Foreclosure on a mass scale is really stupid. Some obvious questions:

Can’t we figure out some way to transition buyers back to being renters that saves the cost of foreclosure to the banks and the pain to the homeowner?

Can’t the cities, state governments and non-profits work with the banks to keep perfectly good furniture out of landfills?

Where is our leadership?

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

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We apologize for the barage of emails but we’ve experienced a decade’s worth of financial events in a week. We will give a quick rundown of the government’s actions in the last 24 hours and then discuss what “safe” means.

FDIC-ish Protection for Money Market Funds
The US government will seed a guaranty program to provide insurance for money market funds, similar to the way FDIC provides protection for bank deposits. Details are scant. One key difference will be that the insurance is optional but available to any fund that agrees to follow rules about portfolio investments and pays an insurance premium. Another is that there does not appear to be any cap on the value of insured holdings. A fun trivia fact for you: the money for this initiative is from the same fund Bill Clinton and Robert Rubin used to bailout Mexico during the Peso crisis in 1994.

Troubled Asset Relief Program (”TARP”)
Don’t you love the cute acronym - “TARP”? The US government has announced a huge fund to buy up dodgy mortgage-backed paper. They are pitching this as a similar program to the Resolution Trust Corporation (RTC). The RTC was established to slowly liquidate all the illiquid assets the US government got stuck with when it took over bankrupt savings and loan associations (”S&Ls”) during the 1980s. It was considered a big success because the RTC eventually recovered a lot of money for the US taxpayer by patiently selling off investments over time. The new program is different in that they will buy assets from investment funds and financial institutions that are still in business. This could be a stealth bailout if the government pays more than market value for the investments or a great deal for taxpayers if they buy decent but illiquid assets at bargain basement prices from desperate sellers.

Short-sale ban on all US financial stocks
Holy catfish. In a blatant attempt to prop up stocks (temporarily) and put the blame for recent events on those evil no-good short sellers, the SEC banned short-sales on over 800 different stocks. This looks like a deferral of pain rather than an avoidance of pain and poses a severe disruption in the normal trading of stocks. It is hard to find a metaphor that can express how unprecedented this action is. We actually sent an email to our congressman complaining about it.

What does “safe” mean?
That is a great question and gets to the heart of risk management. There are many types of risk and putting together portfolios of risk that have the highest expected returns given the maximum amount of loss our clients are willing to accept is our business.

Today, we want to talk about two specific kinds of risks. The first kind of risk is that you don’t get the cashflows you were expecting. The second risk is what we will call opportunity risk. You will still get back the cashflow you were expecting but, after you agree to the terms of an investment, a better one becomes available.

An example. You lend someone $100 and they promise to pay you 10% interest in a year plus pay the loan. Tomorrow, they are willing to pay 11% interest. Even though your investment is “safe” in the sense you will still get $110 in 364 days, your investment has lost value because of opportunity risk. If you were to pawn off this loan to someone else, they would only pay $99 for it.

Almost all investments on the planet have opportunity risk. Treasury bills have opportunity risk. Your two year cell contract with AT&T has opportunity risk.

Sometimes we are aware of it, sometimes not. When we buy a bank CD, there is opportunity risk. The banks, however, are allowed to tell us that our $100 CD is still worth $100, even when higher CD rates are now available and you would have to pay massive penalties to get your money out early. This makes them feel good and us feel good.

The money market funds were created to give everyone this same feeling of serenity. Even when things move a little bit (up and down) they always cost $1. We can get out the exact same amount of money we put in, any day. The reality is that the investments that a typical money market fund own still have some opportunity risk and move a little. Not a lot, but some.

In the old days, while the investments in money market funds had a little bit of opportunity risk, they had minimal cashflow risk. We got concerned earlier this year when we saw all sorts of strange asset-backed securities and heavy weightings towards financial institutions appearing in portfolios. We were especially concerned that if one fund had losses from cashflow risk, there would be a panic, mass liquidations and increased opportunity cost losses across the board. Fast forward to Monday and this fear became reality.

When we said that not all money market funds were safe, we meant “safe” in the way money market funds have been sold - as never varying in value. They are safe in the sense that there is no chance you lose all your money or even most of it.

Maybe it is time we all started recognizing that risk is an inherent part of our lives and that our focus should be on understanding the risk and making active decisions about how much and what kind of risk to take.

Elizabeth and Jessica

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

[Formatting problems at the bottom are known issue. Webmaster on the case.]

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The financial sector had taken over our economy. Over 40% of all profits in the US were made by financial firms, a statistic more befitting a small Caribbean tax haven. Financial regulation in this country was inconsistent and ineffective.

Your messengers,

Elizabeth and Jessica

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

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Shocking VP picks, Russian invasions and now a government takeover of Fannie Mae (FNMA) and Freddie Mac (FHLMC)… the news just won’t stop coming.

Our overall view has not changed. The US will have to suffer through a few unpleasant years before the housing market normalizes, financial institutions can get back to business and our economy can get moving again. It will get worse before it gets better. At the end of the day, the financial sector should be smaller and more efficient which would be a positive thing. People will start saving money and that will be a positive thing.

Asset classes around the world have taken a beating lately. The rumors are that many hedge funds have had to liquidate large positions. While this is ugly for current holdings, most of you hold a lot of cash and we have identified a number of compelling investments.

Items of note from the government takeover of FNMA and FHLMC:

Mortgage rates will probably go down. The government is doing a lot of things to get rates down, many of which will eventually cost us all as taxpayers and mean much higher mortgage rates in the future. But in the meantime… there should be some deals available.

Future tax rates will be even higher than we have been assuming. This bailout will cost a lot. If you can contribute to a Roth IRA, you should seriously consider doing so.

This is not the final restructuring. The current specifics of the FNMA / FHLMC deal have the mortgage giants being responsible for something like 90% of all new mortgages over next year or two and then virtually ceasing issuance after that. The concept is that offering really, really low rates on mortgages over the next 18 months will stabilize the situation enough that the government can just leave. Methinks this is not very realistic. Who on earth will step up to fill the void? Homeowners and banks will be dependent on the US taxpayer for years to come. There are some eerie parallels to the Iraq war…

Debt issued by FNMA and FHLMC is money good. Many of you hold shares in your 401(k)s in the Pimco Total Return fund, which had gone “all in” on a bet that the government would do a bail out. It turned out to be a good bet.

In other news:

Washington Mutual (WaMu) got officially placed on super secret probation by its regulators. This is not a good sign. They are offering desperation-level high rates on CDs. This is not a good sign. We have sent out previous warnings about this bank. You should not have more than the FDIC minimum at WaMu. Your family and friends should not either.

Don’t shoot the messengers-

Elizabeth and Jessica

The 2009 unified budget deficit is estimated now at $490 billion. Some of that number is expected and fine - during a recession taxes fall and certain expenses like unemployment benefits rise.

It’s still a really big number - and it turns out that the real deficit is much, much higher.

First, the number doesn’t account for $80 billion in war costs.

Next, the number is for the “unified” budget deficit. “Unified” in federal budget speak means the cash in, cash out budget. This ignores serious obligations the government has taken on this year - veterans benefits to the hundreds of thousands of troups serving overseas, Medicare and Social Security payouts to the baby boomers etc etc.

The real government budget deficit is the number that takes into account all these future liabilities. It is *probably* $200 billion higher than the fictional unified budget deficit, but no one really knows.

Congress mandated that all the major departments of the Federal government start producing auditable financial statements in 1990. Many departments are now compliant but the behemoths - Defense, Homeland Security and State departments - are not.

I love this footnote in a recent report from the General Accounting Office (the government’s internal audit staff) on budget numbers:

Data reported in the Financial Report of the United States Government, hereafter referred to as the Financial Report, for fiscal years 2001 through 2007. GAO disclaimed an opinion on the U.S. government’s consolidated financial statements for these years, other than the 2007 Statement of Social Insurance. As such, the reported amounts may not be reliable.

Or how about this snippet from the same report:

Importantly, emphasis should not be placed on the precise numbers for either a single year accrual deficit or the change from year to year. For the 11th consecutive year, the government was unable to demonstrate the reliability of significant portions of the 2007 Financial Report, from which the data in this update were taken.

The cash on cash number, while in no way an accurate assessment of the government finances is still an important number - because it tells us how much the government needs to borrow every year to pay its bills.

We can project forward 20 and 30 years and the cash on cash number starts looking really, really ugly. All those deferred liabilities start coming due. Our best guess is that they will add $600 billion a year to the current deficit. That will either mean much higher interest rates or higher taxes (50% higher) or elimination of the entire government outside of defense or some combination.

Many of our client’s have written off social security being there for them in their retirement. They are surprised to hear our view that, while we think benefits will be clipped for the wealthy, Social Security will survive. A clear majority of retirees rely on Social Security and Medicare/Medicaid for their retirement and these programs will become even more important as the post- company retirement plan generation retires. These programs cannot and will not go anywhere. We may have an overhaul, eventually, of our health care system but don’t count Social Security or Medicare out.

The good news is that there will be Social Security benefits - the bad news is that tax rates will go up, a lot.

More reading on budget unsustainability

Congressional Budget Office’s report

The GAO’s report

It turns out that the decision to do so was more Citibank’s than theirs.

Citibank unilaterally reduced their $190,000 line down to $10,000 (less than their Citibank credit card) yet kept all the same annual fees in place.

Most agreements allow an issuer to reduce a line of credit if your credit goes south or if your house goes substantially down in value. In our client’s case, neither of these applied.

So why did Citibank do this?

All the banks are feeling pain from losses they are experiencing from home equity loans. In the olden days (i.e. a couple of years ago), hardly anyone defaulted on a home equity loan. If they got in trouble, most people just sold their house at a profit and paid off all the loans. Home equity lines also weren’t given out like candy. Most people who got them actually used them for fixing up their homes. It turns out that the clientale you attract by pitching the virtues of debt consolidation are not the most likely to pay you back if the going gets even slightly rough.

The banks with big portfolios of home equity loans are getting hit two ways. First, they are losing money. Second, the market is hammering them because of concerns about future losses (exhibit A: E*TRADE, exhibit B: Citibank) . It shouldn’t really be a surprise then to see the banks aggressively trying to get rid of any outstanding lines. Batten down the hatches!

From what we have seen, the banks seem to be yanking even lines that they have no right to yank- kinda like the insurance companies that reject all claims the first time they are submitted.

What should you do?

First of all, you make sure that your financial plan does not presume the availability of a line of credit. Everybody needs some cash.

If you know you will need money from your line of credit soon (an imminently approaching house remodel), you should consider drawing down the money NOW.

Finally, if you are in a fighting mood, you probably can challenge some of these credit line reductions. If you successfully do so, drop us a line (info@alexis-palmer.com) - this applies even to people who are not our clients. We will raise a fuss if we see a pattern of banks systematically stepping over the line.

So what did our client do? They are busy so they just closed the line completely. Citibank then had the gall to try and charge them a fee for doing so!

As always, everyone’s situation differs and you should do your own homework or consult your own advisor.

Things I learned:

1) These decisions have a huge impact over how much money people and their heirs end up with and are important to think about.

2) The calculations required to make these decisions are really hard, even for the country’s top financial professionals, and not always intuitive.

3) There were people of all political persuasions in the room and EVERYONE thinks tax rates are going up, way up. As someone said, if taxes were a stock, they would be rated a long term “buy”.

4) The Roth IRA / 401(k) can be great for people of even very high incomes.

5) Congress will allow unlimited conversions to Roth IRAs from regular IRAs in 2010. Currently, you can only do this if you earn less than $100,000. This is a fabulous opportunity for our clients but will be very costly for our nation’s finances without any obvious public benefit.

When you convert to a Roth, you have to pay the taxes on all the income that was sheltered in an IRA, but you and even your grandchildren who inherit that money never pay tax again on any investment or dividend income. You pay $1 today to avoid $2-$30 of tax in the future.

Even though Congress gives up a huge amount of revenues in the future, it still loves this idea because all its budget calculations are done on a 10 year basis. They get all of the benefit from people writing checks to the IRS today without having to account for the taxes people will avoid paying 10-100 years from now. When they passed the provision, they were able to count it as a revenue raising measure.

According to this New York Times article, this one little obscure tax law could cost over $50 billion when all is said and done. I guess we can just add unlimited Roth conversions as reason #932 that tax rates will be headed north.

Anyway, if you are our client, and you got a notice from the HR department about a new Roth 401(k) option and shoved it into a desk drawer, pull it out and give us a call.

If you happen to be a member of Congress, you need to consider revisiting the Roth conversion idea.

As always, everyone’s financial situation differs and you need to consult your own advisor.

If you search for “financial advisor Palo Alto”, you won’t find us unless you use Yahoo search, in which case we are the top  search result.

We have taken some more steps to help people who are trying to find us like implementing an Adwords campaign where we pay to advertise our own name as well as a few more generic terms like DFA advisor, investment advisor, and financial planner Palo Alto. This is helping a little bit but the whole thing is very frustrating.

This whole experience has led to some interesting conversations. People fall into two camps - “Google is evil” and “You can’t complain about a free service being taken away.”  I am personally in the middle. There is a highly symbiotic relationship between Google, the content providers (i.e. us) and readers. We all contribute something and we all get something. Creating content and webhosting are not free. High speed internet access is not free. Running a giant search engine is not free. It is in all our interest to keep the web spam free and to help legitimate businesses reach customers and vice versa on a consistent basis.

Elizabeth Alexis/ Jessica Palmer

Disclaimer: We are not single stock pickers, we generally do not use single stocks in our client portfolios and we use only very public information as the basis of any analysis. We are not offering buy or sell recommendations and you should not interpret any article as such. We are generally commenting on some metric of a company’s business. Stock prices and company fundamentals sometimes go in tandem, sometimes not. For example, a stock price often already reflects expectations of changes in fundamentals.

So why do we bother with single company commentary?

• Dissecting the individual players within the economy offers insights into broader trends.
• Many of our clients have significant concentrated stock holdings that necessitate analysis and sometimes what we learn is worth sharing.
• It also is fun, if you like making financial diagnoses from incomplete financial information like a company’s 10-Q filings. Kinda like House, but a company’s health instead of a real person’s.

The first suspicious thing happened a couple of weeks ago when we reviewed the list of search terms people had used to find our website and one phrase turned up that we knew did not appear on our site. I will not repeat it but let’s just say it is not appropriate in family or professional settings.

I chalked it up as a “mistake” on Google’s part.

Then the number of visitors finding us through web searches dwindled and I started to get worried.

It turns out that there is a nefarious “black hat” spammer who has found a way to sneak in a file that looks like harmless (but is encoded) and puts links to all sorts of adult sites in the footer of certain web pages, invisible to the naked eye but glaringly obvious to the search engines. This boosts the ratings of those sites in the search engines because they have more links.

Unfortunately, it totally destroys the ratings of the host website (i.e. us). There are people who purposely hide certain words in their website that are unrelated to their actual business in order to get more traffic and Google does not take kindly to attempts to trick its search engine. Google stopped checking our site on January 30 and has dropped all but a couple of pages from its search results (our disclaimer and one particular article). At this point, a search for our names won’t get you to the site.

We’ve cleaned up everything on our end and upgraded the software we use to run the site to the latest version. We have begged for mercy from the great Google gods in the sky requested reconsideration.

Now we are just waiting, waiting, waiting for Google to give us the green light again.

We are not primarily a web-based business but it is still disruptive. Many potential clients (even existing clients) find it easier to just search on our name than to remember our exact web address.

Lessons learned?

1) Google does not make mistakes.

2) Monitor, monitor, monitor.

3) Stay on top of upgrades.

4) Live by the sword, die by the sword. We are all increasingly dependent on the web which can give as well as take. I would not be surprised to see some attempt to regulate Google and its ability to blacklist - just wait until some Congressman’s side business gets kicked out. Personally, I withhold judgment until I see how long it takes us to get back in.

This whole thing feels a lot like having your identity stolen and your credit rating hammered. Think of Google as one of the credit agencies, the black hat spammers as the identity thieves and us as the mostly innocent victims who might or might not have been okay if we had taken additional precautions.

There would appear to be a great business opportunity monitoring search results to see if websites have been hacked. I will note that Google, unlike the credit agencies, does not appear to be trying to capitalize on weaknesses in its own procedures by offering such services themselves.