Will's Blog Has Moved!

I have decided to move my blog to Wordpress and eventually my new website: www.willrwright.com

Please follow this link for the new blog: www.willrwright.wordpress.com

Thanks for reading!!

KC Concert

Thanks Dan for a great time at the Kenny Chesney concert!




A whole lot of John Deer-themed green lighting for She Thinks My Tractor's Sexy:

More Bad News for the future of the USD

More news that the countries which hold the largest US Dollar reserves are beginning to “diversify” into other currencies and investments. Friday’s WSJ has an interesting article ($link) about the future of the Kuwaiti sovereign wealth fund:

The Gulf petro-states control a vast hoard of investable funds, one that is sure to grow vaster. Combined, government investment arms in Kuwait, Saudi Arabia, Dubai, Abu Dhabi and Qatar hold an estimated $1.5 trillion. That gives them potential to sway the course of broad global financial markets, including exchange and interest rates, the now-slowed buyout boom and the global credit dislocations stemming from US subprime mortgages.

The Middle East’s government investment arms are at the fulcrum of a longer-term shift in global financial flows from the West’s developed markets to the faster-growing economies of India, China, Southeast Asia and Turkey, places where many Middle Easterners see their fortunes lying in the future. Mr Al-Sa’ad is cutting the portion of the portfolio invested in the U.S. and Europe to less than 70% from about 90%. “Why invest in 2%-growth economies when you can invest in 8%-growth economies?” he asks.

That shift might lower the appetite for low-yielding investments such as the bonds the U.S. government must sell in large numbers to finance its budget and trade deficits. All else being equal, reduced buying of Treasuries and other U.S. securities would tend to weaken the dollar and make U.S. exports more competitive globally, but also burden businesses and consumers in the U.S. by pushing up interest rates.

I highlighted what I think are the most important takeaways of this news, neither of which is positive for the future of the US Dollar:

1. Because of the massive amount of US Dollars and US Treasuries owned by our trading partners, they probably have as much influence on the US economy as does the Federal Reserve.

2. As countries such as Kuwait and China create “sovereign wealth funds”, they will diversify out of US Treasuries into investments with stronger growth potential.

Credit Crunch

In my post An End to the Debt Bubble, I tried to organize my thoughts and present the big-picture synopsis of the events leading to the current market turmoil.

Over the last few days, just about every newspaper, blog and pundit has opined about the “credit crunch”. So, in the spirit of everybody else is doing it so why can’t I?, here’s my interpretation of what’s going down.

What Makes a Credit Crunch?
In a functioning market, there is a buyer for every seller. When you want to buy or sell GE, MSFT, or a T-Bill, there is usually always someone to buy or sell it to you.

Credit crunches and financial panics happen when buyers disappear, or when banks are unwilling to lend money to good credit risks. In the fixed income markets today, there are no buyers, at any price, for even the highest quality mortgages.

If a bank writes a mortgage greater than $417,000, they cannot sell it to anybody, so they have to keep the loan on their books. (High quality mortgages under $417,000 can be sold to Freddie or Fannie) Over the last few years, there have always been plenty of buyers of high quality mortgages – in today’s market, there are none. Thus, if banks can’t sell their loans, they are severely limited in the new loans they can write.

The crunch is not limited to mortgages. The market has broken down for any instrument that is not an obligation of the US Treasury. In fact, many money market funds, which typically hold all manner of high quality paper, are now exclusively buying T-Bills and not buying any commercial paper. For paper that still is trading, spreads have risen, making the prospect of selling more expensive.

Liquidity Crisis, NOT a solvency Crisis:
A typical Mortgaged Back Security will be a package of many different quality mortgages. As a simple example, it might have 75% prime, 15% Alt-A, and 10% subprime. As an absolute worst-case scenario, let’s assume that all of the subprime and Alt-A loans in this MBS default. So, instead of trading at 100, the bond is now worth something like 75 cents on the dollar. If the market were functioning as usual, there would be investors willing to buy the MBS at a price somewhere around 70-75. The owner of the MBS would certainly take a loss, but at least he/she could sell it to raise cash if needed. In the current market, there are no buyers at all and the few that are out there bidding very low – 45 or 50 to continue with this hypothetical example.

What is the Fed doing about this?
Essentially, the Fed and other central banks around the world are providing liquidity. Through their open market operations they are lending money to banks and accepting high quality mortgages and commercial paper as collateral. In effect, trying to function as the market would normally. This is not a bail-out – the Fed is not actually buying any loans, let alone anything even remotely related to subprime.

For sure, the Fed walks a tight rope when it pumps liquidity into the system because it can encourage risk-taking behavior and lead to inflation, etc. Here’s an interesting quote from Brian Wesbury, in today’s WSJ Op-Ed page ($link):

The best the Fed can do is to stand at the ready to contain the damage. In this vein, their decision to cut the discount rate and allow a broad list of assets to be used as collateral for loans to banks, was a brilliant maneuver. It increases confidence that the Fed has liquidity at the ready, but does not create more inflationary pressures. It was a helping hand, not a bailout.

It also buys some time, which is what the markets need. Every additional month of payment information on mortgage pools, and every mortgage that is refinanced from an adjustable rate to a fixed rate, will increase certainty and provide more clarity on pricing.

Even though many, including Alan Greenspan, continue to argue that the excessively easy monetary policy of 2001-2004 was necessary, it was this policy stance that caused the problems we face today. The current financial market stress is a result of absurdly low interest rates in the past, not high interest rates today. In fact, current interest rates are still low on a both a nominal and real basis. Cutting them again causes a further misallocation of resources, and makes the Fed an enabler of the highly leveraged.

Similarly, even very easy money today can’t put off the day of reckoning for subprime mortgage holders who bought homes with no money down and thought interest rates would stay low forever. It can’t help overly leveraged investors who thought they were getting risk-free 20% annual returns. Providing enough liquidity to allow markets to function, while keeping consumer prices as stable as possible, is the best the Fed can do. It should be all we really ask.

An End to the Debt Bubble?

Credit Crunch
Run on the Bank
Sub-Prime Meltdown
Housing Bubble
Central Banks Inject Liquidity

These terms are being thrown around left and right these days and I’ve read and talked so much about it that my brain is about to explode from serious information overload. Here’s my attempt to present the big-picture synopsis of what’s been happening.

Part I: How We Got Here:

Low Interest Rates:
Starting in 2001, after the dot-com crash and 9-11, the economy was teetering on the edge of recession. To stimulate economic activity, the Fed began to lower interest rates. From the corresponding chart (Bankrate.com), we can see that interest rates across the whole economy fell dramatically.

Along with lower interest rates -- beginning with those set by the Federal Reserve -- there was also a dramatic increase in the money supply.

Since interest rates are lower, demand for money will be higher. The Fed sees to it that money will be available through its “open market operations.” Most often, the Fed will engage in repurchase agreements (repos) with the money center banks (Citibank, JPMorgan, Bank of America, etc.). Essentially a repo transaction is when a bank deposits collateral (loans) at the Fed and receives cash in exchange. This cash is then lent to the bank’s customers who are eager to borrow money at low interest rates.

The other option is for the Fed to buy Treasuries from the banks (outright purchases). The Fed buys Treasuries with freshly printed currency, thus dramatically increasing the money supply. As I understand it, the Fed rarely does this because it is considered more permanent and it can be highly inflationary.

Over the past few years, the Fed was not buying US Treasuries but our foreign trading partners certainly were!

In 2006, the US trade deficit was nearly $764 billion: the US bought $764 billion more stuff from the rest of the world than the rest of the world bought from us.

What happened to all of those dollar bills sent to our trading partners? A great deal of them found their way right back into the USA through the purchase of US Treasuries and T-Bills. Consider the massive foreign currency reserves held by the Chinese government: as of June, 2007 they stood at nearly $1.4 trilion. Of this amount, it is estimated that the vast majority is held US Treasuries and other USD debt instruments.

And let's not forget that the US was not the only country with a stimulative interest rate environment. Interest rates and availability of loans from Japan was another hugely stimulative factor.

Increased Risk Appetite:
With so much money available at such low interest rates, the collective risk appetite of market participants across the globe increased. All of this newly created money had to flow somewhere. Because of China’s willingness to produce consumer goods at such low prices, the increased money did not, by and large, slosh into the prices of consumer goods. Instead it sloshed into asset prices: bonds, stocks, commodities, wine, art, and especially REAL ESTATE.

The new money certainly helped to push home prices higher. The other major factor was the increased risk tolerance and demand for risky loans. Wall Street banks created new “structured products” which were sold to investors all over the world. Leveraged products such as CDO’s & CMO’s were created and promised increased yield with low risk to investors. These products contained lots of subprime and Alt-A mortgages yet they managed to receive AAA ratings from S&P, Moody’s & Fitch.

Typically, banks are very careful about who they lend money to because they want to get paid back. In this latest cycle, the borrower’s ability to repay was irrelevant because the mortgage brokers immediately sold the loans to Wall Street. Because of these new products and the strong market to sell them into, Wall Street had a voracious appetite for risky home loans.

Yesterday’s WSJ has a must-read free article about a family in California who bought a $567,000 house with a combined income of $90,000, and NO-MONEY DOWN. Their mortgage was an interest-only, adjustable rate mortgage. At the start, their yearly payments on the loan were $38,400. After a reset which is coming shortly, the mortgage will cost them $50,000 per year. It doesn’t take a financially sophisticated person to realize that this mortgage is totally unaffordable!

But it’s OK because housing prices only go up, right? Wrong – the price appreciation in many neighborhoods was driven by the hysteria and availability of easy loans. Without that, prices must fall.

To be continued...

Consultant or Employee?

For part-time or consulting work, how are you classified by your employer: as a consultant or as an employee?

Since we're primarily talking about taxes in this post, the difference is that an employee receives a "W2" and the consultant receives a "1099" each year from their employer. These forms -- provided to you and the IRS -- document how much you earned in a given tax year. The type of form you receive is important because the tax treatment of W2 income and 1099 is very different.

Employee:
Hiring you as a consultant instead of as an employee, your employer saves a lot of money in taxes. The biggest is Social Security tax -- employers are required to pay the SSA 6.2% of your salary below $97,500. Medicare tax adds on an additional 1.45% of your pay. And don't forget about unemployment, disability and other taxes which your employer pays on your behalf.

When you get paid as an employee, you pay the other half of your "payroll taxes": 6.2% of your wages for Social Security, and 1.45% for Medicare. If you incur any job-related expenses which you don't get reimbursed for, you can deduct them on your taxes. But there's a catch: your unreimbursed-job-expenses are not an "adjustment" to your income. Instead, they are considered a "miscellaneous itemized deduction", and only reduce your taxes to the extent expenses in this category exceed 2% of your Adjusted Gross Income (line 37 on your 1040).


Consultant:
If you work as a consultant, the tax treatment is very different. You -- and the IRS -- will receive form 1099-misc from your "client" (not employer). Items on the 1099-misc are considered "self-employment income" and you still have to pay 15.3% of your pay in Social Security and Medicare taxes. Just as 1/2 of this amount is deductible by your employer when you are an employee, you are allowed to deduct 1/2 as an adjustment to income. Here's where the real difference comes in: unreimbursed-job-expenses are netted against your consulting income. This can result in a substantial reduction in taxable income for many people. Not surprisingly, the IRS would MUCH prefer companies to pay their workers as employees and not consultants.

The reason I'm writing about this topic now is that the IRS recently reached an important agreement with a soccer league in Connecticut regarding their treatment of coaches. Excerpt from $NYT article:

In a case widely watched by youth sports leagues across the country, the Internal Revenue Service has reached an agreement with the Fairfield United Soccer Association that clarifies the employment status of the group’s coaches, the association’s president said yesterday.

Under the agreement, the Fairfield, Conn., league will begin in 2008 to treat about half of its 30 coaches — those not employed by professional coaching associat ions — as employees rather than as independent contractors, and will withhold taxes from their pay. And the league will pay $11,600 in back taxes, according to Jay Skelton, the group’s president, a fraction of the $334,441 in taxes and fines the I.R.S. had assessed it in 2004.

“We said we tried to comply with the rules, and we thought we were, but we made mistakes, so we agreed to pay the tax due,” Mr. Skelton said. “For 20 years all of these coaches have been reported as 1099 employees for everybody. If you talk to 100 clubs, I guarantee almost every one, if not all, would declare these guys as independent contractors.”

It was not the first time the I.R.S. had fined a nonprofit youth sports league, but the proposed penalty was one of the largest, sending worried sports officials in Connecticut and other states scrambling to review the tax code. Mr. Skelton said that over the last two years, about 200 people involved in youth sports had contacted him asking about the resolution of the case. He said the assessment had threatened to put the Fairfield association out of business. (NYT)

The IRS wants the league to treat coaches as employees because the government will receive way more revenue that way. Here's a simple example to illustrate:

Coaches are considered "consultants" and issued 1099's:
Let's say a coach earns $1,000 in a year. The coach can easily cook up $500 of expenses related to the coaching job -- transportation, equipment, gifts, etc. The result is net self employment income of $500. This $500 is the amount which social security, medicare, & income taxes are based.

Coaches are considered "employees" and issued W2's:
Keeping with our above-mentioned example, let's say the coach earned a salary of $1,000 in a year. First, the employer & the employee would pay a total of 15.3% of the salary in payroll taxes. Second, the $1,000 salary would flow directly to the coach as "ordinary income". The $500 in job-related expenses are not allowed to be netted against this income. It is quite possible that the coach will not be able to deduct the $500 because he or she probably won't have miscellaneous expenses (including unreimbursed-job-expenses such as these) which exceed 2% of AGI.

Bottom Line: How you are classified -- employee or consultant -- makes a big difference for both you and your employer come tax season. Since the government wants you to be an employee (and not a consultant), it could become a little more difficult to keep your status as a consultant. Fortunately, there are some steps you can take to ensure that you keep your consultant status. I'll try to post about that topic soon.

Final Softball Game...Victory!

Congrats to the Trois Pistoles on a great victory to end the season! The game was marked by extraordinary infield play and great hitting. Check out all the pics over at Flickr and the videos on YouTube.