The Burden of Debt

By Charles Webb

Regardless of political affiliation, everyone should be extremely concerned by the level of debt that is being accumulated by our government. The projected deficit numbers are unprecedented by any historic measure.

Just two years ago, the total debt of the federal government was 69% of our gross domestic product. Last year it was 83%; this year it has risen to 94%. By 2013 or 2014, if we continue current economic policies, it will exceed 100%. And those numbers don't even include the tens of trillions of dollars in future Social Security and Medicare promises that are already with us (future unfunded liabilities).

How bad is it? Last year, the International Monetary Fund released its annual review of U.S. economic policy. Its summary contained these bland words about U.S. fiscal policy: "Directors welcomed the authorities' commitment to fiscal stabilization but noted that a larger-than-budgeted adjustment would be required to stabilize debt-to-[gross domestic product]."

Delve deeper, and you will find that the IMF effectively pronounced the U.S. bankrupt.

Section 6 of its July 2010 selected-issues paper says: "The U.S. fiscal gap associated with today's federal fiscal policy is huge for plausible discount rates." It adds that "closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14% of U.S. GDP."

The fiscal gap is the present value of the difference between projected spending (including servicing official debt) and projected revenue in all future years.

To put 14% of gross domestic product in perspective, current federal revenue totals 14.9% of GDP. So the IMF is saying that closing the U.S. fiscal gap from the revenue side requires, roughly speaking, an immediate and permanent doubling of our personal income, corporate and federal taxes, as well as the payroll tax. That also assumes those higher rates would have no negative impact on the economy, which of course they would.

So what is the solution? This debate is now raging on in Washington and clearly falling along party lines. On one side of the debate, the Democrats want to raise taxes on wealthier tax payers as a way to slow the deficit. I emphasize slow because the administration has not offered a plan that projects a balanced budget. Instead, there are only hopeful projections that show the deficit becoming more manageable.

The Republicans, on the other hand, believe that by cutting taxes the economy will grow its way out of this pile of debt. In truth, they're both wrong. I would summarize the two positions as tax and spend vs. borrow and spend.

Our problem is clearly in spending. The following table shows a breakdown of the federal budget over the last eleven years.

One interesting line item shown is Net Interest. Interest rates in 2000 were roughly 3 times higher than they are now. Yet the government's interest expense is now 27% higher. This shows you how much the country's debt expense has grown. It also gives you some idea of how bad an increase in interest rates would be on the budget problem. That number alone could easily double in a matter of a few years. The potential increase in taxes on the wealthy (however you want to define that) may simply go towards paying the higher interest cost and make no contribution towards closing the budget gap.

The relationship between economic growth and interest rates poses an interesting problem to a government in debt. The best way to tackle the debt problem is to grow your way out of it. Higher economic activity will lead to higher tax revenues. However, higher economic activity also leads to higher inflation and interest rates. Thus, the government's interest expense rises and consumes much of that additional revenue.

Attacking This from the Top Line

In 2000, federal tax revenues totaled just over 2 trillion dollars. Peak revenues topped out in 2007 around 2.57 trillion dollars. Even after the real estate bust and ensuing financial collapse, tax revenues only declined to 2.1 trillion - higher than any year before 2004.

On the other hand, congress' Office of Management and Budget is estimating expenditures to be 3.8 trillion this year and reaching 4.47 trillion in 2016. There is no way that deficits of these levels can possibly be addressed through higher taxes. By comparison, the total net worth of every billionaire in this country is estimated at 1.3 trillion. You could confiscate every penny of every one of those households and not even cover the deficit of one year.

The following table displays the current sources of tax revenues.

To put these numbers in the proper context, to close the budget gap, individual taxes would have to double, corporate taxes would have to quadruple, payroll taxes would have to more than double, or some combination of the three. Anyone who thinks this is possible or reasonable is simply out of touch with reality.

Tax policy has real economic consequences. It's unreasonable to expect that tax revenues will increase by simply raising tax rates. To be clear - tax rates are not the same thing as tax revenues. The more tax rates go up, the more those subject to taxes shift their resources from productive activities to areas designed to shelter their income. The reverse is true when high tax rates decline.

There is plenty of historical evidence of this reality. The best example of this was when top tax rates were slashed in the nineteen-eighties. Billions of dollars were freed up and directed towards productive activities when the top marginal rates were slashed. So much so that this country was pulled out of one of the worst economic situations ever faced.

When the wealthy shelter their income, they don't invest in things that create jobs. They also don't repatriate overseas earnings. Our comparatively high corporate tax rates are currently keeping billions of dollars in other countries. Simply raising tax rates is counterproductive.

What to Do

In our opinion there is only one way to tackle the deficit. The government simply needs to spend less. The deficits have become so large that these spending cuts are going to have to focus on the largest programs and agencies. This means pushing back the retirement age for social security, wrapping up military operations and getting healthcare costs under control.

We've written extensively about our thoughts on Social Security over the years so we won't rehash that now other than to say that the government needs to get out of the pension business. The wars will eventually draw to an end.

Healthcare is a trickier issue. What we don't think is that pushing millions of people on to Medicaid is going to do anything but bankrupt the states and lead to yet more bailouts. We've also written about healthcare reform so we won't get into that again.

The bottom line is that the biggest programs will have to be radically changed which will take political will. Beyond that, general spending needs to come down and only grow at the same rate as the rest of the country (CPI). It's inexcusable to see the percentage growth numbers in every category from 2000 to now. Keep in mind this was during some of the lowest inflation years in our country's history.

It appears that the market will ultimately force change. Yesterday S&P downgraded the rating on U.S debt. This was an unimaginable occurrence in our lifetime.

Market Flash (March, 2011)

Japan and the Markets
The news coming out of Japan has become pretty scary over the last few days and the global equity markets have reacted accordingly. As Japanese officials are trying to cope with the country’s worst destruction since World War II, investors are trying to sort what the impact of the world’s third largest economy will be globally. The initial reaction seems to be to sell first and figure it out later. It’s quite understandable that Japan’s near-term GDP is going to be severely affected by these events and the 11% drop in their markets yesterday is justifiable. What is far less certain is how this will affect their trading partners, energy demand, currency markets, commodities and the like.

Adding to the confusion, all of this news is on top of the ongoing chaos in the Middle East. Trying to digest all of this news and information in real-time is, to say the least, a bit overwhelming. Therefore, we think it’s important to step back and look at the bigger picture and not try to assess the impact of every piece of news coming out of Japan hour by hour.

The Big Picture
Near-term, there will certainly be supply chain and distribution interruptions. These will likely cause manufacturing headaches over the next month or two. Japanese domestic manufacturing will likely be slowed considerably throughout the country. This is not just due to the direct damage but also to their reduced power generating capacity. Longer-term, the rebuilding efforts will require massive amounts of materials and equipment. We’ll likely see higher commodity prices of specific goods when those efforts get underway in earnest. Lastly, the Bank of Japan has already promised that it will provide all the liquidity needed to soften the economic blow to Japan.

In addition to these foreseeable events, there will also be a number of significant energy policy discussions that will come out of all this. There’s no way to project the outcome, but surely we’ll hear a lot about alternative energy vs. conventional sources. There will be winners and losers in this debate. Those will be nuclear plant and equipment manufacturers, oil and gas producers and wind/solar firms.

My Portfolio
Beyond the human concerns, the next most obvious question is how this will impact our clients’ portfolios. Our best guess is very little. Last year’s stock market performance was driven by improved earnings and the Fed’s easy money policy. Those two forces are still very much in place. This is the reason we were optimistic about 2011’s potential and still are. There will undoubtedly be a good bit of volatility, both up and down, as the news out of Japan swings from bad to better. Our guess is that six months from now this volatility will have passed and the markets will be refocused on economic matters.

We think the more relevant economic news is what’s going on in the Middle East. Oil supply disruptions are of a far greater concern in our opinion. We hope that the Japanese crisis doesn’t take the international focus off the fighting in Libya. Oil prices above $100 per barrel are a more immediate threat to the economic recovery here and in Europe.

As always, we’ll continue to monitor the news and invest accordingly, but for now we don’t see a need to change our strategy. If anything, our goal of emphasizing portfolio cash flow over the last few years should help smooth the returns in times like this as well as directly meet our clients’ monthly income needs.

Modern Day Gold Rush (February, 2011)

By Charles Webb

The Modern Gold Rush

We're often asked by our friends and clients if we think something or another is a good investment. That something or another is usually a security or asset class that has had a meteoric rise in value the year before. Over the past year, we have fielded a lot of questions about gold. This should be no surprise to anyone who is familiar with what gold prices have done over the past couple of years. Therefore, we felt this would be a good topic for this month's memo.

I think it's first important to discuss what an investment is because that word is used pretty loosely these days. An investment is something that will either provide you income or increase in value. If the investment is something that generates income, it has to have some sort of earnings that generates the cash flow. Investments that increase in value usually have an earnings stream too. That's what makes them more valuable over time. But not all appreciable assets are backed by earnings. Instead, they are scarce in supply and high in demand. Commodities, gold included, are a good example of this. Collectibles are another good illustration of scarce assets with high demand. So if you want to invest in something, it needs to fall into one of these camps - income or appreciation.

Too often money is directed towards things that on the surface look like investments but in fact are something else. Two common examples are insurance and options. These are really risk management tools and not investments. Another area that we see money flow into is various stores of wealth. These assets are parking places for wealth. Currencies are the best example of this and you'll often see money flow into different currencies in times of political turmoil. Precious metals are another popular parking place for wealth.

This is where things get a little confusing because some things are both commodity investments and stores of wealth. So the question of should I buy gold, silver, platinum, etc. really depends on what you're trying to accomplish. If you truly want to invest in gold, you should do so because you think the demand is rising. The question then becomes what is the best way to buy the gold? In our opinion, exchange traded funds (ETF's) are the best way to own it. These are shares issued against actual gold deposits held in a vault at a bank. Probably the least efficient way to own gold would be through the futures market. This is because you don't own the gold but instead own the right to purchase it at some predetermined price over some period of time.

In most cases though, we are asked about owning gold as an inflation hedge. This is more akin to using it as a store of wealth. The appeal here is that it is believed gold's value will change with inflation and thus as a store of wealth, your wealth in gold will rise or fall with inflation. As Americans, our wealth is stored in the U.S. dollar. Your bank accounts are held in dollars. Your stocks and bonds are priced in dollars. Whenever you sell something, you receive dollars. Many people today are worried about the value of the dollar and are looking for something else. Foreigners also own a lot of our currency. They too are nervous.

These concerns arise because of the budget crises and the huge increase in the money supply promoted by the Federal Reserve. In theory, as the money supply is increased, the value of each dollar is diminished. It's simple supply and demand. Over the last few years, we have seen some decrease in the value of the dollar but nothing dramatic. The reason for this is that there has also been a corresponding increase in demand for our currency, keeping things in check.

So we've identified two possible reasons why you might like to store your wealth in gold. The next question is how good is gold at addressing these concerns? As it turns out, gold doesn't do a good job at all. As a reserve currency, there quite simply isn't enough of it to fill the need. Since the beginning of time, it is estimated that 165,000 tons of gold have been mined. At $1,200 per ounce, that is only 6.6 Trillion dollars. That's only a tiny fraction of the value of the worldwide economies.

As an inflation hedge, time and time again, gold's price has shown itself to march to the beat of a different drummer. There is no better example than today. Inflation and interest rates have been at record lows for years. Yet, in spite of this, gold's prices are at record highs. Clearly, something else is driving the price. In addition, it is completely impractical to transfer enough of your wealth from dollars to gold to make much of a difference in your finances.

The thing really driving gold prices is the aspect of gold as a commodity. The consumption of gold produced in the world is about 50% in jewelry, 40% in investments, and 10% in industry. India is the world's largest single consumer of gold, as Indians buy about 25% of the world's gold, purchasing approximately 800 tons of every year, mostly for jewelry. What I believe is the real driver of gold's price lately is the 40% used for investment. This smells a lot like a bubble.

Gold is being bought just for the sake of owning it. Without a corresponding increase in industrial demand, it's reasonable to wonder what will be the underlying support to the price. Through modern finance, it's incredibly easy for large sums of money to flow in and out of any asset. When the crowd moves away from gold, you have to wonder what that will mean for the price.

Like any asset bubble, there will be those who win big. There will also be those who lose big. The problem is you can't research, forecast or model the crowd. At this point you have to ask, is this investing or gambling?

What's Your Number?

By Lori Eason, CFP(R)

With the recent credit crisis, it has become much more difficult to obtain credit making your credit history and credit score more important now than ever. I have always wondered, what exactly is a credit score? How is it determined? What can I do to improve it? I figured some of you might have similar questions as me so I decided to research the topic and share my findings.

Last week, I decided it was time for me to pull my credit history and make sure there are no signs of identity theft. We have all been warned about the increasing risk of identity theft with technology advancing. It had been over a year and a half since I looked at my credit report and I remember that being a trying process. I had been misled by the ads of FreeCreditReport.com, the ones with the obnoxious lyrics that get stuck in your head! I mistakenly thought that it was actually an easy process to get my “free” report. Everything went fine until I saw a charge of $14.95 on my credit card statement. Of course I called the company and after getting very firm, they agreed to remove the charge. I later found out that other friends of mine had the exact same experience. In fact, there have been multiple lawsuits concerning those advertisements.

This time around, I decided to research the ways to get a copy of my report and came across the Federal Trade Commission’s link to AnnualCreditReport.com. I read about my right to receive a copy of my credit report from each of the three reporting agencies, Experian, Equifax, and TransUnion, once every 12 months due to the Fair and Accurate Credit Transactions Act of 2003. I had heard about this rule before, but didn’t know the best way to go about getting my report. This website was clearly where I needed to be. I chose one agency and looked over my report and everything appeared to be fine. But one thing was noticeably absent from my report, my FICO score. Of course, you have to pay for that feature!

So what exactly is a credit score? It its most general sense, a credit score is a number used by lenders to estimate the likelihood that a person will pay his or her debts. This number not only impacts whether or not you are approved for credit, but can also impact the interest rate you receive when you finance a purchase. The most widely used credit score is the FICO score, an acronym for the creators of this score, the Fair Isaac Corporation. This score takes into account various factors in five areas: payment history, current level of indebtedness, types of credit used, length of credit history, and new credit. Mathematic models are used to calculate a number between 300 and 850. Generally, a score above 650 indicates an individual has very good credit history.

So as I mentioned, there are 5 areas that are evaluated in determining your FICO score. I’d like to give a little insight into what each of these encompasses and which ones have the biggest impact on your score. Payment history is the biggest component, making up 35% of your score. But the definition of a late payment warrants further explanation. The credit bureaus are only notified if your payment is more than 30 days late. Payments that are between 30 and 60 days late can lower your credit score, but the negative impact is generally temporary and only harms your score for a couple months, assuming only one or two payments are that late. Payments over 90 days late severely hurt your credit score and can damage your credit for up to 7 years.

The second biggest component is current indebtedness also known as credit utilization, making up 30% of your FICO score. This is the ratio of current revolving debt (such as credit card balances) to the total available credit limit. It is perhaps the most interesting component. You can improve your FICO score by paying off debt and lowering this ratio OR by applying for and receiving a credit limit increase. Closing existing revolving accounts typically has a negative impact on your score. This is kind of a Catch-22 as it in a way encourages individuals to obtain unnecessary credit and leave inactive accounts open, which is not a very safe practice due to identity theft.

Length of credit history is the third most important component, making up 15% of your total FICO score. This includes time since accounts were opened and time since account activity. A longer credit history provides more information and offers a better picture on long-term financial behavior, which hopefully is a good thing and will help your score! It is impossible for a person who is new to credit to have a perfect credit score and in fact, many new college graduates have a very difficult time getting a credit card or financing a purchase at first because they have no credit. This is one instance when student loans actually help you!

The fourth and fifth components each make up 10% of your FICO score. There are several types of credit and you can benefit by having a history of managing different types. Some examples are installment, revolving, consumer finance, and mortgage. The last component is new credit. Credit inquiries for new credit can hurt your score, but inquiries that were made yourself to check your credit, by your employer for employee verification or by companies initiating prescreened offers of credit or insurance do not have any impact on your credit score. They will still show up on your credit history report. Also, individuals shopping for a mortgage or auto loan over a short period will likely not experience a decrease in the scores of these types of inquiries. That being said, it is a good practice to avoid opening too many credit cards in a short time frame because such behavior could suggest that you are in financial trouble and need access to a lot of credit. You should especially avoid opening new lines of credit if you are in the midst of buying or refinancing a home or financing some other large purchase.

While the actual formulas used to calculate credit scores are not public information, this breakdown of the 5 components and their allocations was disclosed by FICO. Each of the three credit bureaus mentioned above, Experian, Equifax, and TransUnion, have a slightly different method of calculating FICO scores and thus your score may vary slightly between the three.

To conclude, I definitely think it is a good practice to check your credit history report at least once a year. There are two main reasons for doing so, protection and accuracy. You need to make sure that there are no signs of fraudulent activity and that everything listed on your report is in fact credit you applied for or at least are aware of. Also, it is not uncommon for incorrect information to be reported that could potentially harm your credit. The only truly free and federally sanctioned website for requesting your credit report is www.AnnualCreditReport.com. On any other sites, you really need to read the fine print. The same goes for obtaining your credit score which is not part of your free credit report.

New Year, New Cost Basis Reporting Rules

By Lori Eason, CFP(R)

2010 has been filled with a lot of uncertainty and chaos surrounding taxes (one year disappearance of the estate tax, expiration of the Bush tax cuts, temporary Social Security tax cut, etc.), but one thing is for sure, 2011 brings big changes with regard to cost basis reporting. I'm sure you all remember the Emergency Economic Stabilization Act of 2008, a.k.a. the "Bailout" bill. This law authorized the US Secretary of the Treasury to spend up to $700 billion to purchase distressed assets and make capital injections into banks. It also introduced various tax provisions, one of which comes into effect January 1^st, 2011, the new cost basis regulations. These rules will drastically change the way cost basis is reported to the IRS and affects brokers, financial advisors and investors in a major way.

The new provisions will be gradually phased in over the next three years, with stocks leading the way in 2011. Brokers will be required to keep track of cost basis for stocks acquired after January 1, 2011 and form 1099-B will be expanded to include this data as well as classify whether a gain or loss was short term or long term. As you know, 1099s are sent to both the taxpayer and the IRS, so the purchase price of securities sold reported on your tax return will now have to match what was sent to the IRS. This is the same as how currently the total securities sales amount on your tax return has to match the proceeds from sales figure on your 1099. Until now, the IRS has never had a broadly reliable way to confirm cost basis and could only detect misreported cost basis info through an audit. These changes are expected to generate more than $6 billion in additional tax revenue over the next 10 years. Cost basis reporting on mutual funds, ETFs and Dividend Reinvestment Plan shares is set to be phased in on January 1, 2012 and reporting on all other securities, including options and fixed income investments, will be phased in on January 1, 2013.

It is important to distinguish between covered and uncovered securities. Covered securities in 2011 are stocks purchased on or after January 1, 2011. Brokers are only required to report cost basis info on covered securities on the 1099s sent to the IRS. However, many brokers, including Charles Schwab, have decided to provide all cost basis info they have available (for covered and uncovered securities) on 1099s sent to clients to avoid confusion as to why some securities show cost basis and others don't. Taxpayers must realize that it is still their responsibility to report cost basis info for all uncovered securities to the IRS because brokers will not be doing so.

Just because the burden of reporting cost basis is shifted from the taxpayer to the broker does not mean everyone else is off the hook. At the time of sale, the person placing the trade must select which tax lot is being sold. The selection must be made between the trade date and settlement date, generally 3 days, and once made, it cannot be changed. In the event that no tax lot is specified, the IRS requires a default tax method be used - First In First Out (FIFO) or Average Cost, if eligible. One of the most cumbersome requirements is that brokers must immediately file corrected tax forms with the IRS when they receive corrected information. As many of you are aware, corrected 1099s can greatly delay tax filings and cause multiple amended returns.

The concept of keeping track of cost basis info and choosing tax lots at the time of trade is not new to us. We have always traded in a tax efficient manner and therefore chosen the most prudent lots to sell. Our portfolio management software keeps track of cost basis information and whenever we receive assets transferred into a taxable account, we have always made an effort to get the most accurate cost basis information available from the client. For those of you who have accounts managed by us, you shouldn't notice any significant changes from your end except the 1099 you receive for 2011 in early 2012 will include cost basis info. These figures should match the information contain in the Realized Gain and Loss report we send in January. For those of you with accounts not managed by use, it would be wise for you to educate yourselves further on these changes and understand how your brokerage firm's trading policies will be affected.

While brokers have had 3 years to prepare for the changes about to take place, it would be very optimistic for us to assume this transition will happen smoothly. As mentioned above, the legislation will take place in 3 phases with stocks, the simplest type of investment, being Phase 1. Things get much more complicated down the road when fixed income securities such as asset backed bonds become subject to the new rules in 2013. As always, the devil is in the details.

To Convert or Not to Convert, That is the Question (November, 2010)

By Lori Eason, CFP(R)

Since the dawn of 2010, there has been a lot of talk about the expiration of the Bush era tax cuts. Among the cuts is the disappearance of the $100,000 Roth conversion income limit for this year only. This means that you can opt to pay taxes on your traditional IRA balance over the next two years in exchange for tax free withdrawals during retirement. For months I have read article after article portraying this opportunity as an easy decision and sure way to save money on taxes, but in reality there are many changing variables that greatly affect the benefits to conversion.

The logic behind the conversion for investors is to pay taxes now at a sure rate before taxes increase. But today’s tax rates are not low and adding the additional income created from the conversion to a taxpayers ordinary income can easily push them into a much higher tax bracket. So why would someone volunteer to pay taxes now when they could be deferred to a later date?

There is no argument that it only makes sense to convert if you have funds available to pay the taxes outside of your IRA. Otherwise you would reduce the potential tax free growth on that amount, defeating the purpose of the conversion. But even if you have enough cash flow or taxable savings to pay the tax bill, you have to consider the opportunity cost of using that money to pay taxes when it could be invested and earning a return.

The decision to convert depends heavily on what your goals are with your IRA. If your primary goal is to leave as much money as possible to your heirs and you don’t need any IRA funds for your retirement, a Roth conversion is probably a good idea for you. You would escape the Required Minimum Distribution rules which require traditional IRA owners to take a minimum calculated amount from their IRA annually beginning at age 70 ½ and therefore pay taxes on those withdrawals. In addition, the benefit of tax free withdrawals is passed on to Roth IRA beneficiaries who then take the non-taxable withdrawals over their life expectancy.

For the rest of you who plan on using your IRA to at least partially fund your retirement, the decision requires a lot more thought. One big unknown factor that can greatly sway the results is life longevity. It can take many years to make up for the amount of taxes you have to pay now and the lost potential earnings on those dollars. This is where the opportunity cost arises. As an example, if you convert a $200,000 IRA, it can generate a combined federal and state tax bill as high as $80,000. Not only has your savings been reduced by $80,000, you also lose all the future earnings that that $80,000 could have ever made. In order for the conversion to be a good idea, the sum of the taxes not paid on Roth withdrawals would have to add up to more than the opportunity cost. The way the math works out, the longer your time horizon, the longer the Roth has to catch up. For this reason, if you are already retired or within a few years of retirement, it is unlikely that you’ll benefit from converting. If you live long enough to see it, the Roth IRA will eventually pull ahead of the traditional IRA, but this is assuming Roth withdrawals are never taxed.

This brings me to the last, and in my opinion, most important point I am going to make: what guarantee do we have that congress is not going to change the rules on tax free withdrawals from Roth IRAs down the road? Imagine this: 20 years down the road, the deficit is still huge, republicans and democrats are still fighting, and tax receipts from traditional IRAs are declining because the government in effect collected those back in 2010 through conversions. It is not inconceivable that they would look toward all these privileged retirees who have diligently saved and already paid taxes on their traditional IRAs and are withdrawing hundreds of thousands of dollars each year…tax free. That sounds like an easy place for the government to pocket some much needed revenue. Maybe it would be a good idea to means test the tax free benefit, only allowing those who withdraw under a certain amount each year to avoid taxes. We have certainly seen these sort of games played in the past (Social Security) and I wouldn’t put it past our government.

I don’t find it a coincidence that during these times of unprecedented deficit and uncontrollable federal spending, these conversions are so highly promoted, after all how rosy does an extra $662 billion in tax revenues look to the government? While I can see why it makes sense to covert to a Roth IRA in very specific situations, in most cases the cost and political risks just don’t seem to outweigh the benefits.

What's This Foreclosure Mess? (October, 2010)

By Alan Gaylor

It is impossible to watch the news these days without hearing stories about our country’s continuing real estate bust and the resulting wave of foreclosures. The number of foreclosures in the US hit 1.65 million in the first half of this year. That is an increase of 8% from the same period a year ago, and a 5% decrease from the previous six months. As one would expect, with this many people losing their homes, there has been a lot of talk about finding a way to keep these people in these homes by restructuring their loans and instituting a foreclosure moratorium. In addition, there has also been a lot of controversy surrounding the foreclosure process. A big part of this controversy pertains to who owns the loan and thus who should be initiating the foreclosures. On the surface, this would seem to be an odd problem to be faced with. To understand how this came about, you have to first understand the modern mortgage process.

Many years ago, homebuyers would borrow money directly from their bank to finance their home. The bank would make the loan and the homeowner would directly make mortgage payments to the bank. The bank would hold the home as collateral and keep the loan in their portfolio for the full term of the note. Nowadays, bank and mortgage brokers originate loans but do not keep them. They package these loans and sell them to investors in a process called securitization. This is where the government entities Fannie Mae and Freddie Mac and Wall Street come into play. They group hundreds of similar loans together to create a mortgage backed bond. These bonds are then sold to investors in the private market. Typical investors are mutual funds, insurance companies, pension plans, individual investors (our clients included), etc. It takes so much money to finance all the homes in this country that mortgage backed bonds is now the largest segment of the bond market, currently 9 trillion dollars.

Most people think that the financial institution they make their payment to is the same company that holds their mortgage. In most cases, this is just the loan servicer and instead the homeowner’s debt is part of a mortgage pool and is owed to the bondholders. This confusion lends itself very well to politicians with an agenda and the media who likes to portray this as a “Main Street” verses “Wall Street” issue.

There is no dispute that in almost all cases, foreclosures have been initiated on homeowners who have defaulted on their loans making this a “failure to pay crisis” rather than a foreclosure crisis. In fact, a lot of the mortgages have been past due for more than a year, or in some cases, two years before foreclosure proceedings occur. The controversy surrounding the foreclosure process involves how the paperwork was filed when the loans were securitized and procedural errors during foreclosure. In either case, these are mere technicalities slowing down the inevitable and preventing the property from being owned by individuals who can afford it.

As painful as the process appears, we need the foreclosures to continue before we can move forward as a country. These losses are felt throughout the economy and not just by the banks. Property values in general will not begin to recover until this large inventory of distressed properties are back in the hands of responsible owners. The longer it takes to turn over the property, the bigger the losses. There are real expenses associated with holding property such as insurance, maintenance and taxes.

Another fallacy is that the banks and Wall Street are the ones bearing the brunt of these losses. In reality, these losses are being felt by almost all the citizens of the country directly as taxpayers and indirectly as investors and pensioners. So far the taxpayers are on the hook for $213 billion to bailout Fannie and Freddie. These two government-backed mortgage finance companies own or guarantee over half of the $12 trillion U. S. mortgage market.

There are many structural changes that will take place in the mortgage market as a result of this crisis. Underwriters will have an incentive to have higher underwriting standards, there will be fewer types of loans available, borrowers will be subject to higher credit standards and home ownership will be less viewed as a right, all changes that will be very helpful and need to take place. What is not helpful is for Washington to continue to demonize the very mortgage market participants, bankers and investors that make housing affordable in this country.