Weakonomi¢s » loans

Three New Ways To Pay For College

The Weakonomist — Mon, 07 May 2012 14:09:42 +0000

Somehow, our elected officials in Washington have managed to agree on the issue of student loan interest rates. It’s a cause for celebration. Federal student loan rates are set to double soon if new legislation doesn’t get signed. Everyone agrees, and yet they’ve still made it political.

In Washington the only currency is political capital. It benefits a politician’s career more to get in the way of legislation than it does to actually work towards getting something passed. I’m not a huge fan of student loans, and only consider them a last resort option. Nowadays they’re the only option for many. That’s because schools continue to jack up tuition and they don’t bear any the risk if their students can’t afford to pay back those loans.

Perhaps they should be responsible in some way for students being able to pay their bills. Colleges don’t have to compete on price because each one offers such a different experience. They’re able to charge what they want because the people borrowing the money aren’t thinking about a return on the investment. Economists might see this as a broken market. I agree. So here a few ways to pay for college that could help balance this out a bit more:

Equity Stakes: This is a brilliant idea that encourages entrepreneurship. Clarkson University is holding competitions among potential students to pitch business ideas. The best ideas get full rides to the school and in return Clarkson gets a 10% stake in the company. If Harvard had done this with students like Mark Zuckerberg and Bill Gates they’d have an endowment so big half their students could go to school for free. This is a bit risky, but it’s a great way to align incentives. Everyone wants these kids to succeed. And universities have the resources to incubate ideas.

School Financed: If schools think their product (education) is so valuable, perhaps they’re willing to provide the loans for you. Given the appropriate interest rate they could recover a few losses and even make a profit. You’ve seen this with vehicles; GM and Honda both have/had in house financial services companies that provide the lending for their products. The parent company bears the risk. There’s no reason a school couldn’t do this too.

Income Based: Like the equity stakes, this option forces the school to make sure their students are successful. Instead of taking a stake in a company, you get a cut of that student’s future income. Maybe it’s 5% of pre-tax income for 20 years, or 10% for 10 years. The student could be given options just like they have for student loans. The school would do everything to get the student into a good paying job. Perhaps alums could cut their obligation short by hiring new grads from their school too.

Every one of these options puts some of the risk on the school itself. Right now they don’t have any risk. Successful schools will thrive in this environment. Crappy ones won’t. There’s no reason why the school shouldn’t have skin in the game. And there’s really no reason for the government to have so much in it either.

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How Timeshare Companies Make Money

The Weakonomist — Mon, 19 Mar 2012 13:15:20 +0000

Either online, in the mail, or direct phone call, almost everyone has at some point seen an ad for timeshares. They usually look like great deals on free or very cheap vacations. The fine print specifies one must attend a sales session. Most of us are aware of timeshares but have heard bits and nuggets from the news or friends of friends about how bad they are. But even if you’re staying away from the business you should still know how it works.

What is a Timeshare?
Timeshares are fractional ownership of property. They’re common in most vacation destinations and Florida is likely the king. Buyers of timeshare literally own part of a property and the percentage they purchase gives them the right to that property for x% of the year. So if you buy 1/26 of a condo timeshare you get 2 weeks a year. Owners can choose to use those weeks or rent them out just like any vacation property. There are two basic types of timeshares, deeded and right to use. Deeded timeshares give you actual fractional ownership of the property (including the taxes). Right to use timeshares give you access to the property but are technically long term leases and the contract will expire at some point.

Timeshare developers tend to build large resorts in vacation destinations and instead of operating as a hotel or selling the condos to individual purchasers, they sell fractional ownership to lots of buyers. This is a much larger market with people that have lower incomes.

So timeshare companies are real estate developers and they make money selling property? Got it.

Not quite.

How are you going to pay for your two weeks a year?
The typical buyer of a timeshare isn’t going to have the cash to buy a share outright. The few financial institutions that would lend you the money aren’t going to treat it like a lower risk mortgage since they don’t want to repossess a week of vacation that’s difficult to sell. Timeshare company Westgate provides in house financing (how convenient!) and charges interest rates more commonly seen on credit cards. They provide the financing by actually borrowing from banks at rates more commonly seen on mortgages. The spread between the rate they pay and the rate they charge customers accounts for more than half of that timeshare company’s income.

Timeshare developers will also serve as the property managers. And a beach front condo facing an oncoming hurricane is going to have some maintenance fees. The developer will set those fees and you have to pay them. So timeshare companies make money in three ways: the actual sale of property (or contract), spreads on the mortgage to pay for the property, and maintenance fees.

Not a great deal then?
Pretty much. Timeshares are usually sold as impulse buys. The company will woo customers with free trips to visit a resort in exchange for a tour and sales pitch. Buyers will likely leave with their paperwork signed.

Getting rid of timeshares can be difficult as well. There is a secondary market for them but like buying a new car you aren’t going to get your money back. Wikipedia has an uncited number saying 50% of the original price is just marketing costs and other fees. This does mean that buyers on the secondary market are more likely to get a good deal than buying straight from the developer. However this is likely a lesson most timeshare buyers have to learn the hard way. Timeshares can even sell for $1 so people can get out of paying for the maintenance fees and taxes (the loss may also be a write-off), but the buyer should be wary of how much those fees and taxes are.

Summing it up
A family that makes $75,000 is by no means struggling, but they aren’t really the types to be considering a lot of luxury purchases. Like most luxuries, timeshares aren’t an investment. They don’t really go up in value. But the targeted timeshare buyer is unlikely to be a sophisticated shopper considering the interest rates they end up paying and impulse purchase nature of the business.

Surely though, there are people that enjoy their timeshares and find good value in them. If you’re the type of person considering a timeshare, do your homework and meet with more than one company to look at options. The advice of this author is to stay clear but if you must have one make sure you pay cash and be confident you are getting a good deal by comparing prices with competitors. You can read more about the business and a guy who has risen and fallen in the industry check out the Businessweek article below.

Read: Versailles, the Would-Be Biggest House in America

Image: GGtimeshares

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This Time Is Different (Updated 3/12)

The Weakonomist — Thu, 08 Mar 2012 15:35:02 +0000

No matter where we have been over time in this recession, there have been people saying this time is different. Everything form the financial crisis to the real estate bubble to blah blah blah.

For the most part these are things that I ignore. Every time is different. This time the recession was harder, and the recovery has been slower. We’re still pretty fragile but things look brighter every day.

But because every time is different there are some things that stand out once in a while. I was playing around on the St Louis Fed site the other day and accidentally charted a couple of economic statistics. The data points were GDP and household debt.

This time it is most certainly different. For the first time since the 1950s, total household debt has fallen c0nsiderably. And it did so right before it was about to surpass annual GDP and go parabolic. When the Great Recession hit everyone cut back and those with the means started paying down debt. Part of the reason we slipped into recession was due to the pull-back of our borrowing (and bank’s willingness to lend).

The two lines seem to be highly correlated but now the correlation seems to be negative. What that’s really saying is that consumer debt is not really driving the economy as much any more. Which leaves the question: what is? We should all know by now. But if you need a hint, check here.

The dramatic increase in government spending is not only responsible for the recovery, it’s likely still propping it up. What we should be worried about is how long this is sustainable. Experts disagree on how much government debt we can accumulate, but no one denies that it can’t last forever.

As much as personal finance mavens decry consumer debt, this borrowing has been essential to our economy for a long time. If we continue to reduce our borrowing and get smarter about what kind of borrowing we engage in (which is fine) then we’re likely to need government spending to pick up the slack or the economy will be weak for some time.

And that of course does mean: this time is, ahem, dissimilar.

3/12 Update:

It’s been a couple of days since this post originally published, but new data has come out. This post previously questioned whether this divergence was sustainable. And, apparently, it isn’t! This data is published quarterly and the previously dated charts showed data dated for July of 2011. The October report came out and sure enough household debt increased for the first time April of 2008. It’s tough to see even in this zoomed version of the graph to click and it will get bigger. It’s a small increase, but it has to start somewhere. We’ll try to keep an eye on this going forward.

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Weak Links: How Doctors Die

The Weakonomist — Mon, 27 Feb 2012 15:24:49 +0000

In the blogosphere there are tons of link roundups out there. But there’s only one that irregularly and is handpicked by me. Enjoy the best of the web from the last couple of months:

Doctors die differently: This was perhaps one of the most thought-provoking articles I’ve read in the last year. A significant portion of health care spending is geared towards prolonging life for someone on the decline. In many cases a patient’s quality of life suffers greatly as a result. Think of someone undergoing chemotherapy and still succumbing to cancer. It seems many doctors would elect to pass on the chemo if the survival rates are low. They don’t want to be resuscitated, put on ventilators, or suffer through huge expenses just to survive a couple of months longer in possibly great pain. In other words, they aren’t dying the same way many of us will. We don’t think about how we want to die and so loved ones usually default to life preservation at all costs. Is that the right way? To be honest I haven’t thought about it either, but I’m starting to.

How much student loan debt to people really have? NY Times Economix takes a look at who the 1% are with student loan debt. Most people aren’t suffering under a huge debt burden. But a vocal minority can be loudly heard. Still, debt or not, we’re still suffering from an imbalance of jobs to pay for the debts out there. For my thoughts on student loans and the suggested reforms so far see here.

Dylan Ratigan’s take on the mortgage settlement: Essentially, it’s not going to help the housing market. Only one thing will.

For the last three years, the policy has been to impose a political solution to a math problem. It hasn’t worked. America simply has too much mortgage debt to pay back. Serious economic thinkers across the spectrum, from Democrat Alan Blinder to Republican Martin Feldstein to New York Fed President William Dudley, believe that there is only one solution — writing down the enormous creaking mound of debt. This solution is currently off the table, because writing down these unsustainable debts could cost our fragile banks enormous sums of money and possibly lead to a restructuring of one or more of our major banks

Ratigan also notes that 50% of homeowners with mortgages are underwater. Thankfully that is an incorrect statistic and it’s less than 25%. Beyond that, a worthwhile read.

How good are football expert at predicting the playoffs? If they were good, this wouldn’t be an interesting article. There’s always next year guys.

When we’re losing we do better: If your team is down by 1 at half-time you should be in good spirits. They win 8% more often than the team with a 1 point lead. Eventually though this goes away, every two points of lead increases the odds of winning but about 7%. But what makes sports so interesting to many people is the thrill of a comeback and witnessing odds-defying performances.

Audits of rich people increasing: This was a widely reported story a month ago but it didn’t get that much traction beyond initial coverage. I’d like to see a chart showing audit trends of different income classes breaking out which party has the most power.

Why Your Meteorologist has a Shot at the Nobel in Economics: Nail, head.

“What I found then was another example of a very complex, interacting system. It [meteorology] had a big advantage over economics because the fundamental theory was very well understood.”

Why swearing helps with pain: Like any drug, just don’t use it too much or the effects might stop working.

Tornadoes only work on business days: Tornadoes are much more common during the week and research shows a connection with pollution.

Beeronomics: The study of all things beer and brewing. From price differences all over the world to how production is integral to a society. The argument for this emerging field is simple, they’ve already been doing it with wine and more people drink beer.

Carnival of Personal Finance #347, The Giants Edition: To better spread the good word of how great Weakonomics I’m participating in a Carnival of Personal Finance. Check it out for the best personal finance artciles in the blogosphere. Naturally of course, I was editor’s choice.

Image: The National Guard

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The Megalist of Calling the Housing Bottom

The Weakonomist — Tue, 07 Feb 2012 15:23:50 +0000

As of this writing we are converging on the 6th year of this housing mess, and for almost 6 years we’ve heard people from the head of the Federal Reserve to real estate experts to Jim Cramer say we’ve reached the bottom of the housing market. For too long self-interested parties have made claims the worst may be over. They’ve all been wrong. It’s time to chronicle this journey. Starting with the end of January in 2012 and going back to 2006 I’ve compiled a list. Please note the listed sources aren’t always the ones making the claims, it’s just who published the claim.

Please enjoy the list:

1/31/2012 Homeownership rates fall to 66% as downturn nears a bottom – USA Today
1/10/2012 Has The Housing Market Hit Its Bottom? – Forbes
12/8/2011 Is the Housing Bottom Finally in Sight? – Kiplinger (my favorite!)
9/27/2011 This Has To Be The Housing Bottom – Seeking Alpha
6/21/2011 The Housing Bottom Is Here: Economist Russell Price Explains – Daily Finance
4/24/2011 We Could Be Near a Housing Bottom – Seeking Alpha
2/2/2011 Why the Housing Bottom Might Be Here – US News
1/28/2011 U.S. housing bottom seen in mid-2011: poll - Reuters
11/19/2010 Housing downturn has hit bottom – The Business Journal
10/25/2010 Rising Home Sales Point to a Housing Recovery – Daily Finance
10/8/2010 3 Signs the Mortgage Market Has Hit Bottom – Smart Money
5/12/2010 US Housing Prices Projected To Reach Bottom In Q3 2010 – NuWire Investor
4/27/2010 We Have Met the Housing Bottom, Maybe – The Atlantic
4/22/2010 More Signs of a Housing Bottom – Seeking Alpha
1/29/2010 In hard-hit markets, some see signs of bottom – MSNBC
2/12/2010 Builders: Housing bottom is here – SunSentinal
12/15/2009 Builders Say 2009 Marks Housing’s Bottom, 57% Predict Revenues Increase in 2010 (I checked, and a few did have revenue growth, most didn’t, and 2011 was worse) – World Property Channel
10/30/2009 Moody’s: No Housing Bottom Until Q3 2010 – Wealth Daily
8/21/2009 We Called It: The Housing Bottom – The Street
5/13/2009 Yet Another Greenspan Housing Bottom Call – Barry Ritholtz
2/9/2009 U.S. Housing Market May Bottom in 2009, Zandi Says – Bloomberg
10/27/2008 UCLA sees O.C. housing’s bottom by next summer – OC Register
8/27/2009 Cramer Calls the Housing Bottom (Q3 2009) – CNBC
8/17/2008 Greenspan sees housing bottom, criticizes bailout – Fosters
7/24/2008 The Media Are Missing the Housing Bottom – National Review (Larry Kudlow called this one)
2/21/2008 No housing bottom until ’10: CP Morgan – Reuters
1/15/2008 Mortgage bankers expect housing market to bottom out in third quarter – BizTimes
1/8/2008 Stable Existing-Home Sales Expected in Early 2008, then Gradual Rise – National Association of Realtors
12/19/2007 Is Collapse of Home Prices About To Hit the Bottom? – The Sun New York
12/1/2007 Will Home Prices Hit Bottom in 2008? Yes, but . . . – Kiplinger (again? of course!)
11/26/2007 Deere Sees a Housing Bottom in 2008 – Seeking Alpha
9/14/2007 Hovnanian Chief Says Housing Bottom Is `Very Near – Bloomberg
8/16/2007 Contradictory News Suggests Housing Bottom Could Be In View – Realty Times
5/25/2007 Housing Market Nears Bottom – Forbes
4/20/2007 Housing Bottom Callers – Calculated Risk (Hank Paulson here)
4/17/2007 IMF believes US housing market may bottom out – Reuters
2/17/2007 NAR Says Existing Home Sales Have Hit Bottom – Realty Times
2/8/2007 Housing still on down slope Economists say no recovery until midyear; prices face record fall – Market Watch
12/21/2006 Housing ‘close to bottom,’ realtor-group economist says – Market Watch
12/5/2006 Home builders see bottom of housing slump – CNN Money
11/15/2006 Housing slide may deepen; New forecast sees bottom in 2008 – Boston Globe
10/6/2006 Greenspan Says `Worst’ May Be Past in U.S. Housing – Bloomberg

When will we see the real bottom? It could be soon, one of the few people I trust to have an unbiased opinion (and someone who has attempted to track all the prior claims for a bottom) explains there are actually two housing bottoms to look for and they may be closer than you think. We’ll see if he’s right, or if he gets added to this list.

If you have more articles you want listed claiming a housing bottom, put them in the comments. While there are many stories that talk about the bottom, for the sake of this list just look for headlines.

Image: Nick Bastian Tempe, AZ

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Pay Me To Borrow Money, From You

The Weakonomist — Mon, 06 Feb 2012 15:43:13 +0000

That’s what the US Department of Treasury may be telling investors in the near future. What that effectively means is that the rate the US pays to borrow money would be negative. Investors would be paying the US for the privilege to lend to them? How can this happen in a world where our debt was downgraded just last fall? Interest rates on US debt have done nothing but fall since the downgrade. An astute reader can see that this is counter-intuitive, after-all if your credit score fell from 750 to 700 you couldn’t expect to get the same rate on a loan could you? Could you?

Maybe you could. Because interest rates aren’t just driven on the likelihood of default, they are also dependent on the market. And while the US went from being “near perfect” to “perfect-ish”, the global bond market has been in turmoil. This means that the US is still considered the safest place in the world to park your money, and so rates have fallen. Just as a person with a 700 credit score today can get a better loan rate than someone with 750 a couple of years ago.

Rates have gotten so low they’ve actually been at zero percent recently and traded at a negative yield in the secondary market. The US Treasury may soon offer some short term Treasury bills with what’s called a negative coupon. When investors submit bids for the bills they might offer $101 for a bill worth $100. Under normal circumstances they might bid $99. In 4 weeks the US would give them $100 back in either circumstance. When investors are allowed to bid $101 for the a $100 bill, that is a negative return, or negative interest rate. The idea of investors paying for the privilege to lend money to the US is so weird the Treasury systems will have to be updated just to make it possible. But this is something that has already been happening in the secondary market for these bills and so by updating their systems, the Treasury would either have to borrow less or could perhaps consider taking the proceeds and putting it towards our national debt.

Negative interest rates are not common, but you can effectively see them all around you. Think about your checking account. When you deposit money into a bank you are loaning it to them. They will pay you a small rate (if at all) for allowing them to borrow it. But then the bank slaps you with a couple of fees every month and even if you are getting interest the fees more than offset it. So you’re paying the bank for the privilege to lend them your money. Banks don’t see it this way because of all their overhead, but essentially that’s what you got.

Does it make you kind of wish banks would just get rid of fees and charge a negative interest rate? Part of me feels that way. Ditch all the fees, just charge 1% per year based on some kind of average balance. But that will never fly because each account has a basic fixed cost. If it costs $100 a year (it’s actually more) to keep a checking account going and they need $20k in balances to make that back then they aren’t going to charge wealthier customers for their business. They wouldn’t need to because they could make the money back elsewhere. People with balances below that line will just cost the bank money. So you’d end up with a segregated population that is divided by the people who pay for the privilege to lend the bank money and have access to their cash, and the people that are paid to have the same access.

Banks know that middle and lower-income demographics won’t respond well to that, so instead you have the al la cart menu fees which, while annoying, have the appearance of being fairer. Plus no consumer is going to park $50k in a place that pays -1%. So while the Treasury is looking forward to indulge in a little negative interest rate territory don’t expect to see it show up on your banking documents for a long time.

Read: Treasury may let investors pay to lend to U.S. government (Reuters)

Negative Bill Auction Yields Would Avoid ‘Grab-a-Thon’ (Bloomberg)

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Our Cars Tell The Story Of Our Consumption

The Weakonomist — Thu, 02 Feb 2012 15:13:49 +0000

Joanne Muller over at Forbes did some interesting digging on the car buying habits of Americans. Less than 40% of rich people (defined in this case as those making $250k+) actually buy luxury cars. And about 8% of people earning less than six-figures do. Now that doesn’t sound all that crazy but Thomas Stanley extrapolated a little bit more from those numbers:

I estimate that there are 2.5 million households or nearly 2.2% of the total that have annual realized incomes of $250,000 or more. Using Ms. Muller’s estimates that 39% of “the rich” buy luxury brands, one can estimate the number who do so, approximately 975,000. Ah, but this population is much smaller than those households who drive prestige makes but have annual incomes under $100,000. About 30 million households have annual incomes in the $50,000 to under $100,000 bracket alone. Translated: 8% of 30 million = 2.4 million who are buying luxury cars but are not in the so-called “rich” category. This population is nearly 2.5 times the size of the high income/luxury vehicle buyer.

In other words, most of the people buying luxury cars make less than $100,000 a year. That alone is interesting but we can go back into the numbers and learn more.

Dr. Stanley discusses in his post that the average price paid for a car by a millionaire is just over $30 grand. For the decamillionaire: $40 grand. So when someones wealth increases by factors, their spending on vehicles increases by fractions. That means that at some point on the wealth stream we stop spending more on our cars. But with so many people buying luxury brands with lower incomes it’s clear that until we reach that point, we’re overspending on cars. It sounds like that many people are faking being rich, until they actually are. Then they scale back.

This implies two things about rich people:

After a certain point projecting status becomes less important and money is spent on things with more value (maybe a second home, private school for the grandkids, charity).
Once we cross a certain point we start saving a greater percentage of our incomes

These two things are not mutually exclusive.

But what does it all mean? These numbers tell me a story about people that live beyond their means, and it’s not just with cars. It’s with purses, vacations, clothes, jewelry, food and even gifts. Most displays of economic status are not likely to be proportionate to the actual status. It is only and indicator of willingness to pay.

Personal Car Advice:

Should you be the type that struggles with figuring out exactly how much money to put towards a car, here’s my little formula. Take your total household income and subtract out any debt payments that aren’t for a mortgage. Take half of that and you’ll have the total maximum value one should ever have for their vehicles. An example is in order.

Say your household makes $90k and after student loan and credit card payments you clear $80k. Half of that is $40k so you should never have cars totaling in value beyond that. For a family with two adults that’s two cars worth $20k each. That is not to be confused always having cars worth that much. Each car should be owned for at least five years and new purchases should have at least 50% down and paid off within 2 years. Buy a car where you can do that. Get all that?

Now, spending more than $30k on any one car should be considered a luxury purchase and made in all cash. If you can’t swing those things then you can’t afford the car you want. If you can’t follow all that definitely just buy a car that costs 25% of your income, all cash.

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Kill Off The Mortgage Interest Deduction

The Weakonomist — Fri, 20 Jan 2012 14:56:30 +0000

You can find a poll to support just about anything. And recent polls support that idea. Another recent poll is showing people are very interested in changing the income tax deduction on mortgage interest and about a quarter of people are okay with eliminating it altogether.

Back before the days of the mortgage crisis I always thought the deduction to be kind of silly. It was believed that the deduction would encourage more people to buy homes, and that home ownership was better for the economy. A number of policies were put in place to encourage home ownership, especially at the lower income levels, and that’s partially where the subprime mortgage originated from.

The deduction didn’t make sense for a couple of reasons. First of all, it isn’t really fair to allow a deduction on mortgage interest and not something for rent. Second, I would expect most lower income people able to get a mortgage would probably just take the standard deduction instead of deducting interest anyway.

A number of ideas have been proposed to encourage home ownership among lower income earners and many could serve as a potential replacement for the interest deduction. The most well-known is the first time home buyer tax credit. This famously put a temporary floor on housing prices when it was available to people. When it expired, prices fell again. If this were available only to first time buyers then it does a good job of helping people get up and running. Unlike the standard deduction, it would likely play more of a factor into the home buying decision.

Another idea is to limit who can take the deduction based on income. If you make a certain amount, you can’t deduct. From a government revenue perspective that sounds nice but I don’t think it’s fair. Perhaps the solution would be to make it so you can only deduct interest on the first mortgage, not a HELOC or mortgage for another house.

Here’s what sucks about the mortgage deduction today though. I don’t think it plays a factor in anyone’s decision to purchase a home. It’s just a nice to have. Since it’s a deduction you have to file for each year, it doesn’t have the effect of lowering the purchase price or keeping your payments low. Likely, all it does it boost your federal return a little bit every spring.

Honestly, I think there should be some equity. If we’re going to subsidize monthly payments on mortgages, we should do the same for rent. Just like if you have to buy your own health insurance, you should be able to deduct that too. But tax policy in this country isn’t efficient or well-planned. That’s why I’m very much in support of changing the way the deduction works now. But, because I don’t think the current deduction even factors in 99% of home-buying decisions, I’m okay with eliminating it completely.

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Flyover States and MFing Global

The Weakonomist — Thu, 15 Dec 2011 15:21:04 +0000

There are some elements of finance that even I struggle with. For example, how can you draw a line from a wheat farmer in Nebraska to a bankrupt brokerage in New-York City? Maybe that connection is easy, but why is the farmer’s money missing just because the farmer’s brokerage company went bankrupt? And why are the funds belonging to the wheat farmer in Saskatchewan just fine?

If a bank goes under then technically speaking a customer’s assets should be just fine. Maybe the bank no longer has the resources to manage your money, but your money should still be find, be it investments or cash. These assets would be transferred to another institution.

But with dedicated brokerages there are some different rules (mind you these rules may apply elsewhere too). Brokers can engage in their own financial transactions and MF Global had done just that. They bought European debt. You know how that went. So they lost a bunch of money. But part of the deal with their bets on debt requires posting collateral (because they borrowed money to buy the debt). That collateral can come from customer funds. So if you are a farmer and post collateral to make trades in wheat futures, MF Global can use your collateral as their own. One would question the logic behind this, and many have. This is why there are limits on how much of this can be done, and it is against the law to use Canadian funds to do it.

American and British funds are fair game, which is why the Nebraskan wheat farmer can’t seem to get his money back. That money is missing because even with the rules on posting collateral as collateral, MF Global may have simply broken the rules to make its own trades. So why is MF Global in such a mess? If you aren’t following there are two problems. The first is they made bad bets with their own money, the second is they may have broken the rules with posting customer money as collateral for those bets. If you want to know more about this read up on the Shadow banking system, repurchase agreements, and rehypothecation.

Now all you east coast and west coast people who don’t work on Wall Street may wonder why some wheat farmers have anything to do with a broker you’ve never even heard of. Look at it this way, imagine you averaged $75,000 a year in income over the last 10 years. But some years you made $15k and other years $150k. You had absolutely no control over what it would be. If someone offered you the chance to guarantee your income in advance for a small fee, would you take it?

Of course you would. Essentially this is one service a broker like MF Global offers. Farmers take advantage of it to smooth out the price of their product. Everything from corn to pork can be as volatile in price as a stock, so farmers don’t want to stress about how much their wheat will be worth once it’s grown. They use brokers like MF Global to engage in contracts that lock in prices ahead of time. MF Global takes a small fee, and may also collect collateral if prices aren’t paid up front. This is the collateral that ends up getting used in the rehypothecation (you haven’t looked it up yet?).

I hope people in the middle-states aren’t offended by my headline, but it helps draw attention to the idea that the global economy is truly global. A small town farmer’s money very easily got tied up in the European debt crisis and with a firm that is doing no favors for Wall Street’s reputation for recklessness.

MF Global’s bankruptcy is the largest since Lehman Brothers back in 2008. Thankfully this seems to be an isolated incident and not a domino. Hopefully new rules will be put in place to prevent such reckless behavior, should it be determined rules would have actually prevented this.

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The Fall Of Finance

The Weakonomist — Tue, 13 Dec 2011 15:10:21 +0000

Even though Occupy Wall Street has lost some of its muster, the message has been loud and clear, people are pissed off. The easiest target has been Wall Street, and it will likely remain that way for some time. They certainly deserve a lot of the blame, blame they’ve been getting since 2007. Over the last handful of years a lot of stuff has come out. Some of it criminal, quite a bit of it immoral, and still more simply questionable.

However, there comes a time when the law of diminishing returns kicks in. I suspect as we enter the 6th year of housing issues we’ll start to see that. For some perspective, one should note that there are very few people left at the big finance companies that can be considered responsible for the crisis. Most of the execs that were running the show at the most screwy companies are gone. What’s left are people who are simply cleaning up the mess others left behind. Many of the ones most responsible for the financial crisis have quietly stepped out of the spotlight and most of them left before you ever had a chance to know them. Heard of Sandy Weill, Herbert and Marion Sandler, Martin Sullivan, Daniel Mudd? I could keep going. And you can look these people up on your own. They disappeared, and if 1% of the Occupy Wall Street protestors could tell you who they were I’d be shocked.

It’s not just the public who have turned their backs on Wall Street, Wall Street has too. The financial companies are worth so little these days, and they continue to struggle. The stock market would actually be up this year if it wasn’t for the banks getting killed so much. And their five year performance is just as bad. Below are the average market caps (investing term for company size or value) of the five largest companies in four sectors of the S&P500 exactly five years ago yesterday:

Technology: $158 billion
Consumer Staples: $121 billion
Energy: $168 billion
Financials: $188 billion

It’s clear who the big dog is in 2006. However since then the landscape has changed. Here’s how things look now for those companies:

Technology: $158 billion—————-> $236 billion (50% increase)
Consumer Staples: $121 billion——–> $139 billion (7% increase)
Energy: $168 billion———————> $170 billion (1% increase)
Financials: $188 billion—————–> $130 billion (38% decrease)

This is far from scientific*, but no matter how you measure it, finance is literally a fraction of what it once was. Hundreds of billions in value are gone. It continues to shrink too. 2012 won’t be a good year for these companies, even if it is for other industries. They can’t make money on loans, and they can’t even do it on checking accounts any more.

There has been a generational change in finance. It has and always will play in important role, but finance will likely be so regulated for the next couple of decades it will be relegated to the background, where it rightfully belongs. Out of sight, out of mind. Finance has entered the dark ages.

For now though the targeted attacks simply start to have less and less meaning. And not just because there might be better targets out there. But please continue to attack greed and corruption, it will help keep it out of this industry and others in the future. Technology: you’re on watch.

*Nerds can email me for specifics.

Image: Look him up

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