I bought my first home in 1990 at the top of the Southern California real estate market and promptly found myself with an "underwater" mortgage. And although I owed more than the home was worth over the next seven long years, I never walked away from ...
Continue reading If It Feels Good Do It: Maybe Strategic Defaults Aren’t So Bad After All
Inflation 101: Why Avatar Isn’t the Biggest Movie of All Time (And What Movie Is)
This past week, the technologically ground-breaking 3-D movie Avatar was hailed across the globe as the new king of the box office world, "topping" Titanic's box office take by grossing over $1.859 billion worldwide.
According to the media, this ...
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18 Facts You Didn’t Know About The Federal Reserve System
1. The Federal Reserve System is the United States' version of a central bank. Central banks, also known as reserve banks, are the entities responsible for the monetary policy of a country. The United States has not always had a central banking system. In fact, three separate central banks have operated in the United States at one time or another since 1791.
2. Secretary of the Treasury Alexander Hamilton was a proponent of a strong central government with a central bank. Hamilton dueled with James Madison and Thomas Jefferson, who both argued that the new Constitution did not explicitly allow the federal government to form a bank. However, despite their best efforts neither Madison or Jefferson were able to prevent Hamilton from founding the First Bank of the United States in 1791. Hamilton wasn't as successful in his famous duel with Aaron Burr on July 11, 1804; he died from the resulting gunshot wound a day later.
3. As president, Madison finally got his way when let the original 20-year charter for the First Bank of the United States expire in 1811. Surprisingly, Madison had a change of heart four years later, and asked Congress for a new central bank. In 1816, The Second Bank of the United States was granted a 20-year charter to provide the government two services: 1) establish a national currency, and 2) meet interest and principal payments on the National Debt run up during the War of 1812.
4. In 1832 Andrew Jackson campaigned on a platform opposed to charter renewal for the Second Bank of the United States. With the National Debt on target for being paid off by 1835, Jackson saw little reason for a central bank. After Jackson was reelected, the Bank's president, Nicholas Biddle, unsuccessfully tried to pressure Jackson to renew the bank's charter by contracting the money supply, but it was to no avail. In 1835 Jackson officially retired the National Debt. He retired the central bank one year later.
5. The period from 1837 to 1862 is known as the Free Banking Era because the US had no formal central bank. Instead, state authorities directed the printing and registering of bank notes and issued them to banks in amounts equal to deposited designated securities. In 1863, a system of national banks was instituted by the National Banking Act. Despite its passage, a series of bank panics in 1873, 1893, and 1907 could not be avoided.
6. The third and current central banking system of the United States, better known as the Federal Reserve System, was born in 1913 when, after many painful months of hearings, debates, and amendments, the Federal Reserve Act was passed by Congress. On a Sunday. Two days before Christmas. When most of Congress was on vacation. For the record, Democrats supported the bill while Republicans were against it.
7. Interestingly enough, nowhere in the title or anywhere else in the Federal Reserve Act were the words “central bank.” According to the Concise Encyclopedia of Economics: The primary reason for this omission was the term’s unpopularity with the populist wing of the Democratic Party. Republicans had accepted the label, but, after 1912, no longer controlled either Congress or the White House. That term, many congressmen objected, implied monopolistic control by Wall Street bankers, who would keep interest rates high and conspire with speculators to cause panics.
8. The main motivation for the third central banking system came from the Panic of 1907, which renewed demands for banking and currency reform. A majority of the American public believed that the Federal Reserve System would bring about financial stability, so that a panic like the one in 1907 could never happen again.
9. Don't tell that to Ron Paul: Paul believes that the Fed's ability to print money without any controls is actually the main cause of inflation and the economic bubbles that occasionally plague the country. Paul advocates reduced government spending, lower taxes, and letting the free market manage monetary policy as the proper alternative to the Fed.
10. Ironically, the presence of the Fed could not keep the United States from entering the Great Depression of the 1930s. Many prominent economists including the late Milton Friedman believe that the Fed was directly responsible for causing the Great Depression because they willingly allowed the money supply to slowly decline after the 1929 stock market crash, thereby preventing recovery and economic expansion.
11. The current Federal Reserve System is a quasi-private institution. That is, it is an independent government institution that has private aspects. The System is not a private organization and does not operate for the purpose of making a profit. It is owned by the 12 regional Federal Reserve banks, which are each in turn owned by a combination of regional and commercial banks.
12. In addition to maintaining the stability of the financial system and containing systemic risk that may arise in financial markets, the Federal Reserve Banks have several other functions including clearing checks, providing economic education, establishing economic policy, approving bank mergers and acquisitions, and researching and issuing reports on the regional economy which they publish eight times a year in a report known as "the Beige Book."
13. The Beige Book, so-named because the cover of the Fed's internal hard copies are, well, beige, is based upon reports from regional Bank and Branch directors and interviews with key business contacts, economists, market experts, and other sources. The report's more formal name is the Summary of Commentary on Current Economic Conditions.
14. Back in 1970, when it began as an internal report for people at the Fed, the report actually had a red cover and was known as (you guessed it) the "red book." But the color and the name changed with the report's first public release in 1983.
15. The Federal Reserve also puts out "Green" and "Blue" books with appropriately colored covers that forecast, respectively, economic activity for the immediate future, and forecasts and analysis of monetary policy alternatives. Unlike the Biege Book, however, the Blue and Green books are not made available to the public.
16. The Federal Reserve is also responsible for issuing and destroying the nation's coin and paper currency. The U.S. Treasury, through its Bureau of the Mint and Bureau of Engraving and Printing, actually produces the nation's cash supply and, in effect, sells it to the Federal Reserve Banks at manufacturing cost, currently about 4 cents per bill for paper currency. The Federal Reserve Banks then distribute it to other financial institutions in various ways. Critics believe that the Fed's charter to issue money violates Article I, Section 8 of the US Constitution.
17. The bills in your wallet are officially known as Federal Reserve Notes; they are a form of fiat currency and are not backed by tangible assets such as gold or silver. Alphabetic notations on the front side of each bill identify which of the 12 Fed-bank headquarters issued the note: Boston (A); New York (B); Philadephia (C); Cleveland (D); Richmond (E); Atlanta (F); Chicago (G); St. Louis (H); Minneapolis (I); Kansas City (J); Dallas (K); and San Francisco (L).
18. Conspiracy theorists believe John F. Kennedy was assassinated because of Presidential Executive Order 11110. The theorists argue that was because the executive order was a direct attempt to usurp the Federal Reserve's power. Of course, there are others who find that particular conspiracy theory and supporting argument to be pure poppycock. ;-)
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Paying Off the Mortgage Early? Not So Fast …
In January 2009 I wrote one of my most popular posts to-date entitled Paying Off Your Mortgage Early Is A No-Brainer. In that post I did a detailed analysis that justified why paying down my mortgage was the right thing to do.
That Was Then, This ...
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Inflation: Your Four Best Defenses For Preserving Your Wealth
I kicked off this series on inflation with a warning about why all of us should fear inflation and why the US government needs it to take root in our economy. But I'm not the only one who thinks so.
Forbes posted an excellent article on the coming ...
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Inflation: Why You Should Fear It, And Why The US Wants It
Ronald Reagan accurately warned us in 1984 to be vigilant against inflation because it can come, "like a thief in the night to rob our savings, rob our earnings, and take the bread off our tables."
For this reason, the government is usually on guard against the threat of inflation. In the simplest terms, this is normally done by controlling the amount of money in circulation. It's really a matter of supply and demand. If everybody has more money in their pocket to spend, then too much money chases too few goods and the currency becomes devalued. This, in turn, drives up the cost of everything from gasoline and furniture to food and the price of a ticket to Disneyland.
President Obama's proposed budgets over the next two years call for spending on an unprecedented scale. His proposed budget has a funding shortfall of almost three trillion dollars over the next two years, an amount equal to a staggering 12% of the entire US gross domestic product and twice the size of the worst deficits on record. Indeed, President Obama's own budget people are predicting budget deficits during his time in office to exceed that of all the other presidents combined from George Washington.
So, Len, just how does the government plan on paying for all of this?
In essence, the government has two choices, massive tax increases or high inflation. Naturally, the government is going to take the political path of least resistance.
Indeed, in order to pay its massive bills the United States will have no choice but to abandon its commitment to fight inflation and ramp up the output of the Treasury printing presses. This, of course, will end up flooding the economy with trillions of additional dollars that will not only drive up the prices of goods and services, but also punish fiscally responsible individuals by diluting the value of their dollar-denominated savings and retirement accounts.
Simply put, inflation is taxation without representation. Alan Schram uses the example of a man earning 5% on his savings account, who ends up in exactly the same financial position whether he pays 100% tax on his interest income with zero inflation, or zero income taxes with 5% inflation. And Schram correctly observes that if Congress tried to pass a 100% tax on anything, the public would be marching on the Capitol steps with pitchforks and torches.
The US government's unfettered spending plan is clearly unsustainable with respect to current taxation rates. But instead of suffering the consequences that would come with overtly increasing the taxes necessary to support these insane budgets and associated bailouts, Congress will be content with letting inflation do its dirty work. For that reason I believe inflation rates exceeding those seen during the mid to late 1970s are inevitable.
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Using a HELOC as an Alternative to Refinancing
Recently I was talking with a buddy of mine, who happens to be a higher-echelon employee for a major bank, about my desire to refinance into a longer-term home loan in order to provide me with additional financial flexibility in the event I ever lost my job.
Eventually, our conversation migrated over to when people want to remortgage with bad credit and then on to the case of my mother-in-law. I wanted to also refinance her mortgage for maximum flexibility because she has a very limited monthly income that will become even more limited when she finally retires. Unfortunately, although she is 65, she has very little saved for retirement and therefore she will be almost entirely dependent on her social security payments in the coming years. Here is an approximation of her current situation:
Monthly Social Security Income: $1000
Monthly Mortgage Payment: $400
Remaining Mortgage Balance: $40,000
Value of House: $200,000
As you can see, once she retires her mortgage will eat up roughly 40% of her social security payments, making life quite difficult for her.
After hearing these details, my banker buddy offered up what I think is an ingenious and brilliant alternative to refinancing that was just too good to believe. I'll paraphrase his words to me: Why don't you have your mother-in-law take out a home equity line of credit (HELOC) for the amount of the mortgage and then pay off the mortgage? If minimizing her payment is the ultimate goal, she can pay only the monthly interest payment on the HELOC.
What! Why would anybody ever do that? Isn't it true that the interest rate on the conventional fixed rate home loan is lower than a HELOC?
It is true that the HELOC carries a higher interest rate than if she refinanced into a conventional fixed-rate home loan. But the beauty of this plan is that unlike the mortgage on a conventional fixed-rate loan, the HELOC would permit my mother-in-law to pay only the interest due each month. At current rates, this strategy would lower her monthly payment to somewhere in the vicinity of just over $100 per month. (As an aside: many folks may be interested to know that it is possible to get a HELOC, or even remortgage with bad credit.)
But if you only pay down the interest every month you'll never pay off the house! I know what many of you are thinking: Okay, Len, what is going on here? Just the other day you were spouting off that for those who want to reduce risk by agreeing to trade the desire of making more money over the short run in exchange for the security and promise of a steady risk-free return, paying-off the mortgage was a no-brainer!
And in most cases, that is still true. But there are ALWAYS exceptions to the rule. In my mother-in-law's case, being a senior citizen with no nest egg to speak of and very limited income, minimizing her monthly payments easily trumps paying off the mortgage. For many senior citizens with limited incomes who are still responsible for paying a mortgage for a home, it becomes logical to ask: what do they have to gain by paying it off, other than providing their heirs with a bigger inheritance?
With all that in mind, for my mother-in-law it basically becomes a trade between these two options:
1) continue to work as long as she can continuing to pay down (for her) an expensive mortgage in exchange for owning the house free-and-clear by her 77th birthday, or...
2) pay off the existing mortgage with a HELOC and then make payments of just over $100 over the next ten years, using the resulting savings to build a small nest egg and give her more a little extra money in her pocket to boot.
Of course, the key to implementing this strategy requires sufficient available equity exists to tap a HELOC in the first place. Fortunately, even after the collapse of the housing bubble, my mother-in-law still has plenty of equity to qualify.
So why not go with a reverse mortgage? Well, everybody's situation is different. But in my mother-in-law's case, the HELOC allows her to avoid the steep fees and other loan costs (usually over $10,000) normally associated with reverse mortgages. In fact, many lenders offer zero or near-zero closing cost HELOCs. The high closing costs associated with reverse mortgages are attributed in part to FHA insurance required to cover the risk of the loan balance growing in larger than the home’s equity over time. For my mother-in-law, the savings that the HELOC provides are just too big to ignore.
True, unlike a HELOC, a reverse mortgage wouldn't have to be paid off until my mother-in-law moves out or dies. But HELOC loan terms can run for as long as 10 years. When that term is eventually reached, she can decide to either sell the house, repay the relatively small balance or refinance.
In the mean time my mother-in-law, by using a HELOC to pay off her existing mortgage, can enjoy a little more financial freedom and hopefully some added peace of mind in her autumn years.
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Got a Fixed Rate Mortgage? Root for High Inflation.
With all the liquidity that the governments of the world have been releasing into the economy, I believe it will only be a matter of time before we begin to experience a nasty bout of inflation that will force interest rates into territory not seen since the late 1970s and early 1980s.
With that in mind it got me thinking, if high inflation is inevitable, is it still worth it for me to continue to pay down my mortgage with a goal of completely retiring it by the time my son, God willing, graduates from high school seven years from now? For me, the answer to that depends on just how long I think the inflationary period will last.
So what's my situation? As I discussed in my previous post on the benefits of living within your means, I bought my current house in 1997 for $199,000. Over the 10-plus years that I owned the house I have faithfully made extra principal payments in order to ensure that I was mortgage free by the time my first child was out of high school. As a result, today, I owe less than $120,000.
After my latest refinancing goes through, my new mortgage bill will be reduced from $1122 to only $640. This new monthly payment borders on a level approaching the ridiculously absurd! By that I mean the new monthly mortgage is so low that I should be able to pay it with little trouble, regardless of what type of job I have.
Furthermore, the new lower monthly mortgage also has the advantage of putting a much smaller dent into my rainy day fund than my old mortgage. Of course, although I will be going from a 20-year fixed loan back to a 30-year fixed loan, my original plan for now will be to stay the course and continue paying excess principal on the loan to ensure that it is retired early.
Or will it?
Because if inflation goes into or near double-digit territory, as I believe it will, I may be wiser to hold onto that money going toward the extra principal and forget about retiring the debt early.
Why? Because as inflation rises, it erodes the value of the dollar over time. Banks, in particular, hate high inflation because folks with longer-term fixed-rate loans end up repaying those loans with dollars that are worth a lot less than the value of the dollars they originally borrowed. Normally, interest payments are more than enough to compensate the banks for the costs attributed to benign inflation, but when high inflation appears, all bets are off -- for the banks anyway!
High inflation is a blessing for those who find themselves deep in debt -- assuming they still have the means to stay solvent. And who is one of the biggest debtors among us? None other than good old Uncle Sam! Trillions of dollars of debt. For this reason I believe that the Fed will ultimately determine that the best way to reduce the impact of the multi-trillion dollar debt run-up by the United States is to unleash a managed run of high inflation over a period of several years.
Sure they used to talk a good game about reigning in inflation, but I believe they now think that it's their "best" and "only" option out of the debt mess this country currently finds itself in.
That's why, as the household CEO, I've decided after a dozen years of doing otherwise, to officially reverse course and abandon my quest pay off the mortgage early.
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