Fannie & Freddie Problems, Your Home, Oil & Gold - What's Going On?

Fannie and Freddie Problems, Your Home, Oil and Gold - What's Going On?

Shame on advisors who were telling people to never pay off their house but instead to invest the money!  As the stock market has run through some rough spots, the money invested in your home has remained safe and sound.   Yes, home values have fallen in some parts of the country, but this is primarily a reversal of recent years of hyper price inflation.  All in all, home values have maintained their value, especially here in the Midwest.  You have not been hurt if you focused on buying a home you could easily afford, as evidenced by it being one that you could perceive having paid off in fifteen years.  If you were using your home as a checkbook and milking the value every time it was reappraised, you probably have a problem.

Let's focus on the more important bigger picture: what the heck is going on with the home loan organizations?  Did you realize that the number of home mortgages that are in trouble are only a little over 1%?  This doesn't seem like much of a problem on the surface, but let's take a deeper look at what has occurred.

The following chart shows the number of home loans in delinquency.  The current rate is a little over 1%, but most recently the rate was much lower.
The other index shows that home prices have fallen as much as 15%...

You are probably asking yourself how 1% of loans, which have gone bad, could be causing all the market turmoil. First, it doesn't help that home prices are dropping, so consumers have less equity or even no equity in their homes.  Some people kept refinancing their homes to fund their lifestyle, and they were banking on continued price inflation to bail them out.   Now home prices are reversing this trend. This limits homeowners' ability to refinance if rates go down, and it definitely reduces their safety net and ability to use home equity financing.

1% of loans being bad hardly seem like a problem of any magnitude.  To better understand, look at it this way:  if you sold milk in gallon jugs and you made a profit of 5% for each gallon you sold for $4, you made 20 cents for every gallon you sold.  If one of those gallons of milk spoiled you would lose $3.80.  You would need to sell 19 more gallons and make 20 cents on each of them to get you back to break even.

So it isn't that the average home owner is in trouble.  In fact 99% are doing OK.  The real problem is that the profit for each mortgage that Fannie and Freddie hold is razor thin.  These organizations buy mortgages from originating banks and sell them to investors in bond packages.

The capital reserves of Fannie and Freddie were still positive recently, but as the chart indicates the delinquency rate was increasing rapidly.  The U.S. Government anticipated that the capital reserves would soon dry up, so they undertook a pre-emptive strike and took over. This was probably the right thing to do.  Without this protective maneuver the financial markets could have taken a dramatic turn for the worse.  These organizations are extremely important to our economy.   They were mandated by our government to buy the mortgages in order to provide liquidity to our housing market.  Personally, I have to admit that I did not anticipate the magnitude of this problem, so I'm glad our Federal Reserve was on the ball.

The follow-up question is this: how much more gun powder does our government have to bail out other institutions that get into trouble?  It seems to me that we are coming to the end of our ability to bail out other organizations.  Some are simply too big and too important to let fail, others like Lehman Brothers will not be bailed out.  The government may try and facilitate a buyout by another bank, but they can't continue to be savior to everyone.  Detroit auto makers, you will simply have to deal with your own problems.

Our government does, however, have a nearly unlimited checkbook.  You and I have to balance our cash inflows with our expenditures, but the government can just print more money.  So they can push the envelope some when they need to do so.  The consequence of more money floating around is higher inflation.  This is something I need to keep an eye on, and build protective measures into your investment portfolio.

So where is our economy going with all this turmoil?  Warren Buffett says it's going to be a slugfest for awhile but eventually everything will be OK.  In his opinion, it will be well into 2009 or later before things start looking better.

The economist service that I rely upon for research says September and October will remain volatile, but they anticipate by year-end we will see an upturn.  This could possibly be delayed into early 2009.

I don't think I am any kind of prophet, but if you read my book, I'm a strong proponent of having your home paid off by the time you retire.  If you are not retired yet, but have this as a goal you probably find yourself in a safe position because:

1. You did not buy more home then you could afford;
2. You have built up a lot of equity in your home;
3. You have a financial discipline that will help you stand strong during the tough times.  One of the key ingredients in being successful in the stock market is being able to hold on through tough times.  Having your home paid for, gives you a financial foundation and the liberty to stay in the game.

My comment is this; shame on those advisors out there who were telling people to never pay off their house and invest the money.  The only person who made money on this advice was the salesman advisor.

If you disagree with Warren Buffett and the economist service and think that this negative trend will continue until we are all broke, here are a couple of thoughts:

Just two months ago, oil was $147 a barrel and gas prices were really starting to hurt. I was starting to hear the old "They Say" comments of fear.  They say that oil is going to $175, even $200, a barrel.  It's hard to argue with fear, especially when there seems to be no compelling logic in sight. But logic rarely is so simple that it runs in a straight line.  The actual answer is more complex and there are a multitude of other forces that factor in, such as, consumer demand decreases as prices escalate.  Today the price of a barrel of oil is under $100, a 33% decrease.  Now if we can only get the gas stations to reflect this price adjustment, the price of gas should continue to fall to around $2.75 a gallon.  Unfortunately gas probably will go higher in future years.

Similarly this spring, gold was closing in on $1,000 an ounce.  People were starting to ask me if they should be holding gold as a hedge.  It sure seemed like a safe thing to do.  Today gold is around $750 an ounce.  That's a 25% drop in just a few months and makes the stock market issues look like child's play.   Historically gold has been a high risk and low return investment.  These past five years gold has performed much better, that is, until recently.  Remember, gold is not a business and makes no money, it doesn't pay a dividend.  Its only value comes from being used in jewelry and industrial applications.  Generally the short term gains only come from what the next fool is willing to pay you for it out of his fear.

Actually I'm not against clients who desire to hold some gold; it's just that I don't automatically build gold by itself into my portfolios.

The point of all this analysis is to bring a voice of reason to the financial turmoil. Like oil and gold, markets eventually reach a balance.  There are short term gyrations that give the appearance that the world is coming to an end, but eventually rational markets return.  It would be nice to be able to correctly anticipate every major move, but most everyone who tries ends up jumping in and out based on incorrect conclusions.  They are wrong enough times that even when they are occasionally right, it doesn't make up for losses incurred the times they are wrong.

The winners in the long run have a consistent game plan.  My plan includes keeping my debt low, maintaining a balanced portfolio of stocks and bonds, and maintaining my strategy during difficult markets.  This is the direction I try to encourage my clients to follow.

So yes, it has been tough lately.  I guess the core question is whether you believe, like Mr. Buffet that in the end America will prevail.  If you do believe and you're not living off the income from your portfolio, then today is just a blip on the chart.  Buckle up and try not to watch the financial news.  If you are taking a monthly income from your portfolio and it exceeds 5% of the value, then you probably should take a hard look at your budget to see if you can reduce the amount.  Conversely, if you have available resources now is probably the best time to find some great buys.

Sincerely,

Ron Dickinson, CPA, CFP, MPA-tax