Saturday, April 28, 2012

Will I have Enough Money to Retire? A Question for 4.9 Billion World Citizens

Will I have enough money to retire? This is the question millions of future retirees keep asking themselves. How do I know if my nest-egg of x dollars is enough? How can I be sure that I won’t run out of money before I die?

For most of my 5o-something friends, they have only one answer. I will just keep working. Fortunately they work in temperature-controlled offices that keep their working spaces cool in summer and warm in winter. Their idea of heavy lifting is writing a memo arguing against a new expenditure by their homeowner’s association. Their concept of an exhausting day is sitting on an airplane that covers six time zones between stops. For my friends, working until age 7o or 75 is a realistic possibility. However for anyone with a more physically exhausting job, working beyond 7o is a grind rather than an emotionally fulfilling mission.

But even for my friends I ask, what happens then? Will you have saved enough?

Writing in The New York Times, Joe Nocera explores the dilemma. This month he is turning 6o years of age, finding that his physical strengths are waning and wondering what to do. He considered himself a smart investor because he invested in the technology bubble of the 199os and made money—or at least paper profits—for many years. A stock market crash and a divorce later depleted his retirement savings. Then he joined the housing mania and invested in renovation of his home, hoping to make his money back many times over. As a New York Times columnist covering business and finance issues, Mr. Nocera is among the most articulate and literate of consumers worldwide. Yet even he worries about his personal finances.

However Mr. Nocera's problems are those shared by many in the rising global middle class that earns between $1o and $1oo a day. That global middle class is estimated to increase from its current level of 2 billion today to 3.2 billion by 2020 and 4.9 billion in 2030. As noted by the Financial Times, according to the Paris-based Institute for Security Studies in its report Global Trends 2030, within two decades the almost 5 billion in middle class citizens will constitute more than half of the world’s population. By 2o3o, more people will be middle class than poor.

This is encouraging but also rather frightening. The poor suffer from reliance on informal financial service providers, such as loan sharks, and they have no safe way of setting aside their savings for a rainy day. But their biggest problem is in earning enough money to start with.

However it is the new middle class that is most vulnerable to weaknesses in consumer protection for financial services. They are first-time consumers who sign contracts for formal financial services on a hope and a prayer. For such consumers, they are often the first among their family or friends who have entered into a long-term contract with a financial institution. They are the forerunners of others in their family and social groups who need financial services. They need long-term financing to buy their houses and apartments. They need short-term financing between pay-checks. They need a safe and secure place for their savings for a rainy day. They need safe and inexpensive ways to send money home to relatives. They need insurance against catastrophic events. They need to learn the basics of how to use financial services—the risks and rewards of using financial services, their legal rights and obligations when they do so. But financial education will not be enough, any more than it was enough for Mr. Nocera.

It is for all these people that Safe and Fair Finance Blog is written—to help government policy-makers, industry leaders, heads of consumer organizations, members of the academia find ways to help financial consumers. All of their efforts will be needed.
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Friday, April 27, 2012

Can Vampires help us with Financial Education? Maybe.

The financial crisis of 2007-09 hurt us all but some were hit harder than others. In particular, those with weak skills in financial literacy were particularly vulnerable to mortgage brokers selling subprime loans, with adjustable interest rates (but only upwards) and massive prepayment penalties. But the key question is how to improve the financial literacy levels of consumers? The traditional methods of classroom education have only had limited success in raising financial literacy scores for those who chose to sit through the classes. One must therefore ask, “What other methods might work?”

Professor Annamaria Lusardi of George Washington University’s School of Business is setting out to answer just that question. Working with the US Federal Reserve Board, GWU has established a series of lectures and discussions on financial literacy through its Financial Literacy Seminar Series. The lecture on April 20 presented three very different approaches: (1) beefing up the rural library system in the US, (2) distributing both videos and written materials to selected households and (3) providing online games to help gamers learn better financial management skills. All three are geared towards encouraging consumers to save for the future.

The first approach of delivering financial education through the library system was tried in the state of Iowa. Professor Cynthia Fletcher of Iowa State University explained how they developed a program for rural libraries (smart investing@your library), piloting it in one library then expanding the project to 25 more libraries. They put together a user-friendly website of educational materials for users.  With support from the FINRA Investor Education Foundation, they also expanded the libraries’ finance collections, such as a subscription to Value Line which provides valuable investor research on companies. However the third area was probably the most important—they trained librarians in financial literacy. In many small towns, librarians are highly respected as source of information and advice. The thought was to give the front-line staff of the libraries key information on how to access and interpret investment information so that they could share their insights with the users of the library. The researchers noted a 14-28 percent improvement in knowledge of users--and a 53 percent increase in the confidence of all the participating librarians. Best of all, the total budget for the program was under $100,000. It appears that this was a clear winner for rural areas where libraries are an important part of the social infrastructure.

The second approach of using both written materials and videos to reach young workers was presented by Dr. Joanne Yoong of the RAND Corporation. This study was funded by the Social Security Administration through the Financial Literacy Center, and focuses on teaching five key lessons that form the foundation of financial planning for the long-term: (1) harness the power of compounding for investments, (2) understand the impact of inflation on investments, (3) diversify investment portfolios, (4) take advantage of tax-preferred investments and (5) make the most of employer-sponsored matching within your corporate-sponsored 401(k) pension program. Using simple rules of thumb, the videos were able to make clear and easy-to-remember points. The movie we saw emphasized the need to start saving early. If you begin to set aside $4,000 a year at age 21 (and can obtain a 7 percent return), you will have over $1 million by the age of 65. Starting just ten years later at age 31 requires double the amount--$8,000 each year. With stacks of $100 bills, the two actors were able to show just how effective compounding can be over a lifetime.

However it was the third approach that was the most fun. Nick Maynard of Doorways to Dreams described one of their most popular games, FarmBlitz. Their strategy is to use visual clues to motivate the users. In the game, the user inherits a farm and then learns how to borrow to buy seeds and fertilizer for the crops. Debt service is represented by bunny rabbits, which rapidly multiply over time. The farm earnings are represented by trees that grow at glacial pace. What we did not see—but is probably part of the game—is if the bunnies start to eat the crops if a player’s debt gets out of control. The D2D program also includes Bite Club, complete with vampires as disco dancers. The gamer is the manager of a vampire “day” club and needs to successfully manage her club while also taking care of personal finance matters like paying off students and saving for retirement.

D2D is testing how its games can improve the financial capability of employees, particularly around retirement savings. As the introduction to Bite Club warns, when you are a vampire, being dead can be fun. Being dead broke is something else altogether. The game has been tested with Staples in conjunction with New York Life, which provides retirement services for employees. By using product placement as part of the game of Bite Club, the game encourages employees to click on the website of Staples’s retirement funds manager and obtain more information about the savings program. In addition, at key moments, in the game, players are prompted to take real world actions to build financial capability.  The Staples pilot tests have observed strong employee response, with over 9,000 employees engaging with the game.  Most interesting, one pilot tracked that 11% of employees took a positive action in their retirement account.  You can find the games and try them out yourself at

In the meantime, Safe and Fair Finance Blog would like to thank Professor Lusardi and all of her presenters for a fascinating look into the future of financial education.
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Saturday, April 21, 2012

Recipe for Fraud: A Fake Robot to Choose Penny Stocks

For individual investors on the stock exchange, the biggest risk is simple investor fraud. As noted this week in the Financial Times, the US SEC has accused two British twins of touting a phony robot that was able to choose stocks about to double in price. This is a classic example of penny stock fraud, found in all developed capital markets but particularly in the U.S. and the U.K. (where pennies are still used as coin of the realm.)

Alexander and Thomas Hunter allegedly began their scheme in 2007, when they were just 16 years old. Their newsletter talked about a robot named Mari, which supposedly used “algorithms” to identity their stock picks. However this was no ordinary robot stock-picker. The brothers’ newsletter, Doubling Stocks, exclaimed, “Just think, had you put $5,000 on each of Marl’s recommended trades over the last 4 months – you would now have $387,684 clear profit sitting in your bank account.”

However this was not all it seemed to be. According to the SEC’s complaint, the brothers separately advertised to find a programmer to create the necessary software. However one of the brothers, Hunter, clarified that the software should “not actually find stocks at all”, according to the complaint.  Rather, “It should connect to my database and simply request any new stocks I have put in.”

The Hunter brothers made money in two ways. About 75,000 investors (primarily Americans) paid in total $1.2 million to subscribe to the newsletter and obtain a copy of the robot software for installation on their personal computers. In addition, according to the complaint, a stock promoter paid $1.8 million to the brothers to tout certain stocks.

As early as January 2009, the U.K. authorizes froze the bank account of the two brothers. However according to the SEC, they simply opened an offshore account in Panama under a new company name, Regency Investment Group.

Growing up in Canada, I was taught, “if it’s too good to be true, it probably is.” However for many consumers, even those with advanced college degrees, the financial markets appear to be an insider’s game they cannot win. Traditionally investors in U.S. stock market have been 60 percent retail investors (folks like you and me) and 40 percent institutional investors, such as insurance companies and pension funds. However following the stock market crash of September 2008, retail investors have largely pulled out of the stock market and by 2009 represented just 30 percent of the market.

Safe and Fair Finance Blog argues that investor fraud, through schemes such as penny stocks, further erodes that base of retail investor support for the stock market. Safe and Fair Finance Blog thus strongly supports work by financial regulators such as the SEC in cracking down on schemes such as the Mari stock-picking robot.

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Sunday, April 15, 2012

Rising Consumer Debt May be Dangerous for the Economy—but Getting Out from Under is neither Easy nor Fair

It is clear that the rise of household debt--combined with weak consumer protection and financial literacy--contributed to the global financial crisis of 2007-09 and the Great Recession that followed. But the question is whether improved consumer protection and financial literacy can help to address the crisis, once it has landed upon us. That is a far more difficult question to answer.

In its chapter on household debt released this week, the World Economic Outlook of the International Monetary Fund highlights the risks to an economy when household debt rises very quickly—and then housing prices fall. It is with alarm that the IMF report explains how the leverage of the consumer sector rose rapidly. In just five years, household debt in the advanced economies rose by 39 percentage points as the level of debt increased to an average of 139 percent of annual income. Similar levels were seen in the former transition economies of Hungary, Estonia, Latvia and Lithuania.

All countries were hit hard by falling housing prices. By 2011, in the U.S. real housing prices had fallen 23 percent from the peak, 29 percent in Iceland and 41 percent in Ireland. The result has been a drastic decline in spending by households and economic stagnation.

The problem is not primarily the fall in housing prices, argues the World Economic Outlook. It is the combination of a fall of housing prices and very high levels of leverage among households. The report estimates that the difference in four-fold. Consumer spending fell by only 0.4 percent in the low-debt economies that had falling housing prices. However in the parts of the world with both high household debt and declining asset prices, consumption by households declined 4.3 percent over five years.

The report continues to explain how all this happened. Looking at housing crises in the U.S. in the 1930s and today, Colombia in 1999, the Scandinavian countries in the early 1990s and Hungary and Iceland today, the report cites two common characteristics seen just prior to the collapse of the economies: (1) financial innovation and (2) declining lending standards.

Looking at the U.S., in the 1920s, it was the introduction of installment financing of consumer durable goods that brought financial innovation (and looser credit). In particular, General Motors Acceptance Corporation provided consumer financing for automobiles, allowing consumers to pay for cars over time rather up-front with cash. The result was a huge expansion in the credit available to households. A similar form of financial innovation developed in the 2000s. Consumer credit grew by leaps and bounds as “private-label securitization” permitted residential mortgages to be bundled together and sold in the global capital markets, all without a government guarantee. At the same time, standards for extending credit fell with the creation of mortgages described as interest-only, "negative amortization" and the all-time favorite, NINJNA loans referring to mortgages with the borrower had no income, no job and no assets (or at least, none that could be documented.)

By 1925, housing prices had peaked and started to fall. Asset prices were further undermined in October 1929, when the stock market crashed. Some eight decades later, in 2005, housing prices again hit a peak. The bankruptcy of the investment bank, Lehman Brothers, followed in September 2008 and caused the global capital markets to collapse.

In both cases, as asset prices fell, the household sector began to shed debt, or “deleverage” as it is called in the vernacular. The national and global economies slowed down.

The World Economic Outlook estimates that in the U.S. another three million homes will be subject to foreclosure—in addition to the 2.4 million properties that were still in that deep hole at the end of 2011. The report further estimates that for every one million foreclosed homes, between 0.3 and 0.4 percent of national output is lost. If only there were a way to avoid the three million foreclosures, then U.S. gross domestic product would be another 0.9 to 1.2 percent higher. With such large amounts at stake, the report looks at what could be done.

The report suggests four possible solutions. First, monetary policy should be expanded as much as possible so that interest rates are very low. This makes most sense where mortgages are provided at adjustable interest rates. However most variable rate mortgages have already been converted to fixed rate loans. Furthermore the problem is one of a “zero lower bound on interest rates” as economists describe it. Borrowing rates cannot go below zero percent before an Alice-in-Wonderland situation arrives and borrowers are paid to borrow money.

Second, the social safety net should be strengthened. This generally means that unemployment benefits should be extended so that homeowners have some income with which to make their monthly payments. Again the report points to a difficulty—if the government has already taken on so much debt that it cannot (or should not) borrow more. This is the problem for advanced economies worldwide.

Third, the banks should be bailed out. More precisely, the government should buy all distressed debt held by the banks, as was done in the U.S. with the Troubled Asset Relief Program (TARP). However there may be some political limitations on such bailouts. In September 2008, I recall sitting in an outdoor cafĂ© in Washington discussing financial consumer protection policy with one of my colleagues. It was a Friday and office workers were wearing business casual dress. One had a t-shirt with a bold question. “Where is my bailout?” it read, expressing the view of many Americans that households should be given assistance, not the banks.

Fourth, homeowners should also be bailed out by restructuring their residential mortgage debt. It is only in the fourth and last solution that consumer protection and financial literacy play any role at all.

It is this last area—restructuring of mortgage debt—that is gaining attention at the global level. The chief of the International Monetary Fund, Christine Lagarde, is now recommending that—for the sake of the world economy—the U.S. and European governments should restructure mortgage debt of their heavily indebted borrowers. The World Economic Outline provides some justification for this approach. The report argues that for every $1 spent by the government in reducing mortgage debt of financially strapped homeowners, the U.S. economy will grow by $1.30. A similar program for the European Union would raise output by $1.10.

However what the report does not say is that the real question is one of fairness and equity. Should all taxpayers be obliged to bail out the reckless homeowners who would have kept all their earnings, had their bets paid off? Is that fair?

Instead the report provides technical details on two programs that seem to have worked--Iceland after 2008 and the U.S. in the 1930s. The two approaches are very different, even though that had the same objective in mind.

In Iceland, the government revised four different areas to prepare a comprehensive (and effective) solution. First, the laws were changed. The legislation on bankruptcy was amended to allow consolidation of secured and unsecured debt and permit short discharge periods. In addition, the law on mitigation of residential mortgage payments was changed to permit the write-down of secured debt to the amount of the appraisal and conversion of the remaining obligations to unsecured debt. Both revisions allowed the courts to take effective decisions on restructuring personal debt. Second, out-of-court mechanisms were put in place. Third (and most interestingly), a system of debtor ombudsmen were established to supervise negotiations of household debts. Fourth, the banks were encouraged to write down their loans to households.

The U.S. solution from the 1930s was very different. A new government agency was established, the Home Owners’ Loan Corporation. HOLC issued government bonds, which the agency exchanged with the banks for distressed mortgages. Once the mortgages were in the hands of the HOLC, its agents renegotiated the mortgages, one by one, often with debt counseling and even training on family budgeting. It is not clear if the accompanying “financial education” was helpful but it was clearly a resource-intense activity.

According to the World Economic Outlook, the final cost of the HOLC program was just 5.4 percent of GDP even though it rescued one in every five residential mortgages.

Thus the World Economic Outlook provides some useful ideas on ways in which consumer protection and financial literacy might help countries avoid the heavy burden of foreclosures of residential mortgages. Taking ideas from the experience of Iceland, a debtor’s ombudsman might be a useful way of encouraging (and supervising) restructuring of household debts one-by-one with the banks. From the U.S. experience emerge suggestions on effective financial education, at least to provide debt counseling and assistance in preparing family budgets.

However the larger story remains. To avoid the risk of a major slowdown in consumer spending, it would be best to discourage the household sector from taking on too much debt. Safe and Fair Finance Blog proposes a combination of clear consumer disclosure (to make sure that consumers have understandable information about their debts) plus a healthy dose of financial education (to help consumers understand the risks of high leverage).

But then, there is still that pesky question of how to establish basic fairness in a program to restructure household debt. For that, the World Economic Outlook has no suggestions.

Safe and Fair Finance Blog argues that if the system is not fair, it will not be accepted by taxpayers who must pay the costs of the restructuring. It will become yet another argument how capitalism in the 2010s is stacked against those who are honest and play by the rules.
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Wednesday, April 11, 2012

Will We Ever be Able to Trust the Banks Again?

The global financial collapse of 2007-08 was no ordinary crisis. It meandered along, starting in August 2007 with the collapse of the AA and AAA-rated hedge funds managed by the investment bank, Bear Stearns, followed by the merger of Bear Stearns with a leading commercial bank, JP Morgan Chase. The crisis peaked with the bankruptcy of the venerable investment bank, Lehman Brothers, in September 2008 and the first of many Oh-My-God (OMG) moments in the global financial sector. Trouble continued as the U.S. taxpayers bailed out first AIG, one of the largest insurance groups in the world, and then Citigroup, once the biggest bank on the globe. Between September 2008 and March 2009, the global economy appeared to fall off a cliff, as indicated by the graphical charts showing the decline in global economic production. The world’s economy was declining at a pace faster than in the six months after the stock market crash of October 1929, which heralded in the greatest economic depression the world had known. That ended the debate on whether or not extraordinary measures were in order. There was no longer any question that massive action was needed.

The world’s financial regulators then pulled out all the stops, with coordinated massive injections of cash into the money supplies of the world’s largest economies. It was the shining moment of the Group of Twenty (G20) countries that represent 85 percent of the world’s total economic output each year.

And yet, something far more fundamental has changed. It came down to trust. Public trust in government, in banks, in financial service providers had been deeply eroded. Public trust had shifted—and it shifted worldwide.

The Edelman Trust Barometer bears witness to the changes. The Barometer consists of a survey of over 25,000 respondents in the 25 largest countries in the world. The survey has been conducted every year for 12 years. The 2012 survey provides fascinating insights and some very useful suggestions for leaders in government, business and civil society.

The 2012 survey shows that the publics in fewer than half the countries trust their governments to “do the right thing.” The governments coming out best are those with strong civil responsibilities—the United Arab Emirates, China, Singapore. Those who garner the least public trust are all in Western Europe, starting with Ireland.

Furthermore when asked about the best role for government, 31 percent said that governments should “protect consumers” and another 25 percent responded that governments should curb “irresponsible business practices.” Other roles, such as building the necessary infrastructure for business, were also important but far down the list of priorities. It is clear that the general publics feel that the priority of their political leaders should be to ensure consumers are protected from abusive business practices.

Banks and financial firms come under particular attack. The 2012 survey looked at which industries were the most trusted. At the very bottom of the list were banks, second only to financial service providers. What would you guess would be the number one must trusted industry? The first was technology. The second was telecommunications.

One can also ask why. Safe and Fair Finance Blog argues that it is the technology and telecommunications companies that make consumers feel more powerful—and indeed make them more powerful. No one watching the huge crowds on the streets of Egypt and Tunisia in 2011 and Russia in 2011-12 could doubt how technology and telecommunications have enabled consumers to march together and make their voices heard through their numbers.

Safe and Fair Finance Blog also suggests that governments and financial firms should find ways to join forces with technology and telecommunications to make consumers of financial services more powerful.

The Edelman Survey provides some useful hints. The survey identifies which types of individuals are most respected in the public eye. Academics remain the first most trusted but the 2012 survey shows that other traditional sources are not trusted as deeply as earlier. Technical experts are no longer second on the list, as they were as recently as 2011. Chief executive officers have fallen to the near-bottom of the list of respected sources. Rather it is a person “like me” or a “regular employee” (i.e. not the chief executive) who are most relied upon.

This suggests that finding ways of tapping into the ideas of other users “like me” may be one of the best ways of building public confidence in banks and other financial institutions. On a recent trip to Ukraine, one of my colleagues had used to find out the quality of the hotel we had chosen. Yelp is an excellent way of finding out which are the best service providers--from hair stylists to morticians to car wash companies. One might ask if the same could done for financial service providers.

The Edelman Survey quotes Vikram Pandit, chief executive of Citigroup as saying that the loss “of trust arose not from a failure of capitalism but from specific failures by certain participants in the finan­cial system. We could go a long way to regaining that trust by making the system more transparent, by clearing some of the obscurity that causes people to believe the system is a game rigged against their own inter­ests.” Safe and Fair Finance Blog would like to suggest that Mr. Pandit may be on to something. Making finance transparent and ensuring that consumers are treated fairly are critical building blocks if the public is ever to trust the banks (and other financial firms) again.

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