Personal Finance - Risk Management And Securing Assets

BA 96 Personal Finance – Module 2 Risk Management and Securing Assets 3/2/09 The crisis Risk vs. uncertainty • Risk: probabilities can be assigned with confidence • Uncertainty: no precise probabilities, flimsy foundation, sudden changes Income insecurity: rise of uncertainty in American middle class (online) • GDP grew but all the money went to the top 20% Job insecurity Health insecurity • 25% (?) of GDP is spent on healthcare • Rise of technology  people kept alive longer, more healthcare expenses Retirement insecurity • No more pensions, now 401(k)… and everyone’s are dropping, crap. (paper is on bspace) – Compare this to another asset bubble, explain to another business person – Will have bubble-analysis system ○ Investor excitement ○ Financial boom ○ Market euphoria ○ Profit taking ○ Panic – See JK Galbraith’s Great Depression – 1879 was bigger than great depression – silver, railroads, etc – First one ever: dutch tulips – Japanese land boom ($1million/sq m!) ○ Economy never returned because: banks cant mark assets to true value without going out of business (insolvent), so assets weren’t marked down for 10 yrs  couldn’t loan money ○ No recession, but flatlined for 17 yrs ○ Export-driven economy + feudal economy  All little stores and big car exports  Couldn’t compete against Asian tigers Minsky’s stages • Hedge  speculative  Ponzi ○ People start borrowing because of easy liquidity ○ Easy investments, good profits, so more people borrow to invest… ○ “all capitalist economies get less stable as they go along” (profit  instability) Savings and loan crisis (1980s-90s) • Banking and real estate, surprising • 90% of 585 bank failures were in OK and TX (but biggest was in CA) • $800billion, nationalized banks, liquidated shareholders, sold back into a healthy economy later

○ Only cost $200billion once banks sold back • (why housing prices? Why?) • People say don’t invest in real estate – wtf, who says that… When the dot-com bubble blew, stock speculators were hurt Citibank and BofA are insolvent right now – assets aren’t covering liabilities • Shit. • Victim one: i-banks ○ Industry is defunct (Lehman, Merrill, Morgan, Goldman, gone) ○ People are even willing to buy American treasury bills! Even with no rate of return! Wow, that’s bad. CDS (credit default swap) growth – not insured Balance sheets get weaker and weaker, no insurance, no loans, economy doesn’t grow If you look at unemployment as unemployed + partially employed + given up, we’re at ~14% (GD hit a high of 25% with just the normal calculation of UE) US vehicle sales are in freefall, including foreign-made cars • Honda was doing the best and they just fired their CEO  • GM loses $30billion (AIG lost $60billion today) ○ Insolvent • Auto-worker unemployment + supply chains + everyone else related to the industry… ○ Kept alive as a job program, not for the value of cars. Shit again. Retail sales are worse Restaurant sales down too • Whole hospitality industry, actually Bad analysis • GSEs (Fannie and Freddie and collateralized debt obligations) ○ They didn’t touch the really toxic stuff, tho ○ Goldman, others followed their lead and squeezed them out • Reaganomics – borrowing now, stealing from the future ○ Over-stimulates the current economy • Dot-com bubble led to people thinking housing was a safe investment… oops • 80% of mortgages done by not-banks! Interest-only loans negatively amortize • People began to extract home equity up to the point where they couldn’t take out any more • Couldn’t make mortgage payments • 90% of money borrowed since 2000 is mortgages ○ The kind of mortgage matters  10 vs 30 yrs, different interest rates, etc

Buying Cars (see textbook) • What kind to buy? ○ Logical: warranty, mileage, service ○ Illogical: looks, sexy factor ○ “buy a shitwagon”  Do not buy a new car or a late model because they depreciate SO fast  Cars don’t build equity  Diminishing returns: don’t buy too shitty a wagon  Toyotas and Hondas last forever, if you get the decent ones • Mercedes sucks massively now • Save your money for a home; cars are a waste of money • Check out service costs, replacement costs, gas, taxes, insurance… • Negotiating price ○ Don’t start with sticker price, but buy the consumer report for your location and desired car and they’ll give you dealer invoice price – you start there  For American cars, do NOT pay >$500 over dealer invoice  For Priuses and stuff, it can be more  If they don’t cooperate, leave.  “always screw them one more time” ○ Never involve the used car ○ See “suckers” (movie) ○ Better to buy at end of month, end of quarter, end of model year ○ Stevens creek Toyota, walnut creek Toyota – best deals EVER ○ “the internet makes a buyer’s market” • If you’re thinking to lease, read terms carefully 3/9/09 guest lecture • First lecture all about financial crisis; if you follow the news, things are still going down. $2 trillion in sunk assets, likely stimulus package is not enough. ○ We’re already at 10% unemployment ○ We’re losing 600,000 jobs a month ○ Starting to call this “the Great Recession” • Now we’re talking about buying a house! Guest speaker: Ed Some statistics/introduction: • 9 out of 10 millionaires were created by real estate investments • Biggest investment in your lifetime is your house; makes a big difference in your future wealth • FDR in 1933 – greatest fear we have is fear itself. And today we’re starting to see ripple effect. • Reasons Ed believes this is one of the best times to invest in real estate: ○ Interest rates are lowest ever ○ But we haven’t bottomed out

What is one person’s loss is another person’s gain. We’re starting to see property values that are unheard of. ○ SF is called the 7 x 7 city because that’s how many miles – it’s the biggest little city, b/c from Bay to Breakers it’s completely different. ○ Right now we’re in a buyer’s market. ○ Historically low rates and historically low prices. ○ In San Francisco:  Times were ridiculous recently  Tiny 1 Bd, for $3500 per month, AND needed to have pet resumes!  When the tech bubble burst, prices stayed the same  Right now what we’re seeing is a correction. Misconception that banks are not lending ○ First time home buyers are now jumping in ○ Especially with new tax credit; if you’re under 417k on a loan, you’re looking at a 4% interest rate, and an 18k tax credit ○ Greed caused the crisis: even a dead person could get a loan; if the numbers don’t pencil out, even if the institution says they do, you need to think logically, not emotionally. ○ We were at a negative saving rate, greed replaced respect for these types of transactions 6 out of 10 (probably conservative) wish they knew more about the legal aspects of their mortgage. Probably 10 out of 10 don’t even know what type of mortgage they have or what the details are. Ex: do you have a prepayment penalty?, etc. How old was Warren Buffett when he bought his first piece of property? 12 years old, with money from his paper route. Speculated short term and it tanked our property values – ripple effect. REOs ○ Real estate owned = bank owned properties; banks are flooded with properties right now, especially from foreclosures ○ How do you get REOs – easy, just talk to your banks and get the list of REOs ○ Investors buy these REOs ○ It costs the lender between 40-70k to kick somebody out of a home, with legal fees, etc. that doesn’t even include what the property is worth and what the person owed them.  Ex: house now in Richmond went from $450k to $120k. ○ So investors are coming in and buying at $120k, but what do appraisers use to find value on a property? They use “Comps” – if the last property sold for 120k and that’s the comp, how much is the neighborhood worth, $120k. People who owned homes, if they want to refinance, they just got killed.  They just became a victim of that sale because they can’t refinance if they owe 220k.  So who wins? Investors. ○

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It’s good that the rates are so low – this is what will help us. It’s at 4%. ○ In 1991, what was the highest the 30-year fixed loan got to? 21% 43% of American households spend more than they make. 52% live paycheck to paycheck. 52% of employees get all their financial information at work. You wonder how much 42% don’t have enough in liquid assets for three months 46% don’t even have 5000 in liquid assets including IRAs ○

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How a bank looks at you: ACID • A = assets ○ Liquid – checking, savings, CD, Money Markets ○ Illiquid – bonds, retirement accounts (b/c withdraw only at certain age, otherwise there are penalties) ○ You want to see 3-6 months, with 100% of your liquid assets and 65% for illiquid accounts (b/c they know your illiquid assets are not as much once you liquidate it) • C = credit ○ FICO, it follows you the rest of your life, like an SAT score for life ○ FICO is Fair Issac Company; came from Bill Fair/Earl Issac, engineer/mathematician – created an algorithm, used to have 250 variables and would spit out three digit score telling financial institutions their level of risk; has 10k to 20k combinations; as score goes down, inverse relationship, payments and interest rates go up ○ All the three credit bureaus – over 75% of credit reports have errors in them, thus check it every 6 months, all three are based in low paying states. 1 billion pieces of credit information, most processed by hand. Stays for 7-10 years. ○ Technically FICO can be 300 – 950, both are statistically impossible. Anything over 720 is stellar. What is that line though? 620 is that line. Below it, they won’t really talk to you. Today, it’s going to be 680 because banks have become more conservative.  There are mortgage programs that allow you to borrow at 580+, yes you’ll qualify, but your rates will be very high.  You should check it once every 3 months, because of identity theft  35% = payment history, if you get reported. 30 days after the due date is when it’s reportable.  30% = amount of debt. Need to show correct balances. Never charge more than 30% of total per card (because it’s based on credit to total, not 50 percent, 30 percent. At 70 percent it starts to tank; one card can kill your score)  15% = length of history. (to have a score need at least 6 months of history, otherwise get an N/A) If you close a card after 2 years it will lower your score. 2 years is mature credit, so if you chop off, takes those points away. Everything is per card.  10% = Type of debt. Installment debt and revolving debt. Car, student, same payment every month.

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Revolving you have ceiling and bottom, minimum, all, or somewhere in between. Shows credit management, so more important  10% = New credit. • Self view does not lower. Junk mail or bulk mail, they got it from pulling your credit, NO. Because you're not seeking debt, they're seeking you. If you're really preapproved, why don't they include the card? • Soft vs hard inquiry. Hard inquiry - once you sign the prepayment thingy - 5-22pts. Then they come back and say you're not. Don't get bait and switched into this. You should have 4 accounts total AND bank cards only. 2 to start out, 4 is ideal - visa, mastercard. • Why bank cards only? Because utility (can't use it anywhere else), because of an 8 percent spread higher, your cost of funds is too large. Never should say full account number EOM 30 days. Your credit report is a snapshot! Must be prepared when they snap the shot. Look good 45 days prior to applying. 30 days plus a cushion. Errors corrected, balances correct. DLA is date of last activity. You get 3 credit scores, this is all voluntary! EQ, XPN, TU  All different because they all have diff error rates  For privilege of reporting, pay money .25 per client per bureau Does checking your credit hurt your scores - NO.  Why is won't affect? Because you're not seeking debt! Every time seeking debt, lowers 5-22 points when others do pull, but good is that it goes back in 90 days. Who pulled your credit and the date - so get points back 90 days later.  But there are two exceptions to rule of credit checking hurting scores: house and car are biggest expenditures, so you're allowed to shop- there's a grace period for auto loans and mortgages, a deduping period, against duplication, so within 30-day period only dings you once for car or mortgage pulls, if do both car and house 10-44.  If you're buying house, why are you shopping for a car too? Thinking point. Income is not taken into consideration. It is not on the credit report, which does not necessarily make sense. Credit cards are modern version of drugs, “plastic crack.” It is designed to be that way. Creditors run this show; reporting to credit companies is voluntary; they want it to be lower, so that they can get a higher rate. Average rate on credit card is 16.8%. Average on charge card is 24.8%

If your score is 750 or above, and you have some cards you don’t use, close them two at a time, pull the report and check what it does. ○ FICO’s formula is in a vault in San Rafael in Marin. ○ If you’ve had a card for more than two years, don’t close it. ○ Third rule: Put activity on a card every 6 months, if it goes inactive or idle, your FICO goes down. ○ Never assume an account is closed, the credit report needs to specifically state that it is closed. ○ How does it work with kids? Co-borrower or authorized user? You would get credit on fico as of 2007 as authorized. Ppl starting to build credit off of others credit, so now have to be co-borrower. ○ Does a stolen credit card mean it's closed? Make sure they show it's lost or stolen. ○ On the bottom of credit report there are Notes  If says closed by credit grantor or creditor, that is very very bad; means that they don’t want you. Versus closed by consumer. ○ Months reviewed. Shows number of times they've reviewed you. Sometimes it is every month, sometimes every other year. ○ Could theoretically close out your fico when it is high by not using credit, and basically freeze the fico and only ever use it again for when you want to get a mortgage, you start using the cards again. I = Income D = Debts ○ They do a ratio, a DTI = debt to income. No more than 45% ratio. PITI= principal, income, taxes, insurance, meaning that .45 of every dollar max to debt service. ○ FHA- they will let you put 3% down, but need 43% DTI  FHA is a really good deal. If going to borrow more than 80% of the value, need principal mortgage insurance (PMI)  Monitor for PMI, because YOU need to call THEM and say “I'm requesting MI removed.”  Now PMI is tax deductible, but used not to be. ○ Property taxes are deductible on a home as are mortgage payments. ○ Let's say 300k loan both at 5% at 30 yrs, pmts 1610. If IO, payment is 1250. One size does not fit all, depending on time, etc.  Right now makes sense to do 30 year because rate is so cheap!  For some people, taking the IO makes sense and then invest the difference of $360/mnth.  Few places with passive income stream, includes real estate. ○ How long will the federal and state 18k last? Til November 2009, and February 2010. But likely they will be renewed. ○

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What is the difference between a tax cut vs. tax credit for the 18k? Ed can find out.

Some final advice from Ed: • Don't ever make assumptions. • Partner with people you know and trust and buy together • Everyone needs to be the president of your own home. Key to wealth is having people around you who care. ○ Have: a great tax person, great financial advisor, real estate expert (get these people to call you!!), good mortgage person, an estate planning attorney (will, trust, etc.) You're going to grow with them ○ Meet with them regularly. Whenever tax laws change, you want to know: does it affect me, and what do I do about it. • If you need to put down 20%, if a source gives you down payment money, get a gift letter that is signed, a deposit slip, withdrawal slip from the person's account. It's called sourcing. ○ If it's bigger than 11k per person per year, then subject to gift tax • There's a lifecycle with what you should buy. Start out humble. If use 43%, don't leverage yourself more than 40%. Once you have enough equity, upsize. Capital gains exception law- up to 250k for single, 500k for married, tax exemption. Lived in them for past 25 years. Start modestly, get assistance if need be. • There are no stocks in maslow's hierarchy- but there is shelter, security, and sense of accomplishment. Shelter is real estate, it is a basic need. • For real estate, the tax writeoff and appreciation/depreciation is the icing. 3/16/09 insurance: property, auto, health Risk • Speculative: you can win or lose ○ Insurance: they are the gamblers; they will never make you better off than before but just restore you • Management ○ ID exposures  Probability • Heuristics • Bias (saliency, confusion, etc) • Result (but then you get over/underestimates)  Quantitative analysis ○ Evaluate potential losses ○ Choose tight control  Prevent  Mitigate  Transfer  Deal Insurance • Risk pooling

Law of large numbers  Big pools of identical risk, confidence in loss estimates increases with size  Depends on pool of buyers and no adverse selection ○ Hammurabi’s code spread risk btwn shippers and owners • Origins ○ Ben Franklin 1752  In Philly, 72 people and no losses in first year, 7yr policy, full reimbursement  Mutual company ○ Lloyd’s coffee shop  Insured slave trade ○ Insurance companies – insurance moneys up to GDP of planet, most regulated industry  Lloyd’s  Stock • Corps owned by stockholders • AIG, ACE, Chubb  Mutual companies • Corps owned by policy holders • Liberty mutual, state farm  Reciprocal companies • Associations where subscribers ensure each other • Large law firms  Risk retention groups • Companies formed to insure same industry • Captives • What is insurance? ○ People transferring their individual risk to an insurer ○ Regulated by state, owned by federal govt (re-insurance)  Some aren’t backed by fed, those are higher risk of course Homeowners’ insurance • Insured for an amount, no longer insured for former status of home • It takes 40-50% over policy value to rebuild home • Property and medical portions • Have to be sued for this to happen except for small amounts • Rental policy ○ Only get if you have a lot of valuable stuff ○ If apartment burns down, your stuff is replaced, and you get loss of use ○ 1890s NY policy = current CA policy Auto insurance • $5000 available before suing is necessary for this to work • Collision and general liability insurance • Get comprehensive insurance – covers everything possible • Read everything before signing General liability • When someone is visiting ○

• You have to be sued for this to kick in • Bodily injury and property damage • Switch to professional liability if there’s a contract involved • Property policy: covers your stuff Workers’ compensation • Unlimited insurance if an injury happens at work – but you can’t sue • Firefighters and policemen game the system right before retirement HC Indemnity • Restoring prior financial condition • No profit/gain allowed Subrogation • Insurer pays your claim then seeks money from others (those that injured you) • Waiver of subrogation used in workers’ comp Insurable interest • Can only take out insurance on something you have an interest in (able to sustain a financial loss) • Contingent or expectant interest is not insurance • CA says interest must be there at inception of policy Ideal insurable risks • Definable and measurable • Accidental • Must produce economic hardship and reasonable insurance cost • Not inherently catastrophic ○ Natural disasters -- are adverse selection Peril vs. hazard • Peril causes loss • Hazard increases likelihood or severity of peril ○ Physical ○ Morale – carelessness or indifference to loss, no alarms ○ Moral – insured dishonesty (like arson) ○ Legal Why insurance benefits society • Pays losses to those damaged • Requires loss control measures • Makes credit available • Peace of mind from risky activities Insurance is a contract • Contract law ○ Agreement, competent parties, valuable consideration, legal purpose ○ Adhesion (accept/deny) (if any ambiguity, favor plaintiffs) ○ Conditional (certain requirements) ○ Aleatory (obligations depend on conditions, payments btwn parties inequal) ○ Unilateral (insurers promise to pay) ○ Personal (not for property)

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Utmost faith (rely on each other to uphold contract; if someone lies then contract is void) Indemnity (restores to position of no loss)

○ Tort law • Obligations imposed by common law • Compensation after injuries from negligence or wrongful acts CA code • Domicile (domestic, foreign=another state, alien=another country) • Admitted or not Consulting – 4 D model 3/30/09 Third class slides

Problem: rapids, rocks, sinkholes – Healthcare costs grow faster than inflation and CPI – Employers therefore offer less and less coverage – Weakening retention and hurting recruiting – Higher costs for everyone – Exacerbates affordability and inequality – Produces debt, financial hardship Who doesn’t have healthcare? – 47 million people – Young people like me – 9 million children Costs are increasing – Nat’l health expenditure rose 6.9% in 2005 (2x inflation) ○ $2trillion = $6700/person – 2006: $2.16trillion = $7110/person ○ 16% of GDP (in Europe, only 9-11%) No end in sight – In 2015: will be $4trillion = $12,320/person (57% increase) ○ 20% of GDP, 2.3% faster than GDP ○ Because of baby boomers and rising healthcare technology costs – “you think we’d cover children, but we’re grossly irrational in many respects” – The better technology gets, the longer people are kept alive, then the more they spend in their old age/final years of life  higher costs – No cancer cures or longer lifespans out of all that tech Costs cut earnings in CA – In 2006: employer insurance premiums rose 7.7% = 2x inflation ○ Annual was >$4200, or $11,500 for a family of 4 – No increase in wages since 1973 ○ Premiums going up 4x wages – Growing dissatisfaction, of course Little cause for hope – Market is less competitive ○ Fewer insurers – Public solutions are weak ○ Containing costs in the past has been ineffective ○ Future policy proposals fail to address root causes – In Massachusetts, everyone is required to have health insurance

○ State helps if you can’t play ○ Arnie tried in CA but failed – Key: can’t turn people away because their premiums are too expensive to pay ○ Old or unhealthy, high risk, everyone has to be taken on – No healthcare reform has ever worked ○ FDR tried and couldn’t get it through (but we have social security)  Truman, Nixon, Clinton, Bush – all failed ○ Bismarck in 1880 established universal healthcare, like most welfare states Economic incentives don’t work with healthcare – Nobody wants the cheapest surgeon – People will spend everything they have to save loved ones – Politically, not economically allocated resources ○ Like feudalism ○ Sports franchise works that way too; they’re allowed to collude and price-fix – Part of high healthcare costs is due to litigation (charging more to cover malpractice) ○ Part is also immigration – but they pay taxes  They are more expensive to education than they are to healthcare Other countries – In the EU, you can’t be fired – if you are, the state get 3yrs of salary (tax) ○ Taxed when employees are hired too – Other countries in the G-20 don’t need to pump money in because they don’t work on the US boom/bust cycle ○ Even tho Germany is an export economy, they have more efficient methods – Safety nets – nobody is homeless or without health because they’ve paid heavy taxes to make sure everyone can stay at that baseline thru bad times ○ Don’t go down OR up that far – Watch out where you go because even if your salary is different, cost of living and tax rates are different Long-term care – What happens if you become infirm? People don’t take care of their parents anymore ○ It’s cheap… for now (if you’re under 50) Life insurance – #1 cause of death is either HIV or car accidents – Students don’t really need life insurance because nobody depends on them ○ Need it if you’ve got dependents; spouse or kids ○ Need it if anyone else is responsible for your debts (loans) – Need to disclose all the dangerous shit you do or they won’t honor the claim (remember utmost faith?) – Look at claim cover and small print (definitions and exclusions) ○ Choose carefully – how much would it cost to replace yourself? – Option 1: Pay for it monthly (employers help; the pool is cheaper) ○ Value is 2x salary usually ○ If you skip a payment, it vanishes

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Option 2: Better system: whole–life (not thru employer) ○ It’s an investment – expensive, get dividends on it ○ Is that the right vehicle for investment?  NO –until recently… now returns are better than the stock market ○ Doesn’t go up that much…or down  Pay for security of guaranteed return  The older you get, the more likely you are to need money and the less likely you will be able to get it  more risk-averse – What if your insurance company goes bankrupt? ○ You are toast. ○ (insert AIG bailouts here) ○ State covers other kinds of insurance liabilities up to $1million, but not life – How to buy? ○ Different kinds of agents  Captured agents: hired by a company  Insurance brokers: free agents ○ It is possible to find a buyer-side agent  Agent vs agent, split commission Oral contracts are valid in the US except those that transfer property