Thursday, December 21, 2006

Manage Debt Wisely - Follow Basic Mortgage Rules

Yesterday’s blog about exotic mortgages and the high estimated rate of defaults is a great lead in to today’s column. This is my second installment of my Rules of the Road. Last week, I wrote about credit card debt and car loans (See my December 12th blog listing). This week’s rule:

Rule #2:
Never borrow more money than you can afford to pay back on your current income.

Many people justify taking on unsustainable debt based on the premise that they will earn more in the future or the asset will appreciate. They are borrowing from their future to sustain their current lifestyle. This is a dangerous strategy. What if you don’t earn more in the future? What if you get sick and can’t work or lose your job? Always live within your means, in case tomorrow doesn’t pan out like you expected.

This includes borrowing to buy a house. Do not buy more of a home than you can afford. You may be able to initially side step this problem by using some of the new exotic mortgages discussed in yesterdays blog but it is a risky strategy.

Your monthly debt payments should not exceed 36% of your gross income. So if you are loaded down with credit card debt or a car loan this will reduce the amount of monthly income you have available for your mortgage, property taxes and insurance obligations.

Here is an example: If you wanted to borrow $500,000 to purchase a house with less than 20% down. You decide not to use an exotic mortgage product but to go with a standard 30 fixed rate loan and buy the mortgage insurance (instead of getting the newer riskier piggy back loans usually in the form of a variable line of credit).

The monthly payment for a $500,000 at 6% is $2,998. To do the standard qualifying calculation, you have to add on your monthly costs for Real Estate taxes (approximately 1.1% in California that’s $460), Property Insurance ($100), Homeowner’s Fee ($30) and of course the Mortgage Insurance ($150). In this scenario these total $739. Added to the monthly mortgage payment, your obligation totals $3,737. If you are using the 36% rule then your annual gross income should be at least $125,000 a year.

To circumvent these rules borrowers are reducing payments only initially by signing up for interest-only loans so their payments are lower. These loans may offer a very low initial teaser interest rate of only 3% so monthly payments are $1,250 versus $2,998 for a few months. The buyer initially qualifies based on the reduced monthly payment. After the initial period, the interest rate resets and the payments escalate. The borrower finds themselves trapped with a mortgage that is devouring more than 60% of their gross income. It doesn’t take much for the borrower to fall behind in his mortgage payments and lose the house.

So here is the moral. Don’t overextend yourself by taking on too much debt. You risk losing the house you’ve bought and your credit rating. It is better to wait then over extend.

Libby Mihalka

Wednesday, December 20, 2006

Mortgage Trouble Predicted

Mortgage lenders use to evaluate a borrower’s ability to repay a mortgage as a major consideration in the pre-qualifying process. Now with the advent of specialty financing anyone can initially qualify for a mortgage. Whether the borrower can afford the mortgage payment in the long term is not a concern. These “subprime” or “non-prime loans” are marketed to individuals with less than perfect credit or low incomes. These loans may start with a very low interest rate and monthly payment but over time they charge abnormally high interest rates and fees.

The Center for Responsible Lending issued a study today stating that one in five subprime mortgages entered into over the last two years will likely go into foreclosure. That translates into approximately 1.1 million owners losing their homes.

The complete study can be found online at http://www.responsiblelending.org/

Subprime mortgages were almost unheard of five years ago. Today they are one of the most profitable sectors of the mortgage business. Banks and mortgage companies began aggressively marketing these loans after finding that their higher interest rates and fees made them very profitable. A quarter of all mortgages made in the U.S. are now subprime.

Many of these are adjustable rate mortgages (ARM) that start at very low interest rates with interest-only payments. After this initial period, interest rates adjust up steeply to built-in rates with escalating monthly payments. These loans frequently have larger than normal prepayment penalties, limited documentation and no escrow accounts for property taxes and insurance. In other words, these loans are a recipe for disaster for most low income families.

The alarming default rate predicted by this study should be a wake up call to anyone considering an exotic mortgage. If you can't understand the terms of the mortgage or the initial terms seem to good to be true (with an interest rate well below the prime rate of 5.25%) - then think twice.

Tuesday, December 19, 2006

Rise in Producer Price Index Shows Inflation Not in Check

Today, the Federal Reserve received mixed signals regarding inflation. Last week’s great news that inflation seemed under control, with no increase in November’s consumer price index, was obliterated by today’s report on November’s producer price index. This is the price that businesses charge each other for oil, produce, and metals.

The bad news, wholesale prices shot up 2% in November. The producer price index has not increased that much in a month for over 32 years. These latest figures will make it difficult for the Fed to change its stance from a defensive posture of raising interest rates to an expansive posture of lowering rates anytime soon.

It is unusual to see such a high rise in producer price index not reflected in the consumer price index. It means that companies absorbed the rising cost of production and did not pass it on to consumers in the form of higher prices. If the producer price index keeps climbing at such a high rate, these increases will inevitably have to be passed on to consumers. Inflation!

The economic fog is thickening and there are some strong cross currents. It is difficult to predict which way the economy will go in 2007. Fasten your seat belt and turn on the fog lights.

Monday, December 18, 2006

Outlook for High Yield Bonds Poor in 2007

High yield bonds have generated great returns over the last twelve months gaining over 11%. Just like 2004, the lowest-quality segment of the bond market, has performed the best in 2006. Over the same time period, the S&P 500 gained about 17%, and the Lehman Aggregate Bond Index gained approximately 4.5%.

Bonds with a low credit rating are called high yield bonds or junk bonds. A low credit rating reflects the borrower’s ability to pay interest and principal could be impaired. High yield bonds pay their lenders (owners of the bond) a higher interest rate to compensate them for the increased risk of default.

Junk bonds have risk and return characteristics comparable to a mix of stocks and bonds. In other words, the volatility (price movement up and down) and gains (returns) generated by high yield bonds are more analogous to equities (stocks) than bonds. When compared to stocks, high-yield bonds appear pricey especially when you compare yields. Junk bond yields are close to all-time lows when compared to the earnings yields on both the S&P 500 and Russell 1000 indexes.

It is the wrong part of the market cycle to be purchasing high yield bonds. Most economists expect the economy to slow in 2007. Junk bonds perform best as the economy climbs out of a recession and credit-quality improves. Inversely, junk bonds tend to perform poorly at the end of an economic boom. If the economy falters, companies with less creditworthy debt tend to default on their interest and/or principle payments, hurting the high-yield asset class both directly (through reduced interest payments) and indirectly (a loss of confidence, resulting in a higher risk premium and lower prices).

As of last week, high yield bonds yielded just 308 basis points (100 basis points is 1%) above the 10-year Treasury. From a peak in late 2002, this is a dramatic decline. Back then spreads were over 900 basis points. The current level is well below the historical average, suggesting that high yield bonds are overvalued. Please note, yield differentials typically reach 300 basis points during periods of healthy economic growth, so current spreads are not outrageous given our current level of economic growth. However, the high yield bond market is priced for perfection and if the economy slows high yield bonds will probably perform poorly. It is not a good time to be investing in high yield bonds. On a risk return basis, it would be better to be invested in the S&P 500.

Libby Mihalka

Sunday, December 17, 2006

401k Contribution Limits for 2007

In 2007, the maximum contribution to a 401(k) and 403(b) has been increased to $15,500 from $15,000. The catch-up contribution for employees age 50 and older is the same at $5,000. So if you are age 50 or older in 2007, you can contribute $20,500 to your 401(k) or 403(b).

IRA and Roth IRA limits stay the same in 2007 with a maximum contribution of $4,000 and a catch-up contribution for age 50 and older of $1,000.

Please note that a participant who reaches age 50 before the end of the calendar year is considered eligible for the catch-up contribution that year.

This week I'll cover IRA and Roth IRA contribution strategies and income limitations.

Libby Mihalka

Saturday, December 16, 2006

Great Holiday Gifts to Improve Financial Health

Great Financial Gifts.

It is always tough around the holidays to find gifts for your family that are reasonably priced, innovative, thoughtful and useful. For many parents and grandparents, it's hard to know the best way to help raise the money consciousness of your children. Here are a few great gifts for those new to managing money and organizing financial records. The first four suggestions are aimed at young adults. Of course, you can always buy them for yourself. The last is specifically for young children. It is never too early or late to learn how to manage your money. Happy holidays!

If you want to help a friend, relative or spouse increase their financial knowledge, then membership in American Association of Individual Investors (AAII) may be the perfect present. The AAII is a nonprofit organization that provides its subscribers with basic information about investing, financial planning and retirement. It is a totally independent organization and doesn’t accept any advertising. Membership includes a subscription to its magazine, website access, tax guide, mutual fund guide, S&P Stock Reports and membership in its local chapter. Its articles are in-depth and written by informed independent experts. This is also the perfect gift for the financial neophyte or the college senior. Basic Membership is only $29 a year. Their website is www.aaii.org.

Organizing financial paperwork can be a nightmare. That is why “The Financial Planning Organizer Kit” is a great present. I wish someone had given this to me when I was starting out. The kit includes 22 file divider cards, a quick finder index and a 48 page handbook. The handbook helps you organize your vital personal information about bank accounts, health care providers, emergency contacts, credit cards and more. The divider cards help you establish a hanging folder system for your major documents in an organized fashion. Each major filing category such as Bank Accounts, Investments, Insurance: Autos, Boats & RVs, has a divider card that details what sort of papers should go in that file and how long to keep the papers. The quick finder index helps you find where you’ve filed your records. The organizer with a portable filing box and hanging folders would be the perfect present for someone just starting out or who can’t decide where things should go. The Kit is only $24.95 and is available by calling 800-695-3453 or online at www.homefile.com.

Why kids are rarely taught to manage their money has always been a mystery to me. Here’s a book that fills that void and should be given to every graduating high school or college senior. “The Budget Kit: The Common Cents Money Management Workbook” by Judy Lawrence, (Kaplan Business; 3rd Edition) will help anyone learn how to monitor their money. It is a simple, no nonsense guide to tracking your cash with straightforward and easy to use worksheets. The book helps with the day-to-day dirty job of cash management. There is nothing more empowering than taking control of your money, and this kit helps anyone develop a system to do just that. The list price is only $18.95 and can be found at most online stores at a discount.

If you know someone that has never followed business news and doesn’t know where to start, here is a great present. “Keys to Understanding the Financial News”, by Nicholas G. Apostolou and D. Lawrence Crumbley, (Barron's Educational Series; 3rd edition), is not a text book but a concise and easy to read guide that explains the implications of financial news from simple economic data to stock mergers. This book will help the reader tackle any business publication such as the Wall Street Journal, Investors Business Daily or Barron’s. It is only $7.95 and would make a great stocking stuffer. This publication can be purchased online and at some bookstores.

Here is a simple money management experience that teaches children as young as four years old about budgeting, planning and spending. As every parent knows, it is easy to give a child an allowance but it's not always easy to keep track of where the money goes. “The KidsWealth Money Kit” is almost like a game for children but in practice is a personalized system that lets kids manage their money with your help. The kit enables children to set goals and develop a plan to achieve them. It also emphasizes helping others and giving. Money will no longer be just something to ask for and spend but a resource to manage wisely. The kit contains colorful checkbooks, a parent’s guide, a colorful calendar with stickers, a guide for each account with sample tracking pages, a KidsWealth calculator, colored pencils and KidsWealth character stickers. Also available are additional KidsWealth workbooks that are age-specific. What better gift can you give your kids than how to manage money? “The KidsWealth Money Kit” is available at www.kidswealth.com or toll-free at (866) 954-KIDS(5437) for $39.95. The “KidsWealth Trackers” are $7.95 each.

Happy Holidays,
Libby Mihalka

Butter Toffee Recipe

Sorry this is off topic but I need to post my cookie exchange recipe. I've been making this recipe since I was in college (over 25 years). I make it every Christmas and it never fails.

2 1/4 C sugar
1 t. salt
1/2 water
1 1/4 salted butter
1 Bar (4 oz) Ghirardelli Bitterseet Chocolate
1 C Chopped Nuts (usu. Walnuts or Pecans)

Combine first four ingredients in a heavy 3 Quart pot. Stir constantly and bring mixture up to 290 degrees (hard crack stage) on a candy thermometer. Pour into a greased 9 x 13 inch pan. Let cool until hard and then melt chocolate. Spread over Toffee and sprinkle with chopped nuts. Cool until chocolate solidifies and break into pieces.

Don't ask me how many calories are in this candy, I don't want to know.
Happy Holidays,
Libby Mihalka

Friday, December 15, 2006

Consumer Prices, Inflation, Unemployment, and Corporate Profits

Great News! U.S. consumer prices were flat in November. Most economists were expecting a small rise of 0.2% rise for the month. This could allay inflationary fears at the Federal Reserve. The market will now expect the Fed to focus on lowering interest rates towards the middle of 2007 and stop thinking about further rate hikes. Stocks and bonds will trade up on this news.

In other good news, the Labor Department reported that the number of Americans filing for unemployment benefits dropped for a second week. This will begin to allay another fear investors have had that the economy might cool quickly. A long gradual landing of this bull market is what investors are hoping for in 2007.

Robust quarterly profit reports keep rolling in, with Costco, Honeywell and Citigroup all reporting good news.

Consumer spending is now the worry. The economy is a three legged stool with spending by the government, businesses and the consumer. Government and Business spending is expected to be moderate. It is the consumer that has been driving economic growth. Will Americans decrease their spending as housing prices contract? Will a decrease in wealth (caused by falling housing prices) translate into consumption? Many economists and investors have been waiting for most of 2006 for consumers to feel this falling wealth effect and moderate their spending. It appears that the low unemployment rate could be bolstering consumer confidence because consumer spending has not abated. If the consumer stops shopping, then this bull market is probably over.

Thursday, December 14, 2006

Commodities - A Smart Investment Defensive Strategy From The Financial Pragmatist

Over two years ago, I added a position in commodity futures to almost everyone’s portfolio using the PIMCO Commodity Real Return Strategy Fund Institutional shares (PCRIX). A small allocation (approximately 3%) is a great defensive play aimed at bolstering your portfolio if the stock and bond markets have a depressed period of performance.

The performance the last few years has been strong (up approximately 20%). However, the Commodities market plunged beginning in May. Suddenly, investors began to focus on rising interest rates and slower economic growth. The hot money (hedge funds) headed for the exits, aggressively selling commodity futures contracts, commodity-related exchange-traded funds and natural-resources stocks. By the end of September, the Dow Jones-AIG Commodity index fell 13% from its May high.

Is the bull market in commodities over? No and in fact commodities soared over 5% in November 2006. The downturn appears to be merely a necessary correction in an extended cycle that could run into the next decade. China and other populous developing nations have an insatiable demand for oil and metals. As these countries urbanize and build a middle class they will need raw resources to build homes, roads, cars refrigerators and dish washers.
Commodity futures generate return in several ways. First, the futures contracts guarantee a set price at a future date, and commodity producers pay what can be thought of as an insurance premium for that certainty. In essence this can be thought of as compensation for providing insurance to commodity producers who want to hedge their exposure to fluctuations in commodity prices. This insurance is largely independent of changes in commodity prices, so even if prices decline commodity futures can generate a positive return.

Second, the collateral that backs futures contracts is invested and earns a return. It only takes a small amount of the capital to buy the futures contracts. The rest is the collateral. In PIMCO a small percentage of the assets are used to purchase commodity swaps that are designed to replicate the performance of the Dow Jones-AIG Commodity Index (DJ-AIGCI). The remaining assets serve as collateral and are invested in portfolios of Treasury Inflation Protected Securities (TIPS). These treasuries will probably generate returns in the low to mid single digits. This return can be added to the other return components.

Third, individual commodities are uncorrelated to one another, and as a commodity futures index is rebalanced a return is generated over time from reversion to the mean. This happens as strong-performing, over weighted commodities are reduced and weak-performing, underweighted commodities are added. This benefit can only be captured if the index is owned over many years.

All of this is in addition to any returns that would come from price changes in commodities that are different than what the market was expecting—i.e., if actual commodity prices ended up being much higher than what investors were expecting, those future contracts would appreciate in price. That’s what makes commodity futures a good hedge against inflation.

Wednesday, December 13, 2006

New IRS Tax Law Changes for 2006

At the eleventh hour, Congress has restored a few popular tax breaks. The problem is they were so late passing this legislation that the IRS has already begun printing returns and procedures for the 2006 tax season. So make sure you pass this on to anyone for whom these deductions might apply. Here are three major deductions that were just passed:

Tuition and Fee Deduction for Higher Education: This provision allows a parent to deduct a maximum of $4,000 of qualified tuition and related expenses from their income if they earn less than $65,000 as a single filer or head of household. For those filling jointly you can’t have a modified income greater than $130,000. For those earning more than these limits, you can deduct $2,000 if your income is less than $80,000 as a single or head of household filer or $160,000 as married filing jointly. If your modified adjusted income is above this level you do not qualify for this deduction. For more information regarding this new legislation go to this website http://www.house.gov/jct/x-50-06.pdf . This deduction will be available through 2007.

School Teacher Tax Deduction: This has been a very popular deduction that allows educators in primary and secondary schools to deduct up to $250 a year of out-of-pocket expenses for supplies and computer equipment. You do not have to itemize your deductions to get this tax break. So it is available if you take the standard deduction. This tax break is also good through 2007.

Sales Tax vs. State and Local Income Tax Deduction: If you itemize your deductions you can choose to deduct your state income and local taxes or sales tax depending on which is higher. In California, the State Income tax deduction is almost always the most advantageous. Some states have low income or no income taxes but high sales taxes such as Florida, Texas and Washington. If you live in a low income tax state you may want to deduct your actual sales taxes especially if you made a major purchase during the year like a car or boat.

Email this to a friend that might be able to use any of these tax breaks or else they might not hear about them.

A quick reminder, Altamont Capital Management offers tax preparation services at reasonable rates. Please let us know if we can prepare your taxes for you.

Libby Mihalka, CFA
The Financial Pragmatist

Declining Trade Deficit for October Good News

The Commerce Department reported the trade deficit fell to $58.9 billion in October which is much lower than economists anticipated. The 8.4 % drop from September, the biggest percentage drop in 5 years, was primarily caused by moderating oil prices.

Here is the breakdown of the components that were responsible for the decline. Imports of goods and services fell 2.7 % in October, the most since December 2001. The deficit in petroleum products declined by $3.9 billion, to $18.8 billion, the smallest deficit since June last year. Also helping reduce the deficit was and an increase in U.S. exports which rose 0.2 percent, to $123.6 billion. The gain in exports reflects the increased demand for computers, drilling equipment and medicines.

Offsetting, these gains was a moderate increase in consumer goods imports which increased $238 million, to $38.3 billion, reflecting demand for medicines, toys and stereo equipment.

Why is a declining trade deficit good? Well, it means we owe other nations less money. A deficit is created when one country buys more goods and services from another country then it buys from them. A declining deficit is similar to a falling loan balance. Paying off debts is always a good thing. It strengthens our economy and the dollar. One reason the dollar has been falling compared to other currencies is our increasing trade deficit. For the dollar to keep its status as the world’s reserve currency, the U.S. needs to keep its trade deficit in check.

Tuesday, December 12, 2006

Federal Reserve Leaves Interest Rate Unchanged

The Federal Reserve held tight leaving its key overnight interest rate at 5.25%. The Fed gave no hint whether it would be changing interest rates anytime soon. Many economists expected the Fed to allude when it might start cutting rates. Instead, the Fed held open the possibility that it might increase rates if inflation does not moderate. It also expressed concern regarding the slowing housing market. The Fed described the housing slowdown as "substantial". This is stronger language than the Fed has used before.

The Fed is talking tough to keep a lid on inflation in hopes that it will not have to act tough and raise rates again. The stock market pulled back today (Tuesday December 12th), finishing slightly lower as investors grappled with the Fed's economic assessment and worries about accelerating inflation.

Friday’s release of November’s consumer price data will give us an indication of the Fed’s success at taming inflation. The Bloomberg poll predicts a 0.2 % increase, after food and energy items are removed. The increase for October was 0.1 %.

Credit Cards and Car Loans Decrease Your Financial Security

Debt is a tricky thing because sometimes it’s good and sometimes it’s bad. Most financial messes are caused by poor debt management or just lousy risk management. Over the next two weeks, I’ll share a few basic rules to keep you out of trouble.

Rule#1: Never finance the purchase of a depreciating asset.

In other words, never secure a loan to buy anything that falls in. For instance, a car is a depreciating asset. It declines substantially in value the moment you drive it off the showroom floor and yet you are paying interest and financing charges making the car even more expensive. Instead, the best way to purchase a car is to save the money now while you are still driving your old one. Financing an auto purchase with a five year loan will cause you to pay 20% more for a car due to the interest (assuming 7% interest rate). If you save for the car over five years (invested in a money market account earning 5%) it will cost 12% less because of the interest you have earned.

If you finance clothes, furniture or a nice lifestyle using your credit cards the costs are even higher. That $30 sweater may end up costing you well over $100 dollars. It is risky to extend yourself using credit cards. What if you can’t make the payments? The interest rate triples overnight and not just on the card you are delinquent but all of them. Most of America is only three pay checks away from default and eventual homelessness. Minimize risk by minimizing debt. Be smart, plan for a rainy day by saving and keeping your lifestyle expenses in check.

Monday, December 11, 2006

The Federal Reserve Meeting, Inflation and Interest Rate Changes

The big news this week is the Federal Reserve's scheduled meeting tomorrow (Tuesday). However, the Fed is not expected to make any big moves and should keep interest rates steady at 5.25%. Despite some of the recent gloomy news, the economy has been performing well. Why? The Service Sector of the U.S. economy is chugging along on all cylinders; it’s the manufacturing part of the economy that is causing some economists to worry. That’s the sector that manufactures things and builds homes, which appears to be on the brink of recession while the Service Sector continues to surge. The simple truth is that the Manufacturing Sector represents only one-fifth of the economy, and is not as important as it used to be. The Service Sector is the motor that now drives our economy. So what will the Fed focus on? It will look intently for any signs of inflation in the Service Sector. The members of the Federal Reserve will scrutinize all the employment and labor cost statistics. They will be worried about the low unemployment figures and the recent increase in wages. The Fed will remain cautious on inflation but they won’t take action. Do not expect a rate cut anytime in the near future.

Friday, December 8, 2006

Financial Pragmatist a.k.a. Libby Mihalka

In the blogging world it is important to pick a fun and witty name for your blog. The Financial Pragmatist is not exactly the most electrifying name out there. However, I love the name because it captures the essence of what I hope to accomplish. This blog will be a straightforward, articulate, non-biased resource for those seeking financial and investment information and advice. I have had my own practice now for over 10 years. I have also been in the financial industry for over twenty. My goal is to distill some of this knowledge into digestible chunks and feed them to you on a continual basis. I will try never to waste your time or insult your intelligence. In fact, I hope to challenge you.

Another purpose of this blog is to provide a supplementary place that my clients can go and read my current investment ideas, new financial planning strategies and tax changes. My quarterly newsletter has gotten too long. (My previous quarter’s newsletters can be viewed at http://www.altamontwealth.com/ .) Eight pages is a lot to absorb at one time. My goal is to post my ideas here and then try to only put a condensed version in my newsletters.

Enjoy the blog!
Libby Mihalka
The Financial Pragmatist

Thursday, December 7, 2006

Investment Performance Commentary for November

Money and Investing - Performance Results November

Surprisingly, November was another good month for all the asset classes. The large-cap S&P 500 gained almost 2%, while smaller-cap stocks, as measured by the Russell 2000, gained 2.6%. Based on Russell indexes, value edged out growth in both the large- and small-cap areas. I was surprised by the strong performance this month of small caps. As I have explained in my previous newsletters (which can be found on my website http://www.altamontwealth.com the strong out performance of small cap stocks cannot be maintained indefinitely based on current valuation. Mid-caps were the anomaly this month: their 3.6% gain was significantly ahead of both large- and small-caps, and growth beat value by 70 basis points (that’s 0.7%). I frequently find that Mid Cap stocks don’t perform as expected because most of the investment world does not recognize them as a separate asset class.

The foreign stock Vanguard Total International benchmark was helped by a declining dollar, and posted a 3.7% gain in November. On the bond side, the Lehman Aggregate Bond Index was up 1.2%; high-yield corporates gained 1.6%, and developed markets foreign bonds climbed by 2.8%. Among our tactical asset class weightings, commodities gained 5.5% and emerging local markets bonds were up 2.2% (both positions are funded from an underweight to bonds). REITs gained another 4.7%, bringing their year-to-date tally to a dizzying 37.6%. I do not recommend owning REITs because they are over valued compared to the market value of the real estate they hold. They are still being valued primarily on the high current dividend rate.