Too Good to be True

Sherlock Holmes and Lt. Colombo both teach us to look to the small things if we wish to understand. It is not the broad generalizations but the small details that contain the clues to unlocking complex riddles in life.
The New York Times’ financial section on 12 February 2008 carried an article on the spreading ‘subprime crisis’. The article mentioned two specific personal cases, Don Doyle in Northern California and Brenda Harris in North Las Vegas. Both these areas have been hard hit by the subprime crisis. Here is what the NYT tells us about Don Doyle.

“An example of the spreading credit crisis is seen in Don Doyle, a computer engineer at Lockheed Martin who makes a six-figure income and had a stellar credit score in 2004, when he refinanced his home in Northern California to take cash out to pay for his daughter’s college tuition.
“Mr. Doyle, 52, is now worried that he will have to file for bankruptcy, because he cannot afford to make the higher variable payments on his mortgage, and he cannot sell his home for more than his $740,000 mortgage.
“The whole plan was to get out” before his rate reset, he said. “Now I am caught. I can’t sell my house. I’m having a hard time refinancing. I’ve avoided bankruptcy for months trying to pull this out of my savings. ...
“In refinancing their home in 2004, Mr. Doyle and his wife were doing what millions of other homeowners did in the last decade — tapping into the rising value of their homes for home improvements, paying off credit card debt, college tuition and for other spending.
“The Doyles took advantage of the housing boom by refinancing their home nearly every year since they bought it in 1995 for $275,000. Until their most recent loan they never had a problem making their payments. They invested much of the money in shares of companies that subsequently went bankrupt.
“Still, Mr. Doyle does not regret refinancing in 2004. “My goal was clear: I wanted to help my daughter go through college,” he said. “It wasn’t like it was for us.”

Brenda Harris is featured slightly less in the article but has her picture in front of the house she bought in 2006 plus a video link. From the photo, Brenda is Afro-American. Here is what the article tells us about her.

“Home prices in the North Las Vegas neighborhood of Brenda Harris, a technology analyst at a casino company, have fallen 20 percent to 30 percent. The builder who sold her a new three-bedroom home on Pink Flamingos Place for about $392,000 in 2006 is now listing similar properties for $314,000. A larger house a block down from Ms. Harris was recently listed online for $310,000.
“But Ms. Harris does not want to leave her home. She estimates that she has spent close to $40,000 on her property, about half for a down payment and much of the rest on a deck and landscaping.
“’I’m not behind in my payments, but I’m trying to prevent getting behind,’ Ms. Harris said. ‘I don’t want to ruin my credit.’
“In addition to the declining value of her home, Ms. Harris, 53, will soon be hit with a sharply higher house payment. She has an option adjustable-rate mortgage, a loan that allows borrowers to pay less than the interest and principal due every month. The unpaid interest gets added to the principal balance. She is making the minimum monthly payments due on her loan, about $2,400.
“But she knows she will not be able to pay the $3,400 needed to cover her interest and principal, which she will be required to pay once her loan balance reaches 115 percent of her starting balance. And under the terms of her loan, which was made by Countrywide Financial, she would have to pay a prepayment penalty of about $40,000 if she chose to refinance or sell her home before May 2009.
“She said that she now wishes she had taken a traditional fixed-rate loan when she bought the home. At the time, she asked for a loan that could be refinanced after one year without penalty. She said her broker had told her a week before the closing that the penalty would extend until May 2009 and that she reluctantly agreed because she had already started moving.”

At first glance, Don and Brenda seem to have much in common. They are about the same age, early fifties and therefore thinking probably about retirement. Each seems to have a pretty good job; and each got caught in a financial trap with a mortgage now higher than the current market value of the house which guarantees it, meaning they are in negative equity, with the mortgage payments increasing. They seem pretty representative of the thousands of others caught in similar situations.
But their stories also have significant differences when we look at the details. One obvious but unstated and never mentioned difference is that Brenda is both black and female – two strikes before she even gets to the plate.
There is also a major difference in these two different investments, even though each is its owners’ home. Mr. and Mrs. Doyle are speculating repeatedly on the rising value of their house in order to finance ‘investments’ in high-risk stocks. In short, they’re gambling. They have “refinanced nearly every year since they bought their house in 1995 for $275,000.” That means on the order of ten re-financings! They said they did it to finance their daughter’s college education. But what did they actually do with the money? They “invested ... in shares of companies that subsequently went bankrupt.”
There is a saying: “If it sounds too good to be true, it probably is.” Did the Doyle’s really believe their house’s value would increase by about 300% within a decade? (Nine years, actually. Less than a decade!) That’s simply too good to be true. They borrowed against their home about double what they originally paid for it; and within nine years had jacked up their debt to three times the initial price of the house. There’s another saying: “Never bet the ranch.” This is just what they did.
Had they taken these re-financings, paid off the original mortgage, and put the rest into even very conservative investments, they would now own their house free and clear and have well over half a million dollars of assets, providing quite nicely for their daughter to go to college as well as their own retirement.
While no doubt they did genuinely and sincerely want to send her to a ‘good’ college, and while no doubt they told themselves (and others) this was their objective, it doesn’t explain their conduct. This is what J. A. Schumpeter calls “the teleological error’, thinking we understand the causes of some human action by focusing on the actor’s purpose(s).
Let’s be honest. The Doyles were leveraging their home to gamble, with the game of choice being the stock market. And gambling is as addictive as tobacco or liquor or marijuana or cocaine, and potentially as destructive. Playing the stock market the way the Doyles were playing it is not about investing. It’s about the visceral thrill of seeing your stock jump in trading value; it’s about being part of an ‘inner circle’ of savvy players; it’s about having talking points at cocktail parties and Little League games; it’s about looking in the mirror and thinking “Yeah, I’m cool, too!” But it is not about building up a nest egg for one’s retirement. Someone planning and preparing seriously for the future doesn’t repeatedly mortgage their home to the hilt in order to put the money into speculative stocks.
That strategy doesn’t work. For every buyer, there must be a seller. For every winner, there have to be losers sufficient to generate the winnings. Actually, there have to be more losses than winnings because the house also gets its cut. It is not mathematically possible to everyone, or even most players, to win the lottery
Let’s not put all the heat on Don Doyle. He couldn’t have done this on his own. There were clearly bankers and financial advisers and stockbrokers involved, although the article doesn’t mention them. These were the ‘professionals’ who should have been able to see that Don’s game couldn’t go on. But they were likely getting fees based on each trip round the musical chairs. So why be the party pooper?
Brenda Harris’ case is quite different. Brenda only bought her house in 2006. With her good employment status, it is not clear why she got into such a convoluted mortgage instead of a more straightforward “Fanny Mae” mortgage. But then, after we see her picture and then learn about her getting hustled into double the penalty period she was expecting, we learn that the mortgage company was ... you guessed it ... Countrywide Financial!
Now the pieces fall into place. Given her gender and race and finance provider, there was no way Brenda Harris was going to get a Fanny Mae prime mortgage. Brenda wasn’t playing the market; she got played by it!
Both Don Doyle and Brenda Harris were, to some extent, victims of their own desires. Don wanted a quick and painless ride into wealth. Brenda wanted a crack at the American Dream. Each of them got his or her window of opportunity, went for it, and took the plunge. But as they dove, each made the same error; they put to sleep their natural sense of caution and critical judgment. Each slipped into the logic of hearing what they wanted to hear, of seeing what they wanted to see, of believing what made them feel good to believe. Verifying facts, seeking independent qualified technical advice, demanding full disclosures: these basic rules of prudence got buried under the hubris.
Both Don and Brenda will now have a devil of a time getting out of their fix. My sympathies go to them both, although rather more to Brenda than to Don.
I wish I could offer more, and be hopeful. But if I look honestly around, I don’t think I can. Today’s Financial Times carried an article about the US government’s Pension Benefits Guaranty Corporation – a sort of FDIC program for private company pensions – quietly deciding to shift its portfolio mix by doubling its “riskier assets such as equities” and “alternative investment vehicles including hedge funds”. Then, down inside the article, towards the end, came the explanation. “Last year the equity portion of the corporation’s investments returned 16.5 per cent while the fixed-income portion returned just 3.4 per cent.”
That sounds exactly like Don Doyle’s strategy, only writ larger, much larger. 44 million workers have their pensions relying upon that safety net. Yet an average annual return of 16.5% is simply not sustainable. You can get it on paper and on a small scale from time to time. But not in hard cash on a regular basis over several decades and for 44 million pensioners! That’s just too good to be true!
We should learn from Sherlock Holmes and Lt. Colombo! When we look honestly at the details, it is clear we can’t go on like this. The way our economy currently works is not sustainable.