Sunday, August 29, 2010

Lender of First Resort

Neither a borrower nor a lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
Hamlet Act 1, scene 3

Sound advice given by Polonius to his son Laertes, but there are times when one cannot avoid borrowing money, such as when buying a home. The usual solution is to borrow from a bank, but there are some fortuitous circumstances in which we can do better.

The banking system is a pass-through mechanism, it is a borrower from some and a lender to others. The banks charge a good vig for the service: today you get no more than 1.5% on your deposits but pay at least 5% on a mortgage. That's a 3.5% spread, which of course includes not only profit for the bank but also servicing fees, bad dept provisions, etc. That's $3,500 for every $100,000 borrowed just in the first year, on top of mortgage initiation costs!

When my father bought a new house several years ago, he borrowed money from friends and family rather than going to the bank. He paid a rate that was between what we were getting in a bank at the time and what he would have to pay on a mortgage (today, that'd come out to about 3.25%) which was a big win for everyone - both the lenders and the borrower got better rates than they would otherwise. Additionally, he benefited from having no mortgage fees and the ability to make "all cash" offers on properties.

Of course before you lend significant sums to your friends and family, you must be very extremely comfortable in their willingness and ability to repay you back in the agreed manner. But when it works, it's a beautiful thing.

Good Debt

Who we are and where we come from shapes our financial attitudes more than we realize. Sometimes this is good (e.g an immigrant tradition of frugality) but sometimes less so - and in my life this has manifested itself very strongly as an aversion to debt. I came to the US as a child, and neither I nor my family understood that not all debt is bad. While I am ecstatic to be debt free, looking back, I see a missed opportunity to have taken on good debt. As Chef says, there's a time and place for everything, and it's called college.

By the time I started college, I had enough money saved to pay for a few semesters' worth of room and board. While in college, I had up to 3 jobs at a time and made enough to support my education and even save something. Consequently, it never crossed my mind to take out student loans - there was no need for it and I felt pride not needing help.

I have at times wondered what that pride has cost me, and wanting to give substantial advice to the 18 year old asking for it at GetRichSlowly, I crunched the math.

If I had taken the loans out, I would still have worked and earned money. But this money could have been invested at interest rather than going to the school. Foregone interest on these funds is the opportunity cost of not taking the loans. For those interested in the math, it's bellow, but the short answer is: I would have been $2,723 richer at the time I graduated in 2003 had I taken the loans.

My credit score would have benefited as well from having history of borrowing and repaying a loan.

So long story short - debt (especially subsidized debt!) can work for you if you have the knowledge and discipline.

How I arrived at the $2723 figure. The following math calculates the interest that would have been earned if I had borrowed interest-free and invested my own money at the prevailing CD rate each of the 4 years of my undergraduate education.

Freshman Year, 1999
  Max Loan:               $3500
 4 year CD rate in 1999: 5.95%
 Value of CD in 4 years: 3500 * 1.0595^4 = $4410

Sophomore Year, 2000
  Max Loan:               $4500
 3 year CD rate in 2000: 7.339%
 Value of CD in 3 years: 4500 * 1.07339^3 = $5565

Junior Year, 2001
  Max Loan:               $5500
 2 year CD rate in 2001: 5.181%
 Value of CD in 3 years: 5500 * 1.05181^2 = $6085

Senior Year, 2002
  Max Loan:               $5500
 1 year CD rate in 2002: 2.956%
 Value of CD in 3 years: 5500 * 1.02956 = $5663

Total Value of CDs:  4410 + 5565 + 6085 + 5663 = $21,723
Total Loan to Repay: 3500 + 4500 + 5500 + 5500 = $19,000
Interest:            21723 - 19000 = $2,723

Sources of data:
Subsidized loan limits:
CD Rate history:

Reading the Newspaper Will Keep you Adequate

I've recently re-discovered the New York Times in print and so read Elizabeth Sanberg's "4 Ways Reading the Newspaper Will Make You Rich and Famous" @ WiseBread with interest. Although this wasn't a heavy piece, it reminded me of the opposite thought I had recently, namely that mass media is a dangerous investment guide.

Whether we realize it or not, there are two meanings to "staying informed" in investing:

- Knowing about things before or as they happen.
- Knowing about things after they had happened.

The first type of information is investment gold - it gives you the first-mover advantage in directing your money. This information isn't useful for very long - once others find out, they direct their money the same way and prices change. If you're going to jump on an investment, you want to be the first one to do so. The problem with this type of information is that it's expensive (this is the reason financial firms hire brilliant analysts and move their trading computers as close to the exchange as possible) and it is often illegal to trade upon. For example, an accountant at a firm which is about to release its earnings is in a unique position to predict market reaction to the news - but taking advantage of this information is illegal insider trading.

The second type of information is what we get in mass media - public information well after the event. By the time one reads about a company's earnings in the paper, the trading opportunity has passed.

It is probably a bad idea to invest based on what you read in the news because the price already reflects the news by the time you get it!

I am not saying it's not important to keep up with the news, just don't expect to out-perform the market. Investing on publicly known news carries with it an additional danger - trading along with everyone else. You aren't going to get a good price when everyone is buying (or selling) too.

What about trends? Is the knowledge of general trends out there not valuable for investing? Momentum investors say yes, but fundamentals rarely bear out. One could gauge the point in a trend's life at which it's commonly reported on by thinking about their own field. In my areas of expertise (finance and technology) I find that a concept is old hat by the time I read about it in the Times - in other words experts have been thinking about it for months or years. The money that was there to be made on the trend has already been made.

If anything, a concept's appearance in mass media is a signal for contrarian investors -  in the Greater Fool Theory view of the world, it's an indication that the latest rung of fools is about to do their investing.

When "Flip This House" appeared on A&E in 2005, was that a bullish or bearish signal for real estate investing?

Friday, August 27, 2010

Inaugural Post

Welcome to the new and improved blog of Hell's Kitchen Independent Advisors!

We're a young organization based in New York City looking to provide financial guidance to our clients. Our guiding belief is that almost everyone can benefit from a fresh look at their cashflows, investments, and expenses, and we believe that each client is unique. It is our hope that this blog will give the reader the tools to improve their financial health.

Have a good weekend!