Monday, March 5, 2012

Why isn't Finance Understandable? Here are some Ideas on Fixes

When I talk to my non-finance friends about safe and fair finance, their first response is that, as a first priority, finance should be understandable. One can only wonder why consumer finance is not easy to understand.

From a conceptual perspective, consumer finance is super simple. Financial products sold to households consist of just a few variations of a theme. Loans are provided for a short period of time (such as for credit card borrowing or payday lending) or a long period (to finance a residential mortgage, for example). The interest rates are either fixed or floating, or fixed for a while and then floating for a while, or vice versa. Fees are due when you set up the loan or you pay it back early or you don’t pay on time. It gets more complicated if you provide your house or apartment as collateral, or if your lender insists on life insurance (in case you die before the loan is repaid). It is the same in reverse when you make deposit money in the bank--except that you can't ask for life insurance for the bank. That is why deposit insurance was put in place.

Investing in securities may seem to be same as betting in the casino but there are lots of rules (although maybe not enough rules) on how companies treat retail investors. In general, if Apple sells lots of iPhones and iPads, you (the investor) see the value of your shares rise. But if your company declares bankruptcy, your stock certificates have value only as framed collectors’ items. Buying into a mutual fund (or collective investment fund in Europe) means that you hire a professional to choose stocks for you. You just have to decide on your risk profile and the manager does the rest (for a fee).

Even insurance is not so difficult to understand. If you have a car accident or a house fire, the insurance company pays for most of the damage. The complicated part is if you buy a variable annuity (or investment-linked annuity in Europe), which is really a securities investment camouflaged as insurance. A variable annuity is indistinguishable from a mutual fund but supervised under the insurance regulation rather than securities regulation. But most consumer financial products are not that convoluted.

The hard part in all of this is figuring out how much money you need to save to cover you if you don't work again for the rest of your life, i.e. when you retire. But that's another issue.

In itself, figuring out how to use financial products is simple stuff—or should be. Why is it that people with advanced college degrees have difficulty understanding what they are buying? Why is it more fun to buy a sweater at Nordstrom’s than open a certificate of deposit with Bank of America? Clearly financial service providers have not clued into the idea that consumers like retail therapy—and that for most people, dealing with personal finance is a painful experience. Indeed a 2005 survey by the Royal Bank of Canada found that for most people, selecting the right investment for their retirements was more stressful than going to the dentist.

So what is the solution?

Safe and Fair Finance Blog suggests that as a starting point, financial institutions should be obliged to make consumer information easy to understand. The standard for consumer health information is that it should be understandable for people with just a ninth grade education. Given that 90 percent of Americans have graduated from high school or have equivalency diplomas, this would seem to be a reasonable standard. Why is the same not also required for consumer financial information?

Some people are trying. In a video from Tristan Cooke and Tom Nelson of the Australian firm, Humans in Design, they lay out how residential mortgage statements (in this case from Westpac Bank) could be redesigned. Their view is that customers want to receive clear and concise information about their mortgages. The proposed layout provides clear information that is useful for consumers in making decisions, such as whether to increase their repayments of their mortgages. The graphs also show the impact of changes in interest rates. The idea is that by giving customers clear and concise information about their monthly statements, consumers will feel empowered to make informed decisions about managing their mortgages.

Some of the government regulators are also working on it. The U.S. Federal Reserve Board conducted extensive surveys of shoppers to work out the government-mandated format for credit card statements. What used to be complicated and hidden in fine print is now easy to read—and even easier to understand. What is most striking is the estimate of how many months (or years) it will take to pay off your credit card debt if you only make the minimum monthly payment. Thank you, Federal Reserve.

Safe and Fair Finance Blog hopes that other regulators, consumer groups and just marketing folks also try their hand at making consumer finance understandable for us all.
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Sunday, March 4, 2012

Housing and the Economy -- Which is the Chicken and Which is the Egg?

For those who ask why I continue to forecast declining U.S. housing prices, here is the core of the issue. U.S. housing will not likely recover until the U.S. economy improves...but the economy will not improve until the housing market recovers. It is a classic chicken and egg problem.

Getting out of this vicious circle is difficult. Recovery of the economy depends on spending by middle-class consumers, which represent almost 70% of the US Gross Domestic Product. But spending by those consumers has been stalled by declining housing prices. 

Some suggest modifying the personal bankruptcy code. This is a good idea but its proponents tried to include such revisions as part of the Dodd-Frank financial legislation of July 2010--and failed. Other ideas have also been floating, including the suggestion that government agencies own part of people's houses in exchange for forgiveness of debt. This also seems a little far-fetched.

In the meantime, our current tax policies favor the top 10% of the population (including myself) and leave the rest to suffer declining real wages, increasing expenses for oil and food and health care, and rising costs of a college education. The current strategy of allowing inflation back into the economy (so that borrowers will have an easier time in repaying their debts) is surely not one likely to succeed.

In the author’s view, what is needed is: (1) a fundamental restructuring of the personal tax code to simplify and lower taxes (which always increases tax revenues by eliminating the loopholes), (2) reform of the business environment to make it easy for small businesses to operate and grow, (3) a national education policy to increase the college-educated population to 50% (from just over 20%) of all adults and (4) a viable long-term strategy to reduce total government debt (including state and local government obligations) from the current level of 120% of Gross Domestic Product.

Along the way, we also need to bring our telecommunications policies in line with international practice and increase effective competition among the carriers. In financial services, we are only half-way through the reforms needed to avoid another financial crisis similar to September 2008. Improving consumer protection in financial services and raising financial literacy will eventually be critical but for the moment, regulating financial instruments such as credit derivatives is far more pressing. Stopping banks from using tax-payer funds to finance speculative investments, as former Federal Reserve Chairman Paul Volcker has proposed, is at the top of the agenda but remains difficult to put in place.

Big agenda, eh?

Of this, so far the administration has announced efforts to: (1) reduce corporate taxes, (2) make it easier to borrow for college, (3) develop a bipartisan plan for government debt reduction, (4) strengthen consumer protection in lightly regulated financial services, such as payday lending and debt collection, and (5) adopt the Volcker rule on banks' use of depositor funds. It is a start but not enough to get the economy moving--or solve the housing dilemma--or give the middle-class a chance to realize the American dream once again. 

But at least, we don't have to figure out which is the chicken and which is the egg.
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What can Baseball Teach us about Financial Education?

On a recent flight from Armenia back to Washington, D.C., your correspondent took advantage of the in-flight entertainment to watch Brad Pitt in his 2011 movie, Moneyball. No doubt the story of the success of a small regional (and low-budget) baseball team will appeal to the heart of all true baseball fans. But for the Safe and Fair Finance Blog, some lessons also emerge.

The story’s author, Michael Lewis, is famous for Liar’s Poker, published in 1990 describing Wall Street and the famous investment bank, Salomon Brothers. Anyone who worked in investment banking in the 1980s will find his stories arrestingly accurate.

The basic premise of Moneyball is that players have traditionally been bought and sold based on the wrong criteria. A manager’s decisions about which player to trade for another is based on perception, i.e. the manager’s biases and gut-feel, all of which are based on years of experience but selective recall of that experience. Unfortunately such perceptions are often inaccurate and lead to faulty decision-making. The young assistant to manager of the Oakland A’s baseball team suggests that instead focus be placed on just one data point—the number of times each player reaches a base, called “time on base”. The argument is that the more times a player reaches a base, the higher the probability that the player will move from first base, then to second to third and then home for a run. The more times a player is on base, the more runs will be chalked up and the more likely the team will win the game.

In selecting ball players, managers are often influenced by consensus thinking rather than hard data. Some players look funny when they throw the ball. Some play it safe too often. A once star athlete may have lost much of his power and so is considered ineffective when he still has a lot to give. For one reason or another, some talented players have undervalued qualities. Their market price is based on biases and gut feel. But their value to the team is reflected in the data.

Here Michael Lewis tapped into his experience on Wall Street. Finding tradable assets where the market value differs from the true value—and buying and selling based on the discrepancies—lies at the essence of successful financial investing. Better to buy and sell players using concrete data rather than gut-feel, suggests the young manager’s assistant. For the Oakland A’s in Moneyball, it was a highly successful strategy that changed the way that baseball teams were selected throughout America. It changed the way managers thought about how to win the World Series without busting the budget.

So how can Moneyball help figure out how best to design programs of financial education? Most government officials design economic policies based on a combination of their gut and their interpretation of recent historical experience. However neither is a reliable guide. Instinct is helpful when sudden decisions must be made but economic policy is almost never made in a matter of moments and such gut-feel can lead to poor choices. Better to focus on using concrete data to achieve policy goals. Unfortunately such evidence-based policy-making remains very rare, particularly when related to warm and fuzzy issues such as financial education.

Safe and Fair Finance Blog suggests that financial education programs focus on just two concrete data-points. First, one needs to define a target for success of financial education programs. This might be to achieve a certain level of measured financial literacy among the adult population--or perhaps having your country’s population rank at the top of a survey of financial literacy worldwide.

Second, one needs to identify the critical measure that ensures success in reaching the goal—something equivalent to “time on base”. Is this number of hours of classroom training in personal finance? Currently time in classroom is the most commonly used indicator. Unfortunately it is the least useful of all possible choices. A more helpful target might be the percentage of adult population that maintains bank account (reflecting sufficient public confidence in using keeping extra cash in a bank rather than under the mattress or in a sock). Whatever indicator is selected, detailed and comprehensive statistics need to be collected, published and analyzed.

Only financial education programs are designed based on data of what works will financial literacy measurably improve. Otherwise the best alternative might be to cancel the classes on personal finance and let students enjoy playing baseball.
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