Subprime Mortgage Meltdown

I’m compelled to interrupt the “investing in retirement” theme momentarily to outline how I see the “subprime mortgage meltdown.”

1. Government lowers interest rates to 1% to spur economy
2. World is already awash in liquidity seeking investment
3. People start to borrow (against home equity, etc.) to buy nice things
4. Lenders are increasingly eager to lend
5. People borrow more to invest in higher return investments and pocket the difference
6. Lenders further relax lending standards (but still within government regs -- mostly)
7. People borrow even more to invest in real estate (nothing down, floating rate, minimal
payments)
8. Demand for loans finally pushes interest rates up a notch
9. Fear of even higher rates means less borrowing to buy real estate and some selling
10. Less buying and more selling means real estate prices quit rising and start falling
11. Declining real estate prices take down weaker borrowers (“subprime”) and their lenders, as
well as investors in bonds backed by loans generated by those lenders
12. Government steps in to save the day by tightening lending regulations, which takes down
the remaining weak borrowers, lenders, and bond holders.

All three parties – borrowers, lenders, and government – contributed to this situation essentially in the order listed. But, I’m most disappointed in the government. Just as it did with the S&L crisis of the 1980s, it created a situation that naturally leads to “war” (this is ONLY AN ANOLOGY), stood silently behind the lines as the battle raged, then combed the battlefield after it was over to identify the dead, shoot the wounded, and send the survivors off to fight the next war.

Okay, where were we?

Okay, where were we?

Wednesday’s scenario: You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.

Wednesday’s first question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?

Friday’s answer: It doesn’t matter, even if it happens at the end of the period when the 30% loss will cost you in excess of $41,000, dropping your then nearly $137,000 nest egg to less than $96,000. In the first year, it would have cost only $3,000 (30% of $10,000), but that is $3,000 that would no longer available to grow for 34 years at 8% compounded annually, ending with a value of (guess what) about $41,000. You would end up with the same amount no matter when the loss occurs.

Wednesday’s second question: In your actual retirement investing, do you care when the inevitable losses come – before, at, or even after your retirement?

Yes, you do care. At least, you should care. As most retirement experts will tell you, you have to invest more prudently in retirement because your ability to recover from a financial set-back is increasingly limited. Your earned income has slowed significantly or stopped, so you can’t double-up your saving rate to catch back up. And, you probably have been tailoring your life style to the anticipated size of your nest egg, so a sudden drop in value just before retirement can be particularly difficult to adjust to.

But, there’s another aspect. The losses (and gains) that matter the most are those that happen when you have the most money invested.

Wait. Isn’t this what we just disproved with our answer to the first question?

Nope, this is different. Think about it. We’ll pick this up again later.

Something to Chew on Part 2

(Note: Our “comments” button is acting up again, so I apologize to those who tried to send in a response to Wednesday’s questions and couldn’t get through. It’s supposed to be fixed soon. All I can say is please try again sometime.)

Wednesday’s scenario: You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, of course, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.

Wednesday’s first question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?

The answer: Mathematically, it doesn’t matter. To illustrate the extremes, if the loss were to occur in the first year, the calculation would be $10,000 times 0.70 (to reflect the 30% first year loss) times 1.08 (to book the second year’s return) times 1.08 (to book the third year’s return) etc., continuing 34 times. The formula would be:
($10,000)(0.70)(1.08 to the 34th power)

If, instead, the loss occurred in the last year, the formula would be:
($10,000)(1.08 to the 34th power 34)(0.70)

We all know that A x B x C is the same as A x C x B, right? So, either way, you’ll end up with the same amount – that $10,000 investment will have grown to $95,831.

This is also true, of course, with any subsequent retirement investments. If you invest $15,000 a few months later and it has some good return years and some bad loss years, the sequence of gains and losses again won’t matter – it won’t have any effect on the ending value of this investment. So, this leads us to . . .

Wednesday’s second question: In your actual retirement investing (that’s you, for real), do you care when the inevitable losses come – before, at, or even after your retirement?

Ponder that a bit (if you’re so inclined). If you have some thoughts, please try sending in a comment (if you’re not too frustrated from prior unsuccessful attempts). I’ll give you my views on this next week.

Enjoy the weekend!

Here’s something to chew on. It will take a few paragraphs, so I’ll split it between today and Friday.

This is the scenario. You’re 30 years old and you invest $10,000 for your retirement at age 65. You don’t know it yet, of course, but your returns are going to be exactly 8% in every year except one. In that one year, you will lose 30%.

First question: Assuming your goal is to have the most possible assets at the time you retire, is it better for that loss year to be early in this 35-year period or late?

Second question (begged by the first): In your actual retirement investing, do you care when the inevitable losses come – before, at, or after your retirement?

Give it some thought, share your views with me if you wish (click on “Comments” immediately below), and check back on Friday.

Interesting week in the markets, huh? Tuesday’s stock market downdraft was triggered by one of those impossible-to-predict but inevitable “external shocks” – this one being a nearly 10% drop in mainland China’s stock market in response to fears of increased government attempts to slow their economy. That shouldn’t have been that big of a shock, but add the uncertainty in the U. S. housing market, utterance of the “R” word by former Fed Chairman Greenspan, and some very mixed economic reports and you have the stuff of a market correction. In fact, it produced the biggest point drop in the Dow since the day the markets reopened after 9/11/2001.

I was traveling when this latest sell-off occurred – presenting our economic and market outlook to various groups of credit union boards, managers and members in the Gulf Coast area (which, by the way, is coming back very strongly in most areas, but still bears many highly visible scars from the 2005 hurricanes). The conclusions in my presentation:

• The U. S. is overdue for setback/consolidation (or at least volatility) in our economy, bond markets, and stock markets
• An economic “hard landing” (recession) appears highly unlikely (barring a significant external shock)
• Our interest rates are attractive to foreign investors (as long as the dollar’s decline is only moderate)
• Our stock valuations are reasonable (as long as earnings hold up)
• The global liquidity glut has to go somewhere, and although more and more will go to other nations, we do capitalism best and our markets will continue to get support from foreign investors.

My recommendations ended with:

• Be prepared to see a modest U. S. and global slowdown, increased investment market volatility, but about historically average investment returns.

It appears we’re getting the first two – a modest economic slowdown and increased market volatility. We’ll have to wait awhile to see if we get the third – decent returns – over the next several quarters. And this, of course, will depend on the impact of the next unexpected event, and the next one, and . . . you get the point. But, that’s just part of investing, and of life in general, right?

And then, apart from what I’ll do, is what we’ll do – we the citizens of the great U. S. of A – under the new leadership headed for Washington in a couple of years. I just saw the latest Rasmussen Reports™, one of the better polling sources out there. If the primaries took place this week, here’s very close to what we’d get:

Republicans – Giuliani 33%, McCain 19%, Gingrich 13%
Democrats – Clinton 28%, Obama 24%, Edwards 11%

It also found that, if the actual election were held this week between Clinton and Gingrich, it would be about 50% to 43% in favor of Clinton. If between Gore and Gingrich, Gore would win 51% to 40%.

Both within the Republican Party and between the two parties, the sweep to the left appears to be proceeding unabated. Living in retirement could be quite a bit different a decade from now, as could investing for retirement. Makes these difficult undertakings even more so. But, we all love a challenge, right?

Here’s my dilemma as I approach my retirement and try to prepare for it financially and emotionally.

I have a very good idea of what I’m going to quit doing:

• Going to the office (coal mine) five or six days a week
• Interacting daily with coworkers and clients
• Adding value (taking care of business) for coworkers and clients
• Getting a paycheck

I have a pretty good idea of what I want to start doing:

• Making (and executing) plans with my spouse
• Doing things with and for our sons
• Building things in the shop
• Growing things in the garden
• Making art
• Making music
• Making our neighbors into friends
• Serving on boards
• Reading just for fun
• Napping in the sun
• Organizing our records
• Culling our stuff (eBay, here I come!)
• Volunteering
• Exercising in the middle of the day
• Seeing more movies, concerts, plays, etc.
• Writing more
• Having a glass of wine with lunch
• Managing our investments
• Looking at photo albums with spouse and sons
• Becoming more adept at digital photography and computer graphics
• Traveling
• Walking/running the dog
• Holding the cats

. . . and the list goes on.



So, I’m quite sure about the main things I’ll quit doing. And, I have a long list of what I want to do. What I don’t know, however, is what I actually will do. I can’t do everything on the “want to” list, at least not at the same time, and at an enjoyable pace, and well. So, where do I start? And, what else will be occupying my time and attention?

• Will I still be able to go to bed at a reasonable hour and get up in time to have a full 16+ hour day?
• Should I be doing a little cooking? Cleaning? Shopping? Chatting?
• What about visiting the relatives (you can pick your friends . . .)?
• What if we find we need supplemental income?
• What will I do if I or a family member gets sick or injured?
• What if one dies?
• What if we don’t die before the money’s gone?
• What'll I do?

And that, my friends, is the song, or at least the phrase from the song, that I can’t get out of my head lately. Irving Berlin wrote it in 1923. Several people recorded it, including the version I recall by Linda Ronstadt in 1983.

What’ll I do when you are far away,
And I am blue, what’ll I do?

The song is about the end of a romance, of course. My relationship with my career has been good, but not that good. Still, the end of it will definitely leave me with a sense of loss. And, and lack of direction. It will require me to reinvent myself. And, I’m not sure how much leeway, or how much capability, I truly have in that regard.

So, I can’t help but wonder . . . really, what’ll I do?