The second measure that many lenders and some regulators use to reduce the potential impact of default is to set an upper limit on the amount that can be lent against the appraised value, or market price, of the property. This is referred to as the loan-to-value ratio.
A very common loan-to-value limit is 80% of the appraised value or purchase price. In the example above this would correspond to an appraised value of $750 000. This means that the couple would have to fund $150 000 of the total purchase from their own savings.
Loan-to-value
December 3rd, 2009Ability to pay
December 2nd, 2009Many individual lenders and regulators impose limits on the amount that can be lent based on household income. A common restriction is that monthly mortgage payments cannot be more than 40% of disposable income after tax.
This puts an effective cap on the value of the loan that can be made. Under the above condition a couple earning $10 000 per month after tax would be allowed to pay a maximum of $4000 per month in mortgage payments – $48 000 per year. At a 7% mortgage rate this equates to a maximum loan of approximately $600 000 for a 30-year loan.
Credit Appraisal
December 1st, 2009Housing loans are subject to the same basic checks as are applied to loans for consumer finance but will be subject to additional scrutiny. A letter from the employer containing current salary, position and the length of service with the company is frequently required.
If all the basic checks are confirmed then attention switches to ability to pay and the impact of a potential default risk. For most consumer finance loans the major focus is whether borrowers will repay, based on their past credit record, rather than whether they can repay based on visible income.
Loan insurance
November 30th, 2009There have been attempts to use indemnity insurance to provide the bank with the required buffer without the borrower having to make a down payment. This works by the mortgagor taking out an insurance policy that will pay out to the mortgage lender in the event of the borrower defaulting.
Bankers always maintain that their lending policies are prudent and conservative. I have never visited a bank where management said anything other than this. Several of these banks subsequently failed under the weight of credit losses.
Lenders are, however, prone to herd behavior. When the property market is strong there is a temptation to lower the loan-to-value multiple figuring that even if they lend at current valuations (i.e. 100% loan-to-value ratio) within a year rising property prices will have restored the bank’s collateral buffer. Markets do not go up indefinitely, however; from time to time they correct. Sometimes this correction can be severe and last for many years.
Single, Double, and Triple Divergences
November 25th, 2009In fewer cases, double and triple divergences will occur. A double divergence is one in which three momentum peaks are declining and price is rising in each case. Most often. the second momentum peak is only slightly lower than the first, and the last peak drops off indicating that price is soon to follow. Multiple divergences are expected to be more reliable than single, and represent a prolonged period in which prices are rising at a slower and slower rate.
Risk and Return
November 18th, 2009Probably the most fundamental decision that an investor must make concerns the amount of risk that she is willing to bear. Most investors are risk-averse, meaning that, all other things the same, they dislike risk and want to expose themselves to the minimum risk level possible. However, as our previous series of posts indicated, larger returns are generally associated with larger risks, so there is a tradeoff. In formulating investment objectives, the individual must therefore balance return objectives with risk tolerance.
Attitudes toward risk are strictly personal preferences, and individuals with very similar economic circumstances can have very different degrees of risk aversion. For this reason, the first thing that must be assessed in evaluating the suitability of an investment strategy is risk tolerance. Unfortunately, this is not an easy thing to do. Most individuals have a difficult time articulating in any precise way their attitude toward risk (what’s yours?). One reason is that risk is not a simple concept; it is not easily defined or measured. Nevertheless, the Investment Updates box contains an article from the Wall Street Journal about risk tolerance that has a short quiz that might help you assess your attitude toward risk. When you take the quiz, remember there are no right or wrong answers.
Directional Parabolic Revision
November 12th, 2009In 1980, the entry rules were revised to include an added use of the ADX when it is greater than the +DI 14 or the -DI 14. Because the ADX serves as an oscillator and indicates turning points in the trend, when the ADX exceeds the magnitude of the current +DI14 or -DI14 and reverses, the current position should be closed out. If the ADX remains above both the +DI 14 and -DI 14, the market is extremely strong and liquidation should stop. The ADX is intended to be a leading indicator for liquidation only. Reversal of the current position only occurs when the Parabolic stop has been penetrated, and the new trade agrees with the direction of the Parabolic System.
The addition of an oscillator to a trend-following system allows trades to be closed out at more favorable positions than the usual trend exits. If the new direction carries through and the position is reversed, the added feature has worked perfectly; however, if prices turn back in the original direction, a reentry may not be possible. The revised rules are unclear concerning reentry into a position if prices fail to penetrate the DPS and signal a reversal. A reentry might occur if the ADX falls below both the +DI14 and -DI14, indicating that prices are no longer extreme, then turns back in the trend direction. Once reestablished, the DPS can be used and additional exits using the revised rules would apply.
The size and growth of the US government
November 9th, 2009What exactly does government do? Has its role in the economy shrunk or grown over time? Data on government spending shed light on these questions. Total government expenditures (federal, state, and local combined) were only 9.4 percent of the U.S. economy in 1930. (Note: GDP is generally how economists measure the size of the economy. The term will be explained more fully in a macroeconomics course.) In that year, federal government spending by itself was only 3 percent of the economy. At the time, this made the federal government about half the size of all state and local governments combined.
However, between 1930 and 1980, the size of government grew very rapidly. By 1980, government expenditures had risen to 32.8 percent of the economy, more than three times the level of 1930. Moreover, the federal government grew to about twice the size of
despite the fact that they were growing rapidly, too. Over the last two decades, total government spending as a share of the economy has been relatively constant at approximately one-third of GDP. The major categories of federal spending are health care, national defense, Social Security, and other income transfers. Education, administration, and public welfare and health constitute the largest areas of spending for state and local governments.
Frequency Distributions and Variability
November 6th, 2009To get started, we can draw a frequency distribution for common stock returns .. What we have done here is to count the number of times that an annual return on the common stock portfolio falls within each 10-percent range. The height of 11 for the bar within the interval 32 percent to 42 percent means that 11 of the 72 annual returns are in that range. Notice also that the range from 22 percent to 32 percent is the most frequent return interval since the bar in this interval is the highest representing 16 of 72 returns.
What we need to do now is to actually measure the spread in these returns. We know, for example, that the return on the S&P 500 index of common stocks in a typical year was 12.83 percent. We now want to know by how much the actual return differs from this average in a typical year. In other words, we need a measure of returns volatility. The variance and its square root, the standard deviation, are the most commonly used measures of volatility. We briefly review how to calculate these next. If you’ve already studied basic statistics, you should notice that we are simply calculating an ordinary sample variance and standard deviation, just as you may have done many times before.
Investor Objectives, Constraints, and Strategies
October 30th, 2009Different investors will have very different investment objectives and strategies. For example, some will be very active, buying and selling frequently, while others will be relatively inactive, buying and holding for long periods of time. Some will be willing to bear substantial risk in seeking out returns; for others, safety is a primary concern. In this last section, we describe, in general terms, some strategies that are commonly pursued and their relationship to investor constraints and objectives.
In thinking about investor objectives, the most fundamental question is: Why invest at all? For the most part, the only sensible answer is that we invest today to have more tomorrow. In other words, investment is simply deferred consumption; instead of spending today, we choose to wait because we wish to have (or need to have) more to spend later. There is no difference, really, between investing and saving.
Given that we invest now to have more later, the particular investment strategy chosen will depend on, among other things, willingness to bear risk, the time horizon, and taxes. We discuss these and other issues next.