Be Prepared

It's the Boy Scout motto. I know, I was one. In fact I was an Eagle scout which may explain why I tend to be prepared. Be prepared for what? Doesn't matter just be prepared.

In the past week Life has thrown me three curve balls. Thankfully, I was prepared and none of the three individually or combined will force us into bankruptcy or foreclosure or worse.

This post is tagged Personal Finance so what does being prepared mean? Simple, able to absorb the shocks of life without crashing your finances. Here's my personal examples for the week.

First, my wife and the entire marketing division at her company from the CMO on down were laid off. While it was a surprise we were prepared in a few ways to handle it. One, we have enough emergency savings and we live far enough within our means that this doesn't prevent us from making ends meet. It may slow down our retirement plans some if it drags on but it doesn't derail them. Second, she is well educated. I've stated in earlier posts and linked to articles at the Times and WSJ that show people with high levels of education are less likely to lose their jobs and when they do they bounce back faster. Thirdly, we have both cultivated our networks over the years so within days she had credible leads with an inside track on several positions.

These three actions prepared us for surviving a layoff.

Second, I have an older car. It's German and expensive to repair. But its still less costly than buying a new car. Turns out my car decided to break down yesterday. The failed parts and labor to replace them rang up to $1,100 which is not in allocated in the monthly budget. No worries, we have our emergency fund. Yes it is already being hit from the layoff but it was sufficiently funded to survive more than one problem.

Once again, being prepared takes a potential budget buster and reduces it to a disappointment and a minor hassle.

Third, just after we went to bed last night we smelled smoke then the fire alarm went off. We each grabbed a kid, and I called 911 and had the fire department out in less than 2 minutes. It turned out to be an aquarium filter burned up and no actual damage to the house but we didn't know at the time. However, had it been the worst we were still prepared. Our insurance was up to date. Our important documents were safe and most importantly, houses and material possessions don't matter in light of the health and safety of our family.

That said, we were prepared and able to mitigate the potential loss by acting quickly and ensuring what was most important (people) were safe then dealing with the financial implications. We also would have been able to afford the deductible had the house actually burned.

When it comes to personal finance the Boy Scout motto should be your motto as well. Be prepared. Be prepared for layoffs, be prepared for injuries and illnesses, be prepared for catastrophic damages to your property.

Be Prepared.

Leverage, Working Parents, Child Care, and the Housing Bust

When I first started out in business I wanted to be an Underwriter for and Insurance company. What I didn't realize at the time was quality data management and widespread acceptance of risk modeling was fast replacing underwriters in the work force. But I still spent a couple years working in the insurance industry and learned a couple things about underwriting.

A lot of pundits attribute the housing bust to poor underwriting by the banks and over leveraging by the consumers. Both of these are valid points but I believe one encouraged the other.

When applying for a mortgage the banks ask about your income and your current liabilities. Assuming they actually bother to verify those or not they leave out a large expense that impacts a family's ability to pay. This is where the working parents and child care fits in.

For simplicity lets say a bank will approve a loan for 3x the household income.

The typical household income is $50k per year for ease of math. That means a loan of $150,000 is available to the household. Using a simple 30 year loan at 6% that brings the P&I to $900 a month which is just shy of 25% of the gross monthly income.

Here's where it can get ugly. Lets say this household has a couple kids and one spouse stays home to take care of them. However, they would like a larger house. The banks don't ask about child care expenses on loan applications. Therefore the spouse who stays at home could go out and get a job for $25k a year and bring the household income up to $75k.

This now qualifies them for a loan up to $225,000. Their P&I increases to $1,350 and their monthly gross goes up to $6,250 which lowers the percent of income going towards the mortgage to 21.6%

For the consumers this looks fantastic. Bigger house and a lower percent going towards the mortgage. Here's the catch. Taxes not withstanding the child care that would be needed would have to cost less than $212 a month to keep the total outflow to mortgage and child care even at 25%. I don't know about you, but I can't find child care anywhere near that price and even if I could I'm not sure I would feel comfortable using it.

Let's be generous and say the family can find care for $500 a month for both kids since they are old enough for after school programs and don't need full time daycare. That still pushes their outflow to 30% for these two items.

The net is, since the underwriting for the loans ignores these recurring costs it encourages consumers to make decisions that actually leave them with less money than they would have started with. So next time you hear someone say they can't afford to quit and stay home with the kids, take a second and asses whether that is true or not.

Sunk Costs and Loan Modifications

I had the opportunity to have a conversation with Jodi Beggs over at Economist Do It with Models last week. As we rambled over several topics we got onto the housing issue and specifically loan modifications.

Jodi disagreed with me on two counts. After taking the weekend to mull them over I accept one and reject the other.

First was on the issue of whether banks are foreclosing on consumers to punish them rather than modifying their loans. Now I for one believe that if you sign a contract it is your responsibility to fulfil it or accept the consequences of failing to do so. If those consequences include losing your home that's your problem not the banks. I also believe enforcing a contract is not a spiteful act. For that matter I don't believe a corporation such as a bank is truly capable of spite or the desire to punish. Those are human attributes to me. This does not preclude agents at the bank from acting callous or mean spirited to those affected.

Her second disagreement is on the issue of sunk costs. Regardless of what has happened before, the banks should look towards maximizing their future profits and sometimes the best course would be loan modification. The specifics would come down to, would the bank make more money keeping someone in the home versus foreclosing. I'm sure there is enough data by now to model that and score loans accordingly to determine whether foreclosure or modification is the best profit maximizing route for the banks.

I'm sold, sunk costs have no place in considering what's the best way forward.

But that still leaves a bad taste in my mouth. The consumers that are more profitable to the bank with a modified loan will benefit from a windfall. They are getting a break on their debt. I understand that in some cases withholding the windfall makes everyone worse off and life is not always fair, but that doesn't mean I have to like it.

Driving with the Rearview Mirror

Knowing where you've been is useful information. It allows you to quickly figure out where you are. But too many of us use the same information for moving forward. Works great on a straight with no traffic, otherwise expect a crash.

Year over year reports on key metrics make managers happy. They are simple and concise and easily quotable in the 30 second elevator speech when the opportunity arises. That cake is a lie.

What happened last year doesn't matter now.

If last year peaked and this year is flat all your metrics will be down. Time to fire someone. Doesn't matter if last year's peak was driven by some external force.

Last year was down all year and this year is flat. Time for a promotion. You raised your metrics year over year compared to all the red ink from last year.

Last year there was massive recession. This year the business is back. The managers still around must be geniuses.

The point is, year over year comparisons are only truly valuable when both years are comparable.

When that is not the case, you're much better off comparing to a plan or a model.

Best and the Brightest

I often dismiss the fact that I work on the front lines of immigration. As an analytic professional my colleagues come from all over the world. I've worked with the Chinese, Japanese, Russians, Albanians, Iranians, Argentinians, French, Germans, British, Indians, South African, and several more from every populated continent.

I think about this as Fortune has an article on Immigration Brain Drain and the debate over H1-B visas. Many of my colleagues have been beneficiaries of H1-B at some point in their career and many of them eventually pursue the path to naturalization.

I've heard the arguments that every time an immigrant is hired it is for less money than a comparable American would earn. Sometimes it's true, sometimes it's not. It is always on a case by case basis. The real issue is, every time an analytics position is filled from a foreign national it is because the comparable American didn't exist.

Yes these are the best and the brightest coming to our shores. But right or wrong, there is a premium for being able to speak English without a foreign accent. If anything, it is their salaries that are being depressed not ours.

The simple fact is, the demand for analytical professionals is increasing. Just ask any recruiter. The only way to fill the supply is with Americans who make fun of anyone who remotely tries to study algebra or we fill them with the creme of the crop from the rest of the world.

I for one believe we are better off for it.

Can we say Game Theory Case Study?

My Alma Mater has been embroiled in the athletic conference realignment bonanza for some time. My personal opinion is that Missouri does join the Big 10. I am neither a sportswriter nor a collegiate administrator so my opinion in the matter means squat.

That said, within the past couple hours speculation has begun to yield towards action. Colorado is the first school to officially leave the Big 12. There is a lot of money at stake for the schools, and the conferences and there is every possibility the Big 12 will be no more in the near future.

There will be winners and losers in this realignment just as on the playing field. Only here, rather than athletic prowess determining the outcome it will be business acumen.

I smell case study.

The events as they unfold will beg for analysis for years to come. Most of the analysis will come from a financial perspective. That's all well and good.

But this is a game, albeit a high stakes multi-billion dollar one. As I stated there will be winners and losers. Game theory can be applied in real time to help the various institutions make the best decisions to support their own interests. Game theory should also be applied in retrospect to determine what actions, if any, the various players could have taken when the outcome wasn't what was desired.

There is much to learn about the poaching activities amongst cooperative and competitive coalitions. Politicians would do well to learn the lessons we are about to experience.

Default is not an Option

A friend of mine pointed me to a blog entry that suggests the USA should default on its debt as a strategic course to bail us out of our ballooning national debt. The blog entry can be read here.

I disagree.

It took me all of 5 minutes to come up with a number of reasons why this would be a bad idea. In the interest of full disclosure, I readily admit I will not offer any solutions of my own.

1st) defaults would mean we don't pay the principal back on t-bills. You think the current recession was bad, wait till every financial instrument fails because they all rely on the fact that to date the t-bills have been infallible.

For example, a default in t-bills would put a halt to the mortgage industry as banks rely on low interest t-bills that they can borrow to supplement deposits to loan out at higher rates to homebuyers. Currently the leverage rate is approaching 95%. In other words your mortgage is almost entirely supported by loans the bank has taken out. If the bank can’t borrow risk free t-bills then they will not lend you any money to buy a house. The current housing market crash will be a pleasant memory in this situation.

2nd) blaming the 10 year deficit projections on Obama is not acknowledging the full picture. GWB inherited a surplus and quickly and consecutively ran massive deficits for 8 years which Obama inherited a year ago. In fact I'm sure you can easily Google Dick Cheney's statement that "Deficits don't matter." The fact is, some federal debt is a good thing, see t-bills above. The amount of debt is up for debate.

3rd) Hyperinflation will not save us since many of our obligations are tied to inflation. Interest on the national debt is 4.6% of our annual budget. Wiping that line item out of the budget will not have a material impact in light of Social Security (19.6%), Defense (18.7%), Unemployment (16.1%), Medicare (12.8%), and Medicaid (8.2%). If you truly want to balance the budget to get us out of crushing national debt, there are many other areas that are worth considering first. Hyperinflation will not aid in these obligations and will likely make the situation worse.

4th) the US enjoys many financial privileges because we are the international currency of choice. The world denominates its international trade in dollars and this provides us many benefits. Specifically our international purchases (oil, goods from China, etc) cost us less since we do not need to convert our currency. A bankruptcy buy the US would drive the other nations of the world to switch currencies they hold in reserve and thus increase our international transaction costs.

Mr. Reed does make a point I agree with. In a way passing these debts to our children is taxation without representation. Clearly I had no vote in whether to establish Social Security that is currently 1/5th of outlays and projected to grow much larger.

I do not have an answer and there are much better minds than mine working on the problem but I am confident that the US government declaring bankruptcy would be an unmitigated disaster.