The ECB dumps a half trillion dollars on world markets

You better grab your umbrellas, because the European Central Bank (ECB) is making it rain to the tune of 350 billion euros, or just under five hundred billion dollars. Yes, thats a lot of cash. The ECB’s move was meant to restore liquidity to short-term banking markets which have been rocked by problems with the sub-prime mortgage market.

In short, the wall street whiz kids who engineered the back end of the stupid mortgages that were given to people who shouldn’t have qualified over the past few years has caused such turmoil in the financial markets, that the world’s largest investment banks have pulled back short-term lending in recent months becase 1) they don’t want to lend money out to struggling mortgage-related special purpose entities looking for short-term cash to stay afloat, and 2) they don’t know how much cash they will need on hand to shore up their own balance sheets as they sort out their mortgage-related losses.

So – is this a surprise? It was a little bigger than expect, but more importantly, it shows the world central banking system’s proclivity (government-backed central banks that regulate capital flow for the world’s largest lenders, who in turn lend to people like us) to flood the market with additional capital (i.e. print money) at a moment’s notice when bankers make mistakes, or market forces play themselves out.

When the world’s central banks continue to open the spigots of cash, worldwide money supply continues to go up, reducing the value of dollars — i.e. causing inflation. Watch out for your wallets!

There are a couple glaring obvious things wrong with CPI:

Food and Energy are excluded – Yes, the core CPI index excludes food and energy prices because they are too “volatile.” Food and energy costs have exploded over the past five years. So even though food and energy costs are the big part of the budget pain in normal American families, those price categories are simply left out of the index.
Income, Investment, and Housing Taxes are Not Included – Taxes are a huge burden on American families – and tax receipts as a percentage of total national income have risen steadily with time. According to the Urban Institute Tax receipts have risen from 9.5% of GDP in 1929 to over 26% in 2002. Since only about 50% of the population actually pays taxes, and since many tax systems in the US are progressive – i.e. your tax burden goes up as your income and consumption trends go up, taxation is a huge and growing component of the overall household cost equation. Its funny that the government decided to leave their own bill out of the equation, huh?
Implied Future Taxation from Government Borrowing – The government is currently spending several hundred billion a year more than it collects in tax reciepts, so sooner or later, we will have to pay for it. So just like spending on a credit card, government borrowing looms over our head as a huge current cost that we just aren’t paying at this point. The same can be said of the trillions of dollars of unfunded future liabilities for Social Security and other entitlement programs that will come due over the next few decades.
The Substitution Effect – The government uses a little accounting trick called “substitution” to calculate the basket of goods that are used to calculate CPI. Thus, if a unique hand-made toy goes up in price, the government will substitute it for a cheap plastic toy shipped in from China by Wal-Mart. Since China has been shipping over cheap manufactured goods over the past ten years, we have seen the “basket of goods” tilt that way. So, we aren’t really judging the cost of the same standard of living, but rather the basket of goods is looking more and more like a Wal-Mart shopping cart.

You know its funny – if you look at CPI numbers – or the Consumer Price Index put out by the government, you would think that inflation has been running at a lowly two to three percent for the bulk of the past decade. In fact, CPI growth has averaged just around 2.6% over the past ten years. The consumer price index is released by the US Bureau of Labor Statistics and it is supposed to measure price changes in a typical “basket of goods” that a US household would purchase. Thus, households, industry leaders, government officials, economists, and finance gurus watch CPI to determine inflation, and people make investment, wage change, and financial decisions based in part on that data. Very important stuff, really.

So – going by CPI – something that was $100 ten years ago would cost $132 today. That doesn’t seem too bad considering that wage growth has significantly outpaced CPI growth (this is somewhat of a self-fulfilling thing since employees demand wage increases starting at inflation), and the stock market and housing prices have appreciated at a much higher average pace than 2.6% per year. But doesn’t seem fishy here? I know for a fact that costs have been going up like crazy – think gas, education, taxes, medical costs, food, hmm… nothing here seems to be staying the same. Seems like all those things have gone up in costs quite a bit more than 2.6% per year. Has anyone tried to go to a pro sports game recently? Anyone?

So – to the point of why housing shouldn’t be considered as part of an investment portfolio, a recent study shows US housing prices plummeting. This is something that all of us know, and the Year-to-Year number (down 7%) isn’t that bad, but it does show that housing values can be volatile, and given that housing is such a large chunk of most people’s expendable incomes, and their inherent illiquid nature, it illustrates the pitfalls of using housing as a cornerstone of a financial strategy. The image is from the Wall Street Journal.

It is always nice to be validated by a major news source, but the themes of our recent article Why You Should NOT Look At Your House As An Investment were retold in a story on the front page of the WSJ Personal Journal section. In Why Your Home Is Not the Investment You Think It Is WSJ writer David Crook goes through the reasons why “houses are not very good investments.”

He did have some interesting bullet points that add some weight to my article. He discusses some fairly heavy downturns in regional housing markets:

• If you bought a house in Los Angeles in 1990, just as the real-estate market turned downward, you would have had to wait a decade for your home’s value to return to what you paid.
• If you bought in Rochester, N.Y., in 1980, you would have seen only a mediocre 4% annual growth for the next 25 years.
• If you bought in Dallas in 1986, as the oil boom went bust, your home wouldn’t have appreciated at all before 1998.

Consider that the next time someone tells you “it will keep going up.” Now, I am not a doomsayer, but I do think that risk should be included in any “investment” decision, especially when it is such a large hunk of one’s overall financial picture.

He also had one other good point that may help some folks get over the shame that goes along with being a lowly renter in our society: “Buying a house with a long-term mortgage is just another form of renting.

Mortgage interest is rent that you pay to your lender for the use of its money rather than to a landlord for the use of his house. Yes, the government picks up a portion of that with the tax deduction, but most of your monthly payment neither builds equity nor is deductible. It just goes down the same black hole that sucks up any other renter’s money. And it takes 20 years before a typical borrower pays more principal each month than interest.”

Exactly right! WSJ – thanks for seeing things our way!

Rooms To Go, America’s largest furniture retailer has been advertising a “no interest until 2011″ offer for buying furniture at their stores. It appears to be a sweet deal, borrow the money for your furniture at no interest, and then you could use that money to pay down high-interest credit cards or achieve a return by investing that money (or you could just spend it).

Unfortunately, there is no such thing as no-interest financing!

Here’s why: When you buy something without paying cash, you are paying for two things. You obviously have to buy the item, but you also pay for the money to finance that purchase. Money is never free, because of the time-value of money. Lets use the Rooms to Go example to illustrate the point:

1. Rooms To Go sells you a set of furniture for $5000 with the “no Interest” until 2011 financing plan, lending you the money to buy the couch.

2. Rooms To Go must either come up with the cash for that loan by borrowing the money or using cash from operations. Typically, companies borrow the money so they can use their cash from operations to invest in their operations (opening new stores, hiring people, advertising, etc). Even if they didn’t borrow the money, there would be a cost to the money, since if they could get a 10% return on investing cash in opening a new store, the opportunity cost of that cash would be 10%.

3. AAA Corporate bonds are trading now at a 5.1% yield. That means, if Rooms To Go had excellent credit, they could borrow for as low as 5.1% interest. However, there are other costs associated with lending money to customers for furniture. Some of those customers – likely as many as 10% of the customers – would default on the loans. There are also costs to administer the loans, billing, collection, etc. All together, the cost of the loan would represent an interest rate (or borrowing cost) of 7-12%. Assuming a 10% interest rate, the results are scary:

A four year “zero interest” loan would cost $1020 in interest, you just pay it up front! This assumes a 10% borrowing cost.

You may say, “hey – that doesn’t matter to me, because Rooms To Go is paying the interest, not me.” Well, that is not entirely true. Rooms To Go is selling you a furniture set for $5000, but they are covering borrowing costs of $1000. How much is the furniture really worth? $4000! You are not getting an interest-free loan. They are just baking the interest costs in up front in the purchase price. To make matters worse, there may be things in the fine print that trigger huge penalties when you miss a payment or pay late, even if it is just a simple mistake.

Low or no-interest offers are not a good reason to finance a depreciating asset. It very rarely makes sense for an individual to finance a depreciating asset like furniture, a car, a TV, etc. Don’t fall into the traps of slick financial packaging. Pay with cash, and buy what you can afford. One other thing – when you buy with cash – make sure to use any financial offers as a bargaining chip. Certainly never pay $5000 for a furniture set with a “no-interest” loan offer, because you are paying up-front interest for a product when you aren’t even borrowing any money.

Sounds crazy, right?

The justifications for buying a big expensive house are many. I am sure you have all heard “it’s a tax writeoff,” “you are only paying yourself,” “you will grow into your payments,” and many more. But, the biggest excuse people use when making stupid decisions with home purchasing is: “its an investment.” Because of a healthy real estate market and cheap financing in recent years, people assume that buying a home is a money-making proposition.

Everyone has an uncle or a friend who bought a house at $200K and sold for $350, and now they have a Lexus and some nice clothes. This does happen, but if you want to look at buying a home as an investment, you must carefully weight the costs and the risks involved. After looking at a home purchase in more detail, I hope you will agree that purchasing a house should NOT be viewed as an investment in your portfolio, but rather a place to call home that you might make a few extra bucks on. Your home should be gravy on top of a well-balanced financial gameplan, not the foundation.

Many real estate agents, mortgage brokers, and even your office buddies may imply that by “investing” in a home, you will be much better off financially. Buying a house is often portrayed as such a Panacea that homeowners are bound to “cash out” someday with tons of money. It is very true that it often makes sense to buy a house, and I would not argue otherwise, but here are five reasons why a house should not be looked at as an investment:

1. High Risk – Most people look at rising home values and clearly see the potential financial return from buying a house, yet not many folks honestly assess the risks of home ownership. Lets compare putting $x per month into a home versus an alternative investment such as stocks or bonds. If you lose your job or run into health problems, and have trouble contributing $x per month to your investment (or mortgage), the situations are vastly different. If you cannot pay your mortgage for a year, you can lose the total value of your investment as well as be kicked out of your house. You could lose your entire capital investment in that situation, whereas with stocks or bonds, one can easily stop contributions for a short period of time or even dip into those funds in the case of a hardship. Also, external risk factors such as neighborhood changes, crime, traffic, taxes, and natural disasters should be considered as well.
2. Non-Diversified – Almost by definition, it is impossible to diversify your investement with owning a house. You own one house in one geographic area and any risks fall directly on your shoulders. The saying for this one is “too many eggs in one basket.”
3. Low Liquidity – It is relatively difficult and costly to buy and sell a home. Sure, a home can be sold quickly, but it always involves substantial work, effort, stress, money, and risk.
4. Emotional Considerations – Investors typically make poor decisions when they are emotionally attached to an investment. We have all heard stories of people who are heavily weighted in their company stock and see their financial fortunes go down with a sinking ship since they are “true believers.” The same can be said for houses. It is not necessarily bad to be emotionally attached to a house, but this is not a good omen from an investing standpoint.
5. We sell and buy again – Perhaps the most significant financial consideration with homebuying is that we pour hundreds of thousands of dollars into a house in order to get a future payout. However, when that payday finally comes, its not like that gives us a nest egg for retirement… you have to BUY ANOTHER HOUSE. And unfortunately, the prices of those houses have appreciated as well, so most of the appreciation you get in a house will be dumped back into the purchase of another home. Again – not a bad thing, but certainly not a way to get rich.

Lets look at the numbers. How rich are we going to get? Lets take a $200,000 home purchase with a $20,000 down payment, a 6.5% interest rate and a 30-year mortgage. Lets also assume that the housing market in your area is appreciating at a healthy 10% per year and the home is sold after 10 years. After closing costs, property taxes, homeowner’s association dues, homeowner’s insurance, and maintenance expenses, one can expect to pay over $265,000 over the first 10 years of owning the home after subtracting out the interest-rate deduction. After ten years, your house has appreciated nicely and is worth $519,000! Alright!!

However, you still owe $152,000 on the loan and after paying real estate commissions and expenses to get your home ready for purchase, you clear $325,000 on the transaction. Alright!! Yea!! But wait, you paid in over $265,000 month after month in order to get $325,000 after 10 years, not such a great investment. This equates to approximately a 4% compound rate of return, which is just slightly above what the long-term inflation rate is, and significantly less than one would earn in a diversified securities portfolio. Then you have to turn around and buy another house. You can get rich, but you probably won’t do it with buying a home.

Okay, here is the scary calculator. How long will it take you to pay off your credit card?   Keep in mind that this calculator assumes that you are paying down all of your new spending and putting at least $1/month towards principal.  So when you put in the amount that you will pay towards the card, make sure to subtract out what you would spend towards that month.   For example, if you typically pay $300 per month towards your credit card, but spend $200 on that card in that month – put $100 in the payment field.

We should have a little fun with this.   Post your amount below.   I want to see who is in the most trouble.

Welcome to Calcrat.com.   This is a brand new site, and we hope to help demystify personal finance, taxes, investing, and the like.  Please send us suggestion and comment on the various calculators and tickers to help us improve.  Thanks!