the Wealthy Canadian

Yesterday I told the story of Joe, an unfortunate victim who got caught in the jaws of the credit trap.  Joe made liberal use of his credit to buy all the things he never wanted. Then watched as it spiraled out of control.

To be fair cheap credit can be a great thing.  It is the ease with which we get it and how we use it that determines whether or not it is a good thing.  Easily obtained credit and cheap credit are two different things.

Financing a house at 4% is definately cheaper than financing it at 4%.  Being pre-approved for twelve different credit cards at the same time while purchasing that dream home is ease of credit. Combining the two can be deadly.

Here are a two tips to help avoid the credit trap.

1. Pay cash for everything!  You can only spend what you have.  An alternative for the more disciplined is use free reward credit cards to pay for everything (and get the cash back, or free groceries) – but only buy as much as you can back with cash.  This takes much more discipline and you need to be extra cautious for the trap.
2. Buy only what you can afford.  It is reasonable to assume that you will need to take out a mortgage to buy a house but buy one that makes sense given your income – not what you can afford based on the monthly payments!

That is it, two tips to sum it up.  Buy what you can afford and pay cash (or equivalent).

Paying the maximum payment you can afford every month for a house is not a house that you can afford.  What happens if/when the payments go up?

If you want a big screen TV, plan for it in your budget.  It may takes months to get enough cash but you will know that you will have enough to pay for it.

Thinking of a car loan?  What happens if you finance that shiny new Escalade for $50,000 and a few months later get into an accident that destroys it?  By that time the car has depreciated, as car do, to below what you owe on it.  E.g., insurance offers you $40,000 but you still owe $45,000.

Joe, an average office worker, has been pre-approved for a $300,000 mortgage plus he has a three credit cards with a total limit of $25,000 and a constant bombardment for other ‘pre-approved’ cards.  Joe earns $48,000 per year at his office job as a pencil pusher.  After taxes and deduction Joe earns $3000/m.  Joe’s favourite phrase is ‘Carpe Diem’ and has no savings.

Joe has always wanted a large house with a white picket fence.  So, he buys one for $300,000 (no money down), amortized over 25 years at 4%, his payments are $1578/m.  He bought in at a good time though, prices have seen dramatic appreciation so his house is now assessed at $350,000.

Joe lives near a lake, he loves water skiing so he decides to buy a boat (and truck to haul it around, of course).  The price tag for the new toys comes to $50,000.  He doesn’t have the money but, luckily, his bank offers him a Home Equity Line of Credit (HELOC) on the equity that now exists in his home.  The HELOC rate is a low 5%.  The great part is that he doesn’t need a re-payment schedule, he can pay interest only  but decides to pay it off over 25 years.  Payment = $290/m.

Joe pays for everything with credit and tries to pay off the full amount every month.  Unfortunately, there always seems to be a good deal on something that he needs.
Month one: 50″ plasma & home theatre combo sale.  Price = $6000
Month two: a much deserved vacation away from work.  Destination, Cabo.  Price $3000
Month twelve: etc.  By this point Joe has somehow seen his credit card debt maxes out at $25000.  At 18% financing, his monthly interest payments are sitting at $375/m.

Total income: $3000/m

debt service liabilities: $2243/m
Other liabilities (food, property tax, utilities): $500/m

Net income: $257/m  Joe is still keeping his head above water (although he’s not really paying down his debt and he still has no emergency savings.

Unfortunately, interest rates have risen.  His house now costs $1800/m (at 5.5%) and his HELOC is up to 7%, so the payments are $350/m.  Property taxes have also gone up to help pay for the infrastructure in the new subdivisions.

Total income: $3000/m

debt service liabilities: $2525/m
Other liabilities (food, property tax, utilities): $550/m

Net income: -75/m  Yikes!  To cover the shortfall, Joe gets another credit card.

Joes truck needs a new transmission, $2000
His house needs a new water heater, $275
Economic downturn means that Joe gets ‘downsized,’ he’s a smart guy and gets a job quickly but has to settle for $45,000/yr, or $2800/m

Monthly payments keep increasing, he sees the power of compounding… in reverse!

Joe has fallen victim to the Jaws of the Credit Trap!

Suppose that you and I are both planning on buying houses in the near future.  As luck would have it we both need the exact same size mortgage.  Both of us went out and got two quotes each for our mortgages.  The two quotes are for a fixed rate and a variable rate.  The following are our quoted rates:

Because you have a better credit rating than I do, you have an absolute advantage in both quotes.  However, the interest rate differentials are not the same.  You have a 1% advantage in the fixed rate, but only a 0.5% advantage in the variable rate.  Therefore, when we compare our possible mortgages, you have a comparative advantage in the fixed rate.  Are you ready for the curve ball?  I have a comparative advantage in the variable rate.  Why, because you have me beat by a larger degree in the fixed rate.

You happen to think that interest rates are certainly going to go down so you would prefer to buy the variable rate mortgage.  I, on the other hand, think that rates can go nowhere but up so will get a fixed rate.

You and I, being the creative types, engineer a swap to leverage our comparative advantages.

• You get the fixed loan (even though you want the variable)
• I get the variable (even though I want the fixed)
• You and I then agree to swap payments (we are called counterparties to this agreement):
  • I pay you 5.75% (I’ll explain this number later)
  • You pay me Prime

  

Therefore, when you add up what we pay in total:

We both end up with the type of loan that we wanted at a better rate than we were quoted.  That is the reason for the odd 5.75% payment that I promised that I would explain, it is where we make use of both our comparative advantages to give us both a better rate.

1. Find the difference between the two fixed rates: 7.0-6.0 = 1.0%
2. Find the difference between the two variable rates: (Prime +1.0) – (Prime + 0.5%) = 0.5%
3. Take the difference between the above two: 1.0% – 0.5% = 0.5%
4. That number is the rate advantage that we can share.  So divide it by two.  0.5/2 = 0.25%

Therefore, instead of a direct swap of payments, I pay you 0.25% less than what You are paying to the bank, and we both come out ahead.

The big risk in this is that we have to trust each other to honour our payments to each other regardless of how prime moves. This is the simplest type of swap, called a Plain Vanilla Swap, but one of its siblings has been implicated in the global economic woes – the Credit Default Swap

For those in the the northern hemisphere, we are experiencing the longest night of the year.  Indeed, this is a dark time, the nights are long and it appears that we are being consumed by financial calamity.  Banks are failing.  The auto industry, led by the so-called Big 3, is on the brink of ruin.  A few months ago the world was dying from environmental decay (haven’t heard much about that lately, I wonder if it’s feeling better).  Oil has dropped roughly 75%.  And of course, the mining, forestry, retail, tourism, airlines, … sectors are also claiming that they need public funding or they’ll face bankruptcy.

It is important to remember that the moon, the seasons, and the economy are all cyclical.  Unlike the seasons we cannot predict with any degree of certainty how long the economic cycle will last.  Bear markets tend to start quickly and bull markets tend to recover slowly.  We’ve definitely seen the stock market tank very rapidly over the past months.  However, the indices appear to be stabilizing, despite the bad news that surrounds us, despite the tax loss selling, and despite the Madoff Affair.  We are likely in for a long road to recovery, hangovers are never fun.  But things will turn around, and hopefully, we have nowhere to go but up.

Image courtesy of Yahoo Finance

This is not the time to mourn, but to dance.
Merry Hibernal Solstice everyone.

Continuing on my previous discussion of futures pricing, I will introduce the concept of arbitrage.

Arbitrage is taking advantage of a price difference in multiple markets.  In the futures market an arbitrage opportunity presents itself when the basis between the spot and futures prices deviates from the normal cost of carry.

There are times when a futures price is more expensive than it should be, i.e. costs more than the spot + the cost of carrying the asset.  During these times an arbitrager could sell futures contract and buy the asset.  This is know as Cash and Carry Arbitrage.

e.g.,
Gold currently costs $1000 / oz, and has an associated cost of carrying (storing, insuring, etc) of $10 / month.
A 3 month gold futures contract, for some reason, currently costs $1060
The arbitrager performs a Cash & Carry by purchasing some gold and selling a futures contract to deliver gold in three months.

cost of gold = $1000
cost of carry = $10/month x 3 months
Income from futures sale = $1060

Net = $30.  Mr Arbitrager made an easy $30.

There are other times when a futures price is cheaper than it should be, i.e., costs less than the spot + the cost of carry.  During these times an arbitrager could buy futures contract and sell the asset.  This is know as Reverse Cash and Carry Arbitrage.

hmm, this may not work quite as slick.  I cannot sell the asset today if I don’t own it!  Don’t worry, you may be able to borrow it from someone else and then sell it:)  Yeah, I know, they may not like you selling their gold, but you will get the gold back because you bought a futures contract.

e.g.,
Gold currently costs $1000 / oz, and has an associated cost of carrying (storing, insuring, etc) of $10 / month.  A 3 month gold futures contract, for some reason, currently costs $940.  The arbitrager performs a Reverse Cash & Carry by:

• borrowing the gold from his girlfriend
• giving her his prized stamp collection as collateral
• paying her rent
• selling the gold
• purchasing a futures contract to receive delivery of gold in three months.

Mr Arbitrager made $100 by selling the gold and buying a cheap futures contract.  However, he will still need to pay rent on the borrowed gold and he loses the enjoyment of his stamps until the gold is delivered.