Investment Commentary

April, 2010
By Richard W. Boyer, CFP, CFA

Health Care Reform & Investor Behavior

Health care reform is here. Whether you are looking forward to it or whether you are dreading the changes it will bring to your life, it is here. Barring constitutional challenges from Republicans regarding the Administration’s legal ability to mandate the purchase of anything (in this case, the purchase of health insurance) to the legitimacy of the vote (the fact that the Senate and the House did not vote for identical bills….a detail they claim they can resolve through a process called reconciliation), it is here and “it is what it is”. Of course, since very few people (including the Congressmen who voted for it) have read the bill, we are not really sure what “it” is.

Although I couldn’t possibly provide a complete summary of the bill, here are a few highlights of which I am aware (some are estimates provided by the Congressional Budget Office):

• The bill will provide health care coverage for everyone, including the approximately 32 million Americans who do not currently have coverage.
• It will cost $940 billion over ten years (CBO estimate).
• Every American will be required to purchase insurance or pay a penalty. Lower income citizens who cannot afford it will be subsidized by the government.
• Insurance companies cannot deny coverage to anyone.
• Employers with more than 50 employees that do not offer health care coverage will be subject to a penalty. It appears the final bill will carry an annual penalty of $2,000 per employee after the first 30 employees.
• The cost of this coverage will be paid for by fees from companies in the health care industry (pharmaceuticals, insurance companies, etc. because they will be the beneficiaries of 32 million new customers) and by higher taxes.
• The Medicare tax, which we all pay on every dollar of earned income, will be increased. In addition, a 3.8% Medicare tax will be assessed on “investment income” for individuals who earn more than $200,000 or married couples who earn more than $250,000. This means the amount you earn above those limits will incur an additional 3.8% tax on interest, dividends or capital gains.

Obviously there is a lot more to this bill than I could begin to list here. The bill is over 2,000 pages. The website that outlines what this bill will allegedly provide is www.healthreform.gov. As you might expect, the website is a list of all the benefits of health care reform with no mention of any drawbacks. It’s like attending a sales pitch for variable annuities. The Financial Planning Association printed a timeline (you can download a copy here) showing when the various pieces of health care reform take effect.

As a taxpayer and an investor, here are some of the financial results of health care reform that we are confident you can expect:

• The top marginal income tax rate will revert back to 39.6% which was the top tax rate prior to the Bush tax cuts.
• The tax on qualified dividends, currently 15%, will increase to 20%.
• The tax on long-term capital gains, currently 15%, will increase to 20%.
• As mentioned above, if you earn more than $200K (or $250K for a married couple), all the above tax increases could effectively be increased by an additional 3.8%. It’s conceivable that, for some people, the tax on qualified dividends and the tax on capital gains will increase from 15% to 23.8%.

What remains to be seen is if the various tax increases actually result in the expected amount of revenue. Americans have proven to be rather creative in reducing/avoiding taxes. If the total amount of reported capital gains last year was $1,000,000, the 15% tax would have resulted in tax revenues of $150,000. If you raise the capital gains tax to 20%, it stands to reason that you would expect revenues of $200,000. Except it’s not that easy. In the face of higher taxes, investors are more reluctant to “realize” capital gains. They may hold stocks longer….or they may sell stocks in 2010 in order to realize the gains PRIOR to the tax increase.

Instead of paying dividends, companies might use corporate cash to re-purchase shares. Investors might be more attracted to such a company….or they might be more attracted to a company in a growth stage that does not yet pay dividends.

We think there is a good likelihood that municipal bonds, which are exempt from federal income tax, will become more attractive as the tax rates are increased. If you earn 5% interest but have to pay a tax of 35%, you are left with 3.25% after taxes. Therefore, a municipal bond that pays 3.25% provides you with the same return because you don’t owe federal tax on the municipal bond interest. However, if your tax rate increases to 40%, the taxable interest is reduced to 3% and the municipal bond paying 3.25% becomes more attractive.

As investors jockey to position themselves to pay the least amount of taxes, we fear tax revenues may fall significantly short of the CBO estimates needed to pay for health care reform. I don’t mean to bombard you with numbers but I think it is important to know what the Congressional Budget Office is saying today. While reading the following, remember that our country’s largest annual budget deficit (as a percent of GDP) since World War II was 6%. It was during the Reagan administration. The budget deficit for 2009 was over 12% of GDP. The CBO estimates future deficits to be:

2010	$1.5 trillion	10.3% of GDP
2011	$1.3 trillion	8.9% of GDP

The annual deficits decline slightly to about $800 billion in 2014 and then begin climbing again to well above $1 trillion in 2020. The deficit each year is the amount we spend more than we earn. It is then tacked on to the total amount of debt our country owes. The CBO estimates (PAY ATTENTION TO THIS) that our total debt held by the public would grow from $7.5 trillion today (53% of GDP) to $20.3 trillion in 2020 (90% of GDP!!).

One of the best ways to generate higher tax revenues is to reduce unemployment. Shortly after election, the Administration declared that unemployment would decline to 8% by the end of 2009. It is still 9.7% and the CBO estimates it will be 9.5% through 2011 and that the average unemployment rate will be 6.5% for the three years following…..another reason to be skeptical of projected future tax revenues.

The gap between tax revenues and expenditures may eventually become so great that raising income taxes might not be effective. At some point we might see a movement for a Value Added Tax (VAT). This amounts to a federal sales tax at the point of purchase. However, because it taxes the poor as well as the rich, it is not a popular option. Any version of it will exempt purchases typically made by the poor (food, clothing, health care items, etc.) and will NOT exempt purchases typically made by the wealthy (nice cars, fancy restaurants, jewelry, etc.).

The Home Affordable Refinance Program, which was scheduled to expire this June, is now extended to June 30th of 2011. Let’s face it….the image of the Administration suffered as it made health care reform a priority over the economy and unemployment. This is a major election year. There are 7 months until November and significant efforts will be put forth to stem the tide of home foreclosures. Here are a few of the problems, some of which have been touched on in previous Investment Commentaries:

• More than five million households are more than three months behind on their mortgages. They are at risk of foreclosure.
• Unlike the first wave of sub-prime mortgage foreclosures, many of these delinquent mortgages are “prime” borrowers who have lost their jobs and are now at least three months behind on their payments.
• Eleven million U.S. borrowers owe more on their home than it is worth. Some of these homeowners are realizing that it may take many years for the value of their home to be worth what they owe. Because of this, an entirely new financial strategy has emerged. It is called the “strategic default”. A strategic default is when you have the money to make your mortgage payment but you decide that making the payment does not make financial sense….so you quit making the payment. Many of these borrowers are not even interested in dealing with the mortgage company to get a reduced payment. If you owe $400,000 and your home is worth $300,000, why make ANY payment?

However, the default (strategic or otherwise) and eventual foreclosure looks bad on your credit report for many years. So a new aspect to the Home Affordable Refinance Program is to assist the homeowner with a “short sale”. In the above example, instead of going through foreclosure, you are actually allowed to sell the house for less than what you owe ($300,000). In this transaction, the servicing bank gets $1,000, and the homeowner gets a check for $1,500, referred to as “relocation assistance”. The bank only gets $300,000 instead of the $400,000 it is owed but most banks understand that, in a bankruptcy, they are not going to get what is owed.

Why would the mortgage company and the borrower go along with this?

• Foreclosure is probably not going to bring in more than $300,000. The mortgage company should get as much in a short sale as a foreclosure, possibly more.
• The house doesn’t sit empty for months as many do after a foreclosure. Many empty homes have been damaged, either by the exiting homeowner or by vandals, depressing the value of that home as well as the neighborhood. This causes the mortgage company to receive less than in a short sale.
• There is less credit damage to the borrower than in a foreclosure.

There will still be complicated problems. Many homes have more than one mortgage. Second and third mortgage lenders can block a short sale unless they are also cut in on the money that is being handed out by the government. Meanwhile, if you paid cash for your house, you get nothing.

I occasionally write about my local economic anecdotal evidence….counting real estate signs as I ride my bicycle. Having endured the worst winter in my adult life, it has been a long while since I have been riding. As a reminder, I began counting real estate “for sale” signs in the summer of 2007. It was at that time I was aware that a significant mortgage/real estate problem was developing. I ride the same route every day and the ride takes me through three different developments of slightly different socioeconomic classes (but none of them very poor). In the summer of 2007, I counted as many as 8 signs. In 2008, the number of signs climbed to 25 and last summer I counted as many as 26. The weather finally warmed up and I took my bike out on the first day of April. The number of for sale signs has dwindled to 15. There are several potential reasons:

• The economy is getting better and my neighborhood is returning to 2007 levels.
• The real estate market is in between the “sub-prime” mortgage crisis and the “Alt-A”/”Option ARM” crisis and we will see more homes for sale in the next year as those mortgages re-set their interest rates.
• Banks are so inundated with defaults, they are not yet able to force a foreclosure even though the borrower has stopped paying. If so, we will eventually see those homes for sale.
• Many of the Alt-A and Option ARM mortgages were part of the previous round of defaults. This means that, even though the interest rate on their Adjustable Rate Mortgage has not yet re-set, the borrower had financial problems for other reasons that caused him/her to stop making payments on that loan. So that mortgage which we expect to go “bad” in the future won’t go bad because that borrower defaulted last year.

The stock market increased about 5% in the first quarter of this year. We continue to feel the primary driver of risky assets (stocks included) is the risk-free rate of return which continues to be close to zero. Investors don’t like earning “zero” so money doesn’t sit in money market funds very long. The Federal Reserve Bank states they are leaving interest rates near zero because they fear the economy is still fragile, the primary evidence being 9.7% unemployment. Unemployment does not appear to be rising but, for a recession as long as this one, it is being very stubborn about declining. Although the stock market may continue to climb, we remain vigilant about not exposing our clients to excessive risk.

Save Your Greenbacks—Don’t Fall for Green Energy Scams

FINRA (Financial Industry Regulatory Authority) is the largest independent regulator for all securities firms doing business in the United States. Part of FINRA's role is to serve as an investor educator and advocate, proactively addressing emerging regulatory issues before they harm investors or the markets. The following article is from a recent FINRA Investor Alert.

It seems like everybody’s going green these days—even fraudsters. However, the “green” they are after is your money.

FINRA is issuing this Alert to warn investors about green energy investment scams that dangle the promise of large gains from investing in companies purportedly involved in developing or producing alternative, renewable or waste energy products. To avoid putting your portfolio in the red, learn how to spot potential green energy scams and know where to turn for help.

Spotting Potential Green Energy Investment Scams
There are legitimate and not-so-legitimate green energy investments. Like many investment scams, green energy investment pitches may arrive in a variety of packages—from fax, email or text message solicitations to webinars, infomercials, tweets or blog or message board posts. Regardless of how you first hear about them, green energy ploys typically contain classic red flags of fraud.

In particular, fraudsters may try to lure you with very aggressive, optimistic and potentially false and misleading statements or press releases that create unwarranted demand for shares of some small, thinly traded company. The con artists behind the scam can then sell off their shares, leaving investors with worthless stock. This is what’s known as a “pump and dump” fraud.

Continue article >>

Related Links:

In just four questions FINRA's Scam Meter will help you tell if an investment you are thinking about might be a scam

Go to Scam Meter >>