6 FACTS ABOUT MORTGAGES

This post is inspired by the Buzzfeed.com style article of "Top (#) of things that (blank)." For the non-enumerated version of this post, look here.

Here are 6 facts about mortgage amortization:

1. Longer amortization can make you money: Mortgages are often the cheapest form of capital available to the general public (lower than secured loans or lines of credit). By paying less every month for a mortgage, a borrower can reinvest the savings in an RRSP and get more back in taxes than interest savings from a shorter amortization.
2. Longer amortization does not mean you must be in debt longer: Most mortgages have favorable prepayment options that allow you to pay back a mortgage considerably faster than the length of the amortization. Good prepayment options can shorten your amortization to shorter than 5 years!
3. Longer amortization means more optionality: Many borrowers don’t have stable, predictable income. These borrowers can benefit from longer amortization if they have a bad year and need to pay less every month. In good years, they can use prepayments to accelerate their mortgage payments.
4. Longer amortization increases the risk on the side of the lender, not the borrower: In corporate lending, a lender will shorten amortization if the borrower is seen as risky. Low-risk borrowers can get loans with no amortization at all. Longer amortization is lower risk to the borrower since the required debt service is lower and the borrower has more excess cash.
5. The shorter amortization policy is a form of collusion between lenders: Longer amortization is riskier for the lender, so lenders will compete with each other by extending amortization. Forcing shorter amortization mandates a collusion between lenders since it prevents that kind of competition.
6. High Net-Worth individuals are able to get long amortization products that others can’t: Longer amortizations have not been eliminated since High Net Worth individuals are able to get longer amortizations by finding lenders that are not covered by specific policies, working with “friendly” institutions that vie for their business or borrowing through a legal loophole like setting up a corporation for the specific purpose of borrowing funds.

HOW NOT TO HELP

It is widely accepted that a modern democracy cares more about the public perception of policy than its effectiveness. If you don’t believe that statement then a simple rewind of your Google search to the rhetoric surrounding issues like Obamacare and raising the debt-ceiling should be evidence enough. There are other policies, many outside of the US, that seem to go completely unnoticed by the public, or are even touted as a great thing for the public, when they are actually serving to undermine the very public that endorses them.

An example of this ignorant acceptance of a policy (that I have always been critical of) is the elimination of longer amortization mortgages to the Canadian public. The policy is one thing, but the positive press regarding the policy is outrageous. Back in 2011, the Globe and Mail had an article called “Good riddance to 35-year mortgages” (found here) that was precisely this kind of positive press. The article makes the case that the 35 year mortgage was simply too long and that “even 25 years seems too long to spend paying off such huge debt.” According to a BMO poll (also from the article) most Canadians agreed with BMO stating that “(56 per cent) think a shorter amortization period is a good thing, with those aged 35 to 44 the most inclined to agree (77 per cent).” I struggle to find another contemporary example of such a gross misunderstanding of the costs and benefits of a policy.

The benefit of this policy is skewed heavily in favor of powerful lenders and away from the borrowing public. Since the beginning of the low-interest rate environment, rate competition between lenders was so marginal that it was making very little optical difference to their customers (borrowers). In order to compete, the only move a lender had was to extend their amortization thereby lowering the cash flow required from the borrower. Extending the amortization put the lender in a risky position since the borrower would have more of the lender’s money for longer. Lenders were forced into this kind of risk competition instead of a more typical price competition. In order to prevent competition, lenders could set a price and an amortization that they could all live with and all make money at an agreed upon risk level.

The problem for the lenders is that this solution is a type of collusion, and collusion between competitors is illegal as stated by Canada’s Competition Act (which exists in other forms in other countries as well). So how do you get around a policy that is preventing you from colluding with your competitors? The answer is simple – just enact another policy that mandates the collusion that you are looking for. The policy in question would force lenders to take their 30, 35 and 40 year products off the shelves and, with only shorter amortization available, lenders would no longer have to compete in terms of amortization.

The next step was to sell this change as a benefit to the borrower. Before the removal of these products, the borrower was “forced” to be in debt for 30, 35 or 40 years, or so it was commonly claimed. A 35 year amortization does NOT mean that the borrower will be in debt for 35 years, even the Globe and Mail article acknowledges the benefit of prepayment options. Many mortgages allow you to pay 20% of the principle in any given year, which means that you could pay the whole thing back within 5 years, even with a 35 year amortization! Using prepayments can convert your long amortization mortgage into a short amortization mortgage. The article uses a simple calculation to show how much more interest a borrower would pay with a longer amortization than a shorter one. This is a completely bogus example since it does not take into account the time value of money or the prepayment option in the longer amortization which would serve to lower your interest payments.

Getting rid of longer amortization mortgages just means that you lose the option to pay less each month, it does not mean that you MUST take longer to pay it back. A longer amortization means lower monthly payments, which can be a life saver for those with a small business or variable income (commission-based income or other performance-based income).

It is also important to note that High Net-Worth (HNW) individuals are still able to get those long amortizations by finding lenders that are not covered by the policy, working with “friendly” institutions that vie for their business or borrowing through a legal loophole like setting up a corporation for a specific purpose. The general non-HNW public, in turn, are given fewer options in how to purchase a home.

A common rebuttal to my position is the observation that people who are entering the real estate market are often bullied into buying a more expensive home because they can afford a longer amortization. This is true, but shorter amortization does not fix this problem. People are still bullied into the same situations with shorter amortizations since the lenders' metrics are based on cash flow, and those metrics have not changed. The only difference is that the lenders are now getting their money back more quickly, which is an extra burden on the borrower and lower risk for the lender.

The correct solution is to educate the borrower of the risks that exist with debt and mortgage products and present them with all available options. Instead we accept that the general public is unable to be educated in this manner and enact a policy to protect lenders by mandating their collusion. If that’s your idea of help, then please stop helping.

YOUR IDEA SUCKS

The iPod was my idea. I came up with it significantly before the launch of the first iPod, and I used to talk about it often when I was critical of portable CD player technology. Same thing with the iPhone, I came up with that in 2001 right after the launch of the first iPod beating Apple's launch by 6 years. I can actually claim the same thing about the whole Apple hit lineup. My streak isn’t even exclusive to Apple, I came up with the idea for tabbed browsing, spam filters, the smart home, mobile-based ride sharing and many others that are currently the foundation of successful tech startups today.

The paragraph above is not some analogy, it is absolutely true and there are basically three types of reactions to it:

1. The skeptical reaction – “if it was your idea, then why aren’t you the CEO of Apple, or Uber, or Nest etc.?”
2. The believer’s reaction – “Wow! You need to get a lawyer and sue those guys, you could get millions! Or billions!”
3. The correct reaction – “Who cares?”

“Who cares” is the correct reaction because the ideas were worthless. Because I am outspoken about the tech sector, and I am a shareholder in a mobile startup (www.imhangry.ca), I get told great ideas for a tech company all the time. There is only one catch, of course, and that is that I have to execute the idea while giving the originator of the idea a small equity stake, or the idea might even be given for free (quite generously). If you are one of those people who think that this is an equitable arrangement, this message is for you.

You probably think that this kind of an arrangement sounds like a reasonable partnership between an idea person and an execution person. I have news for you – we are all idea people. We live in a society with a collective confirmation bias. We often trivialize success and misunderstand failure. The narrative for success becomes a search for a hero and we often attribute it to an idea or a visionary. Failure, on the other hand, infects everything around it as the root cause is passed like a hot potato between ideas to environment to staffing decisions etc. (Note that this method of external attribution, often through media coverage, runs contrary to the proverb "success has many fathers, failure is an orphan").

The truth of the matter is that success is much more complex than either side of the narrative would have us believe. The success or failure of an idea is dependent on an ever growing list of factors of varying importance, and the idea itself falls pretty close to the bottom of that list. Wired.com recently had an article (found here) about how many dot-com failures were actually great ideas. Of course they were, but to say they were great ideas is a loaded statement.

Take an example that everyone is familiar with – Facebook. The so-called “idea” of Facebook was thought of before Facebook, and a million times over at that. Myspace is probably the most cited example as being a Facebook predecessor. You might be tempted to point out that Facebook and Myspace were not really the same thing and that Facebook had a cleaner interface, that its growth strategy was smarter etc. and therefore the idea was technically different. But the only reason that we are able to get so granular about Facebook vs. Myspace is because of our intimate knowledge of each product. If we took an example from the wired.com article, say WebVan vs. Amazon Fresh and Instacart, and looked at it with the same knowledge we have of Facebook and Myspace then we would immediately see how the comparison of the two is unfair.  

From the outside, two businesses might seem very similar, but from the perspective of an operator they are likely to be wildly different. Take Uber and Hailo, for example. From an end-user perspective the two ride-sharing companies seem virtually identical. After a little bit of research, however, you will come across the fact that the two have a very different approach in how they enter new markets, deal with regulatory conditions, market the company, deal with their employees and establish partnerships. From an internal view, the disparity between the two would grow even larger. The failure of one of these companies should not taint the ride sharing concept as a bad idea, nor should the success of the companies win the label of “great idea”. The idea is not what makes the company great, what makes it great are all the things that surround and support the idea.

The idea, by itself, is worthless, and there are at least two major facts that show this. First is that virtually all startups pivot because the original concept is simply not working as expected, or a better opportunity arises. This just shows that the original idea is either wrong or not specific enough to create success and the company’s success is more dependent on its flexibility than its original concept.

Second, ideas are given away for free today. If you want to try your hand at a startup but you aren’t sure what you want to do, you can go to various places online, or in your community, to find a startup idea that is up your alley. Ideaswatch.com is one such place online, but you can also check out forums in your area of interest, or network with local entrepreneurs. Chances are that if you’ve thought of it, someone has already tried some version of it, and can impart some relevant knowledge.

The moral here is that if you have a great idea, and you’ve been thinking about how to do it, then by all means, do it! On the other hand, if you simply don’t have the time, knowledge or resources to pull it off and you need to get someone else to do it for you, then I’m sorry, your idea sucks.

THE ETHICAL CAPITALIST - PART 3

Part 1, Part 2

There are few things better than watching a video by a jolly bearded fat man during the holiday season. I am, of course, referring to Slavoj Zizek and the video that was posted in the comments in Part 1 (found here). This post will be a response to that video, and a bit of an elaboration on that response toward the end.

I want to be clear, I like Zizek. I think he presents some good points and he does it in an entertaining way. He is completely unfazed by his lisp and accent as he powers through tongue twisters of Anglophone philosophical prose and social commentary. This confidence, combined with clever book titles and turns of phrase, is what I think has earned him the popularity of much of the western world. My high-level criticism of Zizek, however, is that he will generally start off with a good idea but, using a semantic (and albeit poetic) distraction, he will reach conclusions based on an appeal to intuition and emotion rather than a careful reasoning of the facts.

In the video, Zizek groups a variety of economic issues and paints them all with his “Cultural Capitalism” brush. It is a common technique to compare your opponent’s position to something ludicrous or unethical in order to make your position seem like the only viable option. You may have experienced an extreme but common example of this when, in a discussion, someone compares your opinion to that of a famous dictator (see Godwin’s Law), or calls you by a label with which you feel no association. Zizek employs this technique, though subtly, when he plays fast and loose with concepts like capitalism, consumerism and evil. Capitalism and consumerism are NOT the same thing, but many people have come to believe that one implies the other. Consumerism is a cultural phenomenon that has the potential to arise in any number of economic settings. Consumerism is to capitalism what the keg party is to social drinking.

Zizek implies that the current state of “Cultural Capitalism”, which he describes as the pairing of consumerism and anti-consumerism, is likely to increase into the future, and presents Tom’s shoes as a ridiculous example of this model run amok. As mentioned in Part 2, Tom’s shoes is not an ethical agent at this point, it is what I called proto-ethical. It is an experiment that is filling a demand in the current market. As the market changes, becomes more informed and more educated, so too will the business model. These cause-marketed companies, like Tom’s Shoes, are a mere stepping stone, not a final destination as Zizek would portray.

Ironically, the accurate and eloquent presentation of issues in the current system, as done by Zizek and his peers, will serve as a catalyst to educate the public. As mentioned in parts 1 and 2, education is key to the public making informed purchasing decisions, and ultimately driving demand toward the ethical. Zizek, in a way, describes this evolution in the video when he talks about Soros doing things the “old way”, then Starbucks, then Tom’s shoes. Each step has an element of market demand-driven iterative improvements and experiments.

There has been some question as to whether the description of the economy using evolutionary theory is valid. The short answer is yes, and it has nothing to do with them both being of “natural causes”. The analogy is not new, and ultimately originates with Thomas Malthus, who identified a problem with the increase in the food supply versus the speed at which population was increasing. Malthus found that the result from the growth disparity would be a mass extinction due to a scarcity of resources. Malthus’ idea was foundation for Charles Darwin’s Origin of Species and Adam Smith’s Wealth of Nations, of course Darwin and Smith replaced extinction with competition.

Subsequent theories and improvements on Darwin and Smith have been applicable in both fields. From game theory to fractal geometry, applications designed for one system ended up in the other and the fields of economic theory and evolutionary theory became irrevocably linked. The power of the evolutionary analogy comes through a second time in Zizek’s video when you consider the fact that the theory only allows for incremental improvements which result in inefficient and seemingly illogical intermediate forms (like the “semantic over-investment” in Starbucks and Tom’s).

The point here is that capitalist agents respond to their environment, which in their case is consumer demand. As I stated in part 2, the ultimate responsibility rests with the consumer since the consumer ultimately shapes the environment. When I watch Zizek’s video I’m reminded of one of those conversations I’ve had, after hours of talking, I realize that I actually agreed with my opponent the whole time. Zizek’s points do not disagree with the Ethical Capitalist model, he rightly points out that capitalism has caused capitalist agents to change. What he fails to realize, or mention, is that these agents will continue to change as shaped by demand. Every point that Zizek has made represents an evolutionary stepping stone, not an end-point, that makes up the environment that will produce the ethical agents that we are waiting for.

The plan is for the next post to cover choice in the market, then predictions for the future and finally follow-up with some conclusions. If there is a really good point made in a comment or message then there might be an extra post or so to cover that.

Thanks for reading!