Tuesday, November 11, 2008

Annuities a Basic Overview

This paper is an introduction to Fixed and Fixed Equity Indexed Annuity Contracts. It is not prepared as a product endorsement of any one contract or insurance company. When considering annuities it is important to understand the details of the contract being offered. Part of every investment consideration is how the particular investment fits into your overall plan. This paper will outline some of the basic features of funding fixed and fixed indexed annuities but for a full understanding you will need to meet with an advisor. Once the advisor understands your unique financial circumstances a specific recommendation can then be made.

Some Questions to consider

What is most important to you when you look at your retirement accounts?

  1. Is it Growth?
  2. Life time income?
  3. Guaranteed principal protection?
  4. Tax Deferred or Tax Free appreciation ?
Believe it or not there are investments that offer all of these and more.

These investments are: fixed and fixed equity indexed annuities. An annuity is simply, a savings account with an insurance company. An annuity can be funded with either qualified money (pretax dollars) or non qualified money (after tax dollars). When considering an annuity one needs to understand the various components that make up this saving vehicle.

Guaranteed Surrender Account Value

Think of an annuity as if you were putting your money into two or three buckets. Each bucket is filled with the same dollars, but each treated differently by the insurance company.

The first bucket is: the Guaranteed Surrender Value Account (GSV).

This account is guaranteed by the insurance company at a fixed interest rate. Basically no matter how the other buckets perform, this account at the contracts’ inception has guaranteed value each year for the length of the contract.

Current Account Value

The second bucket is: the current account value (CV).

This bucket can either have a fixed interest rate for a predetermined period of time, example: five years.

It might also have an index crediting method to a cap. The caps are adjusted annually by the insurance company depending on market conditions.

I like to keep the index crediting method simple. One simple method is an annual point to point credit based on one of the market indexes like the S&P 500, Dow Jones Industrial Average or a Bond index.

When this method is employed the money in the bucket is tied to a market index and not invested directly in the market.

There are many types of index crediting methods. Your time horizon and sophistication will determine your comfort level with each method. Typically your advisor will choose the best method based on the current market. Each year you may change the method of crediting on your contract. So it is important to have an annual review with your advisor prior to changing strategies.

Surrender Charges

All annuities have a surrender charge as a percentage of current account value (CV) that declines each year depending on the length of the contract.

Surrender charges are actually a positive aspect to annuity contracts. The surrender charge allows the insurance company to make long term investments and prevents contract holders from making a “run on the bank” that would put other contract holders at risk. Typically the surrender charge is in force for the entire term of the contract allowing you to walk away without penalty or roll the contract into another annuity at the end of the term.

Life Time Income Riders

This is an optional third bucket where your initial funds are can be used to calculate a guaranteed life time income benefit (LTIB).

This account is completely separate from your Current Value Account and is only used to potentially calculate a life time income benefit.

All annuities can be annuitized and guarantee income for life. The LTIB rider is different from annuitization because it is not a return of principal and interest but based on a guaranteed value at inception.

You can choose a rider to be added to your contract, typically there is a nominal cost for the rider and in some cases no cost at all. Every contract is different but the riders all work in the same manner.


Depending on the term of the contract the insurance company might offer a bonus on money invested into the contract. Today these bonuses range from 5% to 10% with some bonuses paid later as a loyalty reward.

If the bonus is paid day one then $100,000 would create a CV account of $110,000 day one; also if you have the LTIB rider that account would also receive the bonus. Both the CV and the LTIB account will receive future interest credits based on $110,000. This is very popular because of the recent losses experienced in the market.


This is an introduction to some of the factors to consider within annuity contracts and is not meant to be an exhaustive explanation. If you are considering placing some of your money into an annuity contract you should fully understand the guarantees of the contract and the riders you are purchasing. Annuities are a great way to get tax deferred growth on your money; avoid probate while enjoying contractual guarantees. Many annuities also have other benefits: Nursing home / terminal illness waivers of surrender charges as well as no surrender charge on the death of the contract holder. Most modern annuity contracts are highly liquid as well. In most cases 10% may be withdrawn each year without surrender charges.

There are penalties from the IRS if one makes a withdrawal prior to age 59 ½ of 10% plus ordinary income tax on any earnings. The financial professional who offers this product must ensure it is suitable for your circumstances.

I am available to review all this information in detail and am looking forward to hearing from you.

Call me at: 978-927-1121

Eric S. Erickson, RFC®

Become Tax Free in 3

When I hold a work shop one of the first questions I ask the group is:

Where do you believe future income taxes will be by a raise of hands?

1. Lower

2. Same

3. Higher

In every case guess when all the hands shoot up into the air? That’s right; each time I ask 100% of the group think future tax rates will be higher. Why?

There are a lot of reasons to think future income taxes rate will be higher:

  1. USA Today calculated in May of 2007 that American tax payers are on the hook for 59.1 Trillion dollars* in liabilities – this is before the recent financial meltdown and bailout package
  2. There are 78 Million Baby Boomers retiring in the coming years
  3. New government spending plans

Some experts believe the current highest marginal tax bracket of 35% might go as high as 60% in the near future. What does this mean to the population that has recently retired or will be retiring in the next 5 to 20 years? That the after tax value of your retirement income is in jeopardy of being significantly eroded by higher taxes.

How can you prepare your nest egg from this impending decline in spending power?
One solution is to move as much of your tax deferred retirement accounts into tax free accounts as soon as possible.

There currently exists a three year window of opportunity to transform your deferred retirement (401(k)/ IRA) accounts into tax free accounts. This window closes by the end of 2010 under current tax law!

It is very important to act immediately and ascertain if you are in a position to take advantage of this opportunity. Call us today to learn more and schedule an appointment to begin the process of protecting your future income.

Excerpt from USA Today Article pre-market melt down

*”…Bottom line: Taxpayers are now on the hook for a record $59.1 trillion in liabilities, a 2.3% increase from 2006. That amount is equal to $516,348 for every U.S. household. By comparison, U.S. households owe an average of $112,043 for mortgages, car loans, credit cards and all other debt combined.
Unfunded promises made for Medicare, Social Security and federal retirement programs account for 85% of taxpayer liabilities. State and local government retirement plans account for much of the rest.
This hidden debt is the amount taxpayers would have to pay immediately to cover government's financial obligations. Like a mortgage, it will cost more to repay the debt over time. Every U.S. household would have to pay about $31,000 a year to do so in 75 years….” 5/29/2007 -- By Dennis Cauchon, USA TODAY

Friday, October 17, 2008


Facing the challenges that our current market conditions pose can be overwhelming. Many of us in our 40’s, 50’s and 60’s are very worried about our retirement accounts devaluation in recent weeks. There is a lot of fear in the market as well as uncertainty surrounding the government involvement in our major financial institutions. The buy and hold strategy that has been the hallmark of the mutual fund industry seems to have failed. Many of our retirement accounts are invested in mutual funds and we have experienced more than a 30% drop in value of these accounts. Will the general stock market recover? Yes - the only uncertainty is when. The Dow Jones Industrial Index took 25 years to recover after the crash of 1929 and it took only 2 years after the 1987 crash. The most recent down turn in early 2000 we had high volatility after September 11, 2001 until a low in 2002. Some histories to consider for both the DOW and S&P 500 indexes are at the end of this paper.

Given the stock market history there is a high likelihood that it will recover eventually but the time frame is always unknown. Many of today’s boomers have not saved enough for retirement and any down turn creates a high level of fear because the clock is ticking and no one is getting any younger. So what can be done right now to protect and grow assets for future retirement?

First, there are two concepts that need to be discussed. What is the difference between short term and long term money and the best and worse places to park these funds? Short term money is liquid funds you need for emergencies such as short term unemployment and life’s unexpected occurrences. Short term money is liquid. Short term money should be parked in a safe guaranteed place. Safe guaranteed places can be FDIC insured bank accounts such as laddered Certificate of Deposits (CDs) and Deposit Bank Money Market accounts. Long term money is funds that won’t be used for at least ten years. This money should be parked in long term investment accounts. It is a mistake to park long term money in CDs or Money Markets for two reasons: low rate of return and interest is taxed as earned. Unless you are very near to retirement and will be drawing on this money in the next five years one should not keep long term money in these accounts. If you are worried about investing directly in the stock and bond market, in investments like mutual funds, here are some solutions. I have strategies that have a very high likelihood of success and are easy to implement for one’s long term safe retirement money.

Annual Lock in Reset Concept

What if I told you that you could open a ROTH IRA or ROTH 401(k) and this account had no limit on funds that could be invested AND there are no income limits that disqualify you from opening this account? In addition what if you had a roll over 401(k) or self-directed IRA in which you could not lose your principal but had some upside market return potential. Welcome to the new world of annual lock in reset concept. There are investments that act just like either a ROTH or Traditional IRA that have principal guarantees and market returns without the downside of market loss. Here is how the concept works.

A lot of financial advisors recently have given up trying to select the best mutual fund to recommend to their clients. Most stock based mutual funds are judged against the performance of the S&P 500 index. Each year many mutual funds advisors earn bonuses based on how well their fund performed when compared to the S&P 500. 30% of the mutual funds do better than the S&P 500 each year with only one problem - the mutual funds that make up this 30% are not consistent each year. It is hard to pick the funds that will be in the 30% because you will be wrong 70% of the time. The other problem with mutual funds is that the manager is paid a percentage of the return on the funds and this can be expensive. Many financial advisors have concluded, eliminate the manager and invest directly in an index based mutual fund. Since the industry is based on the S&P 500 why not just buy a mutual fund that mirrors this index without the high expense of an active manager. The annual lock in reset concept takes this one step further.

Instead of investing directly in the S&P 500 index just buy a Call Option to get a piece of the index return if it is positive without incurring the down side risk if the index loses value. The yield on the money invested is the only portion that is at risk not the principal. An example of how this works would be buying an option on a piece of real estate. Assume you have $50,000 in the bank that you are saving to purchase a home. You have earned $2,000 in interest on this money. You find a home that you are interested in but you are uncertain about buying in the current market. You offer $2,000 for the option to buy the property in 12 months for $250,000. The seller accepts your offer because he really needs the $2,000 now. In 12 months you determine if you want to exercise the option to buy. The seller keeps the $2,000 regardless if you buy the property. If the market has appreciated you buy the house. If the market has decreased you let your option expire. All you have risked is the yield on your money not the principal. This is how annual lock in reset works as well. I have included a slide from a seminar presentation I give that shows how annual lock in reset works when compared to directly investing in the S&P 500 index. This is a snap shot of hypothetical 3 year period of time.

The first year the S&P 500 gains by 10% therefore the $100,000 investment is now $110,000. If you are invested in an annual lock in reset, then this gain locks in and becomes principal. This is not the case if you are in an indexed mutual fund. The second year the S&P 500 loses 10%. If the annual lock in reset investment has a minimum credit of 1%, then you get the 1%. But if you are directly invested in the index, then your entire account will lose the 10% and in this case have only a principal balance of $99,000. In the third year if the S&P 500 gains 5%. The annual lock in reset account is credit the 5% and again this gain locks in as principal. As you can see that over this three year period the lock in reset account has a spread of 13% over directly investing in the index.

While the annual lock in reset concept is probably the best safe investment one can have for long term money there are some caveats. If one invests directly in the market their investment will raise and fall with the market. For example, in a year where the market experiences a 25% gain their investment will be credited with this entire gain. In these years the annual lock in reset concept will have a much lower return because the market gain will always be capped anywhere between 6.5% to 15% depending on the investment. Conversely if the market experiences a 25% loss the money invested directly in the index all the money is at risk for this loss. In the annual lock in reset only the yield on the money is at risk never the principal so in a market decline either 1% or 0% is credited to the account. Over time the annual lock in reset is a safe place to keep some of your long term money and it should yield respectable returns with very limited risk. In addition these investments if funded properly can either be entirely tax free in your retirement years like a ROTH or tax deferred like a tradition IRA. Lastly many of the traditional IRA like accounts offer up to a 10% bonus on money invested – this might help make up for some of the losses already experienced in the current market.


• August of 1987 highest close 2722.42 and October of 1987 lowest close 1738.74 -36.13%

The DOW fully recovered these losses by October 1989 close of 2791.41

• January of 2000 highest close 11722.98 and October 2002 lowest close 7286.27 -37.85%

The DOW fully recovered by December 2006 with a highest close of 12510.57

• October of 2007 highest close 14164.53 to Present October 16, 2008 close 8786 -37.97%

When the DOW will fully recover and move past this recent high is unknown.


• September of 1987 highest close 321.83 and October of 1987 lowest close 347.08 -23.23%

The S&P fully recovered these losses by October 1989 close of 353.40

• March of 2000 highest close 1498.58 and September of 2002 lowest close 815.28 -45.60%

The S&P fully recovered these losses by late 2007 close of 1526.75

• September of 2007 highest close 1526.75 to the present October 16, 2008 close of 929.13


When will the S&P fully recover and pass this recent high is unknown

Thursday, October 9, 2008

What are Legal Reserve Life Insurance Companies

An Explanation of the Operation of a Legal Reserve Life Insurance Company, underwriters of Annuities.

Through devastating world wars, financial recessions and depressions, sweeping epidemics, earthquakes and fires, inflation and deflation, the life insurance industry has protected people to a degree unmatched by any type of financial institution in the history of the world.
Today the life insurance industry provides more than a trillion dollars of death protection to American consumers.

The financial reliability of the life insurance industry, even in times of financial panic, was demonstrated convincingly during the Great Depression of 1929-38 when some 9,000 banks suspended operations while 99% of all life insurance in force continued unaffected. Reinsurance, acquisitions, and mergers protected virtually all policyowners in the affected companies against personal loss.

Unlike most industries where size is a major measure of financial stability, life insurance's unique series of safeguards can make even the smallest company a tower of strength. In 1949 Mr. Leroy A. Lincoln, then president of the world's biggest life insurance company, Metropolitan Life of New York, stated: "You're as safe, as well protected and the cost is just as cheap if you buy from a small insurance company as from the largest."

The State Insurance Department

The State Insurance Department is a most vital department in each of our fifty states. Acting on its own state's insurance laws and regulations, it supervises all aspects of an insurance company's operation within that state. In addition, the State Insurance Department licenses all companies and agents to sell insurance within its boundaries. It must also approve all policy forms and in some cases, sales materials before they can be offered to the public. The Departments review complaints from consumers and mergers of companies which do business within its boundaries.

Required Reserves Ensure Payment of Policyholder Benefits

A large percentage of each premium dollar calculated by actuaries for each company goes into the policyowner's reserve fund. This policy reserve (Legal Reserve) fund is a liability to the life insurance company. The fund is established as a way of determining or measuring the assets the company must maintain in order to be able to meet its future commitments under the policies it has issued.

The reserve liabilities are established as financial safeguards to ensure the company will have sufficient assets to pay its claims and other commitments when they fall due. These assets are kept intact for payment of living and death benefits to the insureds. Life companies that comply with the legal reserve requirements established by the state insurance laws are known as legal reserve life insurance companies.

Periodic Company Examinations

Every year all legal reserve life insurance companies submit annual statements to the insurance departments of each state in which they are licensed to do business. The format and contents of the forms used are prescribed by the State Insurance Commissioners and they are a detailed report of an insurance company's financial status that is important in evaluating the company's solvency and compliance with the insurance laws. Every few years, depending on a company's home state law, all companies operating in more than one state undergo a detailed home office zone examination of its financial position. This audit is conducted by a team of State Insurance Department Examiners representing the various zones in which the company is licensed to do business. Companies licensed in only one state are subject only to an annual home office examination by their State Insurance Department.

Additional Security Safeguards
  1. Reinsurance: Nearly every legal reserve life insurance company further protects its policyholders by reinsuring part of the coverage with a life reinsurance company. This is done when the company will not or cannot undertake a risk alone. Reinsurance prevents relatively sizable claims from depleting a company's policy holder reserves. The amount reinsured depends on many factors such as the size of the individual claim and the number of claims a company can expect.
  2. Surplus: The surplus is the amount by which a company's assets exceed its liabilites. The surplus protects the policyholders and third parties against any deficiency in the insurer's provisions for meeting its obligations. The determination of the optimum amount of surplus that a company will retain must be based on experience, current conditions, and an awareness of the primary goal of maintaining a strong company that is always able to pay claims as they arise.

In the unlikely event that a company's annual statement or its own examination reveals possible financial weakness, one of several avenues is open to the company: (1) Produce additional operating capital; (2) Sell its business to another life company; (3) Merger into another financially stable life company. A legal reserve life insurance company simply does not close its doors and go out of business declaring that all policies are null and void. Legal reserve life policyholders enjoy personal security safeguards unknown by other types of business.

Yours for Life

Another unique advantage of legal reserve life insurance is that if one company is purchased or merged into another, there is no change whatsoever in the policy benefits or premiums. Legal reserve life insurance companies have established a public responsibility to respect both the letter and the spirit of laws and regulation so the interest of their policyholders are always protected.

Policyholders Protection Comes First

Today, as has been the case for many years, it is unlikely for the policyowner of legal reserve life insurance companies to lose their policy benefits. Through strict state insurance department regulations, the establishment of many state insurance guaranty associations and because of the insurance industry's history of financial stability and public responsibility to operate in a manner not detrimental to the welfare of the community, your policy is secured by industry safeguards.

Written by Jeff McLeod

Thursday, October 2, 2008

Comedians Create a Sketch about the Current Situation but You Need To Educate Yourself

In this YOUTube video is a funny populist take on our current economic meltdown by two British comedians. While this is humorous, it does demonstrate a fundamental lack of understanding of what caused our markets not to work.

There are four key components to this melt down:

(1) Crony-Capitalism
(2) The Federal Reserve Itself
(3) Mark to Market Accounting Rules
(4) The Sarbanes-Oxley Law

While these four components are not exhaustive of all the causes these are the major actors of our current situation. I intend this article to be the beginning of a discussion on alternative ways to solve our current crisis as well as explain some of its root causes. I have included the video because it does demonstrate what most American’s believe to be the cause; fat cat greed, incompetence and bad lending decisions. I know that some readers will dismiss some of the arguments in this article and all I can ask is to continue educating yourself on rational economic principles. Never stop thinking for yourself and don’t believe the headlines that are meant to sell newspapers and news broadcasts.

Let us consider where we are today and the nationalization of our financial institutions. I will argue that neither a bailout or rescue plan that will put the American tax payer on the hook for mortgage loans is a good idea. I argue instead the current mess is the direct effect of our Federal Reserve System along with good intentioned laws e.g. Sarbanes-Oxley and Mark to Market accounting rules.

Crony Capitalism

The first key is something called crony-capitalism. Crony-capitalism is when market participants give lip service in defending free market capitalism while at the same time making deals with government officials to regulate and limit their competition. There is no doubt business owners are not necessarily defenders of free competition but their bottom line. If you follow the money into Washington it is easy to see why certain decisions get made and certain regulations are passed. This is not partisan this happens with Politician’s on both sides of the aisle. These cronies pretend to be for capitalism and free markets but will ask for the government to subsidize their decisions when they fail as well as regulation to limit competition. In August of 2007 when the private (not government backed– non Fannie Mae / Freddie Mac ) mortgage loans that were packaged and securitized began to no longer be purchased by wall street; there was an immediate sentiment: if it’s not backed by the Federal Government, then how can one know what these securities are worth? As the comedians in the video dramatized it seemed to have been a game of musical chairs with the last person holding a pool of mortgage money was left wondering if maybe too much money was paid for these security packages. What the video fails to explain is that in these mortgage packages all the mortgages are not equal. All the mortgages were not made to unemployed first time home buyers unable to make their payments. Not all mortgages even ones that adjust necessarily only adjust higher. The fact is that over ninety years the line between the government sector and the private sector in mortgage money lending has become very blurred.

The Federal Reserve

The Federal Reserve is the first culprit that is the foundation of this mess. It is neither politically feasible nor popular to criticize this federal institution when the general population has very little understanding of its role and the destructive nature of its decisions. With the nationalization of our money in 1913, this was the first nationalization project of the federal government. In 2013 the FED will celebrate its 100th birthday. What needs to be discussed and understood is it will also have eroded more of the average Americans wealth than any other government taxing system ever created. This institution can create dollars out of thin air that in turn devalues all the current dollars in the system, otherwise known as inflation – higher overall prices. Increasing the money supply typically drives interest rates lower. That is why there is a direct correlation between the FED decreasing the money supply to lower inflation and interest rates being pushed higher – remember the 80’s and Paul Volker. So what has the FED been doing? Increasing the money supply via federal debt and printing money that has created our inflationary pressures. Where do you think the additional money will come from in this “rescue package”? In my opinion, what the Fed and congress are doing is the largest power grab in the history of the federal government while it allows some private firms to buy assets at fire sale prices. Instead of changing the rules so the free market can correct its mistakes and return to sanity it will just make the government bigger. Do you really think that 95% of the performing mortgage securities have no value? There has to be a reason for this seizure and it is not the market participants “the fat cat Wall Street types”. It is the rules that are in place today that have caused this mess and it lies at our federal government’s feet because they make the rules.

Market Sentiment and Mark to Market

While you watch this video these two comedians do a wonderful job in the beginning of why “market sentiment” comes into play. One major reason is a mark to market. Read this article if you are interested in a fuller discussion of this concept from William Isaac, chairman of the Federal Deposit Insurance Corp. from 1981-1985 that lived through the 1980’s S&L crisis. http://online.wsj.com/article/SB122178603685354943.html?mod=article-outset-box

Yes there is euphoria if you are marking to market in an increasing market or panic if you are marking to market in a declining market. This is what just happened. Why? What if you got an appraisal on your home and the value was determined to be $500,000 last year. Assume you paid $250,000 just five years earlier you feel much richer. What If you get an appraisal today and the home is worth $200,000, then you feel like you took a huge loss. Let say the reason your home was valued at $200,000 is because your neighbor was foreclosed on and the bank sold it at auction. Is your home worth $200,000 really?

What mark to market impels you to do is, complete an appraisal on your home daily, regardless of how long you plan to keep this home. If you did not sell at $500,000 there was no gain and if you don’t sell at $200,000 there is no loss. Just because your neighbor is financially distressed and was foreclosed on and his home sold for $200,000 doesn’t mean you will take the same loss. But under the mark to market rules along with the liability of the Sarbanes-Oxley law; institutions that hold mortgage securities have to mark the price (valuation on the books) of like securities to those of institutions that are distressed and selling at foreclosure sale prices. Further since the market was never allowed to filter out the truly failing mortgage from those that are performing – partly because of how they are packaged and sold – the market has not been able to price the good mortgages and discount the bad. In the simplest terms this can be understood: There were lending products created over the last ten years that had a high likelihood of not performing – bad loans. There were also loan products however non-traditional that have a high likelihood of performing – good loans. The bottom line problem was the market was never allowed to empirically discover the good from the bad.

The Sarbanes-Oxley Law

The Sarbanes-Oxley Act of 2002 (often shortened to SOX) is legislation enacted in response to the high-profile Enron and WorldCom financial scandals to protect shareholders and the general public from accounting errors and fraudulent practices in the enterprise. The act is administered by the Securities and Exchange Commission (SEC), which sets deadlines for compliance and publishes rules on requirements. It also imposes criminal penalties on the officers of a corporation signing off its balance sheet. The SOX law along with the Mark to Market requirements has caused a great deal of the devaluation of the financial institutions.


I think between Mark to Market along with crony-capitalism these loans have not been properly valued. Crony-capitalism prevented the market participants doing the hard work of figuring out what loans were poorly made; it was easier to go to their favorite Uncle Sam for protection. This is what I think began, in the summer of 2007, the mantra: “I am not buying it unless it is guaranteed by the government.” Now the investors are pleading to have the Government to buy these loans now so that they can buy them back at a profit later. Let’s think before we react again and again only to make matters worse for our future. Do you really want to eventually only have large government controlled banks backed by your tax dollars? Do you really want to replace all the private lending institutions with members of congress? Don’t you think it is better to have individuals making daily decisions in their best interest as opposed to a committee making decisions in their best interest – that interest being keeping their job on the committee? If we give this much power to such a small group of people, whom will they ultimately serve? The last question is how can this small group know better? What possibly can guide them in making correct decision? These are my questions I look forward to your answers and further comments.

Further Discussion of the How the Market Works

What is the secondary market that buys non-government backed mortgage debt? The Collateralized Mortgage Obligations (CMO) with their corresponding Credit Default Swaps (CDS) are pools of mortgage loans made to various credit types from A paper to D paper. Each pool is weighted with these credit classes to defend against the risk of any one credit class defaulting. The uncertainty of their overall value is based on how these mortgage loans were packaged. What appears to have happened was when the market began to shift and began to appear that loans were defaulting; the buyers of these pools could not distinguish what classes had the possibility of defaulting. The entire pool was unable to be valued because there was no way to separate A paper from D paper. How did they ultimately become worthless is the real question?

Deposit Banks vs. Mortgage Banks

One first needs to understand the difference between lending money to sell into the secondary market the use of credit lines or hold in portfolio the use of depositor’s money. This is what fundamentally separates the pure mortgage banker from a pure deposit bank. A mortgage banker has short term lines of credit from large institutions that are used to make individual mortgage loans that are either sold one at a time or in a pool. The buyers of the loans eventually are sold to institutional investors (Wall Street) in very large pools -- for this discussion I do not include Fannie Mae or Freddie Mac. Mortgage bankers vary in size from small operations to large national operations. The large and mid-size mortgage bankers were the first of the mortgage lenders to become bankrupt beginning in August of 2007. The larger mortgage bankers had actually created new loan products that were packaged and sold into these pools. These loans were comprised mostly of subprime, Alt A loans and jumbo loans. For the most part these loans were adjustable rate mortgages because of the inverted yield curve at the time. One could classify all loans not backed by the government (conventional – Fannie / Freddie and Ginnie – FHA / VA) into this group. Mortgage bankers had been making these loans since the mid 1990’s. The market had become increasingly competitive over the past ten years with the explosion of these products. Therefore more and more loan programs were created to compete with older loan programs. All the major lenders jumped into this market, including large institutional banks creating divisions for mortgage banking purposes trying to carve out new niches to be profitable. For this discussion I am ignoring Fannie and Freddie and their foray into the Alt A and Sub-prime market because it is an entire article in itself. The deposit banker has the ability to make loans from its deposit base within guidelines defined by banking regulations typically holding 10% of the deposit and lending the remaining 90%. These deposit banks therefore can make portfolio loans up to a defined percentage of deposits at which point it will theoretically run out of money to lend without further deposits. Therefore most deposit banks also sell mortgage loans on the secondary market. Today the only A paper competitive jumbo loans on the market are made by deposit banking institutions for their portfolio. In a future article I am going to expand on why I think Washington Mutual failed but the main reason was it moved away from a portfolio lending philosophy to one that mirrored the giant lender Countrywide.

Secondary Market Stopped Working

Why were the mortgage bankers the first lenders to fail? The main reason for mortgage bankers going bankrupt, take for example American Home Mortgage a national mortgage banker the first major to go under, they had new mortgage pools to sell into the market and found their market closed. The inability to sell their mortgage loans, quickly led to their credit lines being closed because they could not meet margin calls. Why? The institutional banks that gave the originating lender a credit line wanted payments on these lines and when the lenders ran out of money because they could not sell these pools; were forced to sell all their loans at deeply discounted values – a fire sale. These fire sales tie back to the pools that already existed in the market. The owners of these pools were quickly questioned on the value of all the underlying mortgages via accounting standards. The first problem was the accounting rules that institutions had to mark these securities to market which I discuss further in the article. These existing pools now had to be marked to the fire sale market. This is what seized up the market in the first place. In essence all mortgages could not be valued properly and had to be valued at the deeply discounted value of the insolvent mortgage bankers. This created an increasingly negative spiral downward for the mortgage pools. At first I thought what was happening in late 2007, was the large institutions were eliminating their competition by increasing margin calls regardless of the class of mortgage assets being sold. I sat and could not believe that all non-government mortgages all of a sudden had no value. An example is Thornberg Mortgage. Thornberg was a recognized well operated mortgage banker that made loans to highly qualified borrowers with non-traditional jumbo loans. Thornberg is still in business today but has no competitive mortgage loan product to sell. But the questions from firms like Thornberg asked; how can Wall Street paint all mortgage loans with one brush? Thornberg’s argument was there is a real difference between our paper and sub-prime paper and the two are not equivalent. The questions and arguments went unanswered. But maybe Thornberg should have questioned the accounting methods imposed on Wall Street as well as whom the market believed the Government, the Fed, would ultimately back? Over the past few months we all have seen exactly which firms have been backed.