What is concerning Singaporeans are whether their policies are safe.

Patrick Lim from PromiseLand, an IFA house posted abit of guidance on his blog.

In it he mentioned about how this debacle came about and the after effects of it. But what is news to singaporeans is this:

Around 100 worried customers of an AIG subsidiary, American International Assurance (AIA), queued outside its Singapore office to check the status of their policies.

Tan Peng Hock, 60, said he did not mind surrendering a policy worth about $42,000 despite possible losses.

“I prefer to hold cash for the time being…It’s better to be safe than sorry,” Mr Tan told Reuters news agency.

Next he provides the keynotes from the key recommendations for the revised life insurance and general insurance PPF scheme follow by some examples highlighted in the keynotes.

1. membership – which insurers have to participate?
   • Will explicitly cover all registered direct life insurers, except captive insurers.
   • Membership will be compulsory.
2. scope of coverage – which business is covered?
   • Continue to cover all life policies’ guaranteed benefits.
   • Will be extended to cover all accident and health policies written in the life insurance fund.
   • Will apply to both Singapore and offshore policies, as well as both individual and group policies.
   • Will not cover the life insurance business written by overseas branches of registered life insurers incorporated locally.
   • Only the life insurance business written by the branch office in Singapore will be covered for registered life insurers incorporated overseas.
3. level of coverage – how much is being protected?
   • Will protect 90% of the amount of all liabilities of protected policies.
   • With the exception of disability income, long-term care and medical expense insurance policies, all other protected policies will be subject to an absolute cap of S$500,000 for sum assured and S$100,000 for surrender value. A simple ratio method will be used to derive the coverage ratio of the affected policy owner.
   • The aggregate cap will apply on the aggregate sum assured and surrender value of all life policies owned by the policy owner and issued by the same insurer.
4. continuity of coverage – what would happen upon liquidation?
   • Provides for the transfer of in-force policies from the defaulted life insurer to another insurer as long as the transfer is reasonably practicable. The 90% limit and absolute cap on coverage will apply.
   • For remaining policies that cannot be transferred or settled by the liquidator, the PPF will be given the flexibility to run-off the portfolio of policies where practicable for it to do so.

In short, other than disability income, your AIA life policies and term policies should be protected, however to an absolute cap of 90% of your coverage and surrender value and also this amount cannot exceed 500k for coverage and 100k for surrender value (for those life policy that have accumulated cash value). Some Examples are provided here.

APPENDIX 1: APPLICATION OF CAPS FOR LIFE INSURANCE POLICIES

Scenario (a): Total policy benefits do not exceed caps

Mr Tan owns 3 policies from ABC Insurer, which defaults. Details of his policies are as follows:

Sum Assured Surrender Value
Policy 1 $50,000 $10,000
Policy 2 $100,000 $0
Policy 3 $150,000 $8,000
Total $300,000 $18,000
PPF Benefit Caps $500,000 $100,000
PPF Protects 90% of Benefits
$270,000 $16,200
Mr Tan’s policies do not exceed PPF benefit caps and hence will be protected for 90% of
policy benefits. Upon the default of the insurer, Mr Tan’s policies are covered by PPF up
to the following respective amounts:

Sum Assured Surrender Value
Policy 1 $45,000 $9,000
Policy 2 $90,000 $0
Policy 3 $135,000 $7,200
Total $270,000 $16,200

Scenario (b): Total sum assured exceeds caps, whilst total surrender value does not

Mr Lee owns 2 policies from ABC Insurer, which defaults. Details of his policies are as follows:

Sum Assured Surrender Value
Policy 1 $500,000 $10,000
Policy 2 $100,000 $0
Total $600,000 $10,000
PPF Benefit Caps $500,000 $100,000
PPF Protects 90%
of Benefits,
Adjusted for
Benefit Caps
82.5% x $600,000 =
$495,000
82.5% x $10,000 =
$8,250
The protection ratio of 82.50% can be derived from:
Average (90% x $500,000 / $600,000, 90% x $10,000a / $10,000)
a Since the total surrender value does not exceed the PPF cap, this would be 90% of the total sum assured.

Mr Lee’s policies exceeded PPF benefit caps for the sum assured. The average
coverage, taking into account the effect of the cap on the sum assured, is applied across
all policies. As a result, PPF protects Mr Lee for 82.50% of his policy benefits.
Upon the default of the insurer, Mr Lee’s policies are covered by PPF up to the following respective amounts:

Sum Assured Surrender Value
Policy 1 $412,500 $8,250
Policy 2 $82,500 $0
Total $495,000 $8,250

Scenario (c): Total sum assured does not exceed caps, whilst total surrender value does

Mr Lim owns 4 policies from ABC Insurer, which defaults. Details of his policies are as follows:

Sum Assured Surrender Value
Policy 1 $50,000 $40,000
Policy 2 $100,000 $42,500
Policy 3 $80,000 $30,000
Policy 4 $120,000 $0
Total $350,000 $112,500
PPF Benefit Caps $500,000 $100,000
PPF Protects 90%
of Benefits,
Adjusted for
Benefit Caps
85% x $350,000 =
$297,500
85%x $112,500 =
$95,625

The protection ratio of 85% can be derived from:
Average (90% x $350,000b / $350,000, 90% x $100,000 / $112,500)

Mr Lim’s policies exceeded PPF benefit caps for the surrender value. The average
coverage, taking into account the effect of the cap on the surrender value, is applied
across all policies. As a result, PPF protects Mr Lim for 85% of his policy benefits.
Upon the default of the insurer, Mr Lim’s policies are covered by PPF up to the following
respective amounts:

Sum Assured Surrender Value
Policy 1 $42,500 $34,000
Policy 2 $85,000 $36,125
Policy 3 $68,000 $25,500
Policy 4 $102,000 $0
Total $297,500 $95,625

Since the total sum assured does not exceed the PPF cap, this would be 90% of the total sum assured.

Scenario (d): Both total sum assured and surrender value exceed caps
Miss Wong owns 3 policies from ABC Insurer, which defaults. Details of her policies are as follows:

Sum Assured Surrender Value
Policy 1 $500,000 $100,000
Policy 2 $100,000 $50,000
Policy 3 $150,000 $50,000
Total $750,000 $200,000
PPF Benefit Caps $500,000 $100,000
PPF Protects 90%
of Benefits,
Adjusted for
Benefit Caps
52.5% x $750,000 =
$393,750
52.5% x $200,000 =
$105,000

The protection ratio of 52.5% can be derived from:
Average (90% x $500,000 / $750,000, 90% x $100,000 / $200,000)
Miss Wong’s policies exceeded PPF benefit caps for both the sum assured and surrender
value. The average coverage, taking into account the effect of the caps for both sum
assured and surrender value, is applied across all policies. As a result, PPF protects Miss
Wong for 52.5% of her policy benefits.
Upon the default of the insurer, Miss Wong’s policies are covered by PPF up to the
following respective amounts:
Sum Assured Surrender Value
Policy 1 $262,500 $52,500
Policy 2 $52,500 $26,250
Policy 3 $78,750 $26,250
Total $393,750 $105,000

Personally, I don’t think this will affect AIA much. The most likely scenario is that should AIG looks to sell AIA, they can sell it well to other major insurance player globally.

But as a general rule of thumb, you will still lose money on your policies but should this PPP scheme works (which should!) you will still keep the majority of your money.

I thought i will put this up as well. Its a good article that its not all about saving and not having fun. its finding the right balance in life.

From Portfolio.com:

A reader writes:

As a “younger investor” myself looking for ways to
retire with millions (we can all dream), I’ve been trying to start
early and doing my research to figure out ways to gain an advantage in
the long run. Starting young is always helpful. But the idea of timing
the market makes me nervous. At the same time, with the market in the
dumps – isn’t this the best time, as a 20-something, to jump in and
fill my retirement portfolio exclusively with stocks? Maybe if I close
my eyes and look away for a year, when I look back there will be a nice
ROI.

She wrote this in response to my blog entry in June about research saying that if you’re young and investing for retirement, it’s a good idea to take a lot of risk — perhaps even more
risk than putting everything in stocks. But do read the comments on
that blog entry: they’re all very smart, and there are indeed good
reasons not to borrow the money you’re saving for retirement.

What that means is that the first thing you do, if you’re in your
20s, is pay off your credit cards and all your other debt, with the
possible exception of any low-interest-rate student loans you might
have. Only once you’ve done that should you even think about saving for retirement.

But the second thing you should do, frankly, is think seriously
about spending your income rather than saving it. People in their 20s
get more value out of every marginal dollar than they will in their
30s, 40s, or 50s. Steve Levitt puts it really well:

The right reason to save is so you can even out your
consumption. When times are good, you should save, and when times are
bad, borrow.
Most likely, I would never be as poor again as I was starting out. That meant I should have been borrowing, not saving.

There’s a reason why it’s commonplace for parents to give or loan
money to their children, while flows in the other direction are rare
indeed: older people, as a rule, have more money — which means that
one dollar is worth less to them than it is to their kids. When you’re
in your 20s, a couple of hundred dollars can significantly change your
standard of living; when you’re in your 40s, it probably won’t. (And if
you do find yourself, in your 40s, at a point in your life
where a couple of hundred dollars will significantly change your
standard of living, I can assure you that having saved more in your 20s
wouldn’t have changed anything.)

If it hurts to save, then, don’t. You’re only young once: enjoy it.
No matter what the financial-services industry would have you believe,
now’s not the time to worry about your income when you’re 80.

Okay, now we’ve got that out of the way, let’s say you’re in your
20s and you do have some excess cash you want to use for retirement –
maybe you’re in the fortunate position of having an employer who’ll
match your retirement savings, or something like that, in which case
it’s a much better idea to try and maximize those 401(k) contributions.

In that situation, then yes, putting your savings 100% into stocks
makes sense. The worst that can happen is that your retirement savings
go down — but since you weren’t going to touch this money until you
were in your 60s anyway, that makes zero difference to your present
standard of living. Meanwhile, if your investments go up, as stocks
usually do, then you’re precisely where you want to be: leveraging the
magic of compounding for decades.

The key insight here is that you’re making relatively small regular
contributions to your retirement account. As you earn more money in the
future, those contributions will increase in size. The contributions
you make at the beginning of your career are small enough that only a
long period of good returns will turn them into something you can live
off in retirement. If those small initial contributions are wiped out,
you haven’t lost that much, by the standards of your 70-year-old self:
remember, older people are richer. On the other hand, if they do well,
then you’ll feel great.

So yes, if you’re saving for retirement, put 100% of your
contributions into stocks. (If you want to start getting sophisticated,
then maybe buy ETFs of other asset classes like real estate and
commodities, but let’s keep things simple for the time being.) You’re
not timing the market, you’re just giving yourself the maximum amount
of time to see that investment blossom over the decades into something
really substantial.

But if you’re not saving for retirement, don’t let the
financial services industry guilt-trip you into thinking that you’re
doing something horribly wrong. Retiring with millions is all well and
good, but don’t let it prevent you from going out and having fun today.

The whole act of saving money is one they relies heavily on actions that run contrary to people’s emotional and psychological makeup. And to effectively encourage someone NOT to begin establishing precisely the habits and behaviors that creates, and ultimately leads to, financial wellness, confuses me.

I think the bottom line is really this: the act of saving is habitual and needs to be nurtured from a young age. The expectation that we can encourage people not to save in their twenties, and then expect them to just flip a switch once they hit they’re (insert proper age here), is naive.

Our society needs to be weened off of our unsustainable consumption habits, and to a more balanced approach that nets out to savings accumulation. Our culture’s current financial awareness is not such that we can discourage any form of saving, even at a young age.

I think the reader brought up a very good argument, and i tend to agree with him. In my case, its the exact opposite where i was brought up to save and would have a hard time telling myself to spend more money. That’s why i set virtual accounts up so that i can force myself to spend on things that will really add value to me and my family.

What do you guys think of the reply?

Here in an audio interview at financial sense, the author explains

• What are ETFs
• What are active ETFs
• How does ETFs work
• What are the advantages of ETFs

I find that this is a really good primer to know more about ETFs when you are relaxing. Do listen to it.

[Podcast: All you need to know about Exchange-Traded Funds]

I was away for 2.5 weeks. Not a long time, but to me it is an eternity away from the market. I came back to see the same state of affairs in the US consumer market as it was if not worse then i left.

This article is interesting. While i empathize with the people feature in this article, it does raise the kind of tools that they are resorting or can resort to, to get them out of this fix.

Some of these that are mentioned are:

• Reverse Mortgages
• Life Settlement
• REX agreements
• Taking a tax-deductable loan from retirement accounts
• Credit card lines

After a long binge of borrowing, U.S. consumers face a credit crunch and a sagging economy. To sustain their living standards, many Americans are doing what comes naturally: scrambling to raise more cash.

Sheron Brunner, 63 years old, bought a $250,000 life-insurance policy in 1997, planning to leave the proceeds to her three children. She faithfully made her $113 monthly payments. But after retiring in 2002 from her job running a homelessness-prevention program, her finances unraveled. Health problems forced her to siphon her savings. A monthly Social Security check of about $700, her only source of income, doesn’t cover her medical bills and rising everyday expenses. In September, she moved to Wichita, Kan., from San Francisco to cut her cost of living.

It wasn’t enough, so this spring she signed what’s known as a life-settlement agreement with J.G. Wentworth, a company that buys life-insurance policies and other tough-to-sell assets. The contract transfers ownership of a life-insurance policy to a third party, which then pays future premiums and collects the benefit. Ms. Brunner received about $45,000 for her $250,000 term policy.

“It wasn’t what I wanted,” she says. But “with the economy the way it is, I needed that help now.”

As consumers max out their credit lines and banks clamp down on lending, many older and middle-class Americans are resorting to pricey, often-risky alternatives to stay afloat. Some are depleting their retirement accounts, tapping 401(k)s for both loans and hardship withdrawals. Some new fast-cash options allow homeowners to squeeze equity from their houses — without the burden of monthly payments. One new product offers a one-time payment. In exchange, the company shares in as much as 50% of any future gain or loss in the property’s value, typically collecting proceeds when the house is sold.

Americans are resorting to these more extreme measures due to the combination of dwindling jobs, falling home prices, shaky credit markets and a sharp run-up in food and energy prices. Consumer confidence hit a 28-year low in May, according to the latest Reuters/University of Michigan survey of consumer sentiment. Consumer spending and income inched up 0.2% in April from March, but after adjusting for inflation were flat, government data show.

Many people are resorting to more conventional means of borrowing: In March, consumers had a record $957 billion of credit-card and other types of revolving debt outstanding — up about 8% from a year earlier, according to preliminary data from the Federal Reserve.

But businesses are reporting greater demand for newer cash-raising techniques. Reverse mortgages are gaining new favor. Secured by a home’s equity, this vehicle can provide consumers with a lump-sum payout, a line of credit, periodic payments or a combination thereof.

Also flourishing: niche products that quickly unlock the value of a particular asset. Life settlements, once marketed mainly to the wealthy, have grown in popularity as companies target smaller policies, like Ms. Brunner’s. A number of companies cater to people who’ve won personal-injury settlements — which are often paid over a period of years — by buying them out up front, typically for a sum much lower than the amount of the payments sold. Reserve Solutions Inc. of New York offers debit cards to help workers access funds from preapproved 401(k) loans.

Costly Solutions

Though seemingly convenient, each of these fast-money options “is an expensive way to tap cash,” says Tom Orecchio, chair of the National Association of Personal Financial Advisors. “You don’t want to do these things unless you absolutely have to.”

In life-settlement transactions, sellers like Ms. Brunner often receive only about 20% of their policy’s face value. People who sell the rights to their legal-settlement payments often forfeit much of those payments’ value.

Ken Murray, chief marketing officer at J.G. Wentworth, the company that had the life-settlement agreement with Ms. Brunner, says that in many cases, it may be wiser for consumers to do a transaction like a life settlement rather than “incur additional debt in order to finance what you need to do.”

While 401(k) loans generally carry reasonable interest rates, individuals who take them lose some of the valuable power of compounded returns — jeopardizing their retirement security in the process.

Reverse mortgages often involve high fees and costs, which often add up to as much as 5% or 6% of the home value. A homeowner or his heirs must typically sell the house to repay the loan, which becomes due when the borrower leaves the home for more than one year or dies. So an owner who becomes incapacitated and needs an assisted-living facility for more than 12 months could face a huge balance due immediately.

Despite the risks, business in the fast-cash lane has been accelerating. In 2007, 18% of workers had taken a retirement-plan loan within the past year, up from 11% in 2006, says a recent survey by Transamerica Center for Retirement Studies. The number of federally insured reverse mortgages is also ticking up. From January through April of this year, lenders originated 40,068 such loans, compared with 37,020 in the same period last year.

The Financial Industry Regulatory Authority recently issued investor alerts warning consumers about the high costs of reverse mortgages and the opacity of the life-settlement market. More broadly, it also cautioned that some cash-now transactions could hurt consumers’ ability to qualify for certain benefits, like Medicaid. A lump-sum payment from a life settlement or reverse mortgage could leave an individual with too much cash to be eligible for such programs.

The costs of reverse mortgages “are all very straightforward and upfront and disclosed,” says Peter Bell, president of the National Reverse Mortgage Lenders Association. Doug Head, executive director of the Life Insurance Settlement Association, says the life-settlement industry is “pretty good at disclosures,” but notes that regulations pending in a number of states will help improve information for consumers.

Robert Hamzey, a California real-estate agent and financial planner, has been brokering life settlements for years. But last year, as the housing market soured, he started promoting them as a way for his real-estate clients to fund a down payment. “You can’t believe how elated these people are when you find an asset that they didn’t know existed,” he says.

The current environment differs from past downturns. During the last recession, home prices were still rising, many consumers could borrow against their home equity, and credit was more widely available. Now, “real spending is hardly growing, and that’s something we haven’t seen since the early ’90s recession,” says Scott Hoyt, senior director of consumer economics for Moody’s Economy.com.

Because they often have plenty of equity in their homes, but lack sufficient income for everyday expenses, older Americans are finding products like reverse mortgages especially tempting.

Daniel Petelin, 62, lives in a roughly $1.8 million house in Redwood City, Calif. His mortgage debt on the place, about $16,000, is minimal. But the freelance public-relations and event manager, who has an income of about $47,000, is still feeling pinched. “Eggs a few months ago were 79 cents a dozen. Now they’re $1.79.” With gas in his area about $4 a gallon, he’s planning car trips carefully. He has cut back on eating out. And next year, his health-insurance premiums are going up to about $600 a month.

Single with no children, Mr. Petelin doesn’t want to sell the four-bedroom house where his parents lived for nearly 70 years. He’s not interested in a home-equity loan, as he doesn’t like the idea of making monthly payments. Instead, he’s planning to take out a reverse mortgage backed by the equity in his home.

He has shopped around with a few lenders, but has yet to take out the loan because in the midst of the credit crunch, he’s found some banks hesitant to lend the amount he’s seeking — roughly $580,000. Still, he intends to take a loan in the near future because he says he needs the cash.

A Different Strategy

The so-called REX Agreement, launched last year by REX & Co., a San Francisco real-estate investment company, offers a different strategy. Not technically a loan,it gives homeowners a cash payment, typically about 13% of the home’s value. Upon a sale of the home — or the owners’ death — the company pockets as much as 50% of any change in home value during the time the agreement was in force. To qualify, applicants need not have much equity in their home. The minimum is 25%.

Such an arrangement sounded good to Tom Terrill, 75, of Kenilworth, Ill. After being diagnosed with an autoimmune disease in 2001, he didn’t expect to live more than a few years. So, he stopped working and began focusing on enjoying life.

But after receiving a lung transplant in 2005, the retired financial-services executive now has a longer life expectancy — and a rising cost of living that exceeds his Social Security and investment income.

“I needed to do something to get more cash or reduce my expenses or live in a very, very much downsized [home],” he says. In May, he signed a REX Agreement and received about $406,000 in exchange for 50% of any future change in the value of his $3 million home.

Some financial planners are skeptical of such newfangled products. A home can be a valuable buffer against unexpected expenses, and if owners are “taking future appreciation and selling it and using the money now, what are they going to do in the future?” asks Jon Beyrer, a fee-only financial planner in Solana Beach, Calif. He would look at a transaction like the REX Agreement only “as a last resort,” he says.

Tjarko Leifer, managing director for marketing and strategy at REX & Co., maintains that with a REX agreement, homeowners “continue to participate substantially in the future change in value of the property, and the equity you have built up in your home is not eroding over time.”

Even the most financially savvy consumers are breaking some time-honed rules. Paul Herman, 51, is an attorney who represents consumers with debt and credit issues. He recently started a new law practice and went through a divorce. At the same time, his Boca Raton, Fla., house sat on the market for months without selling. With money getting tight, he went to his bank to investigate a business loan. But “with the rates I’d have to pay, it wasn’t worth it,” he says.

He tapped into his retirement savings instead, taking one loan and one taxable withdrawal. His logic: “Why plan for retirement if you can’t make it today?”

I went to the library and was surprised that it wasn’t as packed as SengKang’s Compass Point. I was even more surprised to find all the investment books that you would normally find scarce in the library circulation.

Anywayz, I managed to find The Little Book Of Common Sense Investing by John C Bogle:

Then there is The Future For Investors by Jeremy Siegel

There is also Adventure Capitalist by Jim Rogers

This is a very highly recommended book: The Four Pillars of Investing by William Bernstein

Finally, I also found Tomorrow’s Gold by our generation’s greatest bear Marc Faber

If you guys and gals are living near hougang mall, may wanna hop down there and take a look at them.

Most of you have seen the nifty retirement software available from the likes of Vanguard and T. Rowe Price which provides the mathematical muscle to help you plan your retirement. Input your retirement age, expected lifespan, required annual income, rate of inflation and investment return, and hey presto, you find out that to avoid a golden years diet of Alpo you need the GDP of the average Central American republic.

Problem is, it may quite possibly be worse than that. These calculators all make the same erroneous assumption — that your expected rate of return is the same each and every year. In other words, let’s assume that the real (inflation adjusted ) rate of return of the S&P 500 will be 7% in the future. You might conclude that you can withdraw an inflation adjusted $70,000 of your $1,000,000 Vanguard Index Trust 500 IRA each and every year indefinitely, and maintain yourself with the same real income in the long run. And you’d be wrong.

It turns out that if you have rotten returns in the first decade you will run out of money long before reversion to the mean saves your bacon in later years. To illustrate this phenomenon I went back to good old Uncle Fred’s infamous coin toss, with its return of either -10% or +30%. Let’s assume that these represent real returns. If over 30 years you toss 15 heads and 15 tails you earn a compounded rate of 8.17%. (If you don’t understand why you don’t earn the average return of 10% (the average of -10 and +30), then go back and read Chapter One of The Intelligent Asset Allocator.) If you start with a $1,000,000 portfolio and roll alternating heads and tails over the 30 year period, then you indeed can withdraw $81,700 (8.17% of the initial amount) over the next 30 years before all the money runs out. However, if you are unlucky enough to roll 15 straight tails before rolling 15 straight heads, you can withdraw only $18,600 per year. Reverse the process and roll the 15 heads followed by 15 tails, and you can withdraw $248,600 per year.

This phenomenon was first brought to the attention of the investing public by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz from Trinity University. They looked at the “success rate” of various withdrawal strategies over numerous historical periods, and came to the conclusion that only a withdrawal rate of 4%-5% of the initial portfolio value (i.e., $40,000-$50,000 of a $1,000,000 portfolio) had a reasonable expectation of success. This article can be found in the February 1998 AAII Journal. You can also obtain a lucid explanation of their work as well as their “success tables” on Scott Burns’ excellent website.

On a more basic level, however, you can apply a much simpler acid test to your withdrawal strategy: What would happen if the day you retired marked the beginning of a long, brutal bear market, say on January 1, 1966, and you lived for another 30 years, until 12/31/95? For the first 17 years (1966 to 1982) the return of the S&P 500 was a paltry 6.81%. By gruesome numerical coincidence, this was identical to the rate of inflation for the period, making the real stock return for the whole 1966-82 period zero. The return for the next 13 years (1983-95) was spectacular, bringing the real return for the whole 30 year 1966-95 period up to 5.3%, not too far below the historical norm of 7%.

I next constructed an all equity portfolio consisting of 80% S&P 500 and 20% US small stocks, and mixed this with 5 year treasuries. I assumed that one began the period with $1,000,000 and then calculated results of various withdrawal rates from the following mixes: 100% stock, 100% bond, and 75/25, 50/50, and 25/75 mixes of both. The results are plotted below. The all stock portfolio is the thickest line, and the thinner the line, the less stock. Again, it is important to realize that the amounts on the y axes are in inflation adjusted 1995 dollars. This is the simplest and clearest way of performing retirement calculations.

First, let’s look at withdrawing 7% of the initial amount, or $70,000 (inflation adjusted), per year:

As you can see this is an unmitigated disaster, particularly for the all stock portfolio. All 5 portfolios run out of money in about 15 years, and it really doesn’t matter what mix you use. The great bull market beginning in 1984 came far too late to save even the most patient investor.

Next, $60,000 and $50,000 (5% and 6% of the initial amount):

You still wind up in the alms house, but only after 20 and 25 years. Holding a bit of bonds seems to stretch the money a bit further.

Only at $40,000 (4% of the initial amount) withdrawal rates do things look a little less grim. All strategies holding 50% or greater stock survive the 30 year period. However, even this route was one wild ride.

What devastates the above scenarios is the withdrawal of a predetermined inflation adjusted stipend from a portfolio already ravaged by the market. What happens if instead we withdraw a fixed percentage (as opposed to a fixed amount) of our principal? In other words, if we start with a nest egg of $1,000,000, and withdraw 7% each year, we will begin withdrawing at a rate of $70,000 per year. If our principal then falls 50%, we are left with only $465,000, so we can now only withdraw payments at a rate of .07 x $465,000 = $32,550 per year. This approach has the advantage that we never run out of money, although the stipend amount will fall dramatically in some years. I’ve plotted annual income for 5% and 7% constant percentage withdrawals below. Whereas the plots above showed the real residual portfolio wealth after constant real withdrawals, the below plots show the annual stipends from a constant percentage withdrawal:

Note that for a constant percentage withdrawal the all stock portfolio does better than the mixed portfolios. This is because one is effectively “value averaging” into a falling market by reducing one’s withdrawals when stock prices are low. But the 7% withdrawal rate is still unacceptable, with withdrawals of less than $40,000 in all the later years. The 5% rate works better, but one still has to tolerate a stipend amount which dramatically fluctuates with market conditions. Even this strategy is not for the faint of heart. It produced a real $50,000 income in 1966, which rose to a real $58,803 in 1968, fell to a real $19,965 in 1974, rising back to a real $46,904 by the end of 1995.

Although historical market analogizing can be both embarrassing and dangerous to one’s wealth, this market looks an awful lot like 1966. It would behoove anybody with an investment horizon stretching another 30 years to consider the 1966-95 as a useful reality check.

One point cannot be made often enough — when you retire, are you going to be withdrawing a fixed inflation adjusted amount on a regular basis, or are you going to be withdrawing a fixed percentage of your portfolio? This is not a semantic fine point. If you need a fixed amount, plan on withdrawing no more than about 4% of your starting amount in inflation adjusted terms. A fair dollop of bonds won’t hurt in this situation.

If you can be more flexible and spend a fixed percentage of your nest egg each year, then you can indeed keep you entire retirement stash in stocks and spend 5% annually. Just remember that your stipend will likely fluctuate wildly over the decades of your retirement. Keep a few cans of Alpo in the cupboard if you decide to go this route .

“Larry has written some of the most sensibly and clearly written books anywhere for sophisticated passive investors,” said Jim Wiandt, publisher of IndexUniverse.com and the Journal of Indexes. “Now he has one-upped himself by writing the book we’ve always wanted to give to our friends, relatives and clients when they ask us for tips. With a fireside chat manner, Larry goes through a wide array of complex financial ideas by explaining them clearly through stories. I found the book to be thoroughly entertaining. And investing novices will find it to be invaluable.”

Swedroe spoke recently with IndexUniverse.com editor Matt Hougan about the new book and, more broadly, about his overall investing philosophy.

IndexUniverse.com: Tell us a little bit about the new book, and why you wrote it.

Larry Swedroe (Swedroe): The book tries to take a topic that a lot of people are scared of—money and investing—and bring it into the real world and make it simple and easy to understand by using stories … stories about sports, about family, about the things that aren’t scary. Because the basic concepts are easy to understand, and if you can get people to understand just a few key concepts, they’re going to be much better off in the long run. Most people remember stories more readily than a complicated chart.

IndexUniverse.com: Give me an example.

Swedroe: Well, I’ve found that the best way to teach people about investing is to tie it to the idea of betting on sports. Many people understand betting on sports, and not enough people understand investing. So one of the stories I use in the book is this …

Even someone who doesn’t know much about college football would recognize the answer to this question: If the University of Texas, a national contender for the championship every year, played a school called San Angelo State, which team is likely to win?

Easy, right? If they play 100 times, Texas would almost certainly win 100 of those games.

The problem is, if you’re trying to make money betting on Texas, you can’t do it. To make money, you might have to give the other team a 40-point spread.

As it turns out, the point spread is an unbiased estimator of the outcome. Even though a bunch of amateurs set the point spread by their betting actions, the favorites tend to win by more than the point spread half the time, and less than the point spread half the time. So it’s very difficult to make money betting on sports; the only people likely to make money are the bookies.

How does that tie to investing? Well, ask yourself the question: If you consider two companies, GE and Ford, you know that GE is the better company. But should you invest in GE just because it’s a better company? No, you have to pay a much higher price for GE than you do for Ford … the price-to-earnings ratio makes both of them equally good investments once you adjust for risk, the same way the point spread gives you an equal chance to win. In other words, GE is Texas and Ford is San Angelo State. Just as the point spread equalizes the risks of betting on either team, the difference in the P/E ratio makes both companies equal investments once we adjust for risk.

Most stockbrokers are nothing more than bookies. They just need you to play—to buy and sell stocks—and they pocket the commission. They win. You don’t win by playing their game. That’s why the bookies own the yachts, when it should be the investors that own the yachts.

I use stories like that one throughout my book to break down the myths about investing, to make it clear. Because stories are the easiest way to get people to learn.

If you tell somebody a fact, they’ll learn. If you tell them a truth, they’ll believe. If you tell them a story, it will live in their hearts forever.

IndexUniverse.com: Do you think younger investors with a longer time horizon should hold more small-caps, more international and more value exposure than the broad market? That seems to be the thinking among a lot of the DFA-inspired crowd.

Swedroe: Let’s begin by addressing this question: Why should anybody at all deviate from a market-cap-weighted strategy?

The answer begins by understanding that there isn’t one factor that determines equity returns. That’s what people used to believe—the more exposure to beta you had, the higher your expected returns and risk. But along came Eugene Fama and Kenneth French. They demonstrated that a three-factor model explains returns much better than the one-factor model. Beta explains about two-thirds of returns while the three-factor model explains about 95% of returns. And unfortunately, prior beta does not determine future beta.

They came up with three factors to explain returns:

* Beta: exposure to stocks
* Value: exposure to stocks with lower valuations
* Size: exposure to small-caps

Because small-caps and value stocks are more risky than large-caps and growth stocks, there should be a risk premium for holding those stocks, and, therefore, higher potential returns.

IndexUniverse.com: So a younger investor should tilt toward small and value to achieve higher returns?

Swedroe: There are good reasons why one might want to take on more risk in a portfolio. One reason is that, as you get bigger risk premiums, you have higher expected returns. A young person may have a longer investment horizon than an older person, and therefore more ability to wait out a bear market. Thus, the younger person might be willing to have a higher equity allocation. They won’t always have better returns, but the longer their time horizon, the more likely it is they will benefit from a higher equity allocation and the value premium as well.

The same is true for small and value stocks—they don’t always outperform, but the longer your horizon, the more likely you’ll get the benefit of the small/value premium.

There is a second factor in people’s ability to take risk: the correlation of your earned income to the economic cycle risks that drives stock returns. Someone whose earned income is highly correlated with economic risks—a construction worker, a small-business owner, etc., might want to underweight small/value to the market and also have a smaller equity allocation. On the other hand, people with very low correlations—doctors, lawyers, tenured professors—have more ability to take risk. And that means they can increase both their equity allocations and their size/value exposure.

Age is part of the equation, but it’s just as important or more important to look at the correlation of your income.

IndexUniverse.com: Will small and value always outperform? Or have those premiums been priced out of the market?

Swedroe: The answer is the same as if you asked me if stocks will always outperform bonds. We know that they will not. If they did, there would be no risk. But we must always expect that they will over any time period. The reason is simple. They are riskier. And thus investors price them for higher expected returns.

Well, value and small stocks are riskier and they too must be priced for higher expected returns. At least if markets are acting rationally. But investors must also keep the following in mind: If you own more than the market share of small-caps and value stocks, your portfolio will perform differently than the market. You are taking on what is called the risk of tracking error.

In the 1990s, when large and growth stocks performed well, a lot of people abandoned the small/value exposures. But unfortunately, a strategy is either right or wrong before the fact. We don’t say it was a bad strategy to buy life insurance because we have not yet died. The strategy must be right before we know the outcome. Similarly, the strategy to buy small-cap stocks and value stocks must be right or wrong before you know the outcome. It won’t always work, but it has worked over long time horizons for a very long time. Unfortunately, people make mistakes and typically abandon their strategies at the worst possible time.

Having the discipline to stay with whatever strategy you choose is far more important than the specifics of your asset allocation. If you choose a strategy that you will, in all likelihood, abandon when things get tough, you’ll likely do far worse than if you chose a different strategy and stuck to it.

IndexUniverse.com: Are growth stocks really less risky than value stocks?

Swedroe: Here’s the difference: We have great companies and we have high expected returning stocks. People think those are the same thing, but they are not. In my new book, I have a story called, “Great Companies Do Not Make High Return Investment,” which walks through this in a very simple fashion.

Again, imagine you have two companies, GE and Ford. If we ask people which is the better company, people would say GE. If we ask people which is safer to invest in, they’ll also say GE. After all, if GE goes to borrow money from banks or raise equity in the stock market, they get a lower cost of capital: They have a higher P/E on their stock and a lower interest rate on loans. The lower cost of capital reflects the view by the providers of capital that GE is a safer investment.

But here is where people get confused. GE is a great company and “safer,” and Ford is riskier. But GE may have that greatness priced in. GE’s stock might be traded at a price-to-earnings ratio of 25, while the market average trades at 16 and Ford trades at 7. If the market gets what it expects, people will get the returns off what is bid into the prices: GE gets a lower expected return, because it is “safer,” and Ford gets a higher expected return, because it is riskier.

The problem is if unexpected risks show up. In GE’s case, you’re more exposed to price risk if that happens: The P/E could come way down. In Ford’s case, much of the risks of bad news have already been built into the price, so you are more protected. That’s how people should think of the risk of growth stocks: The price-to-earnings ratio could fall more dramatically than for value stocks. We saw that in March 2000, when the tech stocks were priced as if everything would go right. When that turned out to be wrong, prices collapsed.

The way to think about it is: The odds of something going wrong at GE must be low, otherwise the price would not be high. But if something does go wrong, it could fall sharply. It’s a risk, but one with a low probability.

IndexUniverse.com: Is there a place for commodities, currency, real estate and other alternative investments in most people’s asset allocations?

I believe the answer to that is yes and no. I’ve actually written a book tentatively called, The Only Guide to Alternative Investments You’ll Ever Need. In it, I divide alternative assets into four categories: the good, the bad, the flawed and the ugly.

There are about 20 of these alternative investments altogether. Of the ones you mentioned, real estate and commodities have a place in almost everyone’s portfolio.

REITs in the form of domestic REITs give you broad exposure across a number of asset classes: hotels, apartment houses, etc. There are now even international REITs, which add another benefit of further diversification. After all, there’s an old saying that all real estate is local.

Commodities are a good diversifier, but I would never recommend investing in commodities themselves or in the equities of commodity producers. But I would recommend investing in fully collateralized commodity futures, investable through exchange-traded funds (ETFs), exchange-traded notes (ETNs) and mutual funds. That gives you a passive exposure to an asset class that actually has real expected returns, because you are able to invest the collateral in Treasuries or other instruments. More importantly, commodities are just about the only asset class that has negative correlations to both stocks and bonds. In the nine years that bonds have had negative returns since 1970, commodities are up all 9 years … and they are up on average 30%. And in the eight years when stocks have produced negative returns, commodities averaged a return of about 23 percent. Commodities are volatile, and they tend to perform poorly for a very long time, with then short bursts of very high returns, so you need discipline. Think of them as portfolio insurance. Commodities add a lot of value to a portfolio because they tend to provide their best returns when the rest of the portfolio is having the worst returns.

IndexUniverse.com: What else is in the good category?

Swedroe: I have four other assets in the good category. First, international equities, which I consider alternatives because most investors underweight them. Note that the greatest diversification benefits come from international small-cap and emerging markets stocks. People tend to stick to international large caps, which are a good diversifier, but the correlations are much higher.

The next assets class which I think should be in everybody’s portfolio is TIPS (Treasury Inflation Protected Securities). The literature from academia says that TIPS should even dominate fixed-income portfolio, and I agree, particularly in tax-advantaged accounts.

Two others that I recommend are:

* Stable-value funds, provided they are from very strong credits (AAA providers)
* For some investors, fixed immediate annuities are worth considering, if you need longevity insurance.

IndexUniverse.com: Briefly, what is in the flawed, the bad and the ugly categories?

Swedroe: In flawed, there are a lot of things people invest in that I wouldn’t recommend: junk bonds, venture capital, covered call writing strategies, socially responsible investments, precious metals equities, preferred stock, convertible bonds and emerging market bonds, and private equity. They are flawed in the sense that they might have some positive characteristics (e.g., low correlation), but their negative characteristics more than offset the positives. In other words, there are more effective ways to achieve the same objective.

The bad? Hedge funds, leveraged buyouts and variable annuities. These are all products that are sold, not bought. Once you adjust for the biases in the data and the risks involved, for instance, the data show that hedge fund returns barely compete with T-bills. Variable annuities are way too expensive. The ugly? Equity index annuities. These may be the worst investment known to man. I’ve looked at many of them, and I’ve never found one that looks attractive. Another ugly is leveraged funds. And finally, I would add the broad category of structured investment products put out by Wall Street.

The best advice I can give regarding products created by Wall Street is this: The more complex a product, the faster you should run away from it. It is far more likely that the complexity benefits the seller/issuer than the buyer.

IndexUniverse.com: If you had just five minutes to talk to a 25-year-old who knows nothing about investing, what would you tell them?

Swedroe: The sad truth is that outside of your family and your health, there’s nothing more important than money—not the money itself, but what it can do for you. Yet our education system has failed to educate the public about investing—unless you happen to get an MBA in finance. So my suggestion would be to get educated. First, read James Surecki’s book, The Wisdom of Crowds. Then I would tell him to read Your Money and Your Brain by Jason Zwieg. And then I would tell him to read my books. And if our investor did that, he would know how to avoid all the mistakes most people make. One of my favorite lines is this: If you think education is expensive, try ignorance.

The best news is: As I explain in my new book, the winning strategy is very simple. But it’s not easy: We’re human beings subject to our emotions, and we make mistakes. And that’s where a good advisor can help people. A good advisor develops not only an investment plan, but then integrates that plan into an estate, tax and risk management (insurance) plan.

by Jeremy Siegel, Ph.D.

The recent financial meltdown has brought a torrent of criticism onto our central bank officials. “Rookie Mistake,” cried Bloomberg News. “Flawed Forecast,” proclaimed The New York Times. “They’re nuts! They know nothing!” screamed Jim Cramer on CNBC in a now-famous tirade that has received millions of hits on YouTube.

But if you look at the evidence, you will find that Ben Bernanke, chairman of the Fed, made the right moves at the right time. He skillfully balanced the forces that called for an immediate lowering of interest rates with those that warned that bailing out these sub-prime lenders would encourage financial irresponsibility in the future.

Under Bernanke’s leadership, we will recover from this crisis, but the financial landscape will be permanently changed. The proliferation of “asset-backed” securities that spurred so much lending in the last few years will end. Plain vanilla bank loans and old-fashioned commercial paper backed by the general credit of the corporation will be back in vogue. And believe it or not, one of the biggest beneficiaries will be the stock market.

Path to a Crisis
We need to go back several years to understand the origin of today’s crisis. In response to the recession, the terrorist attacks, and the collapse of the technology bubble, Alan Greenspan pushed short-term interest rates down to 1% in 2003, the lowest rate in more than 50 years, and kept them there for a year. Other countries, also experiencing economic slowdowns and falling inflation, lowered short-term rates dramatically.

As interest rates sank, lenders became hungry for higher yields and borrowers eyed a real opportunity. One way of making risky loans more attractive were backing the loans by “assets” such as account receivables, inventory, and especially real estate. Since home prices were soaring, many borrowers – including some rating agencies – felt there was little risk in these new mortgage-backed securities.

But they were wrong. There was substantial risk if the security was backed by real estate that was sold at an inflated price with no equity cushion.

The first problems with these “sub-prime mortgages” surfaced in February when several mortgage lenders, such as American Home Mortgage and New Century admitted a high delinquency rate. In July, more mortgage woes surfaced and the credit markets tightened.

Nevertheless, when the Fed met on August 8, it had no evidence that loan defaults were rising outside the housing industry or that the real economy was being hurt. Indeed, GDP growth in the second quarter was running at a healthy 4%. In its August policy statement, the Fed acknowledged the disturbances in the security markets by stating, “Financial markets have been volatile and credit conditions are tightening” and recognized that the “downside risks to the economy had increased.”

Although some market observers were disappointed that the Fed did not go to a “neutral stance,” by stating the economic weakness was as great a risk as inflation, most were pleased to see the Fed was aware of deteriorating credit conditions. In fact, the stock market ended the day at the same level reached before the 2:15 p.m. announcement. Had investors been disappointed in the statement, stocks would have certainly sold off.

Problems Spread Internationally

But more troubles soon surfaced. On the very next day, BNP Paribas, France’s largest bank, barred withdrawals from three of its hedge funds that held subprime loans. All of a sudden the crisis took on international proportions. Investors was asking, “Who owned what, how much, and what was it really worth?”

At this point a worldwide panic spread through the commercial banking systems. The overnight lending rate rose as banks feared for the safety of their loans to other banks.

It was exactly this sort of crisis that the central banks were ready for and they acted accordingly. The European Central Bank (ECB) moved first by lending over $100 billion in the overnight market to push the rate bank back down to the official target. A few hours later, when the US markets opened, the Federal Reserve did the same thing.

Central banks can supply unlimited funds to banks by buying securities in the open market and crediting the selling banks with reserves. This increase in the supply of reserves pushes down the price of reserves in the overnight market (called the “Fed funds rate” in the US and the “overnight repo rate” in Europe) and enabled the ECB and Fed to achieve their targets.

Although these actions temporarily quieted the market, they weren’t enough. The following week stocks went into a tailspin as rumors erupted that more hedge funds and buyout firms were encountering serious difficulties. From noon Wednesday to noon Thursday the Dow plunged almost 600 points before staging a late-day rally.

To stem the rout, early Friday morning, August 17, the Fed announced that it was lowering the discount rate from 6 ¼% to 5 ¾% and issued a statement acknowledging that the tightening of the credit markets tipped the risk in the economy towards economic weakness and away from inflation. With the Fed recognizing the seriousness of the situation and taking positive action, markets rallied.

Why Didn’t the Fed Act Earlier?

But questions were immediately raised. Why didn’t the Fed realize on August 8 that the markets were heading for trouble? One simple answer is that the spread of fear and panic is impossible to predict. On August 8, borrowers with good credit could get loans. But by August 17, even credit market for which there was no evidence of rising defaults began to seize up as lenders froze in fear.

Furthermore, had the Fed taken emergency action in the August 8 meeting, it would have been accused of “jumping the gun,” and bailing out the greedy lenders, the investment banks, and the super-rich hedge funds. Indeed, some are criticizing the Fed for this in spite of its careful lending to only qualified borrowers.

Finally, it must be remembered that all central bankers must establish their anti-inflation credibility. Bernanke had been accused of harboring a philosophy that was too soft on inflation and too eager to flood the financial system with liquidity at the first sign of trouble. Jimmy Rogers, the inveterate commodity market booster, toured the world warning about “Helicopter Ben,” a reference to a Bernanke speech in 2002 in which he indicated that if deflation was a threat the Fed could always rain money down on the public from helicopters to increase buying power.

The upshot is that to have shifted policy on August 7 would have been too early. But by August 17, the markets were sufficiently disrupted that action had to be taken. Although the Fed does not want to bail out any impaired asset where poor lending standards were responsible, they also did not want the interest rate on sound loans to rise and choke the economy.

Post Mortem

I think the Fed made the right moves at the right time. But the fallout from this crisis will be with us for a long time. Stocks are thought to be riskier than bonds and much riskier than mortgage bonds. Those that believed they could automatically make junk bonds safe by “backing” them with assets, be they homes or railroad cars, have been proven wrong. It turns out that the best credits are general obligation bonds based on all the firm’s income and assets, not debts backed by dubious assets.

In the long run, all this is a good development for the stock market. In the last decade, more than one trillion dollars has migrated to hedge funds and untold billions to complicated debt and derivative securities. Who will buy those assets in the future? I believe quite a few investors will return to stocks and general obligation bonds – assets that they can buy and sell at any time they want.

Wall Street has rediscovered liquidity and transparency. Stocks and old-fashioned bonds have them; new-fangled collateralized debt obligations and hedge funds do not. A return to basics will be good for both the economy and the financial markets.

With John Mauldin enjoying the beginning of his summer sight-seeing in Europe, its up to us worker drones to address the various goings on the capital markets.

Today, we will take a quick review of the impact of the ongoing fallout from the Housing market on the consumer, and look at what is occurring in the broader financial system. Perhaps we may even discover who is responsible for the entire sordid mess.

How we got to where we are today

You may recall, late last year, I penned a commentary titled Real Estate and the Post-Crash Economy. That discussion reviewed the major events following the 2000-02 market crash and the 2001 economic recession, from the Fed’s extraordinary rate cuts to the entire Real Estate driven economy. You may want to go back and reread that piece, as it provides a lot of context for today’s discussion.

As we noted back then, with housing cooling, we were expecting the economy to decelerate. Mortgage equity withdrawals (MEW), the funding mechanism for so much consumer spending (cars, vacations, plasma screens and home improvement), was sliding lower. That process continues today, as housing has yet to find a bottom (http://bigpicture.typepad.com/comments/2007/08/how-low-will-ho.html).

The economic weakness has shown up first in retail spending figures. Especially hard hit have been the number one and two retailers in the U.S., Wal-Mart and Home Depot. But its not just those two retailers. As the chart below shows, the U.S. consumer appears to be getting tired. Housing is already in a recession, and Automobile Sales are on the verge of one, if not already there. Not just GM and Ford, but Toyota and Honda have seen year over year sales drops in the U.S.

Year to Date Return, S&P Retail Index

Slowing economic activity here has been offset by strength abroad. Robust growth in Asia, Europe and Latin America, along with a weak U.S. dollar, has been a huge boon to American exporters. U.S. corporate profits are actually quite strong, albeit at a cyclical high. The corporate sector has not been hit by Housing – yet.

More recently, banking and finance companies have felt the sting of the housing slowdown. Indeed, it is not just the retailers and auto dealers who have been affected by Real Estate – the entire financial system is being impacted. Let’s look at how that came to be.

Structural Problems from the Wizards of Financial Engineering

My college roommate Mike – he’s a techie who works for a prestigious university, so financial engineering is rather foreign to him – asked me the following question:

In what other arena can the value of an individual unit, used to collateralize a loan, be eroded by the quality of the loans written on other units to other debtors? How are the value of all houses changing based not on any intrinsic change in any individual house or in all houses, but based on the ability of some people to meet their loan obligations?

Well, Mike raises a very interesting point. The short answer is that any asset which gets priced in a free market will be impacted by variations in other assets (including their financing issues), in that market.

Think of the way prices increased in the first place: Homes increased in value, in large part due to easy credit – to the ability for many marginal buyers to borrow, thereby adding to the pool of potential buyers, and therefore the total demand. The opposite happens when credit become tight – less cash to borrow decreases the total number of buyers, reducing overall demand. Prices then fall.

Remember back to the 2000-2002 market crash: When margin clerks were liquidating stocks for those buyers who couldn’t meet margin calls, prices got walloped. It’s the same principle: Borrowed money helped to drive asset prices higher, and when that money is not repaid, then the forced liquidation sales sends prices lower.

To give a more complete answer, we need to look behind-the-scenes at the financial machinations involved in financing homes. It turns out to be far more byzantine than most people realize. Let’s delve deeper, looking at the complex interplay of psychology, liquidity, supply and demand.

Mortgage underwriters – the nice folks who lend you money so you can buy a home – need a steady supply of cash in order to keep lending. That requires two things: a good credit rating, and a liquid credit market to sell existing mortgages.

A large part of this process is serviced by Fannie Mae (FNM), (http://www.fanniemae.com/faq/faq1.jhtml?p=FAQ), the former government agency that is now a private company. They facilitate mortgage financing and securitization of mortgages.

About now, you should be asking yourself “What the heck is the securitization of mortgages?” That is the process by which 1,000s of mortgages are packaged together into bond-like financial products called Mortgage Backed Securities (MBS). Holders of these bond instruments are actually the folks who end up getting most of the interest and principal payment you make each month known as mortgage payments.

As the graphic nearby shows, MBS bond buyers can select a variety of ratings – each with a different potential risk and expected return. This is a huge liquid: Over the past 5 years, between $1 and $2 trillion dollars in new Mortgage Backed Securities were issued in the United States each year.

That’s just the first step of what you will soon see as a rather complex process. There are all sorts of different mortgage paper – some are backed by residential mortgages (RMBS), some by Commercial property lending (CMBS). These various flavors are then sliced and diced into various categories, each rated, and each with a different potential risk and return to the buyer.

ource: Commercial Mortgage Securities Association

If that sounds complicated, well then I have some bad news for you: We are just getting started. From there, these MBS get sliced and diced into an alphabet soup of instruments and their derivatives: CMOs (Collateralized mortgage obligation), CDS (Credit default swaps) CDOs (collateralized debt obligations) and CLOs (Collateralized loan obligations). (See this for a picture of how complex this can get http://bigpicture.typepad.com/comments/files/RMBS.gif)

My personal favorite is CDOn – a generic term for CDO3 (CDO cubed) and higher. These are CDOs backed by other CDOs, ranging from CDO2 to CDO3 to CDO4 and so on.

Each of these is a more complicated instrument, predicated on the previous product. Each new item is engineered with an increasing degree of complexity, and a less transparent degree of risk and reward. They get packaged and repacked and repackaged further still. By the time the whole unholy mess is done, the final instrument is many times removed from the original paper – a simple mortgage.

Its no surprise that many institutional investors and fund managers had nary a clue as to the quality of the instruments they were holding. And that violates one of the most important of Ritholtz’ laws of investing: Never buy anything you do not understand. (http://bigpicture.typepad.com/comments/2007/08/advice-for-rich.html)

The ugly side of low rates: The Reach for Yield

In our earlier commentary, Real Estate and the Post-Crash Economy, we discussed what happened when the Fed cut rates to 46 year lows and kept them there for too long. Everything priced in dollars had a huge boom: commodities, real estate, gold, oil, equities, etc. all rallied strongly.

But one asset class did not get to enjoy much of a boom at all: fixed income products. Ultra-low rates have a positively dreadful effect on those institutions that rely upon fixed income products to meet their funding and inflation-hedging needs. These include insurance companies, banks, private and public pension plans, trusts and endowments.

With rates so low, they began to feel the temptation to “reach” for yield. Some just a little bit, others with reckless abandon. Thus, another investing rule was ignored: Few things in life are as expensive as the reach for yield.

There are not all that many ways to get significantly more yield without taking on considerably more risk. Over the past few years, a variety of techniques were employed: Some managers crept further and further down the quality scale, in exchange for higher yields. Some took on just a little more risk, hoping no one would really notice. Others borrowed money in low rate nations (like Japan) and invested it in higher rate countries (aka the carry trade). Some used leverage, although that has a variety of inherent problems. Some clever folks tried complexity, which hides the additional risk you are taking on from the view of most observers.

One particular group of folks checked the box marked ALL of the above: certain types (but not all) hedge funds. Aggressive fund managers borrowed lots and lots of money from their prime brokers, and suitably leveraged up, went out and bought into the alphabet soup we discussed, or used the leverage to do a lot of supposedly low volatility trading.

Under normal circumstances, that might not matter much. However, these were not normal circumstances. Over the past 5 years, we have had an enormous credit bubble. The normally staid banking industry was seduced by the monstrous demand for high yielding mortgages to get collateralized into all of these instruments. Farmers know the expression “Make hay when the sun is shining.” Bankers saw the nearly unquenchable demand for mortgages, and they knew it was time to make hay. They replaced the old method of approving mortgages (i.e., a human looking over a loan document) with an automated software program (See this NY Times article). This was a key technological development that allowed them to crank up the machinery to underwrite lots and lots of loans – some good, some bad, some really ugly.

In this headlong rush, lots of foolish shortcuts were taken. Loans were written to people with low FICO scores, on properties with very high loan to value (LTV); Documentation was often poorly filled out. An entire new category was created: “No doc” (no documentation needed) loans. Today, we know these products as “liar loans,” thanks to the commission-driven mortgage brokers who encouraged borrowers to “get creative” when filling out the no doc applications.

Then there are the 2/28 loans. These were primarily offered to sub-prime borrowers – those with weak FICO scores, or modest incomes. These loans typically start at a fixed “teaser” rate for two years, before resetting 300 or so basis points to a variable rate. Disproportionately, these reset mortgages are the ones that have been going into default and foreclosure at alarming rates. And that has caused a cascade reaction all the way through the entire financial system.

Low rates drove the initial demand for mortgages; technology allowed for rapid processing in numbers never before possible; Securitization drove the demand for bundled mortgage purchases; Home Price Appreciation (HPA) kept even poor credit risks from defaulting for a few years. These factors are what led to a huge spike in real estate sales from 2002-2006.

When the history of this era gets written, what we know as the housing boom will likely be reconsidered as a giant credit bubble.

Who was Responsible?

Now, we come to the fun part of today’s commentary: assessing blame for the whole shebang.

I have some bad news for you fans of schadenfreude: The responsibility is widespread, with plenty of blame to spare. I assess the responsibility for the mess to the following:

* Federal Reserve (FOMC)
* Borrowers
* Mortgage brokers
* Appraisers
* Federal Government
* Fannie Mae
* Lending banks
* Wall Street firms
* CDO Managers
* Credit agencies
* Hedge funds
* Institutional Investors (pensions, insurance firms, banks, etc.)
* And back to regulatory role of the Federal Reserve

Let’s look at each of these in turn.

All interest related issues begin and end with the Fed. As we have noted before, the FOMC cut rates extraordinarily low, and then kept them there for far too long. (see Fed Fund Rates, 2000-06)

Regardless of how low rates are, the simple fact remains that many borrowers recklessly took out mortgages regardless of their ability to pay the monthly carrying charges. This was simply reckless behavior, and should be appropriately recognized as such. I was surprised to learn that PIMCO’s fund manager Bill Gross was calling for a bailout. (http://www.cnbc.com/id/20411995) This makes me feel foolish for taking out a mortgage I could actually afford. Had I suspected a bailout of reckless behavior was forthcoming, I would have taken out a $10 million mortgage and gotten a much nicer house . . .

Next up in our cavalcade of criticism: The mortgage brokers. This is a lightly regulated industry, ripe for lots of abuse. Indeed, from videos posted on YouTube to the eventual mainstream coverage, some exotic mortgage brokers had become the new boiler rooms. (http://bigpicture.typepad.com/comments/2006/09/exotic_mortgage.html)

Then there were the Appraisers. In the past, appraisals were assigned on a rotating basis. There was no incentive to inflate appraisals. However, that was when banks were the primary contact with the homebuyers. With the rise of the mortgage brokers, steering appraisal business to those appraisers known to give generous estimates rose rapidly. From there, it was a short step to outright fraud.

Its not like the Federal Government was unaware of the problem. In 2005, more than 8,000 appraisers – roughly 10 percent of the industry -signed a petition asking the federal government to take action. No regulation to prevent this rampant fraud was ever created. http://money.cnn.com/2005/05/23/real_estate/financing/appraisalfraud/index.htm

Then there was Fannie Mae. One might have thought the firm that had been in the business of securitizing mortgages since 1938 would have some insight into what was actually going on in the mortgage markets. No such luck. Perhaps Fannie Mae was otherwise occupied untangling its own massive scandal: An “extensive financial fraud” had occurred with earnings doctored so executives could collect hundreds of millions of dollars in bonuses. (http://www.washingtonpost.com/wp-dyn/content/article/2006/05/23/AR2006052300184.html)

The Banks that underwrote these loans also get some blame. The automation they installed permitted rapid processing of bad credit risks, but it was the outstanding sloppiness and violation of the banks own internal procedures that allowed even more bad loans to get written. Hard as this may be to imagine, some loan documentation was so incomplete that the federally mandated “Truth-in-Lending Disclosures” were omitted. Without the proper disclosures, a mortgage could become “un-secured” – meaning it no longer has a first priority lien on the mortgaged property. (http://bigpicture.typepad.com/comments/2007/08/coming-soon-tru.html).

How did Wall Street manage to overlook all of these issues? Did they actually do their due diligence? Or, was it simply a case of keeping the securitization process rolling? I’ve had conversations with CDO managers and insiders, who stated “We knew we were buying time bombs.” So I doubt it was sheer ignorance. Rather, it appears that as long as deal fees could be generated, Wall Street kept the CDO factories running. http://bigpicture.typepad.com/comments/2007/08/cdo-insiders-we.html

Then there were the Credit Agencies. Far from being objective arbiters of the credit worthiness of these debt instruments, the 3 major agencies – Standard & Poors, Moody’s, and Fitch Ratings – conducted a form of “pay for play.” Working closely with underwriters, they frequently rated paper AA and AAA that would (and will) eventually be revealed as junk. They were tremendous, well compensated enablers of the entire sub-prime fiasco. http://www.portfolio.com/news-markets/national-news/portfolio/2007/08/13/Moody-Ratings-Fiasco

Of course, none of this would really have mattered if a few hedge funds and a much larger number of institutional investors (including foreign central banks – China evidently bought $10 billion in subprime mortgages) didn’t suck up so much of this suspect paper. Through the indiscriminate use of leverage, and by failing to know what they owned, the hedgies also must shoulder some of the blame.

And to be fair, the institutional investors who bought the paper were sold it by Wall Street firms who touted the AAA ratings of the paper. Their lawyers will certainly portray them as the victims when they get to court.

Finally, we come back to the Federal Reserve – only this time, it is not the rate setting FOMC that gets the blame. Rather, it’s the Central Bank’s regulatory authority that gets the blame for sleeping throughout this entire episode. But not to worry: On August 14, 2007, the Central Bank proposed that “consumers have clear, balanced, and timely information about the relative benefits and risks of certain ARM products.” Talk about locking the barn door after the horses have gotten out. (http://www.federalreserve.gov/boarddocs/press/bcreg/2007/20070814/default.htm)

Where do we go from here?

The highly leveraged speculation in mortgage based securities cascaded across the globe. The aggregate foreclosures of bad mortgages led to a near seizure of credit markets. These markets are so essential to the smooth operation of the global economy that Central Bankers around the world had to react by injecting massive amounts of liquidity into financial networks. They have managed to stabilize skittish markets and restore investor confidence, for now.

However, we have no idea exactly how long this might last. And there is reason to suspect that the present equilibrium is quite delicate.

The Federal Deposit Insurance Corp (FDIC) noted that delinquent loans have increased $6.4 billion in Q2. The number of overdue mortgage payments increased 10%. That turns out to be the largest quarterly increase since Q4 1990. RealtyTrac notes that foreclosures are now running 93% higher than one year ago.

Now consider that the underlying cause of the recent turmoil has not been addressed. Estimates put the peak of the sub-prime resets that started this all somewhere between Q4 2007 to Q1 2008.

As we have learned, sub-prime resets result in a large number of delinquencies within about 60 days. Foreclosure proceedings often begin some 90 to 180 days after that. Eventually, these properties come back to market in foreclosure auctions. As Gary Shilling said recently, the mortgage pig is hardly through the python yet.

We should expect Housing market based economic and financial system dislocations to continue for the foreseeable future: At least through 2008, and likely through most of 2009.

Markets seem to have stabilized this week. That may not be a condition that lasts a very long time . . .

- Barry L. Ritholtz