Does the free market corrode moral character?

There were 13 answers. John Bogle, founder of Vanguard, gave his answer. Mr. Bogle concluded,

“Fettered” capitalism has indeed corroded our moral character, by both privatizing the rewards of the market and (in the form of federal bailouts) socializing its risks. Both are betrayals of the free market and its genuine virtues. Our society has a huge stake in demanding higher moral values in a
less fettered market system.

I agree 100% with Bogle’s answer, which he also elaborated in his book The Battle for the Soul of Capitalism. Capitalism has changed from owners’ capitalism into managers’ capitalism. That’s not good.

---
Related Articles at The Finance Buff:

• Missing Name on Forbes 400 List
• Best Mutual Fund Company
• Book Review: Common Sense on Mutual Funds

If I have some money in a fund, I don’t check the prices every day and see if the value of my fund increased or decreased. I let the money ride with the market. But if I add $2,000 to the fund, even if I already have 10 times more in the same fund, I still prefer to see on the next day that my $2,000 move was a good one. It seems I care about the new money much more than I care about the old money, although money is just money. Money has no memory. It doesn’t know whether it’s old or new.

I don’t think I’m alone. I asked a colleague what he would do if he had 100% of his money in stock funds which lost 40%. He said he would hold because the prices are really low today. I then asked him what he would do if he had nothing in stocks but a bunch of cash in a bank savings account. He said he would buy into the market slowly because the prices may go down some more. So if he had old money in stocks, he’s willing to let it ride, but he’s not willing to do the same for his new money. So what’s so special about new money that makes us  care more about it? When does new money turn into old money, at which point we don’t care as much about it any more?

Behavior economists call this phenomenon endowment effect. Whatever form the money is currently in, people have a preference to keep it in the same form. Therefore if it’s already in stocks, people don’t want to sell, fearing that the price is too low.  If it’s in cash, people don’t want to use all the cash to buy stocks right away fearing that the price is too high. Because stocks are riskier than cash, they appear to be extra careful with their new money while they don’t mind losing their old money. It’s related to loss aversion. People are afraid of making a wrong move so they keep the money where it is, no matter where it happens to be.

How do you overcome this behavioral bias? The first step is recognizing money is just money, whether it’s old or new. Be as cautious with old money as you are with new money. Be as aggressive with new money as you are with old money. Make it mechanical. Decide on the rules ahead of the time. Write them down. When the time comes, just do it.

---
Related Articles at The Finance Buff:

• Commutative Law of Multiplication
• Combatting Survival Instincts
• AMO Contact Lens Solution Recalled

Of course the benefit of having this many banks is competition, which is usually good for the consumers. When I was in Canada a few years ago, I was astonished how hard it was to find a basic free checking account (or checquing account as they spelled it). I just looked on a few Canadian bank web sites. It’s still the same today. Even the most basic account has a monthly fee. You need to maintain a $1,000 minimum balance to waive the monthly fee. Then they also charge you for each transaction after you use up your allowance of 10 or 15 free transactions per month. That kind of metered checking account is almost unheard of in the U.S.

Intense competition also can go the wrong way, as we know by now how banks were stepping over each other offering mortgages to subprime borrowers. They can’t charge you monthly fee, so they gouge you on foreign ATM and overdraft fees. I think we have too many banks in the U.S.

---
Related Articles at The Finance Buff:

• Fed Opens the Vault
• Online Savings Accounts and Their Backers
• If Credit Unions Are Better, Why Don’t More People Use Them?

When I tried to figure out how much I can contribute from my self-employment income to the solo 401k, I found that the information on the Internet assumes that the self-employment income is the person’s only earned income. For example the calculation worksheets provided by Fidelity, Schwab, and Vanguard all make that assumption. They don’t consider the cases like me who work at a day job while earning some self-employment income on the side. Because I participate in the 401k plan at work, the maximum I can contribute to my solo 401k plan changes with what I earn from my day job and what I contribute to the workplace 401k plan. The Social Security tax I pay depends on the sum of my salary as an employee and my self-employment income. The salary deferral contributions I can make from self-employment income also depends on how much I already contribute to my 401k plan at my day job. I would think there are enough consultants, freelancers, moonlighters, and bloggers who are in the same camp as I am, but there is very little resource I could find for people who earn their income from a mix of W-2 salary and self-employment.

You know where this is going to lead to, don’t you? I had to create a spreadsheet for myself and I’m sharing it here in case other people like me find it helpful.

Spreadsheet: Solo 401k For Part-Time Self-Employment

This spreadsheet takes into account employment income, contributions to workplace 401k, and self-employment income. It calculates the maximum salary deferral contribution and the maximum profit sharing contribution I can make to my solo 401k plan. If there is no day job, just set the day job related fields to zero and it will work for people who only have self-employment income as well. There are two tabs: one for an unincorporated business (sole proprietorship), the other for an incorporated business. As usual, use this and everything you find on this blog at your own risk, because I’m not a CPA.

I’m going to use Fidelity for my plan because I already have other accounts with them and their plan is free and flexible. Vanguard is going to offer a plan but it looks like they don’t allow incoming rollovers and there is no brokerage option.

---
Related Articles at The Finance Buff:

• A Non-Deductible IRA Is Worth It For Me
• Calculator for 401(k), Roth IRA, then Back at 401(k)
• 401k Loan Double Taxation Myth

I listened to a program about children’s health insurance on the radio the other day. A guest was talking about State Children’s Health Insurance Program (SCHIP). She said  basically “if we can spend $700 billion on bailing out the banks, we can afford to spend $70 billion to insure all children in this country.” What do you think about this new benchmark?

---
Related Articles at The Finance Buff:

• Who Robbed FDIC $6 billion?
• TIPS Auction Step By Step: Read the Results
• Book Review: The Greatest-Ever Bank Robbery

If you use flexible spending account, you should be familiar with the use-it-or-lose-it rule. If you put too much in the FSA, you will lose what you can’t use. In the past I always estimated conservatively. I’ve never lost any money to the FSA. However there is also a cost to that approach. After the money in the FSA is used up, any additional expenses must be paid with after-tax dollars. There has to be a point where losing a little pre-tax money in the FSA is less expensive than paying a lot with after-tax money.

This becomes an interesting math problem.

Suppose your best estimate for next year’s FSA-eligible expenses is $1,000, plus or minus $500 because you can never be sure what your actual expenses will be. Your marginal tax rate for FSA contributions is 32% (you have to include the Social Security and Medicare taxes if your income is below the Social Security Wage Base, $106,800 in 2009). How much should be put in your FSA?

So your expenses will range from $500 to $1,500 next year. We can divide it up into ten smaller intervals: $500-600, $600-700, …, $1,400-1,500. For each interval, we use the mid-point as the proxy and calculate the total after-tax cost. The total after-tax cost is:

FSA Contributions * (1 - Marginal Tax Rate) + Expenses Above & Beyond FSA

For example, if you contribute $1,000 to FSA, and your actual eligible expenses are:

Over the full range of likely expenses, your average total after-tax cost is $805 if you contribute $1,000 to your FSA. After calculating the same for other contribution amounts, we get this nice graph.

The graph shows that putting in the most conservative amount ($500) isn’t the best strategy. Putting in your best estimate ($1,000) isn’t the best either. The lowest average total after-tax cost over the full range of the estimated expenses is achieved when you put in somewhere in between those two numbers, around $800 in our example.

If you’d like to play with your own numbers, here’s the spreadsheet I created.

Spreadsheet: How Much Should You Put Into Flexible Spending Account (FSA)

Math-minded readers probably noticed that by taking a straight average of the total after-tax costs for all ten intervals, I’m giving each interval equal weight. In math terms, it’s called a uniform distribution. In real life, the intervals at either end of the range ($500-600 and $1,400-1,500) will be less likely than the intervals in the middle. So here’s the challenge question for interested readers:

If you assume your next year’s FSA-eligible expenses follow a normal distribution with a mean of $1,000 and a standard deviation of $250 (same $500 to $1,500 range with 95% confidence), how much should you put into the flexible spending account in order to minimize your expected total after-tax cost?

Who knew a flexible spending account involves this much math?

Finally, if you are married and one of you earns an income above the Social Security Wage Base and another earns below, you should have the spouse with the lower income contribute to the FSA. This was explained by indexfundfan.

---
Related Articles at The Finance Buff:

• Open Enrollment, Part 4: Flexible Spending Account
• My Flexible Spending Account Sent Me a Debit Card
• Open Enrollment, Part 1: Health Care

China’s securities regulator has ordered a state-owned power group to cancel oil derivatives contracts it signed with a Goldman Sachs subsidiary which would have exposed the Chinese company to losses if oil prices continued to fall.

A Chinese power producing company was concerned about rising oil prices when oil price was really high (I guess because high oil price increases their cost of production). So they signed a deal with a Goldman Sachs subsidiary in Singapore called J. Aron & Co. As long as the oil price remains above ~$65 a barrel, J. Aron pays them. If the oil price goes below that, they will pay J. Aron. After they signed the deal, J. Aron has paid them $8 million. Until the oil price  came down. When it’s about their turn to pay J. Aron, the Chinese company confessed to their regulator who ruled that the deal was “unauthorized” and the contact has to be voided. They will probably return what J. Aron previously paid them, perhaps even with a small interest. I’m pretty sure if oil price remains high they will keep quiet about the “unauthorized” deal. It’s like you bought a lottery ticket, got the matching number, then have your ticket canceled because the store clerk who sold you the ticket didn’t complete his required safety training last year.

You begin to appreciate why the U.S. stock market declined less than other markets even though the U.S. is the source of the subprime mortgage problems (see previous post Crime and Punishment). At least the U.S. has a legal system that won’t allow this kind of “heads I win tails never mind” business. Southwest Airlines also entered into hedging contracts on fuel prices. In the last few years, they were able to maintain profitability while other airlines lost money because Southwest locked into a lower fuel price through hedging. After the oil price came down, Southwest started losing money because their contract price is too high. Last quarter they had their first quarterly loss in 17 years. Southwest  honors their contract. That’s how business should be conducted.

P.S. I’m looking for study mates for ECON 252. Please let me know if you are interested in studying together.

---
Related Articles at The Finance Buff:

• Did Sunk Cost Fallacy Kill James Kim?
• Why Banks Push Debit Cards
• I Love Southwest Airlines

Do you have bond proposals on your ballot? How will you vote on them?

---
Related Articles at The Finance Buff:

• How a Callable Bond Worked
• Redeemed October 2005 I Bonds
• TIPS During Deflation

This gets better. Under its Open Yale Courses initiative, Yale University made available online, FREE!, ECON 252 Financial Markets taught by Professor Robert Shiller. Outside of academic circles, Professor Shiller is probably most famous for his book Irrational Exuberance. From the course description:

“The course strives to offer understanding of the theory of finance and its relation to the history, strengths and imperfections of such institutions as banking, insurance, securities, futures, and other derivatives markets, and the future of these institutions over the next century.”

This is a real university class. It was taped in spring 2008 while Professor Shiller taught the class at Yale. Every class session is complete with PowerPoint slides, mp3 audio, video, transcript, homework problem set, and reading assignments. You also get to take the mid-term and final exams and compare your answers to the exam solutions. In addition to Professor Shiller, there are also guest lecturers David Swensen of Yale Endowment, hedge fund CEO Andrew Redleaf, billionaire investor Carl Icahn, Blackstone CEO Stephen Schwarzman, and former Treasury Secretary Lawrence Summers. I can’t believe the whole enchilada is entirely FREE! Thank you Yale and the tuition paying Yale students and their parents!

The required textbook is Foundations of Financial Markets and Institutions by Fabozzi, Modigliani, Jones and Ferri. I’m getting a used copy of the 2nd edition for $10 shipped. Thank you Amazon seller! I know what I will be busy with for the next few months.

[Update] P.S. I’m looking for one or more study mates for this class. The homework problem sets don’t have official solutions. I’m looking for people to compare notes with. If you are interested in studying this class together, please e-mail me (address in About Me). Thanks.

---
Related Articles at The Finance Buff:

• Don’t Like Where Your Bet Is Going? Cancel It
• I’m Invited to Celebrity Conference But I Will Not Attend
• Crime and Punishment

The paper confirmed what I suspected when I wrote Mortgage Loans Around the World. Basically the home loan borrowers in the U.S. had it too good. When the system is too good to the borrowers, it’s not so good to the lenders. The lenders are made more vulnerable to credit losses.

The paper compared the United States with other developed countries which also have an advanced financial system for housing and home loans. It revealed several structural factors which made the United States stand out in the world. These factors made it more likely that the U.S. lenders will run into trouble. From the abstract:

“Some of these outcomes seem to have been driven by tax, legal and regulatory systems that encouraged households to increase their leverage and permitted lenders to enable that development. Given the institutional background, it may have been that the US housing boom was always more likely to end badly than the booms elsewhere.”

According to the research paper, the unique institutional drivers for the United States are:

1. Supply of new housing is relatively flexible. More land is available in the U.S. It’s easier to create over-supply of housing in the U.S.

2. Tax system encourages higher leverage and flipping. Mortgage interest is tax deductible. Borrowers tend to maintain high loan-to-value (LTV) ratios.

3. Legal system is swift but generous to defaulters. Home loans are non-recourse, either legally or practically.

4. Lenders could rely on external credit scores. Lenders in other countries must determine the borrower’s credit worthiness on their own. As a result, they are forced to be more careful.

5. Financial regulation did not prevent riskier lending. Regulations were too permissive.

6. Cash-out refinancing is inexpensive in the United States. Having a long-term fixed rate loan that is also refinancable is quite unique in the world.

7. Structured finance enabled subprime and other non-conforming lending. Securitization is more prevalent for U.S. mortgages.

Here’s the link to the full paper if you are interested.

Ellis, Luci (2008): “The housing meltdown: Why did it happen in the United States?“, BIS Working Papers No 529.

---
Related Articles at The Finance Buff:

• Mortgage Loans Around the World
• Our Knowledge of the World and the World’s Knowledge of Us
• Stories from Strapped: Conclusion