Keeping Credit Flowing to Consumers in Need

The credit crunch and subsequent collapse of the nonprime mortgage market claimed many victims, including hundreds of thousands of low- and moderate-income Americans who lost their homes and savings. Today, regulators and policymakers are debating ways to reform the housing finance industry and strengthen consumer protections.

The risk they run is that too stringent regulation could make it harder for borrowers in need to get money. In today's challenging economic climate and with high unemployment, "many Americans borrow to live," notes Nicolas P. Retsinas, a senior lecturer in real estate at Harvard Business School, and director emeritus of Harvard's Joint Center for Housing Studies. In addition, the American economy depends on consumers having access to credit. "The challenge is to avoid the temptation of overcorrecting," he says.

To begin to study some of these issues, the Joint Center held a symposium in February 2010 on Moving Forward: The Future of Consumer Credit and Mortgage Finance." A new book, co-edited by Retsinas and Eric S. Belsky, managing director of the Center, collects papers presented at the symposium that deal with, among other topics, rebuilding the housing finance system, the credit needs of low-income consumers, mortgage finance alternatives, and the regulation of consumer financial products.

What are the options for replacing Fannie Mae and Freddie Mac, and which approach do you favor?

At one extreme, the government's role would be limited to supporting mortgages to lower income households through the existing programs at the Federal Housing Administration. To a first approximation, that's the right approach, but there are times…like the crisis period we just experienced…when markets benefit from government support. At the other extreme, the government would provide a backstop to private firms that would provide broad-based guarantees of mortgage-backed securities [MBS]. This approach would be most similar to the current system except that the new firms would not be government sponsored and would have to pay for the government backstop.

Our paper argues that this approach is problematic on a few fronts. First of all, if the government charges the right price for bearing the credit risk of its guarantee, the effect on mortgage rates is likely to be small. Second, the government guarantee proposals that involve private financial firms are likely to suffer from the same sorts of governance problems that plagued Fannie and Freddie, which will expose the taxpayer to considerable risk in housing downturns. Given that guarantees have small benefits during normal times, these costs are probably not worth bearing. And finally, when markets are stressed, private financial firms that guarantee mortgages are likely to be financially impaired. This will limit their ability to guarantee new MBS issues even if the government guarantee protects old MBS issues. So, in a crisis the government may have to inject capital into private guarantors to ensure that mortgage credit keeps flowing, just as it has done with Fannie and Freddie.

That's why we have advocated a middle-of-the-road approach where the government is just a "guarantor of last resort" in a time of crisis when private mortgage credit dries up. In that case, a government-owned corporation could guarantee newly issued, high-quality mortgage-backed securities to keep credit flowing. This entity could have a small footprint in normal times to ensure that it could ramp up its activities in the crisis.

In a way, this would return the government to its original role in housing finance, which was to facilitate mortgage credit during the Great Depression, a time when markets were functioning poorly. We were happy to see an approach like this included in the administration's white paper.

Measures of Historical Rates of Return

When you are evaluating alternative investments for inclusion in your portfolio, you will often become paring investments with widely different prices or lives. As an example, you might want to compare a $10 stock that pays no dividends to a stock selling for $150 that pays dividends of $5 a year. To properly evaluate these two investments, you must accurately compare their histor-ical rates of returns. A proper measurement of the rates of return is the purpose of this section.  When we invest, we defer current consumption in order to add to our wealth so that we can consume more in the future. Therefore, when we talk about a return on an investment, we are concerned with the change in wealth resulting from this investment. This change in wealth can be either due to cash inflows, such as interest or dividends, or caused by a change in the price of the asset (positive or negative).If you commit $200 to an investment at the beginning of the year and you get back $220 at the end of the year, what is your return for the period? The period during which you own an investment is called its holding period, and the return for that period is the holding period return (HPR). In this example, the HPR is 1.10, calculated as follows:

HPR = Ending Value of Investment/Beginning Value of Investment

= 220/200 = 1.10

This value will always be zero or greater—that is, it can never be a negative value. A value greater than1.0 reflects an increase in your wealth, which means that you received a positive rate of return during the period. A value less than 1.0 means that you suffered a decline in wealth, which indicates that you had a negative return during the period. An HPR of zero indicates that you lost all your money.  Although HPR helps us express the change in value of an investment, investors generally evaluate returns in percentage terms on an annual basis.  This conversion to annual percentage rates makes it easier to directly compare alternative investments that have markedly different characteristics. The first step in converting an HPR to an annual percentage rate is to derive a percentage return, referred to as the holding period yield (HPY). The HPY is equal to the HPR minus 1.

1.2                          HPY =HPR – 1

In our example:

HPY =1.10 – 1 =0.10=10%

To derive an annualHPY,you compute an annualHPR and subtract 1. Annual HPR is found by:➤

1.3                          Annual HPR =HPR1/n

where:

n=number of years the investment is held Consider an investment that cost $250 and is worth $350 after being held for two years:

MEASURES OF RETURN AND RISK

This selection process requires that you estimate and evaluate the expected risk-return trade-offs for the alternative investments available. Therefore, you must understand how to mea-sure the rate of return and the risk involved in an investment accurately. To meet this need, in this section we examine ways to quantify return and risk. The presentation will consider how to mea-sure both historical and expected rates of return and risk.  We consider historical measures of return and risk because this book and other publications provide numerous examples of historical average rates of return and risk measures for various assets, and understanding these presentations is important. In addition, these historical results are often used by investors when attempting to estimate the expected rates of return and risk for an asset class.  The first measure is the historical rate of return on an individual investment over the time period the investment is held (that is, its holding period). Next, we consider how to measure the average historical rate of return for an individual investment over a number of time periods. The third subsection considers the average rate of return for a portfolio of investments.  Given the measures of historical rates of return, we will present the traditional measures of risk for a historical time series of returns (that is, the variance and standard deviation).Following the presentation of measures of historical rates of return and risk, we turn to esti-mating the expected rate of return for an investment. Obviously, such an estimate contains a great deal of uncertainty, and we present measures of this uncertainty or risk.

Defination of Investment

From our discussion,we can specify a formal definition of investment. Specifically,an investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for,

(1) the time the funds are committed,

(2) the expected rate of inflation,and 

(3) the uncertainty of the future payments. 

The “investor”can be an individual,a government,a pension fund,or a corporation. Similarly,this definition includes all types of investments,including investments by corporations in plant and equipment and investments by individuals in stocks,bonds,commodities,or real estate. This text emphasizes investments by individual investors. In all cases,the investor is trading a known dollar amount today for some expected future stream of payments that will be greater than the current outlay.At this point,we have answered the questions about why people invest and what they want from their investments. They invest to earn a return from savings due to their deferred consumption. They want a rate of return that compensates them for the time,the expected rate of inflation,and the uncertainty of the return. This return,the investor’s required rate of return,is discussed throughout this book. A central question of this book is how investors select investments that will give them their required rates of return.

how to make an investment plan 1

The investor who gives up $100 today expects to consume $104 of goods and services in the future. This assumes that the general price level in the economy stays the same. This price stability has rarely been the case during the past several decades when inflation rates have varied from 1.1 percent in 1986 to 13.3 percent in 1979,with an average of about 5.4 percent a year from 1970 to 2001. If investors expect a change in prices, they will require a higher rate of return to compensate for it. For example, if an investor expects a rise in prices (that is, he or she expects inflation) at the rate of 2 percent during the period of investment, he or she will increase the required interest rate by 2 percent. In our example, the investor would require $106 in the future to defer the $100 of consumption during an inflationary period (a 6 percent nominal, risk-free interest rate will be required instead of 4 percent).Further, if the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate. The uncertainty of the payments from an investment is the investment risk.  The additional return added to the nominal, risk-free interest rate is called a risk premium. In our previous example, the investor would require more than $106 one year from today to compensate for the uncertainty. As an example, if the required amount were $110,$4,or 4 percent, would be considered a risk premium.

how to make a Investment plan

For most of your life, you will be earning and spending money. Rarely, though, will your current money income exactly balance with your consumption desires. Sometimes, you may have more money than you want to spend; at other times, you may want to purchase more than you can afford. These imbalances will lead you either to borrow or to save to maximize the long-run benefits from your income.  When current income exceeds current consumption desires, people tend to save the excess.  They can do any of several things with these savings. One possibility is to put the money under a mattress or bury it in the backyard until some future time when consumption desires exceed current income. When they retrieve their savings from the mattress or backyard, they have the same amount they saved.  Another possibility is that they can give up the immediate possession of these savings for a future larger amount of money that will be available for future consumption. This trade off of present consumption for a higher level of future consumption is the reason for saving. What you do with the savings to make them increase over time is investment.1Those who give up immediate possession of savings (that is, defer consumption) expect to receive in the future a greater amount than they gave up. Conversely, those who consume more than their current income (that is, borrow) must be willing to pay back in the future more than they borrowed.  The rate of exchange between future consumption(future dollars) and current consumption(current dollars) is the pure rate of interest.  Both people’s willingness to pay this difference for borrowed funds and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money.  This interest rate is established in the capital market by a comparison of the supply of excess income available (savings) to be invested and the demand for excess consumption (borrowing) at a given time. If you can exchange $100 of certain income today for $104 of certain income one year from today, then the pure rate of exchange on a risk-free investment (that is, the time value of money) is said to be 4 percent (104/100 – 1).