Good Reading -- April 2012
Quoted "Philosophically, the edifice of world regulation was built on two building blocks. One is the idea of the rational man and the other is that there is a reasonable level of conduct in the sales channel. Both of those building blocks broke down to some extent." -- Martin Wheatley, new head of Britain's Financial Conduct Authority Facts & Figures
At a market cap of $550 billion (down from a recent high of $600 billion), Apple is worth more than all of the retail companies in the S&P 500 combined.
Apple has increased in value by approximately $170 billion year-to-date, and that $170 billion increase is compares to the total market caps of P&G ($184 billion), AT&T ($182), Wells Fargo ($176), Johnson & Johnson ($173), Coca-Cola ($167), and JP Morgan Chase ($165).
In December 2011, Americans drove 1.3% more miles than they did in December 2010 but used 2.5% less gas and diesel to do so. (Source: DOT)
In 1950, total U.S. credit market debt stood at $541 billion, or about 145% of GDP. In 2005, it was $38.8 trillion, or 320%.
The peak was above 380% (on debts over $53 trillion) in late 2008 and early 2009.
As of 4Q11 the total had grown to more than $54 trillion, but thankfully GDP has expanded a bit, bringing the ratio down below 355%. (Source: Fed)
Companies in the S&P 500 generated $420,000 in revenue per employee in 2011, up more than 11% from 2007. Total revenue was up more than 17%, though, as employee headcount only increased 5.1%. Net income rose 22.7% and capital spending rose 16.3%. (Source: WSJ.)
The Pennsylvania State Employees' Retirement System has $23.6 billion in assets and paid $1.35 billion in management fees over the past five years while earning a five-year annualized return of 3.6%. Georgia's municipal retirement system, which is forbidden by state law from using alternative asset managers, has $14.4 billion in assets and paid $54 million in total fees over the same period while earning 5.3% annually. (Note that these are extreme examples, but also note that an even bigger problem is that neither fund earned anything close to its required return. The mean public pension return over the last five years was 4.9% against assumptions/discount rates generally in the 8% range.) (Source: NYT)
Fees and return expectations certainly aren't the only problem: see this article about how the largest U.S. corporate pension funds are facing record-high funding deficits, and yet choosing to allocate away from equities in favor of fixed income (despite puny yields and spreads, or "return-free risk") because the recent equity market volatility has made them want to "de-risk."
On a related but contrary note, this is a good article about Yale's David Swensen and the Yale investment policy, which is apparently out of favor (for reasons mentioned above). Another article, "The Curse of the Yale Model," is highly critical -- most of it is warranted, but I also disagreed with parts of it. See here for the transcript of a great talk Swensen gave to MBA students in 2008.
Books
Peter Bevelin of Seeking Wisdom fame is releasing a new book at the upcoming Berkshire annual meeting. A Few Lessons for Investors and Managers from Warren E. Buffett will feature a "selection of useful and timeless wisdom where Warren Buffett in his own words tells us how to think about business valuation, what is a good and bad business, acquisitions and their traps, yardsticks, compensation issues, how to reduce risk, corporate governance, the importance of trust and the right culture, learning from mistakes, and more."
Greg Speicher runs a great blog ("Ideas for Intelligent Investing") and is out with a new book: How to Become a Better Investor: 10 Ways to Improve Your Investment Process. I just read it, and much like his "100 Ways to Beat the Market" series and recent post his recent post "A Blueprint for Being a Lousy Investor", this is a good read. (It's also more of an article than a book -- it's what the kids call an "e-book.") In a nice coincidence, another great blog/newsletter is giving it away free.
Jonah Lehrer on Decision-Making (FiveBooks Interviews) -- a very interesting interview, and you can't do much better than these five books. They're all excellent.
Attachments:
"How to Prevent Other Financial Crises" -- a prescriptive analysis of the financial crisis by Nassim Taleb and George Martin. I don't agree with all of it, but I'm hugely in favor of the "skin in the game" idea. Implementing that, of course, would be a little trickier...
"Tape and Band-Aids Shape the New Investment Framework" -- a talk given by Daniel Arbess of Xerion last month. I read it then and didn't think to include it my last email, but I just reread it and I think that there are plenty of worthwhile thoughts in here, even though I disagree with parts.
Links
"The Money Report" -- a special offering from The Atlantic that is highly recommended. "Economics is so often the economist-eye view of the world. We're out to recreate the consumer-eye view of the world. We're interested in what things costs, why they cost that much, and why they're getting more expensive and less expensive." Part of it is derived from a BLS study, "100 Years of Consumer Spending." Some particularly good articles, all of which are fairly brief:
"Prices are People: A Short History of Working and Spending Money"
"How America Spends Money: The 100 year story of how a nation that feels poor got rich" -- spending on food and clothing in 1900 went from one-half of family budgets to less than one-fifth in 2003.
"Food is Cheap" -- "In 1950, the average farmer fed 20 people. In 2000, he fed more than 120."
"The 100-Year March of Technology in One Graph" -- amazing data/chart on technology adoption.
"Why Some Countries and Cities Are So Much More Expensive Than Others" -- the tale of the NYC nanny making $200,000.
"Gray Nation: The Very Real Economic Dangers of an Aging America" -- an important look at the power of demographics and the likelihood of lower growth in the future.
"Keynes: One Mean Money Manager" -- an excellent article on Keynes by super journalist Jason Zweig. An equally good follow-up is here.
"John Maynard Keynes Was the Warren Buffett of His Day" -- beyond the inept comparison in the title, some worthwhile related thoughts on Keynes in The Atlantic.
My Investing Checklist -- a good, concise checklist from the "Portfolio 14" blog. Thanks to Geoff Gannon for finding this.
Lauren Templeton on Value Investing -- John Templeton's great niece with some interesting thoughts.
"Inside Amazon's Idea Machine: How Bezos Decodes the Consumer" -- interesting profile by Forbes of its "top-ranked" CEO and his company. "We are comfortable planting seeds and waiting for them to grow into trees. We don't focus on the optics of the next quarter; we focus on what is going to be good for customers. I think this aspect of our culture is rare."
"Where the Comeback Has and Hasn't Taken Hold" -- lots of good data.
Articles (see below):
"The Alternative Warren Buffett" -- a stark reminder of the power of compound interest. The original John Kay columns are here and here.
"Warren Buffett's $50 Billion Decision" -- Buffett wrote this mini-biography about his early days. Worth a quick read in case you missed it.
"Financial Sleuth Finds World of Abuses" -- forensic accountant extraordinaire Howard Schilit is back at it with a new consulting firm. His book "Financial Shenanigans," which ran a third edition in 2010, is a classic.
The alternative Warren Buffett
Morgan Housel April 4, 2012
Writing in the Financial Times in 2008, John Kay put Warren Buffett's success into simple perspective: During Mr. Buffett's tenure at Berkshire Hathaway (NYSE: BRK-A, BRK-B), the S&P 500 index has produced an average total return of 10 per cent.
That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that - as Mr. Buffett's have done - your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That arithmetic makes Mr. Buffett the richest man in the world.
A staggering outcome
I thought about that simple - and startling - calculation while reading a short article written by Buffett himself this week in Forbes. In it, Buffett writes: “When I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I'll go back to Omaha, take some college classes, and read a lot - I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, "Compound interest guarantees I'm going to get rich."
Buffett's net worth today, according to Forbes, is US$44 billion. Some quick numbers, then: Since 1955, his net worth has compounded at a rate of 25.08% a year. That got me thinking: What if the skinny kid from Omaha with US$127,000 in 1955 didn't spend the next half-century devoted to stock-picking, business-building, and market-beating?
What if Buffett instead did something more traditional with his money, like put it in an index fund, government bonds, gold, or cash? You can imagine a few "alternative" Buffett scenarios. And like Kay's statistic, they show how powerful compound interest can be over time.
Scenario one: US S&P 500 index fund Including dividends, $127,000 invested in the S&P (or a re-created equivalent) in 1955 would be worth $31.7 million today, which works out to an annual return of 10.17%. That gives us a good proxy to measure Buffett's market outperformance: Of his $44 billion net worth, about $43.97 billion came from so-called "alpha," or returns in excess of the benchmark. That sentence is worth re-reading. For more perspective, Bloomberg has a new tool that tracks the daily net worth change of the world's billionaires. It shows Buffett's net worth changed by $328 million in one day alone last week, or more than 10 times what his entire net worth would be had he invested in the S&P in 1955. Scenario two: 10-year US Treasury bonds $127,000 put in 10-year Treasuries in 1955 would be worth $3.9 million today, for an average annual return of 6.2%. For perspective, if Berkshire paid out half its net income as a dividend, Buffett would earn US$3.9 million every 27 hours, roughly. Scenario three: Half stocks, half Treasuries Split the difference between the first two scenarios, and you get a pretty average portfolio. How much would $127,000 split between stocks and Treasuries in 1955 be worth today? $17.8 million, for an annual return of about 9% - and $43.98 billion less than Buffett actually earned. Scenario four: Gold $127,000 plunked into gold in 1955 would be worth just over $6 million today, the vast majority of which came in the last few years alone. That's about a day and half of Berkshire's hypothetical dividend, if you're keeping track. Scenario five: Cash under the mattress $127,000 in cash in 1955 would be worth... $127,000 today. Let’s put that in perspective. Inflation would whittle the amount down to about $15,000 in today's dollars. You might think it's unreasonable to assume cash is stuffed under a mattress - or some other way to earn a 0% return - but it's sensationally popular these days. Americans alone now have over $10 trillion in bank deposits – earning very, very low interest rates, up $760 billion in the last year alone. Lesson learned Now, these figures are rough estimates at best. It's impossible to know how things like spending and taxes would have actually affected Buffett's "alternative" net worth. What they should demonstrate, however, is how staggeringly powerful even small differences in returns add up over time. You should not expect to earn Buffett-like returns over the next 50 years. In fact, you almost certainly won't. But the difference in earning 3% a year versus, say, 7% or 9% a year, compounded over a few decades, is no less than life-changing. Foolish take-away When you look at where money is going these days - lots going into bonds yielding close to nothing, and little going into stocks that still offer good returns - you see at least one reason why Buffett is abnormally successful: He understands and appreciates the power of compounding returns better than most.
That simple arithmetic, as Kay might say, made him the richest man in the world.
Warren Buffett's $50 Billion Decision
This article, by Warren Buffett, as told to Randall Lane, appears in the upcoming April issue of ForbesLifemagazine, as part of its “When I Was 25″ series.
By Warren Buffett
Benjamin Graham had been my idol ever since I read his book The Intelligent Investor. I had wanted to go to Columbia Business School because he was a professor there, and after I got out of Columbia, returned to Omaha, and started selling securities, I didn’t forget about him. Between 1951 and 1954, I made a pest of myself, sending him frequent securities ideas. Then I got a letter back: “Next time you’re in New York, come and see me.”
So there I went, and he offered me a job at Graham-Newman Corp., which he ran with Jerry Newman. Everyone says that A.W. Jones started the hedge fund industry, but Graham-Newman’s sister partnership, Newman and Graham, was actually an earlier fund. I moved to White Plains, New York, with my wife, Susie, who was four months pregnant, and my daughter. Every morning, I got on a train to Grand Central and went to work.
It was a short-lived position: The next year, when I was 25, Mr. Graham—that’s what I called him then—gave me a heads-up that he was going to retire. Actually, he did more than that: He offered me the chance to replace him, with Jerry’s son Mickey as the new senior partner and me as the new junior partner. It was a very tiny fund—$6 million or $7 million—but it was a famous fund.
This was a traumatic decision. Here was my chance to step into the shoes of my hero—I even named my first son Howard Graham Buffett. (Howard was for my father.) But I also wanted to come back to Omaha. I probably went to work for a month thinking every morning that I would tell Mr. Graham I was going to leave. But it was hard to do.
The thing is, when I got out of college, I had $9,800, but by the end of 1955, I was up to $127,000. I thought, I’ll go back to Omaha, take some college classes, and read a lot—I was going to retire! I figured we could live on $12,000 a year, and off my $127,000 asset base, I could easily make that. I told my wife, “Compound interest guarantees I’m going to get rich.”
My wife and kids went back to Omaha just ahead of me. I got in the car, and on my way west checked out companies I was interested in investing in. It was due diligence. I stopped in Hazleton, Pennsylvania, to visit the Jeddo-Highland Coal Company. I visited the Kalamazoo Stove & Furnace Company in Michigan, which was being liquidated. I went to see what the building looked like, what they had for sale. I went to Delaware, Ohio, to check out Greif Bros. Cooperage. (Who knows anything about cooperage anymore?) Its chairman met with me. I didn’t have appointments; I would just drop in. I found that people always talked to me. All these people helped me.
In Omaha, I rented a house at 5202 Underwood for $175 a month. I told my wife, “I’d be glad to buy a house, but that’s like a carpenter selling his toolkit.” I didn’t want to use up my capital.
I had no plans to start a partnership, or even have a job. I had no worries as long as I could operate on my own. I certainly did not want to sell securities to other people again. But by pure accident, seven people, including a few of my relatives, said to me, “You used to sell stocks, and we want you to tell us what to do with our money.” I replied, “I’m not going to do that again, but I’ll form a partnership like Ben and Jerry had, and if you want to join me, you can.” My father-in-law, my college roommate, his mother, my aunt Alice, my sister, my brother-in-law, and my lawyer all signed on. I also had my hundred dollars. That was the beginning—totally accidental.
When I formed that partnership, we had dinner, the seven of them plus me—I’m 99 percent sure it was at the Omaha Club. I bought a ledger for 49 cents, and they brought their checks. Before I took their money, I gave them a half sheet of paper that I had made carbons of—something I called the ground rules. I said, “There are two or four pages of partnership legal documents. Don’t worry about that. I’ll tell you what’s in it, and you won’t get any surprises.
“But these ground rules are the philosophy. If you are in tune with me, then let’s go. If you aren’t, I understand. I’m not going to tell you what we own or anything like that. I want to get bouquets when I deserve bouquets, and I want to get soft fruit thrown at me when I deserve it. But I don’t want fruit thrown at me if I’m down 5 percent, and the market’s down 15 percent—I’m going to think I deserve a bouquet for that.” We made everything clear, and they gave me their checks.
I did no solicitation, but more checks began coming from people I didn’t know. Back in New York, Graham-Newman was being liquidated. There was a college president up in Vermont, Homer Dodge, who had been invested with Graham, and he asked, “Ben, what should I do with my money?” Ben said, “Well, there’s this kid who used to work for me.…” So Dodge drove out to Omaha, to this rented house I lived in. I was 25, looked about 17, and acted like 12. He said, “What are you doing?” I said, “Here’s what I’m doing with my family, and I’ll do it with you.”
Although I had no idea, age 25 was a turning point. I was changing my life, setting up something that would turn into a fairly good-size partnership called Berkshire Hathaway. I wasn’t scared. I was doing something I liked, and I’m still doing it.
A Financial Sleuth Finds a World of Abuses
By VITO J. RACANELLI
After a five-year hiatus, forensic accountant Howard Schilit is back on the job…and busier than ever.
Sherlock Holmes is back. We're not talking Robert Downey Jr., but rather Howard Schilit, 60, arguably America's pre-eminent forensic accountant.
The author of the best-selling Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports has returned from a five-year retirement. In the booming stock market of the 1990s and early 2000s, Schilit was instrumental in bringing home the importance of forensic accounting to institutional investors. He founded the Center for Financial Research & Analysis in 1994, which sold and published research aimed at uncovering accounting anomalies. Thanks mainly to Schilit's efforts, such analysis is now widely used by the financial community.
After selling his business in 2003, he stayed on for a couple of years before retiring. But he couldn't stay away. "I've been hibernating," he quips, and the "juices began to flow again" in late 2010, when his noncompete clause expired. The result is the Financial Shenanigans Detection Group (www.thefsdgroup.com).
The list of companies that Schilit was either first or among the first to criticize is a rogue's gallery: WorldCom, Sunbeam, Cendant, New Century Financial, among others.
Given the growth of capital markets outside the U.S., Schilit has spent the last two years acquainting himself with non-U.S accounting practices, focusing his gimlet eye on Chinese, Japanese and other foreign companies in which a lot of Americans have begun to invest.
At FSD Group, Schilit takes on specific projects for clients, and offers lectures and training in his sleuthing methods. He's done work on about 40 companies so far—a few of which are discussed below—but undoubtedly, that number will grow.
Barron's: What's going on in the world of accounting, post-Sarbanes-Oxley?
Schilit: Sarbanes-Oxley [the accounting-reform act passed in 2002] is one of a number of attempts over the years by the government to make it less likely there would be financial fraud. But if you think there's no incentive to play games with accounting today, then you're in a dream world. There's complacency, and that's when bad stuff happens.
Before we start discussing specifics, keep in mind, first, that these examples I give may not be a violation of the law or even a technical violation of the accounting rules. Second, auditors are important. I recently had lunch with a veteran auditor, and to any accounting problems I described to him, he replied: "Was it disclosed? If it is disclosed, then we did our job." A company might change its revenue recognition that took a loss to a profit—as we'll see in Ulvac (6728.Japan) below—but the auditors' concern is disclosure. Who is sitting there reading footnotes? People are making their decisions on a press release or a database. In general, the auditors' focus is on a legalistic interpretation. So, if you tied up your neighbor and robbed his house, but you disclosed it in footnote No. 23, it's okay.
Can you give some examples?
In the fiscal year ended June 2010, Ulvac, a semiconductor-equipment company, changed from straightforward revenue recognition, under which revenue is recognized when a product is sold and delivered, to percentage-of-completion accounting. The latter is part of generally accepted accounting principles (GAAP), but isn't meant for every company. It's more used by construction firms, among others, where parts of a project are completed over time. So this company, which always used an appropriate revenue recognition method, turns on a dime in a year when business is very weak and says: 'Now would be a good time to move to percentage-of-completion. Wow, we pick up revenue as the production process is ongoing. How cool is that?'
This is a semiconductor-equipment maker. We are not talking about a five- year construction period for what it does. It helps Ulvac by allowing it to pick up revenue much earlier [then it otherwise might have]. In fiscal 2010, Ulvac reports that their sales are down 1% and profits up 38%. But the fine print in the footnotes says they changed their revenue-recognition, and that in the absence of that change, sales declined 21%, and they would have had a loss. It should say: 'We had a 21% decline in revenue from sales to customers, yet because we had a 20% increase in revenue from changing our accounting, we could still report that sales only declined 1%.'
Another example, please.
At the beginning of 2011, Rakuten (4755.Japan) disclosed that it had changed its depreciation method from the straight-line method to the declining-balance method. Over the life of the asset, depreciation will basically be the same number. Straight-line depreciates an equal amount to each period; the other takes bigger deductions in the early years, and small ones later on. In U.S. dollars, that change added $13 million to Rakuten's operating profit, through a lower depreciation expense. Is there any place in the GAAP rule book that says: 'Thou shall never change your depreciation method?' No. But, in my interpretation, that stinks. It had nothing to do with selling additional products or having stronger margins.
Let's move to China.
China Yurun Food Group (1068.Hong Kong) is a meat company that is taking gains on asset acquisitions, instead of on asset sales. You can't do that in the U.S. or under International Financial Reporting Standards (IFRS).
When you buy a company, if you pay more than its fair market value, you have to put goodwill on your books; conversely, if you pay less than fair market value, you put negative goodwill on your books. If you buy the asset at a big discount to fair market value, the negative goodwill is not going to be picked [as a gain] immediately under U.S. accounting rules. But in Hong Kong, they let companies pick up that negative goodwill immediately, as operating income.
Yurun drove a Mack truck through that accounting [loophole]. It appraised asset values much higher than what I believe is a reasonable fair market value. In fiscal 2010, Yurun made three acquisitions using appraised value at what I believe were inflated fair market values, and they took an immediate gain of 186 million Hong Kong dollars (about $24 million). They understood that the accounting allowed them to book a gain, which represented the difference between what they paid—in most cases, a tiny number—and what the appraiser says it's worth. [The company] got a good deal on all of these acquisitions, and accounted for it with negative goodwill. What the assets are really worth, we don't know. It's as if you bought a condo in Miami for $400,000, and it was worth $1 million before the housing crash.
So, on the day you buy it, you [report that you've made] $600,000. But you don't book income, whether it is sales revenue or investment on securities, on the day you buy the asset; you do it on the day you sell it. The most logical way to express it is that there is a connection between revenue and income when cash comes to you, not when cash is being spent. The more the appraiser says this thing is worth, the more enormous the opportunity for gains. This [type of] accounting is also used in Japan.
How about some domestic examples?
Green Mountain Coffee Roasters (GMCR). In past quarterly statements, such as the third quarter of fiscal 2010, the company made a point of things like 11 consecutive quarters of 40% net sales growth and 24 quarters of double-digit growth. If you do some compounding, the numbers start to get enormous.
There were two important changes in the footnotes describing its accounting policies over the past five years or so. In 2007, Green Mountain recorded revenue when the product was delivered to the customer. Then, it gave rebates; For example, if you buy 1,000 of those little K-Cups, they may give you a 5% rebate. They accounted for rebates as a reduction from gross sales. Fine. Then, when they started having difficulty getting to that magical 40%—this is my interpretation—the revenue-recognition wording in the footnotes became longer; in some cases, revenue was recognized upon shipment. That's not the same thing. Then, instead of treating the rebates as a reduction to sales, in some cases it was treated as an operating expense. Now, my friendly auditor will say: 'They disclosed it all.' But investors would say: 'That stinks.'
Because it flatters sales growth?
When you are telling me the business is still booming, but in order to make that assertion, you changed how you are accounting, that's just not fair play. Is it illegal? No. The auditors signed off on it. But the auditors are part of the problem.
For the fiscal year ended September 2011, Green Mountain reported net income [at] a shade over $201 million before items, up from almost $80 million [a year earlier]. Compare that to the cash flow from operations from that same year. Both measure the business's profitability. Cash flow from operating activities was $790,000 in fiscal 2011, versus a negative $2.3 million in 2010. That is a huge difference. The quality of earnings here looks suspect, because the cash flow should follow along with the net income.
Any other examples?
A recent interesting change to accounting rules was related to earn-outs [payments to the seller] in acquisitions. In the accounting, the acquirer debits intangible assets and credits something called a contingent consideration liability, which is the present value of what you expect to pay for the earn-out from the acquisition. It's a soft number, because in the case of drug companies, for example, buying research and development, you don't know if you're going to be able to get the regulatory approvals [for these products to come to market]. There are many hurdles along the way.
Mylan (MYL), a generic drug maker, in December acquired the rights to a Pfizer (PFE) inhalation technology platform for $348 million. The deal included rights of negotiation for certain Pfizer compounds in various stages of development. Acquirers on a regular basis reassess whether that number is correct. In the fourth quarter, Mylan recorded an earn-out liability of $376 million, most of which is related to the Pfizer deal. That was enormous, compared with the cash it paid in the acquisition, about $22 million. If the numbers were flipped, where they paid close to $400 million, and then there could be another 5% on the table or 10% for the earn-out, that would seem to be reasonable. But here, almost everything is non-cash.
What's the advantage of that?
Let's take a hypothetical scenario: A year from now, approvals don't come, or there are delays. Mylan knocks the contingent consideration liability down to $300 million, from $376 million. Perfectly reasonable.
What's the bookkeeping entry? You have to reduce your contingent consideration liability by $76 million, and you put that amount as a credit to income. You have created, out of thin air, a possibility of bleeding back into income some $376 million. You control the timing of it. Mylan obviously ran this through with the auditors. It is a stupid accounting-rule change.
I'm teaching people to watch for these earn-outs, and look at their accounting for the contingent liability. This could be the big abuse in the next few years, because abusive practices very often stem from accounting changes.
So, what's the lesson?
Don't let your guard down. If you are buying individual securities, you have to do some work. If you don't have the time or the interest or the expertise, buy an index.
What's your perspective now that you are back in the business? Will the next big accounting scam be outside the U.S.?
Frankly, there will be big ones in every market. It's partly human nature. It becomes more and more difficult for the auditors to stop, because the accounting rules across the world were largely written 50 years ago, in an industrial society. As the business models have changed, the accounting rules haven't really been rethought for certain type of transactions.
My goal is to find the companies where there is a disconnect between the underlying economics and how the company presents them, using whatever accounting they choose. Many times, it is completely legal, and in accordance with the rules. But the auditors interpret the rules a certain way, and don't have the imagination to just ask: "Does this reflect the underlying economics of the company?"
Here is how the auditors look at the world: They think of themselves and their legal liability issues first; if it's in the rule book and disclosed, you are covered. Second, they think of their clients. The client asked them to do something, and they want to please the client. A very distant third is they may occasionally ask: How does this look from the perspective of the investor? Investors would be astounded if they realized that this is how the party that is supposed to protect them views the world.
Thanks, Howard.
‘Irresponsible’ Mortgages Have Opened Doors to Many of the Excluded
March 29, 2007
Economic Scene
By AUSTAN GOOLSBEE
“We are sitting on a time bomb,” the mortgage analyst said — a huge increase in unconventional home loans like balloon mortgages taken out by consumers who cannot qualify for regular mortgages. The high payments, he continued, “are just beginning to come due and a lot of people who were betting interest rates would come down by now risk losing their homes because they can’t pay the debt.”
He would have given great testimony at the current Senate hearings on subprime mortgage lending. The only problem is, he said it in 1981 — when soon after several of the alternative mortgage products like those with adjustable rates and balloons first became popular.
When Senator Christopher J. Dodd, Democrat of Connecticut, gave his opening statement last week at the hearings lambasting the rise of “risky exotic and subprime mortgages,” he was actually tapping into a very old vein of suspicion against innovations in the mortgage market.
Almost every new form of mortgage lending — from adjustable-rate mortgages to home equity lines of credit to no-money-down mortgages — has tended to expand the pool of people who qualify but has also been greeted by a large number of people saying that it harms consumers and will fool people into thinking they can afford homes that they cannot.
Congress is contemplating a serious tightening of regulations to make the new forms of lending more difficult. New research from some of the leading housing economists in the country, however, examines the long history of mortgage market innovations and suggests that regulators should be mindful of the potential downside in tightening too much.
A study conducted by Kristopher Gerardi and Paul S. Willen from the Federal Reserve Bank of Boston and Harvey S. Rosen of Princeton, Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market (National Bureau of Economic Research Working Paper 12967), shows that the three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans. These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital.
These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.
And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”
Of course, basing loans on future earnings expectations is riskier than lending money to prime borrowers at 30-year fixed interest rates. That is why interest rates are higher for subprime borrowers and for big mortgages that require little money down. Sometimes the risks flop. Sometimes people even have to sell their properties because they cannot make the numbers work.
The traditional causes of foreclosure, even before there was subprime lending, were job loss, divorce and major medical expenses. And the national foreclosure data seem to suggest that these issues remain paramount. The latest numbers show that foreclosures have been concentrated not in places where real estate bubbles have supposedly been popping, but rather in places whose economies have stagnated — the hurricane-torn communities on the Gulf of Mexico and the industrial Midwest states like Ohio, Michigan and Indiana, where the domestic auto industry has suffered. These do not automatically point to subprime lending as the leading cause of foreclosure problems.
Also, the historical evidence suggests that cracking down on new mortgages may hit exactly the wrong people. As Professor Rosen explains, “The main thing that innovations in the mortgage market have done over the past 30 years is to let in the excluded: the young, the discriminated against, the people without a lot of money in the bank to use for a down payment.” It has allowed them access to mortgages whereas lenders would have once just turned them away.
The Center for Responsible Lending estimated that in 2005, a majority of home loans to African-Americans and 40 percent of home loans to Hispanics were subprime loans. The existence and spread of subprime lending helps explain the drastic growth of homeownership for these same groups. Since 1995, for example, the number of African-American households has risen by about 20 percent, but the number of African-American homeowners has risen almost twice that rate, by about 35 percent. For Hispanics, the number of households is up about 45 percent and the number of homeowning households is up by almost 70 percent.
And do not forget that the vast majority of even subprime borrowers have been making their payments. Indeed, fewer than 15 percent of borrowers in this most risky group have even been delinquent on a payment, much less defaulted.
When contemplating ways to prevent excessive mortgages for the 13 percent of subprime borrowers whose loans go sour, regulators must be careful that they do not wreck the ability of the other 87 percent to obtain mortgages.
For be it ever so humble, there really is no place like home, even if it does come with a balloon payment mortgage.
Austan Goolsbee is a professor of economics at the University of Chicago Graduate School of Business and a research fellow at the American Bar Foundation. E-mail: goolsbee@nytimes.com.