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Where to Put Your Money NOW: How to Make Super-Safe Investments and Secure Your Future Paperback – February 24, 2009
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About the Author
Excerpt. © Reprinted by permission. All rights reserved.
What Went Wrong
Back when Americans listened to music recorded on vinyl and cars had tail fins, buying a house was straightforward -- if not always easy. First you saved for a down payment, then went to a local bank or savings and loan to apply for a mortgage. The bank checked your income and credit records, verified that the down payment was ample to protect its investment in the unlikely event of a foreclosure, and provided the necessary cash from the savings deposits entrusted to it by your neighbors. What you saw was what you got: a mortgage with a fixed monthly payment that would be paid off twenty years down the road.
But big changes were coming -- most of them built around the entry of Wall Street into the home mortgage market. Actually, the seeds of these changes had been planted decades earlier. The Federal National Mortgage Association (later to be dubbed Fannie Mae) had been created during the Depression to increase the availability of home loans for middle-income Americans. One way it did that was to create a "secondary" market for mortgages, based in New York and Washington.
Why, you ask, would investors in some distant city be willing to buy mortgages on houses they had never seen that were owned by people whose names they didn't know? Fannie Mae set broad minimum standards for mortgages based on the assessed value of the house, the size of the down payment, the credit rating of the borrowers -- you get the idea. Then they bought thousands of mortgages that met their credit-quality standard and sold securities that represented claims on the interest and principle for tiny slices of each mortgage in the big pool. That made it possible for an insurance company in Omaha or a pension fund in Dallas to invest with confidence in, say, $10 million in ten thousand mortgages from California. Some of the mortgages might default, but the risk was predictable -- and shared with others who had invested in the same pool.
This secondary market for mortgage-backed securities got a huge boost in 1968 when Fannie Mae was privatized -- that is, sold to private investors -- and it adopted policies designed to increase its profitability. The pace of expansion further accelerated when Congress created a second private "government-sponsored organization," the Federal Home Loan Mortgage Corporation (Freddie Mac), with the goal of giving Fannie Mae some competition.
Banks discovered they could make more money in originating mortgages than by owning them. They began to sell most of their newly minted mortgages to Fannie, Freddie, and other investment firms for a profit, then use the capital they got back to do it all over again.
If "securitization" transformed high-quality mortgages into a standardized investment that could be sold and resold like stocks and bonds, why stop there? Why not create packages of riskier mortgages from loans with lower down payments and less creditworthy owners, then sell the resulting "mortgage-backed securities" to investors willing to bear more risk in exchange for more interest? And why should banks, which had largely switched from investing in mortgages to creating them, get all the action? Why not let specialized mortgage brokers find the home buyers, create the mortgages, and sell them to Fannie or Freddie or a private investment firm that would repackage them as mortgage-backed securities?
Why not, indeed. And for a long time, it looked like a good deal all around. Home buyers, especially those with modest incomes and less than perfect credit, now had a choice of lenders and lending terms. Institutional investors -- pension funds, bank trust departments, insurance companies, mutual funds, even foreign governments -- got to quench their voracious appetites for what seemed to be relatively safe investments that paid more interest than, say, a bond issued by Shell Oil or the U.S. Treasury. In 2001, new issues of mortgage-backed securities reached an astounding $1 trillion.
Wait, it gets better. Mortgage-backed securities created other new opportunities to make big bucks. Uncle Sam had been insuring the timely payment of home mortgages for middle-income families since the Great Depression of the 1930s, charging lenders a small premium for the guarantee. Fannie Mae and Freddie Mac continued the practice of insuring the mortgages behind the mortgage-backed securities they created and sold.
The credit insurance side of the business proved lucrative. With house prices rising by 50 percent between 2000 and 2005, homeowners who couldn't afford their monthly payments usually had the option of refinancing their mortgages instead of defaulting. The prospect of easy profits in guaranteeing mortgage repayments lured other investment firms into the act. Giant insurance companies such as AIG dived into the mortgage insurance business. While they were at it, these firms couldn't resist extending similar "credit enhancement" services in any direction the market pointed.
You want to guarantee the repayment of your $5 million loan to Company X five years from now? Just write a check to the Acme Insurance and Storm Door Company today for $100,000. The game was so lucrative that it was extended far beyond the sales of credit enhancements to the actual creditors. You haven't loaned any money to Company Y, but would still like to place a bet that it will default on its bond obligations in ten years? Write us a check now, and we'll pay you $1 million if Company Y does indeed go belly-up.
Once liberated from the necessity of selling services to real creditors and debtors, the credit enhancement business took off like a jackrabbit at a greyhound convention. At its peak in 2007, some $62 trillion worth of guarantees were outstanding -- a figure that is much larger than all the debt of all the debtors in the world.
Meanwhile, the big investment firms were hiring mathematicians (the insider's term: quants) to tailor esoteric new securities from the mortgage-backed securities as well as from other sorts of assets -- for example, securitized credit-card debt and securitized car loans. The advantage of these collateralized debt obligations, or CDOs, was that they could be sliced and diced in a zillion ways according to when the investors wanted their money back and how much risk they were willing to bear. A CDO might, for example, give the owner a claim on the first 80 percent of the interest on a specific pool of mortgages -- a pretty safe bet in most cases. That would leave the claim on the last 20 percent to an investor willing to take much bigger chances.
Of course, the more complicated these securities got, the harder they were for the mere mortals who bought them on behalf of pensioners, life insurance policyholders, etc., to understand. A problem, you say? Yet another opportunity, Wall Street replied.
A handful of companies had long been in the business of assigning credit ratings to newly issued bonds. They made their money by charging the bond issuers for the service. The debt of, say, General Electric might be rated AAA, the highest rating. A successful midsize auto parts manufacturer might only earn a BBB rating ("satisfactory credit at the moment") because it faced growing competition from China and its financial health was linked so closely to the auto-sales roller coaster.
It didn't take a lot of imagination to extend the ratings concept to all manner of newfangled securities -- including, of course, the ones backed by home mortgages. This effectively transformed metaphoric black boxes stuffed with only the quants knew what into assets any institutional fund manager thought he/she could understand. So now the Central Bank of China or the pension plan for municipal employees in six small towns in Norway (both real examples) could invest in impossibly complex securities backed some way, somehow, by loans made to, say, homeowners in Riverside, California.
Good Times Must End...
As the economist Herb Stein once said, "If something cannot go on forever, it will stop." The long boom in housing prices came to a shuddering halt in 2006 and began a steep decline that is apparently not over. Not surprisingly, housing developers and real estate brokers have been badly hurt, as have their employees and the myriad industries supplying everything from lumber to appliances to the bloated housing sector.
But this had all happened before -- in fact, it seems to happen every fifteen to twenty years. And while in the past the deflation of housing bubbles had led to real hardship for lots of people, housing busts didn't bring the mighty American financial industry to its knees. What was different this time around?
The bubble did inflate faster this time and affected housing prices in more regional markets. But the mega-shock was largely a consequence of changes in Wall Street that left all the big players (not to mention the rest of us) far more vulnerable to surprises.
Bankers Don't Act like Bankers Anymore
When banks retained the mortgages they originated, they had a strong interest in making sure that borrowers kept up their payments -- or at least invested large enough down payments to protect the creditors in the event of foreclosure. During this last housing boom, however, most mortgages were quickly sold to investment firms to be repackaged as securities. As long as somebody would buy them, bankers weren't too picky about to whom they extended the credit.
That explains why banks were happy to make even "liar's loans" -- mortgages in which the applicants were required to declare their income, but the banks promised not to check whether they were fibbing. Still, why didn't the investment firms that bought the mortgages pay more attention to the risk they would never be repaid? Because these firms didn't have much incentive to care either, as long as somebody would buy the mortgage-backed securities from them.
This goes on and on. Why were the pension funds, mutual funds, insurance c... --This text refers to an out of print or unavailable edition of this title.
More About the Author
I'd been writing about economic policy for magazines since my days in graduate school. And I had written one non-technical book about economic growth, too. So when The New York Times offered me a position on its editorial board writing editorials about economics, I leapt at the opportunity. Had a terrific time generating opinions. And I even think I did some good, in ways big and small - everything from advancing the cause of airline deregulation to making it possible to buy reading glasses without a prescription in New York State.
A decade later, I moved from the editorial board to The New York Times' newsroom to report and analyze the economic news, to write a weekly column about economics and to roam other sections of the newspaper in search of cool things to write about. Among the coolest: going to Ferrari driving school in Italy and flying a MiG-25 (I had lots of help from a test pilot) at a field 50 miles from Moscow.
To keep busy in my spare time, I wrote automobile reviews for The New York Times and published a slew of books on personal finance for small investors. As you'll see if you read my new one, WHERE TO PUT YOUR MONEY NOW, I write about the subject like an economic journalist - lots of analysis, very little jargon, no fantasies.
Then, a decade ago, I got an offer I couldn't refuse to edit my own magazine about economic policy, the Milken Institute Review. The Institute, which is located in Santa Monica, California, is non-profit and non-partisan, and has given me terrific leeway to draw on experts from both inside the organization and among independent professional economics. I still do some economic research (mostly about energy and climate change) and I write the occasional opinion piece about economics - see my stuff in the Wall Street Journal, New York Times, and a neat website called the Economists' Voice.
I live in Southern California with my wife (a college professor specializing in literature), teenage daughter, two dogs and five, very pampered chickens. Oh - any you might just catch my automobile reviews, which still appear occasionally in The New York Times (right behind the sports section on Sundays)
Top Customer Reviews
Despite the fact the book doesn't deliver on its subtitle promise, it generally doesn't steer the reader wrong. In addition, the author pokes holes in some common misconceptions about saving and investing. The advice he gives in this vein is more valuable than the price of the book, several times over. It can prevent a person from making matters even worse, which most investors invariably do.
I was pleased to see that he tackles the "gold harbor" theory and explains why gold isn't a safe harbor. When you read the gold bug propaganda, these points are always glossed over or missing, and that's because if you understand those points you won't make the mistake of hoarding gold in an attempt to preserve your wealth.
This book consists of an introduction and six chapters occupying 138 pages. The introduction is unusual in that it wasn't just tossed in there per the normal tradition. The author had specific goals in mind when writing it, and I found it to be an excellent start to the book.
Chapter One explains how the panic of 2008 came to be. It doesn't explain what set the stage for that panic, and understanding that origin is instructive for understanding where you might invest. However, in subsequent chapters, he does address this but he doesn't go into much explanation.Read more ›
Even though the crisis created fear among people, the author argues that "Fear Is an Expensive Emotion." With fear, people tend to overreact, and this creates tremendous opportunities for those who are willing to think logically. This book helps you to look beyond this short-term economic situation, and invest your money wisely so those long-term goals are still met. Investment basics never change. If you are confused about what happened with the economy and would like to know how to protect yourself, read this book.
- Mariusz Skonieczny, author of Why Are We So Clueless about the Stock Market? Learn how to invest your money, how to pick stocks, and how to make money in the stock market
From: David Peters
To: Peter Passell ; Joan K Peters
Sent: Saturday, February 07, 2009 1:22 PM
Subject: new book
Dear Peter and Joan, Thank you for your new book, "Where to Put Your Money Now".
I began this book and it immediately grabbed my interest. It wasen't with the feral excitement of a murder mystery, but with genuine interest and curiosity about "what happened and why". Although I have been reading about it for months, Peter seemed to nail it with crystal clarity, and conciseness. I didn't have to wade through all the esoteric high finance concepts.
My first sitting was about an hour and a half. (I couldn't concentrate on a woodturning book that long!). I found it light, appealing, folksy charming with an engaging rhythm and cadence I could almost humm to. It was vintage Peter. I could almost imagine you talking telling one of those complicated economic stories in simplified humourous form.
I think this book is a much needed, must read description of our current catastrophe. I have intelligent friends who are bewildered and struck dumb by the crises and need a readable guiding hand. I believe this book is it and I will recommend it to as many folks as I can. I hope it turns out to be a current best seller. Passell rides again! Best of luck, David
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Most Recent Customer Reviews
Great financial advice. Packed with useful information. Planning on going back to school and this was a great starting point for how I should be handling my finances. Read morePublished on May 4, 2009 by Isaac Barnett
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