Calculated Risk, one of my favorite finance and economics blogs, has a great article written by the late Tanta on The Psychology of Short Sales. The piece really hit home for me, because during my recent search for new quarters, I ended up drooling over a lot of short sale listings, only to be warned by my agent that they often take a very long time to execute and frequently fall through. I quickly cooled to the concept.

On paper, short sales are the ultimate win/win for an upside-down homeowner who wants to “walk away,” and a lender who wants to minimize their loss. It lets both parties avoid foreclosure, prevents a house from sitting empty and potentially becoming a target for vandalism, squatters, and generally a source of neighborhood blight, and lets the homeowner remain on the property and leave gracefully when it sells. Plus, potential buyers get a house that hasn’t been trashed by a bitter ex-owner, or had its pipes freeze and burst due to over-winter neglect. Triple win, right?

That’s on paper. In practice, things often don’t work out so well. Because of the way short sales work, there’s often a disconnect between what the various parties involved in the deal think the property is worth. If they can’t reconcile their views, there’s no sale and the property goes back on the market, and eventually to foreclosure.

The biggest difference between a short sale and a traditional bank-owned post-foreclosure property (a “REO”, or “real estate owned”) is that in the latter case, the bank has already taken possession of the property, probably had it assessed, and accepted that they’re going to take a non-negligible loss. It’s just a non-performing asset sitting on their books at this point, one that they’d presumably like to unload at the earliest possible opportunity at an acceptable price. Contrast this to a short sale: the bank has just learned that the current homeowner can’t make their payments and wants out, and has responded by telling them to get a listing agent and put it on the market. They haven’t really written anything down yet. The big loss is still to come.

To a buyer, a short sale property ought to be more attractive than a REO, because it hasn’t been sitting vacant or gotten trashed during a ugly eviction. However, buyers quickly learn to beware these six words in any listing: “offers subject to third-party approval.”

When a buyer makes an offer on a REO, the offer goes to the bank and they get a pretty straightforward thumbs-up or thumbs-down. Either the offer is acceptable and it sells, or it isn’t and the bank is content to let it stay on the market a bit longer. Since the bank already owns the house, they just want to get the most for it they can.

When an offer is made on a short-sale property, it gets forwarded by the listing agent to the bank, who has the choice of whether to accept it or not. If they accept it, they’re almost certainly taking a loss and accepting a writedown on the original mortgage. There is a big psychological difference between this and the REO case, it seems to me: in a REO situation, the bank is trying to recoup as much as it can of an already-realized loss; in a short-sale, the bank is actually taking the loss as part of accepting the offer.

This psychological difference seems to manifest itself in the relative speed with which banks process the two different types of offers. REO offers get decisions rendered quickly; short sale offers can take months to process, during which both the buyer and seller live in uncertainty. This uncertainty causes buyers to make fewer offers on short sales than on REOs, and to offer less for short sales than they might otherwise. In theory there’s no reason why short sales should sell for much below what a regular owner/buyer sale would, but in practice they go for something closer to REO prices. This difference is, to my eyes anyway, almost completely due to the perceived arduousness of the short sale process.

In addition, there’s often a failure on the part of buyers and lenders to understand how the short sale benefits the other party, and how this affects the price they’re willing to accept. This is what Tanta explores in the Calculated Risk article. Lenders are only interested in a short sale if it results in a price that’s significantly (more than 40%) greater than what the property would fetch as a REO, post-foreclosure. Buyers, on the other hand, often try to bid less than what the property would fetch as a REO, on the assumption that the lender ought to be willing to take a little less on a short sale than they would as a REO, since they’re avoiding going through foreclosure. Hence, no deal.

In order to make short sales a more viable option for distressed homeowners who find themselves upside-down on their mortgages and unable to pay for them (or who simply want out and can’t sell normally and cover the mortgage), I can think of several things that need to happen:

• Banks and other lenders need to assign more staff to “special assets” and other pre-foreclosure divisions, and realize that they can avoid needless trouble and expense by going the short-sale route versus foreclosure. They need to gear these divisions to providing fast up-or-down decisions on short sale offers, and empower employees to write down assets significantly (at least as much as the delta between the REO price and the loan face value) in order to make deals happen quickly.

• Prospective buyers need to be better-educated about how short sales work, not only from their own perspective, but also from the owner’s and lender’s. They need to understand why a lowball, sub-REO offer isn’t going to fly with the lender. For a short sale to work, three parties — the owner, the buyer, and the lender — need to feel like they’re making out better than they would have via foreclosure. Offering substantially less than a property would fetch as a REO doesn’t allow that to happen.

• Homeowners considering a short-sale, whether in financial distress or not, need to be better about selling their properties. They need to work hard to make it clear to buyers that they’re not selling a REO, and that the property is inhabited and well-maintained. If a house looks like a foreclosure property, it’s going to get offers that reflect that, and it will almost certainly end up as a foreclosure property eventually. I saw several short-sale properties during my recent search that were frankly worse than the average REO, and that just isn’t going to work.

As it turned out, I didn’t make any offers on the short sale properties that I looked at. Given the time available before I have to be out of my current rental, it just doesn’t make sense. And I definitely wasn’t alone: many short sale properties had been on the market for hundreds of days, while REOs are being snapped up almost daily by hungry buyers armed with low rate pre-approval letters.

Making the reality of short sales better match the concept would provide affordable homeownership to many buyers, a dignified ‘out’ for distressed owners, and smaller losses to lenders and their investors. But a lot has to happen before that will be the case.

I got a letter from BB&T last week, an actual paper letter, on account of owning a couple of shares of their stock. I had already heard the news that they planned to cut their dividend and issue between $1.5 and $1.7 billion in new stock to get out of TARP, but struck me as interesting that they bothered to send out notices, in the form of a letter from the CEO, to all shareholders of record.

The letter is available online here (PDF).

Most news coverage of BB&T’s decision to repay TARP has focused on the dividend reduction, and a remark by CEO Kelly King that it “marks the worst day in my 37 year career.” However, I thought the second page of the letter was really the most interesting:

Many of you have asked why we agreed to participate in the Capital Purchase Program last November. Frankly, we did not need or want the investment, but our regulators urged us along with other healthy banks to participate for the purpose of increasing lending to improve economic conditions.

Them’s fighting words right there, or at least they are by the admittedly low standards of a corporate shareholder communique. For a few months now, rumors have been circulating that healthy banks — like BB&T — were essentially forced or otherwise pressured by regulators to participate in TARP, in order to make it seem less like the plague ward than it really was. This is the first written confirmation that I’ve seen from senior management at a ‘healthy’ bank basically confirming the worst of those rumors.

The key word is that executives at BB&T didn’t “want” the TARP money from the beginning, indicating they must have been pressured or coerced — given ‘an offer they could not refuse,’ perhaps — to take it anyway. The letter doesn’t get into exactly what form that coercion took, but I suspect in time more details, beyond what are already known, will come out. Doubtless it won’t look all good for the banks when it does; in the end all the majors caved, and when they complain Treasury will accuse them of hypocrisy: buying into the plan when the going was tough, but getting buyers’ remorse now that things are looking somewhat better. This is a legitimate accusation that they’ll have to work hard to defend against. The ultimate question will be what the consequences of not participating — essentially calling the Don’s bluff — would have been, and whether they would have been preferable to what actually occurred.

The government, it seems, is going to turn a fair profit on TARP at great expense to the investors in healthy banks. (The sick banks won’t really have lost money to TARP, at least not in the same way that banks like BB&T did, because they actually needed the capital infusion to stay alive; for them it was money well spent.) I think it’s too much to expect at this point that anything will happen to recoup any of BB&T’s TARP-related losses, either the direct ones in the form of interest payments to the government, or indirect ones like the reduced dividend (which arguably they might have to have done anyway, but perhaps not — now we’ll never know) and share dilution.

There’s not much of a silver lining, but hopefully it will prove to be a ‘learning experience,’ albeit an expensive one. After having been so painfully screwed, it’s doubtful that BB&T or any of the other ‘healthy’ banks will have anything to do with similar programs to TARP in the future; whatever coercion was required to buy their participation this time around, next time they will almost certainly be tougher sales.

TARP may not have injected needed capital into the healthy banks, but it may have given them something far more important in the long run: backbone.

When I was in perhaps 5th or 6th grade, I recall my math teacher making a halfhearted effort to get us to play The Stock Market Game as part of our curriculum. It didn’t go very well and certainly wasn’t effective as a teaching tool; I remember a couple of class periods spent pretending to make sense of the NY Times’ stock pages while actually reading the comics, and very little else.

A few years ago when I first decided to play my own little stock market game with some Excel spreadsheets, and found myself learning a whole lot more about economics and the market than I had ever really intended, I wondered why I’d never done it before. And then the memory of that abortive attempt to do exactly that came back.

It strikes me as a rather sadly missed opportunity. Until I started playing with my little virtual portfolio in Excel, I had only a very vague idea of how the equities markets worked — and this is despite having taken the two semesters of required Economics in college. Would I have picked a different major or career path as a result of getting that little bit of fundamental understanding that you gain from playing with a paper portfolio earlier? (And would that have been a good thing?) I have no idea. And really, that question doesn’t interest me that much; I have no regrets, certainly, about my actual choices with regards to education or employment.

What does interest me is trying to figure out why, despite someone’s intentions that we would use the Stock Market Game in our math class, it never ended up amounting to anything.

The first problem, I suspect, is that my poor old math teacher — who had been teaching from the same curriculum for probably 30 years — didn’t know that much more about the stock market than we the students did. (I also suspect that she wasn’t the one to decide to include it in class; it just doesn’t, and didn’t at the time, seem like her style.) That combination was deadly, right off the bat. Whatever educational utility a virtual portfolio game might have — and people are rightly skeptical of them at times — it evaporates instantly when the teacher isn’t knowledgeable and interested in it themselves.

Perhaps the root of this problem was making it part of a math class in the first place. There really isn’t that much ‘math’ involved in maintaining a paper portfolio, and what there is represents pretty basic stuff — if you’re using a stock market game to teach percents, chances are you’re not really getting into what makes the stock market interesting and important; you might as well just stick to lemonade stand examples and save students the confusion.

The stock market game would probably have fit better into the history or social-studies curriculum than into math. That might have also caused the focus of the overall lesson to be more about the equities markets themselves — how they work, why they exist, what the effects are of market fluctuations — rather than simply on generating a short-term return in a virtual portfolio. (That would also go a long way towards addressing most of the criticisms of stock market games as propaganda tools expressed in the article by Maier, which are in my opinion mostly quite valid.)

The second major problem had to do with how the game itself was executed; this being the pre-Internet era, we did everything on paper and got pricing information out of the newspaper. Hopefully this wouldn’t be a problem today; it would be simple to use Google Finance, or even the Excel sheets I played with a few years ago, to do it now, and you’d at least get pretty graphs out of the bargain.

The only benefit I can attest to as a result of having to once try to use, or at least look at, the printed financials pages, is a vast appreciation for the electronic tools that are available today to the individual investor, or even to the merely curious. From the looks of the photos on TSMG’s website, they have changed with the times. (Damn kids will just take them for granted. Get off my lawn.)

Aside from simply replacing graph paper and the Times financial section with some pretty electronic system, bringing in computers also allows for a lot more research than would have previously been possible in a classroom setting. Research and due diligence are a huge component of investing and non-technical speculation, and that’s a lesson that you don’t need to become a stock broker or day trader later on in life in order to appreciate — anyone with a 401k will do.

I think the concept of a stock market game is a pretty sound one, in terms of teaching students about a fundamental and important part of our economy — one which can, as recent events have made plain, affect their lives whether they pay attention to it or not. I can only hope that how that concept is being executed today is better than the pathetic attempt I experienced many years ago.

Roubini Global Economics (RGE) has an interesting article called “Can China Adjust to the US Adjustment” that discusses, among other things, the relationship between foreign trade and the current credit ‘crunch.’ It’s a fascinating article both because of the interesting history it describes, and some of the predictions it makes.

Although we can’t say for sure, it is probably safe to argue that US savings rates will climb back to earlier average levels, or even temporarily exceed those levels, as American households rebuild their shattered balance sheets. If they return only to the mid-point of earlier savings rates, this implies that US household savings must rise by some amount equal to roughly 5% of US GDP, or, to put it another way, that all other things being equal US household consumption must decline by that amount.

Although it may just be that I haven’t been paying close enough attention, this is the first time I’ve seen anyone toss out a hard number estimate of how much they expect consumption to fall by. Pretty much everyone expects consumption to fall by some amount, but ‘how much’ is the real issue.

This decline — whatever it ends up being — will inevitably cause a decrease in China-to-U.S. imports, and that will have to be compensated by either an increase in domestic Chinese consumption, or a decrease in production. The article suggests, and I agree, that the former is highly unlikely. Although Chinese household spending is on the rise, there is just no way that it will rise fast enough or high enough to maintain the insane level of consumption that was until recently being bankrolled by the U.S. Hence, production there must fall.

Of course, falling production means factory closures and job loss, and that means domestic consumption will fall yet further, leading to a nasty downward spiral. The parallels drawn in the article between 1929 in the U.S. and 2008 in China seem pretty well-grounded; except, of course, that in 2008 Chinese regulators have volumes of economic theory and analysis written about 1929 at their disposal, if they choose to make use of it.

[Via MetaFilter.]

One of my favorite uses for Google Reader is to keep an eye on the feed of latest releases from Project Gutenberg and Distributed Proofreaders. Although the great majority of what they archive is of limited interest (at least to me), every once in a while something really cool comes through.

“Successful Stock Speculation,” (HTML version) originally published in 1922, is worth a read. Written as a handbook for the novice investor, just about everything in it is still good advice. I suspect that if more amateur (by which I mean, using their own, as opposed to someone else’s, money) speculators stuck to the very conventional wisdom in the book, far fewer people would lose their shirts in the process.

[The word ‘speculator’] refers to a person who buys stocks for profit, with the expectation of selling at a higher price, without reference to the earnings of the stock. … An investor differs from a speculator in the fact that he buys stocks or bonds with the expectation of holding them for some time for the income to be derived from them.

This is an important distinction which, sadly, seems to have been lost recently. There’s a fundamental difference between speculation and investment; people who buy and hope for a change in price of the underlying asset, so that they can sell and realize a profit, are not investing. They are speculating. This is true whether the underlying asset is stocks, bonds, or real estate. I’d argue that misunderstanding the difference between the two is the root cause of virtually all market ‘horror stories’ (Grandma and Grampa wiping out their retirement, the kids’ college fund, etc.).

As a usual thing, it is a good time to buy stocks when nearly everybody wants to sell them. When general business conditions are bad, trading on the stock exchanges very light, and everybody you meet appears to be pessimistic, then we advise you to look for bargains in stocks. […] When business is bad, nearly everybody thinks business will be bad for a long time, and when business is good, nearly everybody thinks business will be good almost indefinitely. As a matter of fact, conditions are always changing. It never is possible for either extremely good times nor for extremely bad times to continue indefinitely.

Sound familiar? There’s nothing new here; you could read practically the same thing in just about any Warren Buffett book. But the fact that it still works so well, so unusually well in fact, is a testament to how many people just don’t seem to get it.

The same could be said for the book’s advice on picking which stocks to buy:

We maintain that there is only one basis upon which successful speculation can be carried on continually; that is, never to buy a security unless it is selling at a price below that which is warranted by assets, earning power, and prospective future earning power.

Today we might call this “intrinsic value” or “fundamental value,” and this school of thought ‘Value Investing’ (although, for the reasons noted above, chances are it’s not really “investment” but rather ‘value-driven speculation’).

Although other strategies seem to get all the attention during bull markets, it’s the unsexy science of fundamentals that has seemingly withstood the test of time, and is still as useful today — regardless of what the future might hold — as it was in the early 20s.

I was heartened to read this over at Calculated Risk earlier today. It’s mainly a link to a WSJ article, but the punchline is blunt:

Any attempt to keep house prices artificially high will just postpone the inevitable and delay the eventual recovery.

At least somebody seems to get it. Pity that ‘somebody’ doesn’t seem to include, oh, anybody in Washington. At least not yet, but the gist of the article is that the truth is beginning to sink in.

Unfortunately I think it’s too late for that truth to have prevented a costly and probably pointless bailout, but it might be in time to prevent too much meddling in the retail real estate market. Of all the markets that need a good cleansing burn, that’s it. However, it’s also the one prone to attracting the most interference from Congress, as idiots who forgot that a house should be a place to live first — and not an ATM or an IRA — squeal and moan as they learn that actions have consequences.

The most dangerous idea to creep in is that a decline in housing prices is, by itself, somehow bad. Whenever you see someone in a suit pointing to the decline in prices and suggesting that it is a problem to be solved, be afraid. It’s dangerous for two reasons: one, because it’s wrong — inflated housing prices were a symptom of the credit bubble, and their decline is quite natural as that bubble works itself out; two, because it’s an easy target for government intervention.

There’s nothing politicians like better than treating the symptoms of a problem; it’s so much easier, after all, than actually going after the root cause, and most of the time the public never notices the difference.

If the government succeeds in convincing the public (and Wall Street, who on the whole haven’t shown themselves to be much more savvy than the public at large anyway) that the decline in prices is a symptom that ought to be treated, and somehow find a way to prop those prices up at their inflated levels, a generation of financially responsible Americans will be effectively locked out of home ownership. I really can’t imagine anything more toxic to the long-term faith of the public in the markets than that.

Although there are lots of ways to hedge against a fall in the U.S. dollar, I was inspired by this post to look at four funds in particular that seem like promising, low-cost ways for the small investor to flee the dollar, if they desire:

• FXE
• MERKX
• PSAFX
• VGPMX

Starting from the last, VGPMX is a precious metals mining fund operated by Vanguard. Currently it’s closed to new investors, so you’re S.O.L. if you don’t already own shares. It’s sort of the thinking man’s alternative to actually buying gold; instead of buying the gold directly, it invests in companies that mine gold and other precious metals, and which tend to be worth more when gold is high. It would have been a good buy a few years ago, but such is hindsight.

Next up is PSAFX, the “Prudent Global Income Fund”. According to Bloggingstocks.com, it “holds mostly fixed-income securities denominated in foreign currencies. Roughly 70% of its investments were in foreign debt at the end of the third quarter, with the euro, Swiss franc, and Canadian dollar receiving the largest allocations. […] the fund concentrates on the highest-rated debt, such as government securities. And as an extra dollar hedge, 11% of its assets were recently in gold and gold shares.” Basically, it’s very similar to a “money market” fund that you might buy into through your bank or credit union, but with a more diverse set of underlying assets. (Most ‘money market’ accounts invest only in U.S. government or municipal debt.) The gold is sort of a bonus, if you like that sort of thing. Expense ratio totals to 1.28% according to Google.

The Merk Hard Currency Fund (MERKX) is similar, investing in very high-grade government debt in a variety of “hard” currencies. According to Merk’s website, it’s almost 40% Euro, 17% Swiss Franc, 17% Canadian Dollar, and 9% gold. The remainder are other currencies in smaller chunks. Their page provides a good breakdown of assets and sectors, so I won’t duplicate it here, but the biggest government debt is German, followed by Canadian and Swiss, followed by cash and gold. It’s an interesting option to be sure. The minimum investment is $2500 to play, $100 buy-ins once you’ve got it opened. (IRA minimum is $1k.) The net expense ratio listed in the prospectus is 1.3%.

But what if you want to just hold cash, rather than debt instruments? In that case, the CurrencyShares Euro Trust (FXE) might be more interesting. It’s essentially like owning shares in a very big Euro savings account. The funds are actually kept in accounts (one interest-bearing and one non-interest-bearing) with JPMorgan Chase’s London branch, and the fund generates some profit this way, although it’s less than the debt-based funds.

Owning FXE is, at least as far as I can tell, the closest that a small investor can get to opening a Euro-denominated savings account and putting cash in there, without actually going through the hassle of setting up a Euro-denominated account. About the only downside I can see is, because your funds are housed in two giant accounts with JPMorgan, you’re probably not protected by European deposit insurance in the event of a bank failure. (European deposit insurance is a bit of a patchwork at the moment at the moment, too, so it’s not really clear what would happen if things went south.)

Although you buy FXE just like any other ETF, it’s technically not a mutual fund or a commodity, nor is the operator an Investment Company. The ‘fund’ is actually a Trust, and according to the prospectus, “The Shares represent units of fractional undivided beneficial interest in, and ownership of, the Trust.” Although you buy the shares from a company called ‘Rydex Investments’, they’re not the trustee — that’d be the Bank of New York; Rydex just does the paperwork and marketing. There are some fairly ominous-sounding paragraphs in the prospectus detailing the circumstances under which the whole arrangement could be liquidated — possibly to the detriment of investors — and bears reading, although it doesn’t seem like a major risk. (At least not more than anything else these days.)

When all this legal hand-waving — I counted four legal entities to operate it, located in such diverse locales as Delaware, Maryland, New York, and London — is done, the overall effect is that you, the buyer, get an interest rate equal to EONIA less 27 basis points (0.27%), and an expense ratio of 0.40%, on top of whatever the EUR/USD happen to do.

These funds piqued my interest, so I’ll probably be doing some additional research over the next few days and reporting the results. The usual common-sense disclaimers apply to all the information here: it’s not investment advice, get a real advisor if you’re investing real money, don’t sue me if you lose your shirt.