Lenders and owners of mortgage-backed securities learned a few lessons of their own, which for a time made it more difficult and expensive to take equity out of a home. However, most of them have by now taken their lumps and learned their lessons: No more liar loans, and no more rigged appraisals. The mortgage origination market is once again hot, and loans are being made at record low interest rates.

Government, the one entity that never seems to learn, is still out there subsidizing loans: not only via the tax credit for mortgage interest, but also through its patrons Fannie Mae and Freddie Mac (can you believe those are still around?). Consequently, if you have good credit this is the best time to leverage your home equity. Today’s WSJ article on the subject notes:

[P]eople who have a potentially profitable use for that money—preferably an investment—could come out ahead using this strategy. A borrower who takes out a mortgage at 4.5% is essentially borrowing money for free on an after-tax, after-inflation basis, assuming he is in the 33% marginal tax bracket and inflation returns to its long-term average 3% or more.

If you were thinking of moving to a better house this may be a doubly excellent time to do so: The higher end of the market was hit hardest and has been slowest to show signs of recovery. I am trading up to a better house that is selling below its build cost and, thanks to some aggressive mortgage shopping, I am financing the purchase with a 3.5%, zero-point, 5/1 conforming ARM.

One analyst also factors in the effects of taxes and fees to produce “real-real returns,” which are even more pathetic:

Garrett Thornburg, founder of Thornburg Investment Management in Santa Fe, N.M., calculates what he calls “real-real” returns, adjusting stock performance not only for inflation but also for real-world drags such as taxes and fees. Nominally, a dollar invested in the stocks of the Standard & Poor’s 500-stock index at the end of 1978 had blossomed to $22.88 at the end of 2008, including dividends, a sweet gain even after the 2008 meltdown. But once estimates of inflation, taxes and costs are removed, he figures, the investment was worth $3.76.

All of this might be enough to put investors off stocks entirely, until they consider the long-term alternatives. Measured over the 1978-2008 period, rather than over just one decade, stock performance in real-real terms actually is better than that of just about any other major investment class, Mr. Thornburg found: 4.5% a year. Stocks’ ability to keep up with inflation over the very long haul may be their best selling point.

In real-real terms, stocks did better over that period than municipal bonds (2.5% a year), long-term government bonds (2% a year) and corporate bonds (0.2% a year). Real-real home prices were unchanged over those 30 years. Both short-term government bonds and commodities suffered losses.

TIPS have gained substantially since then, but from a historical perspective the current 10-year TIPS break-even rate of 2.1% is still low. (“Break-even” is the realized inflation rate above which an inflation-protected security will pay more than its non-inflation-protected equivalent. In the case of TIPS that would be regular treasury bonds. A break-even rate of 2.1% means that ). Since inflation protection is valuable insurance in a market like this, with low current inflation but exploding money supply (which could easily lead to surprisingly high inflation in the next few years), one might expect TIPS break-even rates to run above the long-run expected inflation rate, which is around 2% per year. Indeed, it is still cheaper to buy TIPS than to buy treasuries and hedge against inflation with options.

However, as I noted earlier, TIPS aren’t a perfect inflation hedge. Bill Tedford, a successful treasury bond portfolio manager and inflation bug, has other ideas on investing for protection against inflation:

In his own portfolio, Mr. Tedford has begun shorting 30-year Treasurys, expecting the prices to fall as interest rates begin to rise. For clients, however, Stephens is encouraging the use of exchange-traded funds to own exposure to real assets. Mr. Tedford says a 5% or 10% position overall “is big enough to protect a larger portfolio.”

Among ETFs, Stephens likes the U.S. Gasoline Fund, the iShares Dow Jones U.S. Oil & Gas Exploration & Production Index, SPDR Gold Trust, PowerShares DB Base Metals Fund and the PowerShares DB Agriculture Fund. The firm also likes Plum Creek Timber Co.

Though Treasury inflation-protected securities, or TIPS bonds, would seem a natural bet, Mr. Tedford says his group just this month sold off its TIPS investments. Real yields on TIPS are barely above 1% now and Mr. Tedford expects those yields will increase as inflation mounts, hurting prices, which move in the opposite direction.

The likely result: “The return on your TIPS could fall 10% or 15%,” basically wiping out the bond’s inflation protection.

I would personally steer clear of gold as an inflation hedge because it is particularly prone to speculative bubbles, and has less intrinsic value than most other commodities. But diversified investments in energy, industrial metals, and the agricultural sector should also serve as good long-term inflation hedges.

While most clones have so far generally kept pace with broad hedge-fund indexes, their performance has been all over the map. Between March 2008 and Sept. 30 of this year, clones studied by researchers at Haute Ecole de Gestion in Geneva and Bank Julius Baer & Co. delivered annualized returns ranging from -21% to 6%. And some clones this year have sharply underperformed broad hedge indexes. State Street’s Premia Fund was up less than 2% in the first 10 months of this year, compared with a 10% gain for the HFRI Fund of Funds Composite Index.

Even Andrew Lo, one of the originators of the “clone” concept, and current manager of a replication fund, has to admit that this concept is missing a big piece of the game:

Being restricted to easily traded holdings, replicators may not capture a big chunk of hedge-fund performance. Anywhere from 10% to 60% of hedge-fund returns may come from a premium earned by holding illiquid assets….

The investor is bombarded with staggering amounts of information, staggering amounts of stimuli that are designed to get the investor to buy and sell and trade, to do exactly the wrong thing, to create excessive profits for these intermediaries that aren’t acting in the investor’s best interests.

Asset allocation is the tool that you use to determine the risk and return characteristics of your portfolio. It’s overwhelmingly important in terms of the results you achieve. In fact, studies show that asset allocation is responsible for more than 100 percent of the positive returns generated by investors.

[T]he other two factors, security selection and market timing, are a net negative. That’s not surprising. They’re what economists would call zero-sum games. If somebody wins by buying Microsoft, then there has to be a loser on the other side who sold Microsoft. If it were free to trade Microsoft, the amount by which the winner wins would equal the amount by which the loser loses. But it’s not free. It costs money. It costs money in the form of market impact and commissions if you’re trading for your own account, and it costs money in terms of paying fancy fees if you are relying upon an investment advisor or mutual fund to make these security-specific decisions. For the community as a whole, all those fees are a drag on returns.

That’s why the most sensible approach is to come up with specific asset allocation targets that you can implement with low-cost, passively managed index funds and rebalance regularly. You’ll end up beating the overwhelming majority of participants in the financial markets.

On the terrible herd instincts of the average individual investor:

One of the great ironies is that if you had talked to the average investor 18 months ago, he or she would have thought it was a pretty good idea to buy stocks. In recent months, the same investors despair about their portfolio and are fearful about putting money into the equity market.

That’s 180 degrees wrong. They should have been cautious 18 months ago, when prices were much higher than they are now. They should be enthusiastic today.

1. The insurer can embed higher fees.
2. You expose yourself to credit risk of the insurer.  If the insurer fails then you could potentially lose the value of savings in your whole-life policy.  In contrast, if a term-life insurer fails you have only lost your most recent premium payment.  (Either way you are at risk of not being able to get a new policy in time.)

The purpose of life insurance is to protect those who depend on you being alive against catastrophic consequences of you not being alive.  Therefore, it never makes sense to insure child who does not produce income on which you depend.  It is not necessary to insure a homemaker if you can fall back on extended family in the event of their death for the essential services they provide.

As with all insurance, you pay a premium for protection (insurers generally make profits after paying claims and business overhead), so it is irrational to load up on more insurance than you need — unless you know that you are at a much higher risk of dying than actuaries think you are.

How much insurance is reasonable?  If a young family depends on your income, and you have no savings, then you should probably get enough insurance that your wife and kids could maintain their standard of living for 20 years (or until the children are independent) from the proceeds of a policy.  A healthy young man can get a 10-year guaranteed-renewable $2MM insurance policy for around $600/year.  After 10 years, hopefully he will have saved some money and his dependents will be closer to independence so he could drop his coverage to $1MM.

You should not buy insurance to provide independent heirs with an inheritance.  If you play your cards correctly you should Die Broke.  Older people should eventually be able to self-insure out of their savings.  Once they have no dependents they should eventually plan to purchase an immediate annuity to provide insurance against outliving their own savings.

Last time I bought a term-life policy I found the best contract through Zander Insurance Group, an independent insurance brokerage company that made the process as easy as it has ever been.

The clearest way of valuing TIPS is in terms of the “break-even rate of inflation,” which is the inflation rate at which an investor would earn the same from TIPS as from regular treasury bonds of the same maturity.  If realized inflation exceeds the break-even rate then investors in TIPS earn more.  If inflation is lower than the break-even rate then investors in regular treasuries earn more.

Considering the break-even rate, TIPS are extremely cheap.  For example, the break-even rate on 5-year TIPS is 1.12% — well below current inflation, historical inflation, and even the Fed’s target inflation rate.  The dollar faces a number of inflation risk factors, and the current market bailout by the U.S. Treasury only adds to these risks.

Since TIPS are an undervalued, tax-inefficient asset that offer inflation protection they make an ideal investment for tax-exempt retirement portfolios.  Investors who want heightened exposure to these characteristics can buy leveraged CEFs that invest in TIPS: E.g., WIW and WIA.

1. Don’t abandon investments unless you need cash.  If you sell during a liquidity crunch you become one of the people paying the liquidity premium.

2. If you buy during a liquidity crunch you collect the liquidity premium.  Therefore you should revisit your asset allocation and consider reallocating your investments to increase your exposure to distressed assets.  (Don’t try to pick stocks or sectors — the information premium during a market crisis can also skyrocket, which means if you don’t have extraordinary information you are at a heightened disadvantage.)  For example, last week a lot of institutions needed to move into short-term treasuries.  They were dumping corporate bonds, stocks, and just about anything else to do it.  Demand for treasuries got so high that buyers were literally paying out for the right to own them (i.e., interest rates went negative).  If you held treasuries and didn’t need the exceptional margin of security they provide it was a good time to cash them in and buy the things everyone else was selling.

In general your portfolio should reflect your investment time horizon and risk aversion — i.e., how long you can keep your money invested, and how much interim “pain” you can tolerate.  The more pain, the more (potential) gain.  During a liquidity crisis you may perceive that risks have gone up and thus be inclined to sell risky assets and move to more liquid assets.  That is exactly the wrong course of action, because it turns you from a liquidity provider into a liquidity demander.  If you succumb to the urge to pull money from the markets you will find yourself in the notoriously underperforming pool of retail market timers who always buy near the top, when everything seems great, and sell near the bottom, at the point of “maximum pain.”

When you see falling asset prices during a liquidity crisis do not think, “Shoot, those assets are riskier than anyone thought, I had better get out too.”  Instead think, “Wow, the market is willing to pay me even more to move into those assets.  Last time I considered those I didn’t think the extra return was worth the risk.  But since that return potential is even higher maybe now it is worth owning them.”

How can you collect the handsome liquidity premium that exists in the current market?  If you own CDs, consider paying the early-withdrawal penalty and putting the money into corporate or muni bonds, whose spreads over treasuries have spiked to record levels.  If you already own bonds consider moving to higher-risk asset classes, or else consider leveraging up using bond CEFs.

If you are in a high tax bracket, tax-exempt bonds have historically offered a slightly better after-tax return than comparable taxable investments.  Over the last year, due to the liquidity crisis in the financial sector, tax-exempt bonds, a.k.a. municipal bonds or “munis,” have become extremely undervalued.  They now offer nominal returns that are roughly the same as taxable equivalents, which means that if you are in a high tax bracket you will end up with a lot more money if you put it in munis.

Clouding the situation has been the fact that bond rating agencies have historically put municipal bonds on a separate but identically named risk scale.  The Wall Street Journal notes, “[I]nvestment-grade corporate bonds between 1970 and 2000 had a 10-year default rate of about 2.3%, far higher than the 0.03% default rate of investment-grade munis.”  I.e., the finance industry has historically pretended that munis are as risky as taxable bonds that in actuality have proven to be seven times more risky.

Munis are not without risk.  Municipal institutions can default on their bonds, and they will be more likely to do so during a recession.  Also, muni bonds are exposed to the same price risks as most other bonds: Their value will decline if interest rates or inflation rise above the levels currently anticipated by the market.  Nevertheless, the risk level of investment-grade bonds is considerably lower than that of stocks or real estate.

First Action Item: If you are in a high tax bracket, this is definitely the time to move any non-retirement assets that you would normally invest in bonds into muni bond funds.  Your after-tax risk-adjusted earnings will be far higher with the munis.  Examples of good funds are Vanguard’s VWLTX, or USAA’s USSTX.

This is also a good time to consider a speculative angle on munis: Not only are they underpriced relative to taxable bonds, but they are also close to “support” levels where even non-taxable entities would start to buy them.  As soon as their nominal yields exceed those of comparable taxable bonds they will be bought by large investors that don’t benefit from the tax exemption — pension funds, endowments, etc.  I.e., they are below their historical and intrinsic price (which is the price a high-tax-bracket investor would pay to own them), and they are so low that they cannot fall much further relative to taxable fixed income.

Buying large amounts of municipal bonds with taxable funds could produce not only an attractive current yield, but also significant capital gains if they revert to their historical price levels relative to taxable bonds.  The best way to speculate on this dislocation is with leverage, and it turns out to be easy to leverage exposure to municipal bonds using Closed-End Funds (CEFs).  A typical leveraged muni CEF will employ leverage of 30% — which means you get roughly 30% more dividends and 30% more exposure to price swings than you would have from a conventional muni fund.  There are literally hundreds of CEFs in the municipal bond sector.  I look for high-yielding CEFs that are trading at a discount to their historical discount.  (There are a number of reasons why CEFs trade at a permium or discount to their NAV.  Without getting into those nuances just follow the rule-of-thumb that the practical “discount” for a CEF is defined with respect to its historical discount.  I.e., you’re getting a bargain if you buy a CEF at a discount to its discount.  Visit ETFConnect to look at the historical discount for any CEF.)

Second Action Item: This is a great time to speculate on munis using leverage.  Just realize that like all speculative strategies this is subject to greater risks: I.e., you can lose more money if things go wrong.  If you have speculative capital to put to work, look for a high-yielding muni CEF that is trading at a discount to its historical discount (I consider the average 52-week discount for this purpose).  Current examples would be:

• BFK (6.5% current dividend yield, and trading at a 6% discount to average discount)
• MVF (6.2% current dividend yield, and trading at a 3% discount to average discount)
• NZF (6% current dividend yield, and trading at a 2% discount to average discount)

Buyers

As a buyer, you will be encouraged to sign a contract enlisting a “buyer’s agent” to help you find a house. In spite of all the industry obfuscation to the contrary, “Buyer Agents” do not work for the buyer. Their incentive is to close a sale with as little work on their part as possible, and with a seller who will give them as high a commission as possible. Hence, as a buyer working with a broker you must keep in mind the following perils:

• They do not have an incentive to show you the best house for your needs. Rather, their incentive is to show you a smaller set of houses you are likely to buy that pay the largest possible commission to them. This means they will typically show you full-commission houses listed for sale with them or their coworkers. Then they will show you full-commission houses listed elsewhere. They may show you cut-rate commission houses. It is very unlikely they will show you “FSBO’s” or other homes with low or zero commissions, or that would require a lot more effort on their part to close.
• They do not have an incentive to help you negotiate the best price on the house you want. Their only incentive is to help you close a sale with as little effort on their part as possible. If you buy a house, it doesn’t matter what they do or don’t do: they get paid the same rate. (In fact, it may be small but technically their incentive is to have you pay as much as possible, since 3% of a higher prices is still a little more.)

Agents may proclaim that they are licensed and that they have a fiduciary duty to their clients. However, in practice this fiduciary duty guarantees you absolutely nothing. So what service does a buyer’s agent actually provide?

1. MLS searches. They will also ask you for your search criteria and will print out listings that meet those (and their) criteria. However, you can now do this yourself on the internet (and can circumvent their filters on low-commission houses). Thus, value to you of this service: Zero.
2. Local expertise. They will be familiar with the communities in your search area. But no more so than anyone else. If you are moving somewhere new you will probably know people at the new place you are going to work, study, or recreate. Ask them instead.
3. Market expertise. Skip it: When you’re buying they always tell you it’s a very tight market and you have to bid high and close fast. When you’re selling they always tell you it’s a soft market so you should be eager to accept the first low offer that comes along.
4. Referrals. They will refer you to home inspectors, appraisers, title insurers, and any other service provider you may want. There is no guarantee that these referrals are based on quality instead of kick-backs or other conflicting interests. Value to you: Zero.
5. Chauffeur service. They will setup appointments to view homes and they will drive you to them. However, you could just as easily make an appointment directly with the listing agent and drive yourself.

Nevertheless, even if you don’t value the chauffeur and appointment services, it still pays to enlist buyer agents if only because most sellers offer them a commission. And most of that commission should go into your pocket. Did you know that it is standard practice in the real estate industry for brokers to give 40% of their commission on any sale to a referring agency? This is why there are so many banks and other services out there offering rebates if you work with a broker to whom they refer you. If you take no other advice from this article, you should at least demand up front that your broker share 40% of their final commission with you.

As a buyer, how can you avoid getting ripped off by a real estate broker?

1. Do not commit to work with only one agent. Every broker will ask you to sign a contract in which you commit to giving them the buyer’s agent commission on any house you buy within a given period. This is absurd – and unnecessary. The industry is suffering a glut of brokers hungry for your business. Visit multiple brokers and tell them you will pay them if you buy a house that they show you. Working with multiple agents can mitigate many of the risks and hazards on the buyer’s side.
2. Negotiate a share of the commission for yourself. Since the standard referral rate is 40%, make it clear that you expect to receive at least 40% of any commission. Negotiate your share upward based on the amount of work they actually do to help you find and buy a house. (Note that in a traditional sale of a $2MM house they will walk away with a $60k commission. What’s a fair wage for driving you to a few houses and sitting at your side during the closing?) Note that in 12 states commission “rebates” are illegal. So in those states don’t call it a rebate; call it a subcontracting fee, partnership share, or something else.
3. Align the incentives. If you aren’t doing your own legwork in the MLS and FSBO sites to find houses you want to look at, then ensure that your broker has an incentive to show you houses that pay low or no commissions. For example, offer to pay them an hourly rate in lieu of commission for their work. Or offer to pay them a minimum “commission” if the seller of a house you end up buying does not.

Sellers

People who want to sell a house are in a less flexible position than buyers. It is practically impossible to list your house for sale with more than one agent. (It is possible to list it with no agents, but even today that all but guarantees that 95% of potential buyers will never see your listing.) Furthermore, unless you offer buyer agents a 2-3% commission then many potential buyers will never be shown your property (due to the buyer agent conflicts of interest noted earlier).

Compounding the situation of the seller is the fact that a good seller’s agent will invest a significant amount of time and money marketing the house. This results in better visibility and, statistically, a higher selling price. Agents deserve to be compensated for this work (if they do it). But there are still many bad agents who will make you sign a contract for them to list your house – often for 6 or more months – and then do nothing to market it. And why not? Even if they don’t do anything there’s a chance someone will offer to buy it during that period, at which point they get their full commission.

Seller agents face most of the same perverse incentives as buyer agents: Namely, they would rather close a deal with less work on their part than with more. Though they get a higher commission from a higher sale price, they are only seeing at most 3% of the upside. Suppose you’re selling a $1MM house. How much harder do you think your agent will work to get you $1.1MM if at most $3k of that extra $100k ends up in their pocket?

As a seller, how can you avoid getting ripped off by a real estate broker?

1. Do not sign a long-term listing contract. An agent might invest significant time and money marketing your house. They deserve to be compensated for that. However, I know top-rated agents who offer listing contracts with a 15-day opt-out. I.e., no matter what they have invested to sell a listed property, the seller can choose to opt out of their contract with 15 days notice. A good agent should offer a contract like this, since if they are doing a good job you have no incentive to take your business elsewhere. An alternative contract would allow you to opt-out if you pay their sunk costs. I.e., if you want to take your listing elsewhere make them hand you receipts and time-logs of what they have invested, pay them for their work at a pre-agreed rate, and move on.
2. Negotiate a share of the commission for yourself. Remember the 40% referral rate and use that as a starting point. You could even insist that the listing be free of any seller’s commission, and instead offer them a fixed fee, or a time-and-materials contract, perhaps with a performance bonus based on how much the selling price exceeds a fair appraisal.
3. Do offer a full 2-3% commission to the buyer agent. Unfortunately, due to the buyer agent hazards there is a good probability that if you don’t offer this incentive you will have fewer lookers, fewer bids, and ultimately a lower selling price. However, this is not necessarily unfair: If your buyers are savvy (as suggested above) then they will be pocketing a large part of the buyer agent’s commission. In essence, you can look at the buyer’s commission as a built-in discount to the selling price. I.e., if your property sells for $1MM with a 3% buyer commission then everyone involved knows that the buyer is really only paying about $970k. (Of course, this isn’t optimal since taxes and fees are typically a function of the selling price. Ideally everyone would agree on the sale and then just reduce the price by 3%. But this is the best we can do in the present conditions.)

The market is overflowing with real estate brokers. Some are very good. Many are just out there playing the lottery – hoping to pick up a listing or a buyer on a big sale and walk away with a single commission that they could live on for an entire year. The good agents will not mind contracting with you on terms like those outlined here.