Wallet Pop beat me to it last week with a post Lenders plan to guess your income from credit report. It was about how the CARD Act "requires lenders to consider your ability to pay any new or additional debt before approving a credit card application." Apparently, that means verifying income, which puts a damper on those really annoying pitches you get to open a store-branded card whenever you try to buy something.

"Retail stores are quite upset about this change in the instant approval of their cards," Bill Hardekopf, CEO of LowCards.com, wrote to WalletPop by e-mail. "Consumers now need to show proof of income when they apply for a card, and not many of us carry this around when we are shopping in the mall."

This made me, briefly, optimistic that the CARD Act would improve my life after all. I hate it when the salesgirl extends the time it takes to check out by asking me if I’d like to save 10% and open a new account. That’s three seconds of my life I can never get back. The only thing worse is when she asks the guy in front of me on line and he says yes.

Alas, I’ve now looked into it and I think it is pretty clear that I will continue to suffer this particular indignity. I read the CARD Act itself (it’s a surprisingly brief 33 pages with giant margins) and found that it says only that a new account may not be opened "unless the card issuer considers the ability of the consumer to make the required payments." Italics mine.

On one hand, this is a delightful dig at card companies, implying that until now they were issuing cards without so much as considering the ability of the borrower to repay the loan. On the other, mandating merely that they consider this factor is bizarrely minimal. It would be like announcing that, henceforth, drivers will be required to attempt to avoid head-on collisions with oncoming traffic.

Of course, I know how the world of government works. Congress writes a one sentence provision and the bureaucrats turn it into a novel-length web of regulations. And sure enough, the Fed has issued an 1155 page amendment to its Truth in Lending (Reg. Z) rules to implement the CARD Act. I did not read the entire thing.

But PDFs are searchable, and I found nothing to rekindle hope that salesgirls will soon limit conversation to a perfunctory "How are you today?"

The Fed interprets "consider" to mean only that, that lenders must include ability to pay in their evaluations in some rational way. And, despite what the CEO of LowCards.com may think, there is no requirement that consumers show any kind of proof of income. When reasonably considering ability to pay lenders are "permitted to rely on information provided by the consumer or
information in a consumer’s credit report."

In other words, to satisfy the implied requirement to have enough information to consider ability to repay, a card issuer need only a) ask the consumer if he has income over a certain level or b) infer that fact from his credit report. In fact, based on my skimming of the regulations, it is not clear to me that a lender could not just put a tick box at the bottom of every application reading "Check here if you believe you can repay this loan."

Or, if the lender worries that asking consumers to tick a box would slow things down too much, an automated analysis of credit history will do. The Fed explicitly allows lenders "to make a reasonable estimate of the consumer’s income or assets based on empirically derived, demonstrably and statistically sound models." That sounds a lot like a modified credit score, which leaves me wondering in what way, exactly, this is a change from current practice.

And just in case you clung to the hope that this provision would have any practical effect whatsoever, the Fed makes clear that by "required payments" it is meant only the minimum payments on the card. So lenders are not required to consider the ability of the borrower to pay off the loan, only the ability of the borrower to keep current on the debt by making the minimum required payments, if need be forever. That’s a pretty low bar to clear.

But I did stumble on some interesting tidbits in the Fed’s 1155 pages of clarifying details. More on that another day.

[Photo: Lotus Head]

Frugal Upstate, from the northern Northern Bits, gave us no fewer than 3 different uses for the juice, technically syrup, that canned fruit is packed in. All are ways you can consume it, but without a doubt there are dedicated frugalists already working on potential uses as a household cleaner.

A fundamental premise of frugalism is that it is not about simply doing without. You can spend less of your precious money and still enjoy the modest and temperate pleasures of life. Along these lines, DebtMaven had an excellent post detailing how she practices frugal drinking. For example, since she will not drink her morning coffee without a bit of Irish Cream, necessitating the purchase of two bottles a month (presumably the 1.75 liter size since all good frugalists buy in bulk) she has switched to Carolins from Bailey’s.

Modern Tightwad has started a year-long tip-a-day program that we are sure to be visiting regularly. January 26th’s edition was entitled Don’t Use A Breast, If a Thigh Will Do. This caused momentary confusion for me before I realized it was about chicken. Frozen thighs cost 30 cents less per pound than breasts, which means that over the course of a year, in which you, like any normal family, would buy 100 pounds of chicken parts, you can save $30. Cha-ching!

Not quite as lucrative, but still totally worth the effort, was January 6th’s entry on how to Streamline Your Bathing. With techniques such as washing with two buckets of water rather than taking a shower, you can save "$10 a year in product and/or water."

Of course, and this is worth emphasizing, Modern Tightwad does not suggest that you should go without bathing, only that you do it frugally. That is a subtle distinction of great importance. Funny About Money, sadly, crossed that fine line, suggesting that for most laundry detergent is not necessary. As all frugalists know, the proper frugal approach is to make your own detergent, not to go without. Not using detergent in the washer would be like not using dryer sheets in the dryer, and we can’t have that, can we?

Similarly, Wise Bread was skating on thin ice when it discussed, but stopped short of endorsing, saving money on heating your home by not heating your home at all. (They made up for it with a very helpful tip that when flying you should pack a starter’s pistol in all your checked bags. Now if they could only invest in a website that loaded properly on my browser.)

Also this month, Bargaineering asked Do Expiration Dates on Drugs or Vitamins Matter? Of course not. Silly blog.

The Sun’s Financial Diary (which I keep thinking should have something to do with Louis XIV, but doesn’t) had some great tips on Where and How to Stash a Stockpile. For example, one of The Sun’s bedroom closets holds not clothes but a large freezer. This is apparently not a problem for sleeping once you get over the "low, constant hum" coming from behind the closet door.

January was also a good month for directions on how to make stuff. Wisdom of the Moon had a surprisingly complicated one for homemade firestarters. And Frugal Antics of a Harried Homemaker shared a recipe for homemade Pop-Tarts.

Besides making our own highly flammable objects and junk food, frugalists like to find amusement during the indoor months measuring how much electricity every item in our house uses and publishing our results on the internet.

And one of the discoveries frugalists make when we methodically measure electricity use is that a 50" LCD TV uses less juice than a 50" plasma one. But, as CanadianFinanceBlog points out, this is only generally, not universally, true. The exception is that plasma will use less power to display darker images, while an LCD uses the same amount of power no matter what it displays.

The obvious conclusion from this is that you should use your LCD for bright well-lit things like daytime talk shows and your plasma for darker stuff like slasher movies. But why not go further? Ditch the LCD altogether and restrict your viewing to the darker palettes. You will have to give up some things. Ice hockey, for example, has too much expensively white ice. Come to think of it, the entire Winter Olympics would be out. But baseball and football would work, provided they were played at night.

Just another example of how being frugal does not have to mean doing without.

The Latte Factor® is not the only registered trademark from previous books that David Bach revisits. Also making a prominent appearance in Start Over, Finish Rich is the DOLP® debt reduction system.

DOLP®, Bach tells us, stands for dead on last payment. What on Earth that means he does not disclose. (Not in this particular volume anyway.) In practical terms DOLP® is a method of deciding which of your debts to pay off first.

In what order you should pay off your debts is a surprisingly controversial topic in the personal finance world. The two leading theories are the Debt Snowball, as advocated by Dave Ramsey, in which you pay the smallest debts first, and the Right Way, as advocated by rational people, in which you pay the highest interest rate debts first.

DOLP® is, somewhat remarkably, a third method. You divide the outstanding balance on each of your debts by its minimum monthly payment. You then pay off the loan that has the lowest ratio of minimum payment to balance first.

Why? Bach doesn’t say. He claims "the DOLP® system works by identifying the card you can pay off most quickly…." But, assuming that that was your goal, isn’t the card you can pay off most quickly simply the one with the lowest balance? That is, wouldn’t the Debt Snowball be the way to go?

Alternatively, if you assume that minimum payments as a ratio to the outstanding balance are proportionate to the interest rate, which is very roughly true, then DOLP® amounts to paying the highest interest rate first. Approximately. But if this is what Bach wants the reader to do, why not just say so? Does Bach think that sorting by interest rate is too complicated?

Or perhaps he thinks it is not complicated enough. After explaining the mechanics of DOLP®, which includes a worksheet you can download from the web, Bach triumphantly declares "now you have a system to free you from credit card debt." It is clearly important that he is giving the reader not merely advice but a system, a finely engineered machine that will take care of the reader’s problems.

Just beneath the surface of the advice of all the personal finance gurus is a concern with the psychology of the audience. Bach, refreshingly, is relatively candid about this. He actually comes out and says that his principal challenge is not getting people to believe that his advice is valid but that they can actually pull it off.

So a great deal of what Bach tells his readers to do is less focused on making them rich than on giving them the feeling that things are under control and that they are on their way to being rich. The main benefit of DOLP® is not really paying off debt in a mysteriously optimal order, but the feeling of reassuring control the reader will get when he makes a table of his debts and applies a "system" to them.

A surprisingly large portion of Start Over, Finish Rich discusses simple bookkeeping and the tidy organization of papers. There is a lengthy and detailed description of the FinishRich File Folder System, including what stationery to get, how to label the folders, and which documents to keep in them. Bach asserts that many people "waste literally hundreds and sometimes thousands of dollars a year" on interest and late fees merely because they cannot physically locate their bills. I have a hard time believing that very much of the interest and late fees paid in this country is due to mere untidiness, but I can see the therapeutic value of neatly labeled file folders for those overwhelmed by money issues.

Other than "latte", the word most closely associated with David Bach is "automatic." Central to his program, as described in Start Over, Finish Rich and all his books, is the admonition to "make it automatic." By this he means that you should set up a web of automated payments and direct deposits that will take care of your bills and see to it that you save, without any further action on your part.

Of course, making it automatic is also a tidy system that will calm fears. Like DOLP®, it is a machine that can be applied to your problems, giving you a reassuring sense of control and of forward motion towards your goals.

I object to Bach’s automation scheme for several reasons. At the margin it can cause some poor money decisions. Although he doesn’t say so, I believe that Bach’s moth-to-flame attraction to homeownership has a lot to do with its automating side effects rather than direct economic benefits. A house is a large illiquid store of wealth that is, relatively, hard to tap. And the part of the monthly mortgage payments that go to principal are forced saving.

Another objection is that automating works by creating a false sense of scarcity and by reducing the number of choices available to the consumer. The basic idea is that you should arrange to have a generous slice of your paycheck automatically salted away before you can get your irresponsible little hands on it. As a rule, I think more options in life are a good thing, even if a few of them are poor. And I have difficulty with any system that relies on my treating myself as if I were two people, a wise one with foresight and a foolish one who can be tricked by the wise one.

But what makes me most uncomfortable with automation, and with Bach’s entire program of tidy schemes, is the message that it sends. Ultimately, Bach is not saying that you are able to control your finances. He is saying that you can only do so with the assistance of elaborate artificial means. You lack the willpower, or are perhaps just too stupid, to pay off your credit cards without a scorecard and a special method. And you certainly cannot expect to be able to save if given the option to spend, so don’t even try.

I am not naive enough to believe that there are not millions of Americans for whom this description fits. But the vast majority are at least capable of operating without elaborate tricks. Bach does not think so, telling us that in his years of doing this he has only ever met one guy who could follow a financial plan "manually." That’s a terrible message to send.

But all is not lost. David Bach, of Latte Factor® fame, has stepped into the breach with Start Over, Finish Rich: 10 Steps to Get You Back on Track in 2010. It works well as a sequel to Orman’s book. Aside from the similar title it shares the same peculiar 4 x 7 1/2 paperback format and a cover laden with gold leaf. (Of course, by law, all personal finance books have some gold leaf on the cover. But this one has an Orman amount.) And Bach cribbed Orman’s gimmick of giving away electronic copies of the book for a limited time to build sales momentum.

But while Orman’s 2009 book had the tone, if not the substance, of a collection of emergency maneuvers to help the reader deal with a calamity, Bach’s 2010 book is more of a pep talk to get the reader back on track now that the calamity is over. Indeed, it is endearingly old school. The goal is to get rich, not merely avoid becoming poor.  And Bach generally resists what must have been a strong temptation to make his book seem more timely by claiming that his advice is specially tailored for times like these.

On the contrary, his message is that what you should do now is what you should have been doing all along. What is a good idea in 2010 was a good idea in 2009 and 2008 and will still be a good idea in 2011 and 2012. I have to admit that I admire that sort of stubbornness, all the more since it limits Bach’s ability to issue new books for 2011 and 2012. Then again, he has never shied away from repeating nearly the same book under a different title.

When the current circumstances are taken into account, Bach tends to use them as a justification for being more aggressive in investments rather than more defensive. He takes the (not unreasonable) position that risky assets, stocks and real estate, are very cheap just now. So go out and buy.

But, at least with regard to real estate, Bach’s endearingly stubborn optimism crosses the line into a foolish refusal to learn from the recent past. He is adamant that if you want to finish rich you must own a house. Long-term, renters lose out. Period.

Over the long haul, homeownership remains one of the best – if not the best – investments you can make. In fact, in the 12 years from 1997 to 2009, U.S. homeowners have seen the values of their properties appreciate by an average of 5.4% a year. (p.119)

It is nice to be reminded that on a twelve year basis houses are still up nicely, but is 5.4% really what the best investment you can make pays? The S&P 500 returned about 5.0% including dividends over the same period. Moreover, that was an atypically good period for houses and a below average one for stocks.

Someday a psychology professor will write a brilliant book explaining how, despite widely available numerical evidence to the contrary, it was once conventional wisdom that owning a house was an easy path to wealth. Then the bubble burst, and the scales fell from everybody’s eyes.

Everybody, that is, besides David Bach. For him it is still 2005. He is dismissive of the idea that there could be an argument against home ownership. “When it comes to real estate, there are three kinds of people: those who own, those who want to own, and those who own and want to own more.” He provides information to help first time buyers get a house with as little as 3% down.

If you already own you will, naturally, want to upgrade. This is a great time to do that. Bach does caution that unless you have the money to carry two houses you should be sure and sell the old one before buying a new one.

That said, you will probably be able to find a tenant if you can afford to rent out your [old] place at 25% below market. In this case, you may not want to sell your old house now, but rather hang on to it until the real estate market recovers – and it will recover. The fact is that if you have the cushion and income to carry two properties comfortably, then this could be a great time for you to rent your home, buy another one to live in, and become a real estate investor. As I said, it’s real estate markets like this one that provide an opportunity for average people to become millionaires. (p.137)

It is not that this was sound advice in 2005 but is no longer sound in 2010. It was a bad idea back then too. But in 2005 everybody else was saying the same dumb things. Today Bach stands out like the last guy driving a Ford Excursion.

To be fair, if you look closely you can find some minor tweaks to Bach’s outlook occasioned by recent events. He says that the proportion of your investment portfolio in bonds should equal your age in percent. That’s about 10-20% more in bonds than he was recommending in The Automatic Millionaire (2004).

And in the obligatory recapping of The Latte Factor® Bach concedes that the 10% investment return assumed in his previous book’s discussions is a bit ambitious. Getting rich from avoiding Starbucks was, you see, first conceived back in the early 1990s, when 10% was a reasonable assumption.

Not to worry, even including recent unpleasantness, for the 42 years ending 2009 the stock market was up an average of 8.76% annually. (42 years being the time the original caffeine addled non-saver had until retirement.)  Compounded over the next 42 years that’s still some serious money. Not quite as much as with 10%, in fact it’s nearly a third less, but still.

Having made this modestly sobering observation Bach immediately proceeds to ignore it and uses 10% in his calculations for the rest of the chapter. Nor does he reconcile these rates of return with his recommendation to have your age in bonds.

But he does have a new Latte Factor® iPhone app. Only $2.99.

[Part 2 here.]

I suppose that if you misunderstood what was meant by the term "existing-home sales," confusing it with the prices for houses, rather than simply the number of non-new houses that changed hands in 2009, you might be surprised. Through November ‘09 the Case-Shiller 20 City was down a little less than 3% for the year. (December hasn’t been reported yet.) That’s a great improvement on the year before, ‘08 was down more than 18%, but it’s still down. So, yes, if you thought "existing-home sales were up" meant that prices were up, your befuddlement might have caused a brief bit of erroneous optimism.

Alas, that’s not what it means. The count of houses sold is of great interest to real estate brokers, who make money on each transaction, and of almost no use to anybody else. True, there is a rough and unreliable relationship between sales volume and prices. (See chart here.) It is enough that if we had no price indexes we might use sales volume as one of our tea leaves to help us guess what was going on.

But we do have price indexes. In the past year or two the Case-Shiller indexes have been broadly adopted as the standard, something that may turn out to be one of the few lasting benefits of the Great Recession. So why would you assume that your readers were concerned about the volume of existing home sales? Could it be that you were confused about it yourself?

Were the item I am talking about from a second-tier personal finance blog it would have been unremarkable. But it appeared in Saturday’s New York Times. And it was written by none other than Floyd Norris, their chief financial correspondent. (The Times is not the Daily Show. That’s a serious title. Norris is their lead guy in explaining things financial.)

Evidence of a weak command of the material goes beyond the headline. House prices do get discussed in the article, but the data used is median sale prices. That’s an order of magnitude more useful than the number of sales, but an order of magnitude less useful than the widely available and often cited Case-Shiller numbers.

If you are not a real estate broker, but a homeowner or thoughtful observer of the economy, what you care most about is the value of houses in general. Median sale price tells you only about the relatively small slice of the housing stock that changed hands recently. (4.6 million houses were sold in ‘09. There are about 76 million owner-occupied housing units overall.) If the sold houses are not a true cross-section of the overall supply of houses, and there is no reason to assume that they would be, then the changes you see in the median sale price may not reflect changes in the value of houses in general. If, for example, there were more sales amongst higher-end houses then the median sale price would rise for that reason alone, even if the values of all houses were unchanged.

And then there is this paragraph:

Sales of new homes continued to sink, even with help from a tax credit for new homebuyers. For the year, just 373,000 new single-family homes were sold, the lowest total since the government began keeping count in 1963.

I don’t want to be an alarmist, but is it possible that the Times’ chief financial correspondent thinks the much talked about credit for new homebuyers is for buyers of new homes, rather than home buying rookies? At the very least, he seems unconcerned about spreading that misapprehension to others.

The Times has been in slow decline for rather a while now, possibly dating back to whenever it started being called The Old Gray Lady. Be that as it may, this is what passes for expert commentary in what is still the most prestigious newspaper in the country, possibly most prestigious media outlet of any kind. Heaven help us.

[Photo: Luigi Novi – Nightscream]

I will start with a correction of sorts. A few weeks ago I wrote a post in which I  mocked the semi-scientific conclusion that watching TV makes you poor. I still stand by my mockery, but in the meantime Wallet Pop has discovered further scientific evidence that Mom was right: Too much TV CAN kill you. (PDF of actual scientific paper written by actual scientists here.)

Come to think of it, my mom never said that TV would make me poor or kill me. She tended towards blind and stupid. Just another way my upbringing was atypical.

And the scientists do not exactly say that TV will kill you, only that watching a lot of it is correlated with keeling over. Specifically, someone who watches 4 or more hours per day is about 50% more likely to shuffle off his mortal coil than somebody who watches less than 2 hours. My theory is that prolonged exposure to reality TV causes a subconscious desire to end it all.

The scientists, however, have another hypothesis. They speculate that, and I am paraphrasing a bit, people who watch 4+ hours of TV a day are fat lazy slobs who need to get off the sofa once in a while and exercise.

But it’s January. Up here in the Northern Bits it’s too cold to go outside and run around. What to do? Not to worry, another bunch of scientists right here in chilly and newly red Massachusetts have the answer, again via Wallet Pop. Apparently, for men between 40 and 70, having sex at least twice a week reduces the risk of heart disease. They are a little short on explanatory theories as to why this might be so, but then again, who cares?

If nothing else, this should greatly increase the number of things you can use your medical FSA money on. And if we can legalize marijuana for "medical" reasons, why not certain currently illegal services? I’m envisioning a nationwide chain of "clinics."

Alas, every ointment has its fly. According to yet another guy in a white lab coat, this time from the UK, when men take their twice weekly medicine, they need to be sure and wear protection. On their wrists. It seems that carpal tunnel syndrome is not just for secretaries who spend too much time at the keyboard. It’s been striking older British gents who have been using Viagra to combat heart disease.

Sexual intercourse can explain the increase in the overall incidence of carpal tunnel syndrome seen in recent years, since it is the most widely practised activity that uses both hands at the same time.

In the UK sex is the most widely practiced (sorry, I meant practised) activity using both hands? I’m moving to England. Here in the States we spend more time texting while driving. Then again, I’m pretty sure that if you get CPS from sex you are not doing it right. Another article on the study ominously noted that CPS is often "caused by the use of heavy vibrating machinery." Come to think of it, I’m happy not to be British.

Of course, it needs to be pointed out that both the heart disease and CPS studies involved only middle aged men. So getting busy twice a week may be more of a challenge for those whose life partners are not also middle aged men and therefore lack incentive.

Apparently, lots of guys have been working around this problem lately. Again according to the ever informative Wallet Pop, men are cheating more during the recession.

Needless to say, this is a topic I know very little about, as I am married to a wonderful and sexy woman who reads my blog every day.

But according to Wallet Pop and another blog that it cites, LimeLife, unemployed men tend to cheat more because of low self-esteem. Sure they do. If your wife catches you, and she’s not buying the heart disease angle, try telling her it’s low self-esteem. Worth a shot, anyway.

Again, I know nothing about this myself. The source for LimeLife’s thesis that cheating and recession go hand in hand is the increased popularity of web sites that facilitate cheating. I had no idea! Apparently, there are several such places.

For example, cited in both blogs was AshleyMadison.com, whose motto is "Life is short, have an affair(TM)." A full membership on the site, which comes with an "affair guarantee" costs $249. They have 5.2 million members. Just thinking about that gets me excited. Not the sex part. I’m talking about the money. 5.2 million at $249 per is $1.295 Billion. Who knew fighting heart disease could be so rewarding?

[Photo: Aaron Escobar]

If the problem is ignorance, then the obvious cure is education. Why not mandate a high school or college course on personal finance? This is a question I have discussed in passing a few times (e.g. here and here) mostly to point out that things are so bad I doubt we could find enough teachers.

Just to be clear, my only objections to teaching personal finance in schools are ones of practical implementation. In principle, more exposure to the issues of personal finance can only be a good thing. Even a disorganized course taught by a confused teacher could not make the situation worse. Or could it?

There is an outfit called the Jump$tart Coalition for Personal Financial Literacy which did a survey of college students in 2008. They found that students who had taken a personal finance course in high school scored lower on a test of financial literacy than those that hadn’t. Oops.

This discovery has been well analyzed in what turns out to be a rich academic literature on the efficacy of personal finance classes. There are even, if you look hard enough, blogs that discuss it. I found this stuff at The Psy-Fi Blog. (I like that blog a lot. A recent post about bank regulation was entitled Basel, Faulty? If you, like me, think that’s clever, you’ll like the blog.)

As amusing as I would find it that what high school courses that do exist are actually counter-productive, that sitting through them actually makes you dumber, I don’t think that is what is going on.

Firstly, it has to be acknowledged that "financial literacy" encompasses a vast and vaguely defined body of material. It is very possible that what Jump$tart quizzed the college students on was not covered in their high school classes. In particular, Jump$tart seems to use checkbook balancing as a litmus test skill. You might as well ask college students if they know how to use the Yellow Pages and properly clean a phonograph record.

Secondly, and more importantly, most of those high school classes were not required courses but were electives. That introduces a significant bias. It could be that those who took the classes tended to do so because they were particularly challenged when it came to personal finance. Or it might be the case that these were relatively easy electives in high school and that weaker pupils tended to take them instead of, say, AP Chemistry.

The Jump$tart study did find a consistent correlation between financial literacy scores and being a good student in general. Students with higher SAT scores, more years of college, and more planned years of college, did better on the quiz. Apparently, better students do better on quizzes. Fascinating.

They also found a correlation with undergraduate major. Science and engineering types did best, with nursing and arts bringing up the rear. Business/economics was, interestingly, in the middle of the pack. I take this as a useful demonstration that a) the academic field of finance is only distantly related to personal finance and b) personal finance is ultimately about numbers. It is not really financial illiteracy we are talking about but financial innumeracy.

There are those who conclude from the apparent fact that high school personal finance courses have no effect that the situation with regard to educating the masses is hopeless. Psy-Fi called the post that started me on this Freedom of Financial Choice is a Myth, arguing that expecting people to understand our modern financial landscape is unrealistic. The blog quotes from a paper by a law school professor who argues, and I am paraphrasing a bit, that efforts to educate the masses are misplaced. Instead we need more government regulation to protect these simple people from the sophisticated profit-maximizing bankers.

I do not think that personal financial education is inherently hopeless. I just think that right now we are bad at it. We can get better, but it will take much effort and some time. In a way I actually think the problem is worse than those that are ready to give up on financial literacy classes. We cannot expect a high school course to be a magic bullet if we do not know what to teach the students.

Moreover, conceding that 90% of people will never understand personal finance and should therefore be kept on the straight and narrow by benevolent regulation is no longer a practical option. Let us not forget that, at least with regard to investing, this was essentially the regulatory regime we had fifty years ago. Revisionist history has it that those regulations were abolished by a cabal of greedy businessmen and other Republicans. But that is not what happened. Mostly those rules, like the limits on what interest banks could pay on deposits and the separation between commercial and investment banking, were overtaken by events. By the time they were formally rescinded they had been practically irrelevant for some time.

Obviating the need for widespread financial literacy through regulation would be getting the genie back in the bottle. It is is one thing to complain that the financial lives of ordinary consumers are now inappropriately complex, but quite another to reverse the trend by banning some of the complicating newish inventions, such as IRAs, ARMs, credit cards, and on-line stock trading.

But the biggest problem with conceding that the masses will never understand our modern money world is that we live in a republic. Most inconveniently, the government that would keep the 90% from harming themselves and others is selected by that same 90%. And they generally don’t vote for politicians from the other 10%. Assuming they even exist.

Since the very start of this blog I have written about how much of the Great Recession was due to millions of ordinary people acting foolishly by, for example, buying more house than they could afford. But they also act foolishly by electing representatives who have even less common money sense than they do.

It might be possible to use government regulation to protect the simple people from the sophisticated profit-maximizing bankers. But then how do we protect the sophisticated profit-maximizing bankers from the simple people?

Obviously, this is a lesser of evils situation, not an ideal one. Not paying any one of them will have negative consequences. Defaulting on the credit cards  will likely result in not being able to use them to buy more stuff. And the other two loans are secured, so not paying those bills could result in the loss of your wheels or roof over your head.

You might think that since shelter is so important, the mortgage would be the most likely bill to be paid. And since buying more stuff on the credit cards is less vital to a person in financial trouble, you might assume that credit cards would be the most likely to be defaulted on. Having your cards taken from you would suck, but not as much as having your car taken.

Not so. Last week Wallet Pop ran a post by Lita Epstein that looked at default data for these three types of loan. Credit cards do turn out to be more commonly defaulted on than car loans, but not by as much as you might have assumed. 1.1% of credit cards were 90 days delinquent in the third quarter. 0.81% of car loans were 60 days delinquent.

But way out in front in the delinquency derby are mortgages. According to TransUnion, in the third quarter of last year 6.25% of US mortgages were 60 days delinquent.

That is a big number and one that is, to say the least, counterintuitive. Isn’t losing the house the worst case scenario for most people? Wouldn’t you want to protect your home by paying the mortgage before you paid the other bills?

Yes and no. As I have argued here, the visceral preference that many people have for paying secured debt first is not, on close examination, as reasonable as it sounds. If nothing else, the interest rates on credit cards and car loans are generally much higher than those on mortgages, so paying them first could be saving the most money.

Then there is the ever-popular topic of strategic default. This is sometimes referred to as homeowners "just walking away" and was for a time called "jingle mail" because the homeowner would (figuratively) mail in the keys to the house. But on reflection it should be clear that this is not what strategic defaulters actually do.

Suppose you owe $400K on a house worth $300K in a non-recourse state and you can’t pay your bills. Do you sign the house over to the bank and move out? Of course not. You just stop paying the mortgage. Eventually the bank will foreclose, but by the time the sheriff shows up to evict you you will have had many months, maybe even a year, of rent-free living.

Needless to say, mortgage delinquency rates are highest in states suffering the worst declines in house prices, that is, the ones with the highest proportion of underwater houses. A staggering 14.53% of Nevada mortgages are delinquent.

So paying credit cards and car loans before mortgages could be the shrewd move after all. How did millions of households cleverly determine that this non-obvious strategy was the best course? I think the truth is that they didn’t.

As the Wallet Pop post discusses, not paying a car loan or a credit card has more obvious and immediate consequences than not paying a mortgage. Stop making your car payments and it will be repossessed. And credit cards may be as important to the American lifestyle as cars. Consumers reason that as long as they keep making the relatively modest minimum payments they will be able to keep using them. The fact that the card company is likely to close an account once they discover that the borrower has stopped making his mortgage payments may not occur to that many people.

Still, not paying the mortgage may be the right answer, even for the wrong reasons.

Earlier this month The Washington Post blamed an increase in typos (e.g. soldiers wearing "shiny black boats" on their feet) on copy editors being distracted by new duties. "Separate online headlines must be written in a way that attracts attention on the Web."

I bring this up because the other week Jason Zweig’s Intelligent Investor column in The Wall Street Journal was headlined "Why Many Investors Keep Fooling Themselves." (Mysteriously, the metatitle, the thing that appears at the top of the browser window, hedged: "Why Some Investors May Be Fooling Themselves.")

It is a good column, worth reading, but it disappointed me for the simple reason that it failed to discuss, even in passing, why many investors keep fooling themselves. It did cover the fact that they do keep fooling themselves, and touched a little on how, but didn’t attempt an answer to what I consider to be the really interesting part, why.

Zweig tells us that "a nationwide survey last year found that investors expect the U.S. stock market to return an annual average of 13.7% over the next 10 years." Personally, I consider that to be crazy optimistic. Average returns for the S&P over the decade just ended were –0.95%. Then again, the 80’s and 90’s averaged 17.55% and 18.21% respectively, so this particular bit of mass hysteria may not be entirely hallucinatory.

Still, it is a big number that few professionals would say out loud even if they thought it to be true. But, as it turns out, presumably sophisticated investors who should know better tend toward the same delusions.

Zweig cites another survey that an investment manager for endowments does of his clients. He asks them what is the least amount of guaranteed return above inflation they would accept as a swap for their actual returns over the next 50 years. In other words, at how low a rate would they be willing to lock in returns in exchange for not taking the risk of investing in things like stocks, bonds, and real estate?

Last year the average answer from this survey was 7.4% over inflation. Add inflation back in, and consider that these endowments would typically have significant bond holdings, and it is clear that these trustees are no less optimistic about stocks than the ordinary folks.

The thing is, locking in a risk-free return for the next few decades, even an inflation protected one, is not just a hypothetical possibility. Anybody can do it. Just buy a Treasury bond. The one maturing in November 2039 will pay you 4.54%, guaranteed. Worried about inflation? There are also TIPS. The longest dated one that I could find, maturing in April 2032, will get you inflation plus 1.98%.

That these endowment managers would only be willing to lock in returns at a number that is far above the actual market clearing going rate for such things can only mean that they are aggressively optimistic. They would not put it this way, but they are essentially arguing that the marketplace is wrong, that it has mispriced risk-free returns in light of the fabulous opportunities available in risky assets. In other words, you would have to be a lunatic to buy a long-term Treasury.

There are serious problems with that point of view, amongst them that the number of Treasuries in circulation is inconceivably large, exceeding even the supply of crazy people with money to invest.

Alternatively, you could believe that the risk-free rates were correct and that the higher returns you expect on risky assets are appropriate given the volatility you are taking on. But the numbers don’t really work.

The zero coupon Treasury maturing in February 2020 currently yields close to  4%. If you believed that 13.7% was the expected return for the S&P over the same period, and that the annual volatility of the S&P was 15.4% (its historical average since 1970) then you would be able to calculate that the probability of the S&P beating the Treasury over the next ten years is 99.9992%. So you get another 9.7% a year in expected returns in exchange for living with that scary 0.0008% risk that the risk-free bond might turn out to be a better deal? Not likely.

No, the bottom line is that although we can all agree that risk is a bad thing, and that in the abstract we would prefer not to have it and even to pay others to take it away from us, optimism about the future keeps getting in our way. Those endowment managers are not interested in paying to have the risk removed from their lives. In fact, they would need to be paid quite handsomely to give up the fabulous upside potential of uncertain returns.

Which is to say that they think they will get lucky. It is exactly the same triumph of emotion over logic that we see with the old index fund vs. actively managed fund question. It is easy to demonstrate that in the long run the average actively managed fund must underperform a low-fee index fund. And yet actively managed funds are much more popular. Why? Because few investors think that their active fund will turn out to be merely average.

I do not have a clever explanation as to why investors keep fooling themselves. (Sorry to disappoint.) But it is clear to me that it is in our basic nature as humans to do so. We have an optimistic bias when it comes to our expectations of the future. There is probably a good biological and evolutionary justification for that. If we were consistently and soberly risk adverse we would probably still be living in caves.

Evolution  aside, this is still another example of non-logical reasoning that should be kept far away from money decisions.  As Zweig puts it

The faith in fancifully high returns isn’t just a harmless fairy tale. It leads many people to save too little, in hopes that the markets will bail them out. It leaves others to chase hot performance that cannot last. The end result of fairy-tale expectations, whether you invest for yourself or with the help of a financial adviser, will be a huge shortfall in wealth late in life, and more years working rather than putting your feet up in retirement.

When the program was first announced to great fanfare in March, I observed that nobody outside the Treasury seemed  to think it would work. Only two months later I had a little fun pointing out how, even by then, it was pretty obvious it was going to miss its unrealistic goals by at least an order of magnitude. By July I was writing about the inevitable finger-pointing that followed the revelation that a program nobody believed in was not, in fact, working very well.

Of course, the Home Affordable Modification Program is still running, and still bravely defended by administration officials with a straight face. And they sure are brave. Last week The New York Times told us that U.S. Mortgage Plan Aided 7 Percent of Borrowers. That figure, apparently, refers to 7 percent of the 853,696 borrowers enrolled in the program, not 7 percent of all borrowers.

That sounds bad enough, but then on Wednesday the Wall Street Journal ran an opinion piece by the CEO of ING Direct USA that put the success rate at only 1%. (His calculation is the number of completed permanent modifications divided by the estimated number of eligible borrowers.)

All of this is fairly predictable, and was indeed widely predicted here and elsewhere. Despite periodic promises from the administration to pick up the pace and/or threaten mortgage servicers with unspecified punishments if they didn’t make it work, the program has been limping along like this since day one.

What is a relatively new development is the dawning realization in certain circles that maybe the whole thing was a bad idea to begin with. Not just that the mechanics of the program were poorly thought through. (Which is true.) Nor that it was founded on the flawed premise that most homeowners facing foreclosure could very nearly afford their houses and just needed a tweak to their mortgage terms. (Also true.)

The new revelation for the Yes We Can Crowd is that maybe the goal of the program was misconceived. Saving a home from foreclosure may be a good thing for the family that gets to live in it (and even then, depending on the terms, maybe not) but it might not be good public policy.  It is just possible that this particular corner of the free market wasn’t all that broken after all.

The very lightly read January 1 edition of the Times carried the item U.S. Loan Effort Is Seen as Adding to Housing Woes. Permit me to quote liberally:

Since President Obama announced the program in February, it has lowered mortgage payments on a trial basis for hundreds of thousands of people but has largely failed to provide permanent relief. Critics increasingly argue that the program, Making Home Affordable, has raised false hopes among people who simply cannot afford their homes.

As a result, desperate homeowners have sent payments to banks in often-futile efforts to keep their homes, which some see as wasting dollars they could have saved in preparation for moving to cheaper rental residences. Some borrowers have seen their credit tarnished while falsely assuming that loan modifications involved no negative reports to credit agencies.

Some experts argue the program has impeded economic recovery by delaying a wrenching yet cleansing process through which borrowers give up unaffordable homes and banks fully reckon with their disastrous bets on real estate, enabling money to flow more freely through the financial system.

….

Behind the scenes, Treasury officials appear to have concluded that growing numbers of delinquent borrowers simply lack enough income to afford their homes and must be eased out.

In late November, with scant public disclosure, the Treasury Department started the Foreclosure Alternatives Program, through which it will encourage arrangements that result in distressed borrowers surrendering their homes. The program will pay incentives to mortgage companies that allow homeowners to sell properties for less than they owe on their mortgages — short sales, in real estate parlance. The government will also pay incentives to mortgage companies that allow delinquent borrowers to hand over their deeds in lieu of foreclosing.

I’m the sort of guy that thinks the free market mostly works and requires government intervention only in exceptional cases. So I have little sympathy with Obamaites who tend to the opposite assumption, that the free market generally does not work and usually needs government intervention. 

Yes, hindsight is 20/20 and tragic flaws are rarely as obvious in real time as they are after things go awry. But seriously folks, this particular tragic flaw isn’t all that subtle.

And it is not as if the goal of the program went unquestioned at the start. For example, see the March 9th post What’s So Bad About Foreclosure? at All Financial Matters.

The core problem is that the people who thought HAMP (or something like it) would be a good idea were blinded by their own ideology. They could only see consumers as well meaning, responsible, and thoughtful, if a bit naive. Businesses, on the other hand, were greedy, incompetent, and cloddishly destructive in their efforts to make more money. So, of course, what was wrong here was that the corporations tricked the wholesome consumers into mortgages they couldn’t, quite, afford. If only the mortgage companies could be cajoled into being a touch more reasonable everybody would be better off. Problem solved.

Alas, it turns out that it was not the mortgage that was unaffordable, it was the house. It is a bitter pill to swallow, but the best way, perhaps ultimately the only way, to make home more affordable for some is to get them into less expensive houses.

[Photo: Stopmangohome]