October 2, 2022

The Zero Sum Game Of Lower Interest Rates And Why Mortgage Rates Will Rise

The Federal Reserve has forced long term interest rates to historic lows in a desperate attempt to “stimulate” both the housing market and the economy in general.  The results have been mixed but the benefits of lower rates to borrowers are undeniable.  Lower rates reduce the cost of large debt burdens carried by many Americans and increases the spending power of those able to refinance.

Exactly how much lower the Fed intends to repress mortgage rates is anyone’s guess but as interest continue to decline, the overall benefits diminish.  Here’s three reasons why the Fed may wind up discovering that the economic benefits of further rate cuts will be muted at best, self defeating at worst.

1.  Lower rates are becoming a zero sum game for the economy as lower rates for borrowers translates into lower income for savers.  Every loan is also an asset of someone else and lower interest rates have merely been a mechanism for transferring wealth from savers to debtors.  Every retiree who prudently saved with the expectation of receiving interest income on their savings have been brutalized by the Fed’s financial repression. Even more infuriating to some savers is the fact that many debtors who took on irresponsible amounts of debt are now actually profiting from various government programs (see Foreclosure Settlement Q&A – A Victory For The Irresponsible).

A significant number of retirees that I know have been forced to drastically curtail their spending in order to make ends meet while others have been forced to draw down their savings.  The increased spending power of borrowers has been negated by the reduced spending power of savers.  This fact seems to elude Professor Bernanke who hasn’t been able to figure out why lower rates have not ignited the economy.

2.  Many consumer who would like to incur more debt are often turned down by the banks since their debt levels are already too high.  Those who can borrow often times chose to deleverage instead, considering the fragile state of the economy.  Anyone saving for a future financial goal (college tuition, home down payment, retirement, etc) is forced to reduce consumption and increase savings due to  near zero interest rates.  The Federal Reserve has destroyed Americans most powerful wealth building technique – the power of compound interest.  A 5% yield on savings will double your money in about 14.4 years while a 1% yield will double your money in 72 years – and that’s before taxes and inflation.

3.  As mortgage rates decline into uncharted territory, the mathematical benefit of lower rates diminishes.  As can be seen in the chart below the absolute dollar amount of monthly savings as well as the percentage decrease in the monthly payment diminish as rates race to zero.

Benefits of a refinance on a $200,000 mortgage diminish as rates decline

% Rate Mo Payment Mo Savings % Reduction Yearly Savings
6.00% $1,199.00
3.00%    $843.00 $356.00 29.70% $4,272.00
1.50%    $690.00 $153.00 18.10% $1,836.00
0.75%    $621.00  $69.00 10.00%    $828.00

Closing costs at lower rates also become problematic, making it impossible to recapture fees within a reasonable period of time.  With closing costs of $8,000 on a $200,000 mortgage refinance, it would take a decade to recoup closing costs.

Many astute analysts have made elaborate and compelling arguments that interest rates can only go lower.  From a contrary point of view, I believe that a future rise in interest rates is a high probability event.  This is the opposite of my prediction in March 2009 when I surmised that mortgage rates would decline to 3.5% – see 30 Year Fixed Rate of 3.5% Likely.

The Chart of the Day has a long term chart of the 10 year treasury and notes that the recent sharp decline in interest rates “has brought the 10-year Treasury bond yield right up against resistance of its 26-year downtrend channel.”

 

Bank of America Refinance Offer Raises Questions On Wealth Accumulation

A client of mine recently received a mortgage refinance offer by mail from Bank of America (BAC).  The offer showed that a savings of $2,225 per year was possible by refinancing to a new 30 year fixed rate mortgage.

My client called me to discuss whether or not a refinance made sense since her rate was only dropping by .375% to 4.75%.  Conventional analysis of a mortgage refinance usually assumes that a refinance only makes sense if the rate is dropping by at least 1 or 2 percentage points.  Other factors used in evaluating a refinance involve the period of time required to recoup closing costs, how many years the borrower intends to remain in the home and a review of the forecasts for future interest rate changes.

In my customer’s case, not only was the rate decrease small, there was also $5,706 in closing costs which included 2 points.  In addition, the savings that Bank of America projected were based on a 30 year fixed rate mortgage.  Since my customer only had 22 years left on her current 30 year fixed rate mortgage, this meant 8 years of additional payments.

The monthly savings of $185.42 ($2,225 yearly) for a refinance came at the cost of adding 8 more years to the mortgage term.  Despite the monthly savings, the total additional payments over 30 years for the new lower rate mortgage amounted to $48,048, including the financed closing costs.

Was Bank of America trying to fatten their bottom line with a refinance that made no sense?  Depends on your perspective and financial status.  For some households on very tight budgets, reducing the mortgage payment by $185 per month can make life a lot easier.

For other households, the $185 monthly savings can help increase long term wealth using a concept that most consumers have either never heard of or don’t understand.  It’s called compound interest, allegedly described by Albert Einstein as “the most powerful force in the universe”.

In the case cited above, if the homeowner saved the $185 per month from a refinance and achieved a 4.75% return over 30 years, the result would be a nest egg of $141,634.  The power of compounded gains over 30 years far exceeds the additional payments of $48,048 at 4.75% interest paid on the declining balance of a 30 year mortgage.  The homeowner winds up with a net gain of $93,586

A 6% return on the $185 per month savings over 30 years would yield $175,904 and a gain of 8% would yield $252,055.

A refinance that did not look compellingly attractive could actually increase long term wealth for those with the discipline to save.  After considering the options, my client decided to refinance and increased her 401k savings by $185 per month.

Disclosure: No position in Bank of America stock

Strategic Defaults – The Difference Between The Rich And “Other People”

Million Dollar Home Owners Falling Off The Cliff

“I think you’ll find the only difference between the rich and other people is that the rich have more money” – Mary Colum

If the difference between the rich and “other people” is money, why are the rich walking away from their mortgages just as fast as anyone else?   This question is examined in a recent New York Times article which cites a serious delinquency rate of 1 in 7 for homeowners with a mortgage over $1 million compared to a delinquency rate of 1 in 12 for smaller mortgages.  The Times’ conclusion is that the biggest defaulters on mortgages are ruthless rich folks with no scruples.

Without citing specific statistical analysis, the Times article seems to draw the conclusion that anyone with a million dollar mortgage would have substantial financial resources that could be tapped to keep the mortgage current.   This may well be the case for some, but drawing from my own experience in the mortgage industry, many homeowners with the million dollar mortgages are financially thin and over leveraged.   For a variety of reasons ranging from ego, poor financial planing or irrational exuberance, many purchasers walk into million dollar homes with empty pockets.

Many of the million dollar homes now in default were purchased when eager buyers believed that home values could only go up and that buying as much home as possible simply meant larger profits down the road.  A ten percent gain on a million dollar home results in a handsome $100,000 gain – ten times the profit from purchasing a $100,000 home.

A few short years ago, at the height of the housing bubble, income was deemed irrelevant when banks granted mortgage approvals.   The proverbial strawberry picker or fast food cashier with average credit could use exotic mortgage programs to buy at any price level chosen, without the bother of a down payment or income verification.    Ever increasing home values then allowed cash extraction from a refinance or second mortgage, once again without the hassles of verifying income.  It should come as no surprise that wannabe millionaires taking the biggest risks now have the highest default rates.

According to the Federal Reserve, “half of the defaults are driven purely by negative equity” when the mortgage debt exceeds 150% of a property’s value.  Since high priced homes have seen large declines in value, it should come as no surprise that many strategic defaults will occur at the high end of the market by homeowners with million dollar mortgages.  The open question is – does having a million dollar mortgage imply a wealthy homeowner?

If a statistical study was done on the net worth of defaulting homeowners who have million dollar mortgages, it would probably reveal that many of these alleged “rich” homeowners have an embarrassingly low or negative net worth.  Consider the findings from one of the most influential studies on the mind set and lifestyles of the wealthy from The Millionaire Next Door: The Surprising Secrets of America’s Wealthy, by Thomas J. Stanley and William D. Danko.

Characteristics of the millionaire next door:

  • Avoids buying status objects or leading a status lifestyle
  • 97% are homeowners with an average home value of $320,000, occupying the same home for over 20 years
  • The average millionaire lives well below his means and spends below his income level

The rich did not get rich by being poor stewards of capital or chasing housing bubbles.  The bulk of those defaulting on million dollar mortgages (strategically or otherwise) are simply poor people, living in big houses they could never afford in the first place.

Living Large

Living Large

The Fed’s Contribution To Ponzi Schemes

12% Returns – “Guaranteed”

You don’t know whether to laugh or cry every time another Ponzi scheme comes to light.

July 28 (Bloomberg) — The U.S. Securities and Exchange Commission said it halted a $50 million Ponzi scheme near Detroit that raised money for a real-estate investment fund and targeted the elderly.

A federal judge in Michigan agreed to freeze assets after the SEC sued John Bravata, 41, and Richard Trabulsy, 26, claiming they lured more than 400 investors by promising 8 percent to 12 percent annual returns, the agency said today in a statement. Of $50 million raised since May 2006, less than $20.7 million was spent on real estate, the SEC said.

“Investors thought they were investing in a safe and profitable real-estate investment fund, but instead their money was being used to pay for luxury homes, exotic vacations and gambling debts,” said Merri Jo Gillette, director of the SEC’s regional office in Chicago.

The defendants allegedly lured investors by saying the fund offered “safer returns” for individual retirement accounts. More than half the proceeds raised by BBC Equities were conversions from investors’ IRAs, the regulator said.

This should sound very familiar since all Ponzi schemes rely on the same ridiculous promises – very high rates of return with virtually no risk.  The promoters of this latest Ponzi scheme promised returns 1200% higher than what is available on a 2 year treasury note with virtually no risk.  400 hundred “investors” took the bait, apparently believing that 12% returns were available with little risk.

Knowing exactly how many potential investors had to be solicited in order to get 400 to sign up would provide some interesting insights on investor behavior.  Do a significant percentage of individuals fall prey to smooth talking con men promising returns that would normally imply high risk?   As we have seen from the Madoff Ponzi scheme, many wealthy and sophisticated investors succumbed to the lure of high returns with low risk.

Desperate Search For Yield Due To Fed ZIRP Policy

This latest Ponzi scheme may be unique in that the perpetrators targeted the elderly.  Con men have a natural instinct to prey upon the most vulnerable and offer them what they need the most.  Many elderly investors who previously depended on interest income from savings have seen their incomes reduced to virtually zero as the Fed has forced rates at the short end to near zero.

Super low cost funding from saver deposits have resulted in huge lending spread profits for the banks.   A Fed zero interest rate policy (ZIRP) is the silent unpublicized part of the bank bailout.   In this zero sum game, the banks are the winners and the savers the losers.  How many financially prudent savers have been forced by the Fed’s policy of zero rates to take high risks (in search of yield) that has resulted in catastrophic losses?

Savers who must have income to survive have been forced by the Fed to assume more risk with longer maturity and/or riskier asset classes.  Some savers, in their desperate search for yield, have wound up losing everything to Ponzi scheme operators.

For retired savers searching for higher yields and who can tolerate price fluctuations, consider allocating some assets into a diversified selection of blue chip companies that pay dividends.  Here are some companies to consider, with stock symbol and dividend yield listed.

Altria Group                           MO              7.2%
Kraft                                    KFT              4.1%
Merck                                   MRK            5.1%
Home Depot                          HD              3.5%
AT&T                                   T                   6.4%
Philip Morris Intl                  PMI              4.6%

Disclosures:  No Positions

Payday Lenders – Predators or Saviors?

Payday Lenders Serve The Financially Inept

One of the fastest growing lending businesses in the country has been “payday lending”.  Without the hassle of a credit check or application, a payday lender will give an employee a cash advance to carry him over to his next paycheck.  There has been huge consumer demand for payday loans as reflected by the growth of  payday storefronts to 25,000 today from zero in 1990.  Convenient locations and quick easy cash entice consumers to take a one week loan on a $300 paycheck for a $50 fee.

Payday lenders argue that the credit losses, overhead costs and the complexity of  administering millions of small loans require them to charge high fees to stay in business.   When Pennsylvania capped interest based fees on payday loans, the payday lenders disappeared from the State.

Responsible Lending.org has characterized payday lending as predatory and forcing borrowers into a vicious cycle where each loan is paid off with another loan resulting in huge fees to the borrower.  Effective annual interest rates can exceed 800%.

A full three quarters of loan volume of the payday lending industry is generated by borrowers who, after meeting the short-term due date of the loan, must re-borrow before their next pay period

Repeat borrowing of what is marketed as a short-term loan of a few hundred dollars has long been documented, but this report verifies for the first time how quickly most payday lending customers must turn around and re-borrow after paying off their previous loan.

Payday lenders generate loan volume by making a payday loan due in full on payday and charging a sizeable fee—now nearly $60 for an average $350 loan. This virtually guarantees that low-income customers will experience a shortfall before their next paycheck and need to come right back in the store to take a new loan. This churning accounts for 76 percent of total loan volume, and for $20 billion of the industry’s $27 billion in annual loan originations.

Payday lenders argue that they are lenders of last resort and provide vital credit that cannot be obtained elsewhere.  If payday lenders cease operating, how would those who had relied on the payday loan get by?

North Carolina provides an example of how consumers fared after payday lending was closed in 2006.   Here are the results of a study done by the Center for Community Capital:

Researchers concluded that the absence of storefront payday lending had no significant impact on the availability of credit for households in North Carolina.  The vast majority of households surveyed reported being unaffected by the end of payday lending.  Households reported using an array of options to manage financial shortfalls, and few are impacted by the absence of a single option  – in this case, payday lending.

More than twice as many former payday borrowers reported that the absence of payday lending has had a positive rather than negative effect on their household.

Payday borrowers gave first-hand accounts of how payday loans are easy to get into but a struggle to get out of.

Nearly nine out of ten households surveyed think that payday lending is a bad thing.

As was the case with aggressive no income and sub prime mortgage lending, many people will borrow money despite onerous fees and high rates.   Financially desperate consumers giving up 15% of their next paycheck to have money a week early are clearly not helping their financial situation.  The government cannot prevent people from making foolish financial decisions, but in the case of payday lending,  tougher regulation seems necessary to protect the financially inept.

Ironically, despite the high fees charged by payday lenders,  it turns out that investors fared no better than the payday borrowers.  Earnings have generally been trending downwards and stock prices have declined significantly.  New State or Federal fee restrictions on the payday lending industry would crush loan growth and profits.  Investors in QCCO and AEA are likely to face continued disappointing returns.

qcco

aea

Disclosures:  No positions.

Financial Sense Eludes Most Americans

Financial Quiz – Which Option Is Better?

Savings - A Lost American Virtue

Savings - A Lost American Virtue

1.  Spend $2.50 today and receive $92 back over the next four years.

2.  Spend 25 cents 10 times over the next four years plus spend $92, at easy payment terms of $1.91 over the next four years.

It seems that most Americans are making the idiotic choice of selecting option #2, according to the WSJ.

Consumers Spurn Fluorescent and LED Models That Can Save Money Over Time

WSJ- The spiral-shaped “compact fluorescent,” around for years, produces the same amount of light as its incandescent ancestor with one-quarter the energy. It lasts for years, provides light in an array of hues, and, by lowering electricity bills, pays for itself in about seven months.

Studies say improving the efficiency of the light bulb is among the easiest ways to start meaningfully curbing fossil-fuel consumption. Lighting accounts for some 20% of residential electricity use in the U.S. — a lot to fritter away as wasted heat. Yet about 80% of all bulbs sold to U.S. consumers are incandescents, which often cost less than 25 cents apiece, about one-tenth the price of a compact fluorescent.

“I buy the cheap ones,” Dallas resident Betty Ferrell said the other day as she reached for a pack of incandescents at a local Wal-Mart store. “They may not be cheap in the long run,” she said, “but they’re cheap for what I have in my purse now.”

In fact, Americans have been so reluctant to buy the new bulbs that the federal government is about to force their hand. A recent law will, in effect, ban incandescent bulbs for most uses by 2014.

But sales of compact fluorescents have dropped in the current recession, to 21% of total U.S. consumer light-bulb sales in 2008 from 23% in 2007, according to the DOE.

Compact Fluorescent Light Bulb (CFL) Math

Calculating energy cost savings
We need two things to calculate how much it costs to light a lightbulb over 10,000 hours: total kWh of electricity used and cost per kWh.

For this exercise, we’ll use $.12/kWh:

    CFL: 230 x $.12 = $27.60
    incandescent: 1,000 x $.12 = $120.00

Now that we have the cost to light both bulbs for 10,000 hours, subtracting the two gives us a cost savings of $92.40 by using a 23 watt CFL instead of a 100 watt incandescent bulb.

Please note: The purchase price of the bulb was not factored into energy cost savings. The typical 100 watt incandescent bulb will last 1,000 hours, therefore, 10 bulbs would have to be purchased to last as long as one 10,000 hour CFL. However, since a single CFL is about the same price as replacing 10 incandescent bulbs, we chose not to factor price into energy cost savings.

Lack of Financial Sense or Flat Broke?

So why would anyone chose option 2?  The savings of $92 over four years was based on replacing only one light bulb.  A $10 investment today for four light bulbs would effectively yield a return of $368 over the next four years.  It’s hard to imagine any other investment producing this type of return.

If the average American can’t come up with $2.50, the economy is probably in worse shape than anyone imagines.

The US is spending billions of dollars each month on imported oil, yet the Government can’t come up with a plan to utilize existing technology that would massively reduce foreign oil imports?  Here’s two easy options – a) impose a tax on incandescent light bulbs that would effectively raise the price above that of a fluorescent bulb, b) instead of sending out another round of “rebate” checks, mail each American 4 florescent bulbs.

On a positive note, the incandescent bulb will be gone in 2014.