Our Sovereign Debt Crisis

[Note: This blog post is almost entirely derived from other people’s work.]

The national debt of the United States is increasing at an alarming rate. The chart below is from Dave Short at Dshort.com. It shows the ratio of Federal Debt to Gross Domestic Product (GDP).

Federal Debt to GDP Ratio

Below is a synopsis of historian Niall Ferguson’s presentation at the Peterson Institute for International Economics, taken from BusinessInsider.com. Ferguson explains the causes and effects of excessive government debt.

What Causes These Sovereign Debt Crises?

  • Excessive debt
        Measured by debt to GDP or to revenue or to exports
  • Excessive interest payments
        Measured by debt service to GDP or to tax revenue
  • Excessive reliance on foreign capital
        Measured by debt to exports or net international investment position
  • Economic weakness
        Low growth
        Low returns on private sector investment
  • Political weakness
        Excessive expenditure and insufficient taxation
  • Irrational exuberance
        Investors keep forgetting to learn from history

What Are the Ways Out of a Debt Crisis?

In theory, there are six ways out:

  1. A higher growth rate of GDP [Possible for the USA, but not likely.]
  2. A lower interest rate on the public debt [We can’t go much lower.]
  3. A bailout, meaning either a current transfer payment or a capital transfer from abroad [Who’s going to bail out the USA?]
  4. Fiscal pain, meaning an increase in taxes and/or a cut in public spending [In our current climate, I don’t think so.]
  5. Increased recourse to seigniorage (revenues from monetary issuance, aka “printing money”) by the central bank [BINGO!]
  6. Default, including every form of non-compliance with the original terms of the debt contract, including repudiation, standstill, moratorium, restructuring, rescheduling of interest or principal repayment etc. [I don’t see the USA refusing to pay its debts, unless we go to war with our creditors.]

Usually, only ways 4 through 6 are used: Cut, Print or Default.

  • Cutters are few and far between
    Only Britain, 1815-1914, reduced debt burden exclusively through budget surpluses, lower interest rates and higher growth, and Britain had the advantage of the industrial revolution
  • Printers
    States with monetary sovereignty [e.g. the USA]
    Sates with debt in their own currency [e.g. the USA]
  • Defaulters
    States with limited monetary sovereignty
    States with foreign currency debt

Lessons of history

What Governments do NOT do with World-War Size Debt Burdens (One exception: Britain 1815-1913)

  • Slash expenditure on entitlements
  • Reduce marginal tax rates on income and corporate profits to stimulate growth
  • Raise taxes on consumption to reduce deficits
  • Grow their way out without defaulting or depreciating their currencies

What Governments USUALLY do With World-War Size Debt Burdens

  • Oblige central bank and commercial banks to hold [buy] government debt
  • Restrict overseas investment by firms and citizens
  • Default on commitments to politically weak groups and foreign creditors
  • Condemn bond investors to negative real interest rates

What Are the Geopolitical Consequences of Crises of Public Finance?

  • In fiscal stabilizations, discretionary military spending is usually the first casualty
  • In cases of default on external debt, conflicts with creditors can arise
  • In cases of currency depreciation, reserve currency status can be lost to a rising rival

Ferguson has succinctly described the causes and seemingly inevitable consequences of the rapidly-growing US debt. I have read other similar arguments giving numerous examples of governments who printed too much money and caused their currencies to crash and lose most of their value. With the national debt increasing, holding the local currency is financial suicide.

Given this irrefutable logic presented by some very smart people, Why don’t I just sell everything and buy gold? click here.

Permanent Link to this post: http://richardkinnaird.com/blog/our-sovereign-debt-crisis/


Sunday, February 20th, 2011 Currencies Comments Off on Our Sovereign Debt Crisis

Why I’m Not Selling Everything and Buying Gold

Lately, I’ve been reading and studying quite a bit about the problem of our national debt.  The growth of this debt is gaining speed like a runaway train, and the interest payments are projected to become an onerous part of future budgets.  All solutions to slowing this runaway train require measures of sacrifice that the US population is unlikely to accept.

We have all been riding the train for so long, that we can’t bear to leave the dining car even though we believe that at the end of the tracks is a cliff over a vast crevasse.  There are still miles of track ahead of us, and this party isn’t over yet.

We read about personal analogies to this national debt.  Families have gone too heavily into debt and have seen all equity vanish in their major investment, their home.  These families have lost their homes, and prospects for a prosperous future have vanished.  Many Americans are able to see how this applies to their own lives, and they are trying to reduce their debts and live within their means.  “Living within your means” was a popular philosophy during most of the Twentieth Century, but fell into disrespect as an outdated and unsophisticated financial strategy.

The logical conclusion to this runaway debt is the crash of the US Dollar.  The only logical outcomes are either 1) Default on the debt or 2) Devaluation of the Dollar.  Either outcome will result in the Dollar losing much of its value and purchasing power.  Pundits have given many examples of this happening to countries in the past.

I have read the logical arguments proving this inevitable result, and I honestly don’t have any logical counter-arguments.  I am regarded as a very logical person, so why don’t I just sell everything and buy gold?

According to most of these logical arguments, the only sure-fire way to preserve my wealth is to convert it all to gold.  History has proven that gold holds its value during times of inflation and the collapse of currencies.  When the currency collapsed in countries in the past, people who had gold survived financially.  So, why don’t I just sell everything and buy gold?

Something has been nagging at my brain as I read these essays of doom.  It’s not that I don’t believe them; I do, and I have blogged about these problems and probably will again in the future.  The trouble is, I don’t believe them “with all my heart.”  Although my logical mind is convinced, I have a nagging doubt – a lapse of faith in the science of economics.

I can hear your response right now, “You are just in denial.”  That may be true, but I am not denying the facts.  I absolutely agree that too much debt is very bad.  Paying off the debt will be bad, and defaulting on it will be bad.  There’s no denying that.

Well then, you say, “You are just paralyzed.  You are so terrified of the inevitable collapse of the Dollar, that you can’t take any appropriate action.”  That’s not entirely true either.  I have a significant percentage of my net worth in gold, but it’s nowhere near “everything.”  So, why don’t I just sell everything and buy gold?

Maybe its because I’ve heard this story before.  I remember Howard Ruff and other gold bugs in the late ‘70’s and early ‘80’s saying much the same thing.  They predicted doom and its been over thirty years.  Surely they didn’t think it would take this long for us to go to Hell in a handbasket.

Also, I am acutely aware that I don’t know everything.  Too many times I have been certain about something only to have something else unexpectedly happen.  And since I am smarter than the average bear, I must conclude that nobody else knows everything, either.  Other pundits may not admit to ever having been wrong, but I am skeptical.

I took a lot of philosophy classes in college, but I have to admit that it took a recent blog posting to remind me of Hume’s problem with inductive reasoning.  You see, all these arguments of doom and gloom rely on the assertion that “This has always happened in the past, so it will happen in the future.”  This is inductive reasoning.  Inductive reasoning draws upon past experience to predict future experience.  One famous example of this is:

All of the swans we have seen are white.  Therefore (“ergo” for you philosophers),
All swans are white.

As Hume points out, it only takes one counter-example, a black swan for instance, to invalidate the theory.  Hume concludes that, no matter how many repetitions there may be, we are not justified in extrapolating things we have experienced to things we have not experienced.  He further concludes that we are not even justified in arguing the probability of things we have not experienced based upon past experience.

On the other hand, George Santayana said, “Those who cannot remember the past are condemned to repeat it.” I have a counter-assertion, “Those who rely on the past are condemned to repeat it.

Let me repeat, I do not see any painless way out of our national debt problem.  It’s just that I am not so convinced that I am willing to go “all in” and sell everything to buy gold.

This blog post is not intended to make you, or me, comfortable with our national debt.  It’s not even intended to be a rationalization for investing in the same old things we have always invested in.  This is just an introspective look into why, counter to logic and reason, I don’t just sell everything and buy gold.

How about that, a blog post with no charts or graphs.

Permanent Link to this post: http://richardkinnaird.com/blog/why-im-not-selling-everything-and-buying-gold/

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Sunday, February 20th, 2011 Currencies, Gold 1 Comment

Worldwide Demand For Gold

Below is a chart I got from HardAssetsInvestor.com.  It shows the demand for gold for the past three years.  It also shows the breakdown on what the gold is used for.

Worldwide Gold Demand

By weight, demand dipped in 2009 and in 2010 returned to the 2008 level.  However, when measured in dollars, demand grew slightly in 2009 and jumped substantially in 2010.

If you are interested in a little more detail, click on the link above.

Permanent Link to this post: http://richardkinnaird.com/blog/worldwide-demand-for-gold/


Thursday, February 17th, 2011 Gold Comments Off on Worldwide Demand For Gold

Our Jobless Recovery

Our current recession has officially “ended.” The government says that recovery has now begun. One area of the economy that has not begun recovery is employment. In all previous recessions since World War II, employment has recovered much more quickly.

Here are two charts from the blog, Calculated Risk.

The first chart shows how employment declined in the past eleven recessions.  The graphs are aligned at the peak of employment before recession and each vertical line represents one month.

Job Losses in Latest Recessions

The second chart shows this same data realigned at the date of maximum job losses.

Job Losses Aligned to Worst Month

Employment in the USA has fallen for more months and has bottomed at a lower level than in any prior recession.  Although employment is rising again, it is increasing much more slowly than in the past.  It will be many more months before we approach levels that we considered “normal” three years ago.

Permanent Link to this post: http://richardkinnaird.com/blog/our-jobless-recovery/


Saturday, February 12th, 2011 Work 2 Comments

The Dismal State of US Employment

Here’s a link to a short and to-the-point article by Gregor Macdonald pointing out that we do not have a recovery in the US labor force:  Gregor.us

Here is one of the two charts from that article showing Non-Farm Payrolls:

Non Farm Payrolls

We are still down by 8 million jobs from the peak in 2008.  For the economy just to maintain the status quo, we need to add at least 125,000 jobs every month.  We should have added about 4.6 million jobs on top of the 8 million jobs lost to be where we were at the peak of our economy in 2008.

Read the article; it’s interesting: Gregor.us

Permanent Link to this post: http://richardkinnaird.com/blog/the-dismal-state-of-us-employment/


Thursday, February 10th, 2011 Work 1 Comment

Bond Funds Aren’t the Same as Bonds

First of all, let me state that I am not advocating investing in Bonds or Bond Funds at this time.  My purpose here is to explain why Bond Funds aren’t the same as Bonds.

What is the purpose of investing in a Bond?  Bonds are supposed to provide a modest income stream while preserving your investment.  If you buy a Bond, all you have to do is hang on to that Bond until it matures, and you will get back 100% of your initial investment.  The only risk is that the Bond issuer might go bankrupt.  Even if  the issuer does go bankrupt, Bond holders are in line ahead of investors to get some of their money back.  There have been a few spectacular exceptions, but most “investment quality” Bonds mature and return the principle to the Bond holder.

All the years you hold the Bond, waiting for it to mature, you receive steady, guaranteed interest payments.  Because of the safety of your investment, you are willing to accept interest rates that are a little less than you might be able to receive in other investments.

During the time you are holding the Bond, its “street value” will go up and down.  Unlike stocks, the value of the Bond, after it is issued, doesn’t depend as much on the strength of the entity that issued the Bond, as much as on prevailing interest rates.  If your $1,000 Bond pays you $40 dollars in annual interest, you are getting 4% interest.  If new Bonds being issued are paying 6%, you would only be able to sell your Bond for about $667.  By paying $667 for your Bond, the $40 that the new owner receives annually is 6% of what he paid for the Bond.

Conversely, if prevailing interest rates go down to 3%, a buyer would probably be willing to pay you $1,333 for your Bond.  The new buyer would be getting 3% interest on that Bond.

As a Bond holder, you don’t have to worry about the ups and downs of your Bond’s value.  All you have to do is wait until the Bond matures and you will get $1,000 for it.

Corporate Bonds are usually sold with a face value of $1,000.  In order to diversify your Bond portfolio, you would have to buy Bonds of at least five different issuers requiring an investment of at least $5,000.

In addition, you wouldn’t want all the Bonds to mature at the same time.  Because you don’t know what the interest rates will be when your Bond matures in five, ten, twenty years or so, you would like your Bonds to mature at different times.  That way, when you have to reinvest the $1,000 from a matured Bond, only a portion of your portfolio will be locked into the new interest rate.  For diversity of issuer and maturity date, you might want to invest $10,000 in ten different Bonds.

The average investor would probably need to use a broker who specializes in Bonds to achieve diversity of issuer and relative stability of interest rates.  Bonds aren’t as easily bought and sold as stocks, and the broker’s commission (spread) tends to be greater than with stocks.  This is why Bond Funds were created.  For purposes of this article, I am lumping Bond Mutual Funds and Bond Exchange Traded Funds (ETFs) into the same category.

Bond Funds own lots of Bonds from lots of issuers with different maturity dates.  This diversity reduces the risk of default from small to miniscule.  It can also increase the interest paid by having some higher risk, higher interest Bonds mixed in with lower risk, lower interest Bonds.  Bond Funds are traded like stocks (ETFs) or like mutual funds.  The commissions are low and the prices are published daily.

All this makes it sound like Bond Funds are the best thing since homogenized peanut butter.  You get lower risk and higher interest without having to invest $10,000.  For ETFs and many mutual funds, there is no minimum required investment.  Bond Funds are within the financial reach of almost everyone, and you can buy them as easily as any other investment.

However, with Bond Funds, you give up one important attribute of Bonds – security of capital.

No matter how long you hold shares in most Bond Funds, you are not guaranteed return of your initial investment.  Like Bonds, the daily value of Bond Funds goes up and down, but there is no maturity date.  You have to pick a time to sell your shares in a Bond Fund.  You could sell your shares for more or less than you paid for them.

Bond Funds

The chart above graphs the weekly price over the last five years of two Vanguard Bond Mutual Funds.  The black line is an intermediate-term corporate Bond Fund, and the gold line is a long-term corporate Bond Fund.  You can see that your initial investment could have lost as much as 14% or gained as much as 12% for the long-term Bond Fund.

Because of this, I don’t see much difference between Bond Funds and dividend-paying Stock Funds.  You get a fairly stable income stream and the value of your investment goes up and down.  Until 2013 at least, dividend payments are taxed at a lower interest rate than corporate Bond Funds’ interest payments.  Interest from municipal Bond Funds can be tax-free.

To be fair, this volatility is nothing compared to the volatility of the S&P 500 stock index.  The chart below compares the Vanguard intermediate-term Bond Fund with the S&P 500 index.

Bond Funds vs. S&P500

Today, the yield of the S&P500 (SPY) is 1.69%, while the yield of the Vanguard intermediate-term Bond Fund (VBIIX) is 3.17%.  For the past five years, the Bond Fund value has risen about 9% (vs. about 1% for the S&P 500) and has a better yield.  The main reason for the increase in value of the Bond Fund is that interest rates have been declining for the past couple of years.  The Bond Funds took a major hit around October, 2008 when everything (Bonds, Stocks, Gold) crashed.  But after about three months, the Bond Fund resumed its inverse tracking of interest rates.

The reason I am not recommending investing in Bonds or Bond Funds right now is that I expect interest rates to rise over the next few years.  This means that existing Bonds will be cheaper when interest rates are higher and the yield will be better.

As long as you realize that Bond Funds do not preserve your capital the way individual Bonds do, Bond Funds can be a useful part of your investment portfolio.  Just remember that Bond Funds, like Stock Funds, fluctuate in value, and there is no guaranteed safety of your investment.

Permanent Link to this post: http://richardkinnaird.com/blog/bond-funds-arent-the-same-as-bonds/


Monday, January 31st, 2011 Fixed Income Comments Off on Bond Funds Aren’t the Same as Bonds

Gold isn’t a Commodity; Gold is the Universal Foreign Currency

Until recently, Gold was always classified as a commodity.  It is traded on the commodities exchanges using futures contracts.  It has “spot” prices like wheat and pork bellies, but Gold isn’t really a commodity.

Commodities get consumed:  Wheat gets eaten, corn gets fed to cattle which get eaten.  Oil gets burned.  Even silver is partially consumed because it is not yet so valuable that every ounce gets recycled.

Gold, however, is never consumed.  It has always been so valuable that except for minute amounts used in electronics, it is recycled.  Not much Gold has been lost in the trash.

Commodities can be hoarded.  If a speculator starts storing large quantities of coffee, sugar or wheat, thereby keeping them off the market, he is said to be hoarding these commodities.  If an exchange-traded fund buys and stores lots of Gold, they are investing, not hoarding.  Gold is not a basic requirement for life like food or energy.

Gold is really a currency, but not just any kind of currency – Gold is a “foreign currency.”  Unlike other currencies, it is foreign in every country.  In the USA, the euro is a foreign currency, but in France, it is money.  In England, the yen is a foreign currency, but in Japan it is money. Gold isn’t money in any country.  Gold is a foreign currency everywhere.  Gold is “the Universal Foreign Currency.”

What makes Gold a currency?  Before the Twentieth Century, Gold was a “real currency” or at least an “alternative currency” in many countries.  Money (coin) was actually made out of Gold (and silver).  Gold was money until all major countries adopted paper money that is not officially exchangeable for Gold.  This paper money is derogatorily called “fiat currency,” but it has, nevertheless, displaced Gold as money.

This heritage of Gold having been money is one quality that has led to its status as a currency.  Another quality is Gold’s heritage as being a store of value.  Many people consider Gold to be a better store of value than money – no matter which currency you call money.

By being a universal foreign currency, Gold can be valued in any “real currency” and “real currencies” can be valued in Gold.  Since Gold is a universal foreign currency, it can be a hedge against all currencies.  Gold can rise (or fall) in value as measured in any “real currency.”  Buying Gold using your native currency hedges against a fall in value of your currency without depending on any other currency to do better than your own.

We’ve heard of people buying Swiss Francs because the Swiss money often retains its value when other currencies fall.  But in these modern times, we can’t even depend upon the Swiss Franc to hold its value.

Like any other currency, Gold can’t be depended upon to always rise in value against the dollar (or any other specific currency).  But at least the value of Gold is harder to manipulate by governments.  Gold is a foreign currency everywhere, so no country can control it.  If a government sells some of its Gold reserves, the price of Gold will probably go down temporarily, but governments sell Gold to raise cash, not to try to drive down the price of Gold.  Governments also buy Gold when they have surplus cash, and this can temporarily drive up the price of Gold.

Today, the USA complains that China is manipulating the value of its currency (the renminbi or yuan), keeping it undervalued to give their exporters an edge against other countries.  Other countries assert that the USA is manipulating the value of its currency by “quantitative easing” which puts inflationary pressure on the dollar.  As countries race to devalue their currencies against all others, Gold stands out as a reference of value to all the currencies.  When investors flee any currency, Gold benefits.  Gold is a universal measure of wealth and a store of value.

Although the US Dollar is the world’s “reserve currency,” I think a case can be made that Gold is the world’s “reference currency.”

Gold isn’t a commodity – you can’t eat it or burn it for energy.  Gold doesn’t get used up and it doesn’t decay or rot.  In a previous post I discussed why Gold isn’t money, but it is a currency.  So don’t think of gold as a commodity, think of it as the universal foreign currency.

Permanent Link to this post: http://richardkinnaird.com/blog/gold-isnt-a-commodity-gold-is-the-universal-foreign-currency/


Thursday, December 2nd, 2010 Gold 1 Comment

10-, 20- and 30-Year Stock Returns

I found a blog post with three interesting charts.  The first chart shows the 10-year return of owning the S&P 500 stocks and reinvesting dividends.  The second and third charts repeat this for 20-year and 30-year periods.

Over the last ten years, your annualized return would be a loss (-1.86%).  Over the last twenty years, your annualized return would be +6.38%.

This is the link to that blog post.

Permanent Link to this post: http://richardkinnaird.com/blog/10-20-and-30-year-stock-returns/


Tuesday, November 30th, 2010 Stocks Comments Off on 10-, 20- and 30-Year Stock Returns

Smackdown: Stocks vs. Gold vs. Housing

In a previous post, we examined the performance of single-family Home values relative to Stocks and various Commodities.  What about a direct comparison of the investment performance of Stocks, Gold and Housing?

The chart below examines the performance of these investments over the last twenty years.  The Stocks (S&P 500) graph does not include reinvesting dividends.  The red line plots Stocks (the S&P 500 index).  The pink line plots residential Housing (the Case-Schiller index).  The gold line plots Gold, and the black line plots a “Balanced Portfolio” consisting of one-third each of Stocks, Gold and single-family Housing.  If I had included reinvesting dividends, Stocks would have performed better.
Investment Performance
As you can see, both Stocks and Gold would have increased about 350%.  Housing would have increased about 200%.  The Balanced Portfolio did pretty well (at 300%) and was less volatile.

Here is the same data adjusted for inflation (using the CPI):
Investment Performance Adjusted For Inflation
I chose the last twenty years because this is about as long as many people hold investments before retirement.  These charts assume that you invested a lump sum of money in 1990.  The performance of an investment really does depend upon when you invest your money.  That’s why financial planners recommend that you invest monthly to “dollar cost average” the money you invest.

What if you had a time machine and could go back in time to invest a lump sum of money?  What would you invest in?  Which investment is best depends upon how far back in time you travel.  The chart below shows the best investment depending upon which year you invested your money.
Lump Sum Investment Required in Specific Year
This chart shows how much money you would have had to invest in order to have $100,000 in 2010.  If you only traveled back to 2006, you would have had to invest more than $100K in Housing or Stocks to have $100K today.  You need to travel back in time to a year where the graph dips lower so that less money is required for investment.  The lower a line dips, the better the time to invest.

If you traveled back to 1990, you could have put your money in either Stocks or Gold (a little under $30K ) to grow to $100K in 2010.  The first chart also shows this equivalence.

In 1999, you wouldn’t want to invest in Stocks, because that was a peak in the market and you would need to invest $125K to end up with only $100K.  1997 to 2003 would have been a great time to invest in Gold.

At no time was single-family Housing the best place to invest (the lowest line).  In fact, there were only twelve years that Housing wasn’t the worst place to invest.  Remember, this is a “buy low” chart; it tells you when you can buy lowest.

The Case-Schiller home price index averages twenty large cities.  There are certainly some cities where home prices have performed better.  There are also some stocks that have performed better than the S&P 500 index.

Just because the house you live in has under-performed as an investment, doesn’t mean that all real estate is a bad investment.  Many people have had good success investing in income-producing property such as apartment buildings, office buildings, etc.  Income producing property has a more rational valuation method than does single-family housing.  Just as the value of stocks is roughly based on the earnings of the stock’s company, income-producing property is roughly valued on the annual rent it produces.  There is a “price-to-earnings ratio” for stocks and a “gross rent multiplier” for income property.  Buying income property is a business decision, buying the house you live in is usually an emotional decision.

So what is the bottom line of the previous charts?  I think one conclusion is “You shouldn’t have most of your assets tied up in the house you live in.”  Also worth noting is that for the last nineteen years, Gold has been the best investment.  For ten of those nineteen years, Stocks were the worst place to invest a lump sum.

The Balanced Portfolio is one-third each Stocks, Gold and Housing.  Some financial advisors suggest that you have ten percent of your portfolio in Gold.  Is ten percent enough to diversify a portfolio?

Let’s see how four different diversified portfolios performed over the last twenty years.  The chart below shows our Balanced Portfolio in black.  A portfolio with only ten percent Gold and forty-five percent each Stocks and Housing is shown in gold.  A portfolio with ten percent Stocks and forty-five percent each in Gold and Housing is shown in red.  And a portfolio with ten percent Housing and forty-five percent each in Gold and Stocks is shown in pink.
Four Diversified Portfolios
It’s obvious that the worst performance is the portfolio that only has only ten percent in Stocks, the red line.

The portfolio that is only ten percent Gold performs best until 2008 when both Stocks and Housing are in decline and Gold starts to take off.

The portfolio that is only ten percent Housing performs second best until 2009 when it takes off and is the best performer.

This chart indicates that the most important part of your portfolio is Stocks.  If at least one-third of your portfolio is in Stocks, you would have done OK.  The two portfolios that had forty-five percent in Stocks (gold and pink lines) generally did the best.

So what kinds of stocks are best?  And what about bonds?  Maybe we will discuss those topics in another post.

Permanent Link to this post: http://richardkinnaird.com/blog/smackdown-stocks-vs-gold-vs-housing/

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Friday, November 19th, 2010 Gold, Real Estate, Stocks 1 Comment

Buying Your House on Margin

Buying stocks “on margin” means that you don’t have enough money in your investment account to buy the stocks, so you have to borrow the money from your broker to make the purchase.  You have to pay interest on this money, of course.  Buying stocks on margin is considered to be very risky.  It is a technique that is sometimes used by “traders” but not by “investors.”  Even the risk-takers wouldn’t hold stocks bought on margin for a long time.

Why do traders buy on margin?  Because it is leverage.  If you buy $1,000 worth of stocks and you only put up $100 of your own money and borrow $900, you are leveraged.  If the value of the stocks goes up 10% to $1,100, you can sell the stocks, pay off your $900 margin loan and have $200 left.  You started with $100 and now have $200 for a 100% profit on a 10% stock value increase.

So why is buying stocks on margin risky?  Because stocks don’t go straight up in price.  As we all know, stocks go up and down daily.  If your stocks go down 10% in value to $900, and you have to sell, you only have enough to pay off your $900 margin loan.  You have lost your original $100 which was all of your money – A 100% loss.  Buying on margin is betting that the stock will go up rather quickly so you can make your profit and then sell to get rid of your risk.

When you buy a house with a mortgage, you are buying the house on margin.  This is the key to making money in real estate – leverage.  So if buying stocks on margin for a short period is considered risky, why is buying a house on margin for thirty years considered a conservative investment?

Borrowing to buy real estate is a conservative investment because real estate always goes up in value.  You never have to worry about your house losing value.  Really, they aren’t making any more land, an increasing population keeps needing more housing; what could go wrong?

The housing bubble could pop; that’s what could go wrong.  Just like “dot com” companies in the 1990’s, anything can become overvalued and must eventually correct.

Here is a chart of house prices since 1950 (the Case-Schiller index):

House Prices

Buying a house on margin would have been a good investment if you bought and sold before 1990.  If you bought after 1990 you would have to wait to sell between 1999 and 2006 to come out ahead.  If you bought since 2004, your house has probably lost value, and you will have to wait several more years before breaking even.

Some families who have bought houses in the last five years have discovered that their homes are worth less than the mortgage.  If they sell, they will have to come up with extra money to pay off their margin account (mortgage).  They are faced with the prospect of continuing to make loan payments on a losing investment, or defaulting on their loan and losing everything.

Here is a chart of house prices adjusted for inflation (CPI):

House Prices Adjusted For Inflation

As you can see, from 1950 until about 1985, house prices mostly kept up with inflation.  The graph has a slightly negative slope from 1954 to 1974 which means that during that period, price increases did not keep up with inflation.

Starting around 1985, housing went through two boom/bust cycles.  From 1985 until 1998, house prices increased and then came back down to where they started.  The second boom/bust cycle started in 1997 and may not have finished yet.  Remember, this is adjusted for inflation.  On the previous chart, the first boom/bust cycle isn’t as evident.

The “conservative strategy” for investing in stocks used to be “buy and hold.”  Buy stocks of good companies, hold them for ten to twenty years, and then sell them at a profit.  It didn’t really matter when you bought, as long as you held the stocks for a long time, you would make a profit.

The stock market “crash” of 2008 – 2009 has caused many investors to question this strategy.  As we will see in a later blog, you could have held stocks for a long time and still lost money — It all depends on when you bought.

The “conservative strategy” for investing in your home used to be “buy, wait and move up.”  Buy your house on margin (borrow money via a mortgage), wait five years, sell at a profit and buy a more expensive house on margin.  It didn’t matter when you bought, because real estate always went up.

The bursting of the real estate bubble has caused home owners to question this strategy, too.  You could have bought your house six years ago, sold it, and not have enough money to pay off your mortgage.  It turns out it matters when you bought your house.

With stocks, you can buy low and sell high.  With your home, if you buy a new house when prices are low, you also have to sell your old house when prices are low.  You can’t “time the market.”  You have to buy and sell during the same market conditions.

Investing in stocks has another advantage – you don’t have to buy your whole portfolio at once.  You can invest a little each month and “dollar cost average” your purchases.  You don’t have to borrow money to invest in stocks.

With a house, you can’t “dollar cost average” your investment.  You have to buy the whole house all at once.  Also, very few people can afford to pay cash; they have to borrow the money.  Interest payments add to the cost of the house.  Houses also require maintenance and property tax payments – disadvantages that stocks don’t have.

I once told my brother that I had never made much money on houses that I lived in.  He replied that it was because I actually kept track of what the houses cost me.  Most people don’t keep track of how much money they actually put into their home.

Houses have a major advantage over stocks – you can live in them.  You have to live somewhere, so why not try to make some money off of it?  This is the same argument that is made for whole-life life insurance.  If you need life insurance, why not use it as an investment?

In most cases, it is better to buy cheaper term life insurance and invest the premium difference.  You have life insurance for the years that you need it, and you end up with a larger investment portfolio.

These days, many former home owners are renting a house for less money than it costs to make mortgage payments, tax payments and maintenance costs.  They can separate their living costs from their investment purchases.

But what about the mortgage interest tax deduction?  Doesn’t being able to write off your mortgage interest on your taxes make home ownership a better investment?

If you buy a house for $200,000 with a thirty-year mortgage at 4.50%, your mortgage interest payments for the first five years will total $43,118 which is an average of $8,624 per year.  The “standard deduction” on your 1099 tax form for a married couple is $11,400.  This means that you would need another $2,776 in tax deductions (such as property tax) just to break even with the standard (no itemization) tax deduction.

Let’s say that you do break even with the standard deduction as described above.  Your monthly payment for mortgage and taxes would be $1,245.  This is probably about how much it would cost to rent the house.

So, if you want to live in a house that costs $200,000 or more, it probably makes more sense to buy it than to rent it.  If you don’t have to sell your current house, it probably makes sense to buy that new house in 2011.  Experts think the residential real estate market, in the USA, should hit bottom by the end of 2011.  Remember, you have to buy low and sell high for margin investing to work.

No investment is perfect, including real estate.  Real estate can be a pretty good investment though, and we will discuss how it compares to other investments in another blog post.

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Saturday, November 13th, 2010 Real Estate Comments Off on Buying Your House on Margin

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I am not a registered financial advisor. I only offer opinions, and sometimes these opinions veer off at weird angles from conventional wisdom (That's probably why you are here). My advice is, "Don't take my advice." Read my sidelong glances at economic issues and form your own conclusions.

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