May 29, 2022

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

Geithner’s Pump And Dump Scheme

Pump and Dump

According to the SEC website, a pump and dump scheme is one of the most common investment frauds and works as follows:

First, there’s the glowing press release about a company, usually on its  financial health or some new product or innovation.  Then, newsletters that purport to offer unbiased recommendations may suddenly tout the company as the latest “hot” stock.  Messages in chat rooms and bulletin board postings may urge you to buy the stock quickly or to sell before the price goes down. Or you may even hear the company mentioned by a radio or TV analyst.

Unsuspecting investors then purchase the stock in droves, pumping up the price. But when the fraudsters behind the scheme sell their shares at the peak and stop hyping the stock, the price plummets, and innocent investors lose their money.

If all of this sounds familiar it should, since we have probably just witnessed one of the biggest pump and dump schemes ever perpetrated at the expense of witless bank share investors.

Consider the scenario: The Pump

Early this year, the financial system is in a panic as banks announce ever greater losses and talk of nationalizing the banking system is rampant.  Public officials fear a full blown banking collapse if worried depositors start a run on the banks.  Public opposition to bank bailouts is intense.

To stop the growing banking panic, the Fed and Treasury announce that the major banks are too large to fail and will not be allowed to collapse.

An easy to pass “stress test” of the biggest banks is announced to prove to the public that the banking industry is sound.

After a cursory examination of the largest banks, they all pass and are told to raise additional capital just to be on the safe side.

Investors start to buy the bank stocks en masse causing many bank stock shares to double and triple in price.

Over $200 billion in new capital is obtained from investors eager to get in at depressed prices.

Treasury Secretary Geithner states that “this transparent, conservatively designed test should result in a more efficient, stronger banking system”.

Witless commentators at CNBC pile on with predictions that the banks will soon be earning billions in profits.

No less a luminary than Warren Buffet adds to the buying panic by stating that he would put his entire net worth into Wells Fargo.

Potentially catastrophic losses on derivatives, commercial real estate, mortgages, off balance sheet assets and credit cards are swept under the rug as frenzied investors pile into a sure thing.

The Dump

Now, however, Geithner’s brilliant scheme seems to be entering the “dump” phase where “prices plummet and innocent investors lose their money”.  Consider the recent price action in major bank stocks:

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Most of the bank stocks peaked during May and have already declined substantially or appear to be in a distribution phase.  Nervous investors are considering the latest horrendous employment numbers and increasing defaults in virtually every major loan category.   There’s no harm in jumping into a pump and dump scheme early on for some quick gains.  It just might now be the time to jump back out.

Disclosures:  None

Pay Back Time For Credit Card Companies

Card Company Practices Draw Heat                                                                                   Credit Cards

The credit card industry has drawn considerable attention in Washington.  It’s the kind of attention that the card industry did not want but probably deserves.   In an effort to reduce mounting credit losses, the credit card industry has increased interest rates and fees and reduced credit lines.   The backlash by consumers has resulted in the  House of Representatives passing the “Credit Card Holders’ Bill of Rights”, which will prohibit some of the more dubious  practices employed by credit card companies.

The new legislation will prohibit retroactive rate increases and the infamous double cycle billing, require 45 days advance notice of rate increases and require that a borrower be at least 18 years of age.

Prior to passage of the new legislation, lobbyists for the card industry were warning of the adverse impact that new legislation would have.

Congressional action may make credit-card debt less attractive to investors, said the American Bankers Association, the American Securitization Forum, the Financial Services Roundtable, the U.S. Chamber of Commerce and others, in a March 30 letter.

House legislation will “have a negative effect on lenders’ ability to offer reasonably priced credit,” said Kenneth Clayton, senior vice president for card policy at the Washington-based ABA, in a statement.

Card lending is unsecured, meaning the bank doesn’t have any collateral to claim when loans go bad. “The industry is taking massive losses on consumer credit across the board,” Kenneth Lewis, CEO of Bank of America, said on April 8. “Banks in the industry are just trying to protect those assets.”

Weak arguments such as these obviously did little to prevent the new legislation.  My advice to the card companies is – make your debt attractive to investors by restricting lending to people who have the ability to pay back their debts.  Sub prime lending of unsecured money to deadbeat customers regardless of rate will guarantee losses.  Responsible lending will allow you to offer “reasonably priced credit”.

Card Companies Victims of Their Own Tactics

The credit card companies have created their own disaster through reckless lending.  For years I have observed credit card companies extending ridiculously large credit lines to borrowers with minimal ability to service their debts.   It was common to see fixed income retirees or low income wage earners with credit card balances far in excess of their yearly income.   Many borrowers, living on the edge, cannot be blamed for accepting the “no questions asked” easy credit and payment terms pushed by the card companies.   The lenders are the ones responsible for ensuring sound lending.

The logical question is why would anyone lend money to people who in the end cannot pay you back?  The answer is that for decades the scheme worked and resulted in huge profits, as noted in Bloomberg.

Citigroup, Bank of America Corp. and the rest of the top seven U.S. card issuers together raked in more than $27 billion in operating profit from credit cards in 2007, according to Bloomberg data. Now they’re mostly earning customer outrage.

It became routine for borrowers to max out credit card debt and then pay it off through a mortgage refinance (using stated income of course) and then repeat the cycle.   This routine produced large profits for the credit card industry until housing went bust.   No surprise that suddenly maxed out and over leveraged customers started defaulting en mass on their credit cards.  Needless to say, the huge losses were quickly transferred onto the backs of taxpayers  via the magic of the TARP program.  Logically reckless borrowers walk away from their debts and reckless lenders get reimbursed for losses – does anyone see a problem here?

As delinquencies spiraled out of control, the card companies implemented new harsh policies to cut their losses. The problem that the card companies face  is that there is no way for them to accurately forecast who will default and who will pay, since they had previously approved cards without bothering to thoroughly verify the borrower’s financial profile – see Capital One’s Losing Strategy. Not knowing the card holder’s income or asset situation and facing huge losses, the credit card industry had no choice but to raise rates and fees for everyone.

The problem with this new “strategy” is that the borrowers willing to pay 18 to 25% interest rates are probably those most likely to default.  No one who has sufficient income and  spends prudently would be willing to owe card balances at ridiculously high interest rates.   Given these circumstances, the customers owing balances on their cards tend to be the highest risk borrowers, which necessitates  higher rates to offset higher losses.  Maybe the credit card guys should rethink their basic lending strategy?

Disclosure: No positions in companies mentioned

Where Have All The Stock Buybacks Gone?

Given the magnitude of the stock markets decline, one would think that there would be major announcements from companies announcing stock buybacks.  I recall after the crash of 1987 when numerous companies announced major stock buyback programs in an attempt to inspire confidence and shore up stock prices.

As reported in Barrons this week,  stock buybacks declined by 90% from last year during the latest 10 day period, this despite the fact that the average stock has declined by around 50%.  So one may certainly be inclined to wonder why corporate America would be heavily buying back their own stock as the market was at all time highs but not now when, arguably, the stock is a better buy due to price declines.  Maybe some shareholder will ask this question of management at the next annual stockholders meeting.  Perhaps a better time to have asked about stock buybacks was when corporate management was spending hundreds of billions to buyback stock when times were good.

I have never been a fan of stock buybacks for these reasons:

– studies have shown that over time, share price performance of companies buying back stock does not exceed those of companies that do not repurchase shares.

-if management cannot intelligently invest funds back into their core business at a greater return than the cost of capital, then they should instead pay dividends to the shareholders, who will at least have something to show for their investment, since as stated above, stock buybacks do not lead to share price gains.   Microsoft was one of the few major corporations that actually paid a substantial dividend  to shareholders a few years back instead of repurchasing stock.

-unless a company is debt free, would it not have been better to have paid down debt instead of dissipating funds buying back stock?   As mentioned in a previous post, GE spent billions on stock buybacks at high prices and now has to borrow money at 10% rates.   I don’t see how this makes sense as a long term strategy.

-how many of the companies buying back stock have their long term compensation plans and bonuses tied to the EPS performance?  Quite a few I would imagine, which makes the decision to buy back stock all the easier since it directly increases management’s pay while the shareholders get nothing.  (Buying back stock decreases the outstanding shares used in computing the earnings per share, so a stock buyback will serve to increase the reported EPS.)

-how hard is it to conceive of the possibility that someday, markets will decline and cash will be dear, so why not pay down debt or simply increase your cash holdings to be used in an opportunistic manner at some point in the future?  Apparently, not too many members of corporate America ever thought about this or else we would now be hearing about a lot of stock buybacks and company buyouts.

-Exxon Mobil has spent billions buying back stock as their oil reserves shrink year after year.  With prices of oil and gas companies selling for a fraction of the price of a year ago, why are they not opportunistically reinvesting in their business by buying cheap oil and gas reserves via cash acquisitions?

-Merrill Lynch announcing a $6 billion stock buyback in 2006 – one for the history books of poor timing and inept management, although it may be topped by Merrill’s prospective owner, Bank of America, who despite needing taxpayers funds from the TARP, decides to invest $7 billion in the China Construction Bank.  I think BAC has a real problem here and the stock price reflects management’s decision making.  BAC’s
“investment” in China, GM executives flying on their plush corporate jet to Washington to beg for taxpayer funds – I think the pattern here is part of the reason for the economic crisis that we are in.

My conclusion is that a shareholder should carefully evaluate an investment in any company engaging in major stock repurchase plans.

Loan Modification – Someone Forgot To Ask The Investors

Purchasers of mortgage debt, formerly known as investors but now known as bag holders were distressed that Bank of America (BAC) did not consult with them prior to deciding to modify customer mortgages, as reported by the Wall Street Journal.   The problem was not with the mortgages actually owned by BAC, but rather the mortgages owned by others and merely serviced by BAC.  Apparently so enamored with the idea of saving the banking industry by reducing the rate and loan balances of the lucky mortgagees, BAC decided to apply their therapy to mortgages that they merely service but do not own.

The problem with attempting to modify mortgage loans en masse is that many mortgages originated over the past 5 years were sold to investors as mortgaged backed securities.  BAC maintains that they can modify these investor owned mortgages based on “delegated authority” per the loan servicing contract they have with the investors.   Obviously some of the investors in the serviced mortgages don’t see it that way and are looking to BAC to make them whole on any write downs given to the borrowers at their expense.   These are the types of issues confronting the industry in their attempts to modify mortgages.

Mortgage modifications are seen as a win/win situation by the FDIC, many banks and some of the mortgaged backed securities investors since it appears to offer the ideal solution – homeowners get to keep their homes, foreclosures decrease and the ultimate loss on the loan modification theoretically is less than   foreclosing on the property.  This may all be work out to every one’s advantage unless property values continue their decline which I consider to be a likely scenario.   Home prices won’t stop dropping regardless of government efforts until the economy stabilizes and until the ratio of family income to cost of ownership reaches an affordable level.

The issue with loan modifications that I and others see is one of moral hazard; this program is institutionalizing the repudiation of debt on a national scale and the cost and negative consequences of this rationale are open ended.  In an excellent article by Peter Schiff, he describes loan modifications as “the mother of all moral hazards” as follows:

“No doubt prodded by the administration, Fannie Mae and Freddie Mac announced a new attempt to stop the fall in home prices and foreclosures through a loan modification program that would cap mortgage payments so that a homeowner’s total housing expenses would not exceed 38% of household income for home owners who are 90 days delinquent.

In a classic case of unintended consequences, the plan will encourage a massive new round of delinquencies and household income reduction as homeowners will jump through hoops to qualify for the program and maximize their benefit. Those who could conceivably economize to meet their existing obligations will now have a strong reason to forgo such sacrifices. Those who are not 90 days past due will intentionally become so. In many cases, dual income families may decide to eliminate one job altogether as reduced mortgage payments combined with lower child care and other work related expenses will likely exceed the after-tax value of the lost paycheck.

Unfortunately, the last thing our economy needs is falling household incomes and even more bad debt. But that is precisely what this plan will give us.”

Transferring all the losses of homeowners, automakers, banks, insurance companies, credit card companies, mortgage companies etc etc onto the balance sheet of the US Government does not correct the incredible excess of leverage that has been ongoing in this country since the early 1980’s; it merely transfers the losses to the US taxpayers and shortens the day that the US Government itself will need to be bailed out.