The Mess in the US – Part II

We last left off with a red hot financial market in the mid 1980’s being led by the fancy MBS (mortgage backed security) and CMO (collateralized mortgage obligation) securities running in tandem with a leveraged paradise known as the junk bond market. The easy money and lavish lifestyles of the 1980’s were not isolated to Wall Street. Savings and loan (S&L or “thrifts”) institutions across the nation were taking advantage of the newly implemented Tax Reform Act of 1986. The new act was passed to update “old banking standards” and allow thrifts to take on more risk in order to better compete in the “complex financial markets” of the 1980’s. Thrifts ran with their new found freedom and grew like wild fire. Some of the more aggressive ones were doubling in size every year with less than ethical lending practices. All this easy money was making thrift executives very rich and further compounded the greed running rampant through the markets of the 80’s.

The fun finally stopped when the “S&L Crisis” hit in the waning years of a decade best known for the King of Pop, mall bangs, and the chia pet. During the crisis, thousands of thrifts failed, housing markets went south, the economy fell into a recession, and the US tax payer was left holding the bag to support a government bailout of the failing S&Ls (sound familiar?). The details of the crisis are beyond the scope of our discussion, but suffice it to say that laxed lending standards and excessive leverage (using OPM…other people’s money), led to the then largest financial crisis since the Great Depression. The go-go age of easy money and risky lending practices had come to an end…for the time being.

The birth of the high tech sector gave rise to the 90’s bull market and pulled the US economy out of its slump. The technology boom ushered in one of the longest bull markets in US history as investors began to believe that “this time it was different” with a new age of development. The tech heavy NASDAQ index grew almost 900% over the decade. Technology was not only changing people’s lives, but it was changing the makeup of the market as well. At the beginning of the decade, technology related stocks made up only 7% of the broad S&P 500 index. By the end of the decade they accounted for nearly 30% of the index.

During the heart of the technology led bull market, something known as the Asian Financial Crisis emerged in 1997 when Asian countries started defaulting on their debt. The relatively young financial system in many Asian countries was weak and suffered from a lack of substantial governance. The inadequate oversight and poor assessment of financial risk led to a dramatic currency devaluation for several Asian countries. As the local currency became less and less valuable, it became impossible for companies and banks to pay off foreign debt (if a company is making money in a local currency that is rapidly devaluing and having to pay off debt in a stronger, foreign currency they are in deep kimshe). The crisis resulted in a sharp decline to the growth of many Asian countries as businesses collapsed and millions of people fell below the poverty line.

Foreign investors were also impacted by the Asian Financial Crisis as a string of defaults on Asian debt left many lenders “up the creek without a paddle.” To avoid repeating this precarious situation, the market brought forth a new product known as a credit default swap (CDS). In its most basic form, a CDS is nothing more than an insurance agreement between two counterparties. The purchaser of a CDS is looking to insure against catastrophic loss (other companies defaulting on debt that they own) in return for a small premium and the seller of the CDS is willing to take on additional risk in return for the premium. When done in this manner, a CDS could be used as a way to hedge a portfolio of fixed income investments. The agreement is similar to purchasing auto or home owner’s insurance on one’s car or property. Unfortunately, that is where the similarities between insurance and a CDS stop.

Unlike insurance, CDS contracts are unregulated, which opens the door to a variety of subtle nuances. First off, a CDS is a bilateral agreement between counterparties. It is not an exchange traded product, it does not have a quoted market value, and in most cases, it is not accounted for on a company’s financial statements. Because of all these factors it is very difficult to pin down exactly how many CDS contracts are outstanding, how many offset each other (e.g. buy a CDS with counterparty A and sell a CDS on the same underlying security to counterparty B), and who has exposure to what.

Another major difference between the insurance business and the CDS marketplace is the collateral requirements for companies selling (writing) the contracts. In the regulated insurance industry, companies are required to have a minimum amount of assets on hand in order to offset a portion of their outstanding liabilities. In the CDS market place, no such regulation exists. Under this “buyer beware” structure, it is possible for a very small counterparty to write large CDS contracts in order to collect bigger premiums knowing full well that they may not be able to make good on the claim if the underlying security ever defaulted.

The last major difference between purchasing insurance and a CDS is the fact that one does not need to own the underlying security in order to enter into a CDS. This would be akin to someone taking home insurance out on their neighbor’s house in hopes that something bad might happen to it so that they can collect on their contract. When one enters into this type of agreement without having any exposure (financial risk) to the underlying asset, the CDS stops acting as a hedge (insurance) and becomes a speculative bet.

The CDS revolutionized the financial markets and how counterparties viewed risk. The CDS industry was estimated to be in the “tens of billions of dollars” when it first started in the mid 90’s and grew to an estimated value of over 55 trillion dollars today. Risk became a commodity that could be purchased and sold by anyone with a phone, a pen, and a piece of paper (and connections to institutions with large fixed income exposure). The catalyst behind the meteoric rise in the CDS market was still to come as our friends MBS and CMO came back to play during the US housing boom at the dawn of the 21st century. But we are getting ahead of ourselves as we have not yet covered the bursting of the tech bubble and the aggressive monetary policy that led to largest housing bubble in US history.

Ciao,
Frugal Franco

Ways to Pay Up Your Graduate Loans

America has one of the most expensive education systems in the world and usually students who want to pursue a higher degree of education would resort to student/parents loans. Asian parents usually have no problem with this because a study shows that 73.2% of Asian parents or immigrants save up for their children’s college education the moment they are born or they call it “college fund” so that they don’t have to think about paying for parenting loans later on. But not all of the American population is like that. Some parents think high school education is enough for their kids but their kids might think otherwise and end up getting a graduate loan. This blog post is to give some options on how to pay back student loans after you have already completed your degree. This is for the purpose of students who don’t know where to start in paying.

1) Get another Loan with lower interest – Paying a loan with another loan is not good but what we are suggesting is you get another loan with a lesser interest to pay back the student loan and all you would pay for is that loan instead of the graduate loan which oftentimes have higher interest.

2) Have a financial schedule – As early as starting your years in college, you should already be thinking about making money or saving up money to pay up for your college loan. You can set up a financial schedule of how much you would save and how much you would need to spend while you are in college.

3) Savings – Paying out your student loans through your savings is a good way to pay it up. Spending too much while still under a student loan is not a good way to go and you will regret that later on because you are never sure as to whether what your financial condition is later on.

4) Make it a priority to pay up – Prioritizing to pay your graduate loan and setting your mind to that direction would eventually let you pay up for it.

5) If you get a job – Ask your company if they have benefits that they will pay for you graduate loan – There are some big companies who would pay for the graduate loans of their employees especially if they found the employee as an asset. Don’t be afraid to go ask the human resource in-charge if they have that benefit.

Benefits of Graduate Loans

There are so many benefits of graduate loans and some points we would like to add it up here:

1) Able to take up a higher degree of education
2) Immigrants have a chance to go to school and get used to the education system
3) Study now pay later benefits

Basically, student loans make it easy for you to study in college but paying it could be a problem if you don’t have it all planned out.

What Have Banks Learned from Crashing the Economy and the Subprime Mortgage Meltdown?

Watching the meltdown in the subprime mortgage market over the past year, I could not help but be reminded other recessions and industry meltdowns. The junk bond scandals of the 1980’s, the Savings and Loan crisis in the early 1990’s, the collapse of the Russian bond market and Asia crisis in the late 1990’s, and the Enron debacle of the early part of the twenty-first century have apparently taught lenders and investors absolutely nothing.

The most important difference between these other scandals and the ongoing foreclosure crisis, though, is how deeply personal this crisis is to homeowners losing their homes. A drop in the value of their 401(k) or other investments is certainly disturbing, but finding out that one has been a victim of the most incompetent lending practices of recent memory and that has led to an inability to stop foreclosure is another matter entirely.

When other markets were heavily leveraged or securitized, the inevitable bursting of the speculative bubble was largely isolated to a specific market or industry. When internet and tech stocks collapsed in 2000 and 2001, the average homeowner in, say Ohio, was not as affected as the state of California. When the Russian currency collapsed in the late 1990’s, there was no widespread concern about the American dollar.

Even other hedge funds that collapsed in the past did not engender the same amount of financial concern as the foreclosure problem. Long-Term Capital Management, a hedge fund that was bailed out by the Federal Reserve in the 1990’s, was interested mainly in the Asian and Russian markets, and the collapse of the fund was a reflection of the weakness of those markets, rather than the American economy.

But the lessons of these other collapses have apparently not been learned by lenders or investors. Or, maybe, they have been learned all too well, and it is the average consumer and homeowner who has not learned enough.

When interest rates were lowered as a result of the recession of 2000 and the attacks of 9/11/2001, banks had a decision to make. And they actively, voluntarily, with no compulsion, decided to pull the trigger. What was that decision?

They decided that they would offer mortgages to nearly anyone who wanted one, whether they could qualify for it or not. In fact, they offered mortgages even to people who could not or simply did not want to prove to the bank that they made any income, let alone enough income. And the banks made billions of dollars from this quite illogical decision.

Once they originated the subprime, ticking time bomb loans, the banks would simply package them together and sell them as securities in the market. Hedge funds, who invest in the riskiest markets possible, ate up these mortgage-backed securities and could not get enough. Because of the rising real estate market, they believed there was no chance of loss.

In the first place, the loan payments were guaranteed to rise, with adjustable rate mortgages. Hedge funds could buy loans with low interest rates and sit on them for a few years until the rates automatically adjusted. And, if the homeowners could not afford the payment, there were no worries at all. They could simply sell the foreclosure properties for even larger returns, after eating up as much of the equity as possible. It was a no-lose situation for banks and investors.

The large banks, of course, knew that real estate prices would keep rising, since they control the money supply through their control of the Federal Reserve System. Lower the rates, give everyone a loan, and let the market spread the newly-created inflationary wealth around.

Then, raise the rates, watch as homeowners were unable to stop foreclosure because their home values dropped, and simply take back all the of the real estate. In this way, banks now own vast amounts of real estate throughout the country that was purchased at severe discounts through county foreclosure auctions.

The hedge funds who were willingly complicit in the scheme? Well, they got a free bailout of their toxic collateralized debt obligations. A few people lost jobs, homeowners and consumers lost wealth in their pensions and retirement accounts, but the offending companies were able to use that inflated money to keep operating with no real consequences. A free market would have punished such awful lending and investing decisions, but the semi-government intervention saved the funds from having to make good decisions in the future.

So, maybe I was wrong: the banks learned the lessons of these other market collapses all too well. Instead of wiping away the wealth of investors in the internet industry, or certain energy companies, or foreign bond markets, the lenders decided that the newest target would be more massive than any before. The homeowners of America who purchased or refinanced within the last seven years are now all caught in the trap of getting a loan on an extremely over-valued property, and many owe more than the house is worth.

The real estate value is gone. For many foreclosure victims, the house is gone. And even rents are increasing in many parts of the country, at a time when job quality is deteriorating and food and transportation costs are rising.

So now, we should ask ourselves, what will be the next bubble to burst? And who will be the unfortunate victims?

Singapore Mortgage Refinancing

Mortgage refinancing can bring you quite a lot of benefits, especially if the current mortgage no longer works for you. It can also mean a major difference in your finances on a long-term basis, and you should really consider it when the lock-in period of your loan ends. Most banks in Singapore will give you a penalty if you repay within 2 years for floating rate loans and 3 years for fixed rate loans.

Before making a decision, you will need to know a few things, such as the outstanding loan, the current interest rate, the tenure, the end of the clawback period, and current monthly repayments. After that, you may use a mortgage broker or research the market yourself, talking to banks about your current status and the options they can offer you, or get on the Internet and find out for yourself.

The next step is to decide what type of loan you want to get.

SIBOR/SOR? The Singapore Interbank Offered Rate (SIBOR) and the Swap Offer Rate (SOR) are daily reference rates set by the Association of Banks in Singapore. SIBOR reflects the rates at which banks pertaining to Asian time zones borrow unsecured funds from other banks in the region. SOR is the cost of borrowing SGD synthetically, by borrowing USD for the same tenor and swapping it out in return for the SGD. Since SOR is tied to the foreign interest rates and exchange rates, it is much more volatile and risky than SIBOR. In contrast, the latter is much more stable.

Fixed/Floating? Fixed rates are traditionally more stable than floating ones, as loan packages based on these will use a pre-determined interest rate for a given period of time after which the rate becomes variable and the package essentially turns into a floating rate package. With floating rates, the interest rate will follow the trend of the benchmark rates. Since in Singapore the daily references are SIBOR or SOR, floating rates follow their movements.

Why refinance?

To lower monthly repayment: after the lock-in period the interest rate is bound to rise, and so in order to lower your monthly repayment you can refinance to a bank with a better package.

To lower the interest rate: if you choose a bank with a more appealing interest rate, you will reduce your monthly payments by quite a bit.

To pay off your mortgage faster: The ugliest part about mortgages is that they are a burden that you’ll carry for decades. Paying them off faster is incredibly appealing, and if you feel more confident about your ability to make bigger payments, you can refinance your mortgage to minimize the duration of the loan.

To cash out on your home equity: this particular feature is not applicable to HDB flats, and is recommended if you need funds for education costs, renovations, business startups, etc; in these cases you might consider a home equity loan. However, this means you will have to get a new mortgage and use cash to service the home equity loan, as CPF is not allowed in this case.

Asian Real Estate As a Hedge Against Inflation

For the last year or more, I kept hearing and reading the word “de-leveraging”. Companies and individuals are all busy de-leveraging. So, basically, people are saving more money, paying off their debts and spending less. Overall, it gives an impression that leveraging is undesirable and should be done away with.

Marc Faber famously said that, in Asia, the family run businesses in Hong Kong and Singapore have very little debt. Many rich families in Singapore do not have any mortgages. He thinks that Asian real estate will continue to do well. This gels with what Jim Rogers thinks about how we should own some real estate and he, in a recent interview in New York, actually said that he would buy some US real estate now if he were staying there.

We should also buy other tangible assets which would keep pace with or grow faster than inflation and protect or grow our wealth in the process. However, most of us are not in the same league as Marc Faber or the rich families he mentioned.

So, what are we to do if we want a piece of the action and own some Asian real estate? Do we work very hard to save money before we buy that piece of real estate? 100% cash upfront and without a housing loan? Or do we put down 20% and borrow 80%?

Quite simply, like any other investment, the answer lies in timing. Buy when the market is depressed or just turning up and hold for the long term. If you believe that the world is going to see extraordinary inflation in future, this is one thing we should do if we have the means. If we have the money, pay 100% cash upfront. If we only have 20% to