lenders were evil, it did a really bad job.

Take Ms. April Williams, who is the main character interviewed for this story and also featured in the box to the right.

“This has stripped us of our whole pride,” says April Williams, 47 years old, who has until August to pay off her mortgage or vacate the two-story Colonial at 5170, where she and her husband have lived for 11 years. “There’s going to be no people left in Detroit if they keep doing this to them.”

They did this to them? Let’s see here – they have an unstable job, but still decide to purchase stainless-steel appliances, custom tile, a new bay window, central air-conditioning, a backyard koi pond… and is that a $50,000 Lincoln Navigator luxury SUV parked in her driveway??

For this specific situation, I feel like both sides are in many ways getting their just desserts. Borrowers like Ms. Williams were greedy, bought more toys than they could afford, and now have to deal with the penalties. Their lenders were also greedy in extending them so much undeserved credit, and I’m sure will be losing money in the event of a foreclosure.

As for the big picture, I have mixed feelings. The capitalistic pro-free markets side of me thinks the system will fix itself. Lenders who got hit with all these defaults will tighten borrowing standards accordingly to maintain profits, while continuing competition will keep them honest. A bail-out would just create a bigger mess of things.

At the same time, I do think there should be regulations that require more simplicity and transparency in mortgage lending and real estate transactions. Everyone I talk to says that they are faced with 6 inches of paperwork when closing on a new home, and none of them fully understands it all. Everybody says “just sign”. There could be a clause that gives up your first-born child for $19.95 and you wouldn’t know it in all that legalese.

New Rules On Tax-Deductible Donations Of Clothing and Household Items

Before we move, we are planning to donate a ton of extra things like clothing, kitchen appliances, and books. Since this might be the first year ever that we can deduct charitable donations from our taxes (yay!), I wanted to check in what documentation I needed to obtain. Apparently, the government thinks too many people have been inflating the values of their old sweaters and other creative deductions:

– In 1986 Arkansas governor Bill Clinton deducted $2 for a pair of used underwear he gave to Goodwill.
– As president, Richard Nixon underpaid his taxes by $445,000, based largely on a huge deduction he took for donating his papers. In response the IRS limited the value of “self-created” documents to the cost of the ink and paper.
– Ordained ministers who tried to deduct their incomes as a charitable donation to themselves!

So, now we have to deal with these tighter requirements from the IRS:

You cannot claim a deduction for clothing or household items you donate after August 17, 2006, unless the clothing or household items are in good used condition or better. However, a taxpayer may claim a deduction of more than $500 for any single item, regardless of its condition, if the taxpayer includes a qualified appraisal of the item with the return. Household items include furniture, furnishings, electronics, appliances, and linens.

To prove your items were in “good used condition or better” in the event of an audit, the best bet is to get receipts whenever possible and to take digital photographs of everything. Another good suggestion from this CBS Marketwatch article:

Take your donations in during the day on a weekday, when the organization is not so busy. Create your own little form that says “These clothing and household items are in good condition, in compliance with IRS rules.” And have the person receiving the items sign and date the form.

As you can still only deduct the “fair market value” of each item, I also found this valuation guide from the Salvation Army to be very handy. Finally, there are even more appraisal requirements if you donate any item valued at over $5,000 or “a group of similar items”. (Nothing in my entire house is worth five grand, so I’m not really concerned about that.)

The Daily Show’s Take on Credit Card Debt

Here’s a funny clip about credit cards from the The Daily Show. Thanks to Ross for the tip.

I especially like the theory that as long as your carry your debt long enough, you can simply die and never pay it off! Why didn’t I think of that??

June 2007 Investment Portfolio Snapshot: Paralysis By Analysis, Call For Suggestions

I haven’t posted my investment portfolio since April, mainly because it hasn’t really changed much. But here’s another snapshot:

6/07 Portfolio Breakdown
 
Retirement Portfolio
Fund $ %
FSTMX – Fidelity Total Stock Market Index Fund $15,132 19%
VIVAX – Vanguard [Large-Cap] Value Index $14,567 18%
VISVX – V. Small-Cap Value Index $14,251 18%
VGSIX – V. REIT Index $8,163 10%
VTRIX – V. International Value $8,686 11%
VEIEX – V. Emerging Markets Stock Index $8,929 11%
VFICX – V. Int-Term Investment-Grade Bond $7,616 10%
BRSIX – Bridgeway Ultra-Small Market $2,126 3%
Cash none
Total $79,470
 
Fund Transactions Since Last Update
Bought $1,000 of FSTMX on 6/26/07 (23.759 shares)

Thoughts
Another couple of months have gone by, and my desire to re-define my asset allocation remains unfulfilled. All I did was buy some more of a Total US Market fund (FSTMX) through my self-employed 401(k). You’d think someone who writes about money on a daily basis would be on top of such things!

But really, I think I might actually be spending too much time on this. As Jack Bogle has stated, “The greatest enemy of a good plan is the dream of a perfect plan.” There is no perfect asset allocation, and I know that. I keep telling myself, I’m not looking for the perfect plan, just a better one which has been well-reasoned out, and one which I should have little reason to tinker with for a long time.

To achieve such a better plan, I have been re-reading each of my favorite investing books on top of many new ones (including All About Index Funds by Ferri, Unconventional Success by Swensen, Only Guide to a Winning Bond Strategy You’ll Ever Need by Swedroe), looking at their research, comparing their model portfolios, and trying to balance all the advice given. But after all these months, my slow deliberation has really just turned into what academics call “paralysis by analysis” and have been just been putting off making a decision for weeks. I do have some overall changes planned, including:

  • Increasing my allocation to international assets,
  • Decreasing my value tilt, and
  • Increasing my bond allocation.

I want to avoid trying to time the market, or chasing recent performance. But I also don’t want to base my decisions on simply trying to avoid the impression of trying to time the market. Although I’m always open to suggestions, I feel I need to some fresh input. Got an asset allocation suggestion? Ideas on a better value/size/country tilt? Another book to read? Throw it at me.

Does Living Longer Mean We Should Change Our Asset Allocation To Include More Stocks?

Recent articles by Bernstein Wealth Management [pdf] and Kiplinger’s Personal Finance suggest that as we continue to live longer lives, this should increase the percentage of our portfolios that we devote to stocks.

Living Longer…
A 2000 study by the Society of Actuaries states that a male who reaches age 65 has a 50% chance of living beyond age 85 and a 25% chance of living beyond 92. Women can expect to live two to three years longer than men. More importantly for couples, you are now looking at a 50% chance of one of you living beyond 92!

Means Some Potential Changes
Bernstein then ran some Monte-Carlo simulations using historical data (for what years, I couldn’t tell) to “help quantify the impact of alternative allocation and spending decisions over varying time periods and markets.” The basic scenario was a couple who retired at 65. The variables were how aggressive the portfolio was (20%-100% in stocks), and how much you withdraw from the portfolio each year (2-7%). Here are two summarizing charts and some of their findings:

altext
altext
  1. If you’re going to spend a relatively high percentage like 5% of your portfolio, it is important to keep your stock percentage at least at 60%. But, increasing it to all the way 100% doesn’t help much, and increases the downside in a bear market.
  2. At a low spending rate, like 3%, then your stock percentage doesn’t matter that much either way.
  3. Although spending and allocation are both critical factors, the former tends to exert a more powerful influence. Simply working a bit longer in order to delay spending can increase your success rate significantly.

Conclusions
Taking into account these findings, the Bernstein paper concludes that although bonds are a traditional safe-haven for retirees, their increased longevity make the growth from stocks important throughout one’s lifetime. They suggest that a proper compromise between these factors is a portfolio of 60% stocks and 40% bonds, along with a 4% spending rate. This gives the couple an 85% chance of having their money last till death.

Glassman of Kiplinger also makes his own suggestions:

Bernstein emphasizes that individual clients’ needs differ. Certainly, but based on this report and other research, I have decided to raise my suggested quick-and-dirty stock allocations for retirement accounts this way: If you’re under 40, there’s no reason not to own a 100%-stock portfolio. Between ages 40 and 60, you can move to an 80-20 stock-bond ratio. Between age 60 and retirement, shift to keep at least 60%, and in most cases closer to 70%, in stocks.

This is much more aggressive than almost all the Lifecycle or Target-dated Funds (see here for a comparison between Vanguard and T. Rowe Price Target Retirement funds.)

My concern would be that with so much in stocks, when people “fail”, they fail by a lot, whereas with bonds it might be easier to compensate for a slow stock market by working part-time. I’m undecided as to if this study will cause me to make any changes.

Prosper Lending Revisited: Will Returns Drop As Defaults Increase Over Time?

Months ago I did a review of Prosper, a website which allows you to earn interest by lending money directly to others (Prosper takes a small cut). After looking at the mechanics of their system as well as their own historical loan data, the main conclusions from my initial review were:

  1. You should avoid loans from those with poor credit rated E and HR like the plague, as they have negative annual returns ranging from -10% to -30% annually. Prosper lenders as a whole priced this subprime market very poorly.
  2. If you stick exclusively to the borrowers with the best credit score (rated AA and A), manage your cash carefully, and the default rates don?t keep rising, you may achieve average net returns of about 8% annually.

A key part of that last sentence is if the default rates don?t keep rising. Sure the initial interest rate may be a snazzy 10-12%, but these loans are all three years in length, and my theory was that as time goes on more and more people will default on these loans. Or maybe some will vary between being late and becoming current again, so that the return stays pretty constant. Now that there is more history in their database, I decided to run some number to test this theory out.

As in my original review, I took all the loans that originated in the first half of 2006. Then, I looked at the ROI (average annual return after taking into account defaults and Prosper fees) as observed on different dates ranging from October 2006 to June 2007. Here are the results:

altext

Summary
It would appear that there is indeed a gradual “decay” of annual returns, with the rate of decay increasing as you drop into the lower credit grades. Although this is not conclusive evidence, it is something to consider if you are expecting a certain level of performance. If I were to lend on Prosper, I would stick exclusively to the AA-rated loans.

Even with AA-rated loans, right now we are less than halfway done with these loans. If these trends continue, by the end of the 3-year term, I expect the average net return to be about 7.6-7.8% annually. Again, this is an average value, and one would still need enough money spread across a number of loans to protect from individual loan risk. 7.7% actually isn’t bad, and is almost enough to make me commit some money to this if the spread above FDIC-insured equivalents remains high enough. I’m currently remaining on the sidelines until I see how the marketplace responds to any federal interest rate hikes.

Frugal Shopping: Which Vegetables Should You Buy Organic?

There are many reasons why people buy organics vegetables, and one of them is to avoid ingesting pesticides. While the benefits are not entirely proven, it is clear that buying organic can be pretty pricey – Whole Foods grocery is even dubbed “Whole Paycheck” for this reason. As found in Money magazine, the Environmental Working Group has a Shopper’s Guide that helps identify the fruits and veggies with the most and least pesticides if you are faced with balancing the cost and benefits of buying organic. The top and bottom 12 are listed on the right.

An EWG simulation of thousands of consumers eating high and low pesticide diets shows that people can lower their pesticide exposure by almost 90 percent by avoiding the top twelve most contaminated fruits and vegetables and eating the least contaminated instead… soft-skinned fruits and veggies, like peaches, apples and bell peppers, retain the most amount of pesticides… Nearly all of the data used to create these lists already considers how people typically wash and prepare produce (for example, apples are washed before testing, bananas are peeled).

Emergency Room Summary Of Charges Arrived

Yesterday I received the list of charges for my emergency room visit earlier this month (for what was found to be a kidney stone). I added my best guess for what each of the charges were for:

Summary of Charges
Emergency Room (Doc + Room) $926.00
Laboratory (Blood Tests) $137.00
Pharmacy (Morphine + Others) $91.26
Professional Fees (Nursing?) $387.00
Radiology (CT Scan + Radiologist reading) $2,375.61
Total $3,916.87

Of course, this is just what was submitted to my insurance, not what I’m actually going to have to pay. My insurance company may have negotiated lower prices, and I have an overall maximum out-of-pocket cap of $1,200 per year. I estimate my eventual bill to be between $500 and $1,000. I guess no Costco Vizio LCD TV this year for Jonathan đŸ˜‰ I’m still just happy to be living a pain-free life right now, and am keeping myself well hydrated.

OpenCourseWare: Fundamentals of Personal Financial Planning

While reading this month’s issue of Kiplinger’s Personal Finance magazine, I found that UC Irvine offers a free online course on the Fundamentals of Personal Financial Planning:

This course was produced by a generous grant from the Certified Financial Planner Board of Standards and by the Distance Learning Center at the University of California, Irvine under the OpenCourseWare Initiative. The purpose is to make widely available to the general public a course designed to provide a comprehensive but easily understood overview of personal financial planning.

This course is not intended to replace the professional financial planner, but to help to make the general public better consumers of financial planning advice. It tries to help those who cannot afford extensive planning assistance to better understand how to define and reach their financial goals and provides basic understanding so they can make informed decisions. The course can also be seen as a reference for individual topics that are part of personal financial planning.

While it seems to be a pretty good basic resource for novice investors, I was actually disappointed as I was hoping to see some of the actual courses one would have to take to become a Certified Financial Planner (CFP). Is it heavy on the math? Mostly memorization? I’ve toyed with the idea of becoming a financial planner before, but it always seems like it would be hard to start out anywhere else besides a commission-based sales job.

Which Store Gift Cards Have The Highest Resale Value?

All this talk about converting free Membership Rewards points into cold hard cash got me to thinking – how much do you net after fees, and which stores have the gift cards or certificates with the highest resale value? My initial guess was that stores that everyone shops at (Wal-mart, Home Depot, etc.) would be the easiest to resell, while the higher-end boutique shops might be tougher due to a smaller customer base and less bidding frenzies.

I decided to test this hypothesis by looking at eBay’s archives. Here was my not-statistically-sound-but-let’s-just-try-it methodology – I took 10 recently completed auctions for each store’s gift cards, taking a variety of gift card values and different sellers. I would then take 5% off the average ending bid to estimate eBay auction fees and then calculate the net resale percentage (ignoring shipping since at most it would be a stamp):

(Ending Bid x 95%) / Face Value = Estimated Resale %

Results
Instead of doing every store under the sun, I tried to take a small sample of different types of stores. Even with only 10 data points per store, the cards often sold in a tight price range, with the relative standard deviation of this small sample size being about 2%. The results are on the right.

As one might have guessed, Amazon.com has the highest resale value, as you can easily spend it online, and they sell everything from groceries to bedding to electronics. Big Box stores Target and Home Depot followed closely behind. Surprisingly, even with a limited presence and fancier products Crate and Barrel also did quite well. My theory behind this is that people tend to spend a lot of money there, so people can buy a bunch of gift cards online, combine them, and still save a large amount – 12% off of $1,000 is $120 saved.

The worst performing out of this limited sampling was Gap. Pottery Barn, Banana Republic, and Old Navy also hovered about the 80% range. Some specialty stores had very few completed auctions, so I skipped them.

Which are good bets for each Rewards program?
Not every points systems offers gift cards to the same stores. Here are my favorite conversions (all 10,000 points = $100 Gift Card):

Starwood Starpoints » Amazon.com Gift Cert.
Citibank ThankYou Points » Target Gift Cards
AmEx Membership Rewards » Crate and Barrel/Home Depot Gift Cards

You can find $100 bonus offers all three of these points programs here.

Keep in mind though, that this is assuming that you aren’t going to convert to other things like hotel or airline rewards. Free flights can also be sold for cash, especially if you have enough to redeem for a business or first class ticket. This can be worth 3-7 cents per mile depending on the route and if you sell directly or through a broker. More on this somewhat tricky practice next.

Free 25,000 Rewards Points ($250 in Gift Cards or a Free Plane Ticket) For American Express Business Gold Card

Update: The below promotion is now expired. The New Business Gold Rewards Card® from American Express OPEN now offers 3X points on airfare, 2X points on advertising, gas, and shipping and 1X point on everything else. The annual fee for this card is $175 but it is waived for all new cardholders. You can also get unlimited additional gold cards for an extra annual fee of $50 but this fee is waived for the first year as well.

If you’ve got a business, even if it’s just a small home-based side business, here’s a juicy offer for the New Business Gold Rewards Card® from American Express OPEN:

 

The New Business Gold Rewards Card from American Express Screenshot
New cardmembers get 25,000 Membership Rewards points after the first purchase. These can be converted to 25,000 frequent flier miles at certain airlines, which can be converted to a roundtrip ticket. According to the terms above, you have to pay $10 to convert that over. Alternatively, you can convert to about $250 worth of gift cards at stores like Home Depot, Crate and Barrel, Banana Republic, Barnes and Noble, and so on. The annual fee is also waived for the first year, after that it is $125.Here’s the fine print:

? Apply for the Business Gold Rewards Card and make a purchase by 12/31/07. Upon the Basic Cardmember’s first purchase, a one time bonus of 25,000 points can be earned toward the Basic Business Gold Rewards Cardmember’s Membership Rewards? account and may appear as separate credits of 5,000 and 20,000 bonus points. The maximum 25,000 bonus points are available to first?time Basic Business Gold Rewards Cardmembers only; they are not available if you transfer an existing account. Welcome bonus points will be credited to your Membership Rewards account 6 to 8 weeks after your first purchase appears on your monthly billing statement. The bonus 25,000 Membership Rewards points may be redeemed for one domestic round?trip airline ticket. Cardmembers transferring points to participating domestic airlines will be charged a fee of $.0004 per point, up to $50. This charge is to offset the excise taxes American Express currently pays to the government on such transactions. Bonus ID: 2329.

Also, see here for more details and a how-to about applying for business cards as an individual.

Considering Changes To How I Calculate Our Net Worth

When tracking one’s net worth, whether publicly or privately, I don’t think there is any one “correct” way to do it. People should measure it however they like in order to achieve useful information out of it. Accordingly, as we get closer to reaching our mid-term goal, I am considering changing how I calculate our net worth. After the purchase of our house, our main goal will mainly be to accumulate enough assets to provide income for the future. Everything that doesn’t help us do this, shouldn’t I just ignore it?

Dropping the value of our cars
Many people ask why I include the value of one of ours car in our net worth, while ignoring the other. It’s mostly legacy reasons. When I first started tracking our balances, I already owned one car free and clear and ignored it from the beginning. When I purchased our second car after getting married, I was faced with the choice of either taking an $8,000 hit immediately, or simply including the Blue Book value of the car in the assets column. I chose the latter because I felt it would help me better track the month-to-month differences.

Since cars are really just a depreciating asset, I’m going to stop tracking the values of them completely.

Ignoring any home equity and mortgage debt
I’ve explored a bit whether owning your primary home should be considered an investment, and also explained how our house is going to be a long-term commitment. Along the lines of this, I’m starting to think that I should just ignore any equity accumulation in my net worth charts and just treat our future mortgage payment the same as our current rent payment – an expense for housing. Since we’ll be living in this home, it won’t generate any cashflow, so why include it?

Perhaps one day I’ll be able to cash out the equity or have the mortgage paid off and be able to live rent-free, but in the meantime it just seems to be a bit of a distraction. This way, I can ignore any short-term increases or decreases in the market value of the house.

What do you think? Personally, I don’t think this will make much difference either way, it’s just a slight change in measurement to help guide our focus.