My new venture: OTC MicroCap Research

While there are plenty of people who write about microcap securities fraud and pump and dump scams, too little of the research reaches the people who need it the most: the small investors who believe in the scams. To help them I have created a new website, The only thing on that website will be research reports on companies, mostly pump and dumps. I will take no positions in the stocks I analyze at that website, take no payment for articles (except from content syndication websites) and I will do my best to distribute my analyses so that the investing public can see it and learn to avoid pump and dump scams that way. I do not claim that there is anything particularly new about what I am doing, but it is something worth doing.

See my introductory post on why I created the new website.

My PacWest Equities (Pinksheets: PWEI) report published prior to the market open today (PWEI is now down over 75% from its open, although the Infitialis report had a lot to do with that).


Disclaimer: No positions in any stocks mentioned. The new website is owned by MorningLightMountain LLC, just like this website; I am the managing member of the company. This blog has a terms of use that is incorporated by reference into this post; you can find all my disclaimers and disclosures there as well.

The Default investment

This post was originally published on my blog on 7/27/2007. Due to blog moves it was not correctly moved to this blog so I have reposted it. 

In what should you invest if you know nothing about investing? While there are plenty of people (most readers of my blog) who enjoys spending time seeking out new and attractive investments, there are plenty of people who do not enjoy that, do not have the time, or do not have the knowledge or the desire to gain the knowledge necessary to invest well. Luckily, there are some good solutions for such “defensive investors”. The standard advice for defense of investors has been to invest in index funds. This is a great idea.

Unfortunately, there are now hundreds of different index funds in many different asset classes. So even choosing in which index funds to invest is now a complicated decision. Luckily, there are now many target date funds. These are funds that are set up for investors who wish to withdraw their money gradually starting on a certain date, usually because of retirement but for other reasons such as paying for college for children as well. So let’s say that you are investing for retirement starting approximately 2040 and paying for your children’s college education starting in 2025. You estimate that it will cost $200,000 for each of your two children and that you will need at least $2 million at the start of retirement. You can plug these numbers in any of various online retirement or savings calculators to calculate how much you will need to save. Then, you invest in two different target date index funds through Vanguard: a 2025 target date fund and the 2040 target date fund.

You use those handy online calculators again to determine how much you’ll need to put into each fund to reach your goals. All that is left for you to do is to faithfully put away money into each of those funds every month like clockwork. You will never have to think about your investments again, except for occasionally checking to make sure that you are progressing well towards your goals. Those target date funds will do all the work for you, investing mostly in stocks at first and gradually sticking more money into bonds as your target date approaches. And the only target date funds you should consider are Vanguard’s funds, because they have the lowest fees around, about 0.21% per year. I think the above plan is the easiest and most generally appropriate plan for the majority of individual investors. However, your investment needs may differ, in which case you may wish to seek out a certified financial planner (CFP) who is compensated on an hourly basis to offer you unbiased and personalized investment advice.

Disclosure: Disclaimer: I own some Vanguard index funds in an IRA and my wife owns a Vanguard ETF in an IRA. We have no target-date funds–all our investments in retirement accounts are in cash or stocks. This blog has a terms of use that is incorporated by reference into this post; you can find all my disclaimers and disclosures there as well..

Taxes for day-traders

See the embedded video for a quick summary of the major tax issues for traders and what business trader status means. Obviously I am not a CPA and I have no formal accounting training. Please see JK Lasser’s Your Income Tax 2012 and Robert Green’s Tax Guide for Traders. If you want to really get hard-core, see the relevant IRS publications:

IRS Publication 550
(the portion of this that relates to business traders as opposed to investors is excerpted below the video)

Please note that futures contracts are treated differently and I do not address that in the video.

Here is the relevant portion of IRS Publication 550 on business traders:

Special Rules for Traders in Securities

Special rules apply if you are a trader in securities in the business of buying and selling securities for your own account. To be engaged in business as a trader in securities, you must meet all the following conditions.

  • You must seek to profit from daily market movements in the prices of securities and not from dividends, interest, or capital appreciation.
  • Your activity must be substantial.
  • You must carry on the activity with continuity and regularity.

The following facts and circumstances should be considered in determining if your activity is a securities trading business.

  • Typical holding periods for securities bought and sold.
  • The frequency and dollar amount of your trades during the year.
  • The extent to which you pursue the activity to produce income for a livelihood.
  • The amount of time you devote to the activity.

If your trading activities do not meet the above definition of a business, you are considered an investor, and not a trader. It does not matter whether you call yourself a trader or a “day trader.”


You may be a trader in some securities and have other securities you hold for investment. The special rules discussed here do not apply to the securities held for investment. You must keep detailed records to distinguish the securities. The securities held for investment must be identified as such in your records on the day you got them (for example, by holding them in a separate brokerage account).

How To Report

Transactions from trading activities result in capital gains and losses and must be reported on Form 8949 and Schedule D (Form 1040), as appropriate. Losses from these transactions are subject to the limit on capital losses explained earlier in this chapter.

Mark-to-market election made.   If you made the mark-to-market election, you should report all gains and losses from trading as ordinary gains and losses in Part II of Form 4797, instead of as capital gains and losses on Form 8949 and Schedule D. In that case, securities held at the end of the year in your business as a trader are marked to market by treating them as if they were sold (and reacquired) for fair market value on the last business day of the year. But do not mark to market any securities you held for investment. Report sales from those securities on Form 8949 and Schedule D, as appropriate, not Form 4797. See the 2011 Instructions for Schedule D.

Expenses.   Interest expense and other investment expenses that an investor would deduct on Schedule A (Form 1040) are deducted by a trader on Schedule C (Form 1040), Profit or Loss From Business, if the expenses are from the trading business. Commissions and other costs of acquiring or disposing of securities are not deductible but must be used to figure gain or loss. The limit on investment interest expense, which applies to investors, does not apply to interest paid or incurred in a trading business.

Self-employment tax.   Gains and losses from selling securities as a trader are not subject to self-employment tax. This is true whether the election is made or not. For an exception that applies to section 1256 contracts, see Self-Employment Income earlier under Section 1256 Contracts Marked to Market.

How To Make the Mark-to-Market Election

To make the mark-to-market election for 2012, you must file a statement by April 17, 2012. This statement should be attached to either your 2011 individual income tax return or a request for an extension of time to file that return. The statement must include the following information.

  • That you are making an election under section 475(f) of the Internal Revenue Code.
  • The first tax year for which the election is effective.
  • The trade or business for which you are making the election.

If you are not required to file a 2011 income tax return, you make the election by placing the above statement in your books and records no later than March 15, 2012. Attach a copy of the statement to your 2012 return.

If your method of accounting for 2011 is inconsistent with the mark-to-market election, you must change your method of accounting for securities under Revenue Procedure 2011-14 (or its successor) available at Revenue Procedure 2011-14 requires you to file Form 3115, Application for Change in Accounting Method. Follow its instructions. Enter “64” on line 1a of the Form 3115.

Once you make the election, it will apply to 2012 and all later tax years, unless you get permission from the IRS to revoke it. The effect of making the election is described under Mark-to-market election made, earlier.

For more information on this election, see Revenue Procedure 99-17, on page 52 of Internal Revenue Bulletin 1999-7 at


Disclaimer: I AM NOT A CPA OR TAX EXPERT! What I say above may be wrong. Please consult your CPA or tax lawyer for tax advice. I use Green’s accounting firm to prepare my taxes. The links for the above books are using my affiliate link. This blog has a terms of use that is incorporated by reference into this post; you can find all my disclaimers and disclosures there as well..

Are your deposits insured? How to avoid losing money in the coming bank Armageddon

I am not one to use the term Armageddon lightly. But when major banks like National City (NCC) and Washington Mutual (WM) are trading under 30% of book and Wachovia (WB) is trading at under 50% of book value, what othe term is appropriate? The market is pricing in a fair probability of a number of very large banks being bought out at firesale prices (like just happened to PFB) or being taken over by the FDIC and then being dismantled.

That being said, while the coming two years will be a very bad time to own bank stocks or bonds or to have uninsured deposits at banks (over the $100,000 FDIC limit), the economy will not completely collapse (though we should have a decent recession) and the world will move on.

The main thing to do is make sure that you and any friends and relatives never have more than $100,000 at any bank. If you wish to keep more, you may want to visit the FDIC website to see if your type of account is protected for more money (some are). You can search for your bank here and find out if it is insured by the FDIC and you can view financial information on your bank, even if it is private. For example, try searcing for “Home State Bank NA” in zip code 60014* (see random note at bottom of post). Then click on “Last Financial Information”, and on the next page click on “generate report”. This brings you to the bank’s balance sheet. If you click on the link towards the bottom for “past due and nonaccrual assets”, you will be taken to the good stuff. You can see that past-due loans have more than doubled over the last year. Unsurprisingly, much of the increase ($2.5m) was from “construction and land development loans”. It also pays to note that this big increase in past-due loans was solely in the 30 to 89 days late category. A more agressive bank might still be accruing interest on those loans. However, this is a conservative community bank and as you can see towards the bottom of the page, all loans that are more than 30 days late are non-accrual. (An interesting discussion of regulatory vs. tax requirements for deciding which loans are non-accruing can be found here.)

If you go back to the main balance sheet page and click on “net loans and leases” you can find the breakdown of loans. This is a good place to find out how risky your bank’s loan portfolio is. Unfortunately for Home State Bank, 20% of their loans are construction and land development loans. This bank is based in the far northwest exurbs of Chicago, so I think it likely that the bank will take a huge hit here. If you click on “1-4 family residential” you can see the breakdown of these loans. Luckily, most of these are first mortgages. Overall, Home State Bank looks okay. What about your bank?

If you have accounts as a credit union, visit NCUA to see details on insurance of your deposits. You can find your credit union and then request that a financial report be emailed to you. As an example I uploaded the report on my credit union. You can download the Excel Spreadsheet here. When analyzing credit unions, be aware that they will generally have more real estate exposure than similar commercial banks. Important things to examine are delinquent loans as a percent of assets (sheet 2, line 21 in the spreadsheet), asset mix including the amount of REO (sheet 4). If you are afraid of a bank run sparked by articles similar to this, take a look at the amount of uninsured deposits (sheet 5, lines 46-50). Delinquent loan info is always interesting (sheet7). For most of the data in the spreadsheet, an average of peer group credit unions is provided as well, making comparison easy. Overall, I think West Community looks quite safe.

What should you do if your bank doesn’t look safe (such as National City, where I have multiple accounts)? First thing that you should do is make sure your deposits are insured. Then make sure that you have enough cash in safer banks so that you can last awhile if you temporarily lose access to your money. Up until now the FDIC has been very good at getting depositors quick access to their insured deposits at a failed bank, but if things get really bad and big banks go down the FDIC could become backed up and take weeks or months to grant depositors access to their money. It pays to be prepared for such a scenario, even if it is unlikely.

*This bank, by the way, provided me with my first mortgage. Easiest mortgage I ever got — my father and I ran into Steve Slack, the bank president, while dining at the local country club, and I mentioned that I was buying a house in St. Louie. Slack gave me his card and told me to give him a call when I get close to finding a house. There are benefits to relationship banking–my extended family has banked there for three generations and uses the bank for a family company.

Disclosure: I am short several regional and local banks. 

It is time to end Americans’ acceptance of debt

Americans have too much debt. That is self-evident. More importantly, there has been a change in the culture to where debt is acceptable and even bankruptcy and foreclosure have lost much of their stigma. A Wall Street Journal article today profiled a woman who is buying a second house in her neighborhood with the purpose of defaulting on the mortgage on her first house. Her credit will be shot, but she will have a house with a much cheaper mortgage (as house prices have fallen greatly in her area).

But the current mortgage crisis is only the pinnacle of the problems with our debt-accepting culture. See the new report by the American Interest, a think tank. They fault credit cards, payday lenders, and especially state lotteries for encouraging spending and debt and discouraging savings. It is amazing to me how much low income households spend on lottery tickets. It is galling how the states take from the poorest and then give it back in welfare, food stamps, and section 8 housing assistance. In the taking the government discourages savings and in the giving it discourages work.

It is time for Americans to learn that it is good to save. Having a nice car is not going to bring you happiness. Having a 4,000 square foot house isn’t going to bring you contentment. But I can assure you that being debt-free and having enough money saved up to not worry will make for less stress, a lower risk of divorce, and more happiness and satisfaction.

Lawyers Behaving Badly

Q: What’s the difference between a catfish and a lawyer?

A: One is a scum-sucking bottom feeder and the other is a fish.

I have recently made the acquaintance of a law firm that appears to use the above joke as its guiding principle. That firm is Friedman & Wexler. I recently got a new cell phone number and it just so happens to be the old phone number of someone who didn’t pay her bills. Friedman & Wexler has been playing the part of the collection agency and has been harassing me with automated phone calls to try to get me (actually, the former user of the phone number, Jasmin) to pay them. I sent them an email and asked them to stop harassing me and yet they keep calling me. Unlike with real collection agencies, no one comes on the phone if I pick up; the message simply says to call them. I am not about to waste my precious time trying to reach someone there and tell them that my name is not Jasmin and that I don’t owe their client money, so I’ll just ignore their calls for the next month and then I will get a new phone number with my shiny new 3G iPhone.

The Coming Mortgage Crisis Part III: Low Interest Rates Do Not Make Housing More Affordable

Many people have argued that the current high house price to income ratio is not reason for house prices to decline, considering that interest rates are very low now. These people argue that what is important is not the actual price of the house, but the mortgage payment required to carry the house (for an example see user jcrash’s comments on my previous aritcles on the coming mortgage crisis at SeekingAlpha).

To some extent, these arguments are correct. Most home buyers use mortgages, and the difference in monthly payments between a 5.5% and a 8% mortgage is staggering. However, there are two important reasons why low interest rates do not mean that houses are affordable now: household debt is at an all-time high and mortgage rates will certainly go higher.

Total Debt Matters

Housing affordability is not independent of the affordability of other consumer goods. What matters for the affordability of housing and all consumer goods is the money available to pay for those goods (ie, money not spent on necessities). Total household debt is at an all-time high. The savings rate is close to zero. The most instructive number to look at is the household financial obligation ratio, or the ratio of income to household debt servicing and house or apartment-related expenses. To quote the Federal Reserve definition, “Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio (FOR) adds automobile lease payments, rental payments on tenant-occupied property, homeowners’ insurance, and property tax payments to the debt service ratio.”

Keep in mind that these ratios do not include other non-discretionary expenses such as food and gasoline, the price of both of which has been increasing at staggering rates, which means that consumers have less ability to service their debt than even the following graph shows (click for a full-sized image). The data are available from the Federal Reserve. The key number to look at is the FOR Homeowner Total (light blue). Over the last decade this has increased from about 15% of income to about 19% of income.

for.pngThese are the costs on debt and home-related expenses that current homeowners pay. Because these are broad averages (many homeowners do not have mortgages after paying them off, reducing these ratios), it is important to look at the change over time. The ratio is currently about 4 percentage points higher than anytime prior to 2000. While this may not seem like much, consider that house prices are set on the margin and that approximately 40% of homeowners do not have mortgages. The marginal home buyer has much larger debt payments of all kinds than ever before, reducing his ability to buy. This alone indicates that home prices need to fall. However, the picture gets even bleaker when we look at mortgage rates.

Inflation Matters

Those that argue that house prices are affordable would agree that lower interest rates make houses more affordable, ceteris parabus. This is true not just for houses but for all capital assets. As interest rates increase, asset prices decrease. As interest rates fall, asset prices rise. If a buyer finances a high-priced asset with cheap financing and does not sell when financing becomes expensive, that buyer will do fine. However, a buyer who cannot hold indefinitely must pay attention to asset prices. Even when payments are equal, it is better to buy a cheap asset with expensive financing than to buy an expensive asset with cheap financing. The reason is simple: interest rates change. Interest rates are more likely to fall when they are high than when they are low. If they do fall, the seller who had bought when interest rates were high will have a capital gain as the price of the asset increases. However, the seller who buys when interest rates are low will take a capital loss if he sells after rates rise.

Inflation in the US is at a 4% annual rate as of March, and investors expect inflation to continue or get worse, as evidenced by the low yields on TIPS (Treasury Inflation Protected Securities). With 15- and 30-year fixed rate prime mortgages near their lowest rates since before the 1960s/1970s inflation epidemic, there is little place for mortgage rates to go but up. Even if housing were fairly affordable now (which the FOR ratios above show that it is not), higher interest rates will ensure that it becomes less affordable and that house prices need to continue to drop.

See Also

Option ARMageddon take on this issue

The Coming Mortgage Crisis: Part 1
The Coming Mortgage Crisis: Part 2

Disclosure: I have significant real estate holdings and I plan on selling short one or more regional banks.

The coming mortgage crisis

If you read the papers and watch the news, you may believe that we are in and have been in a subprime mortgage crisis for the last year or so. That is true. Many pundits are also saying that the subprime crisis is nearing its end. That is also true, to a point. Subprime mortgage troubles will not inflict that much more damage on the broader economy. However, prime and Alt-A mortgages with toxic features will cause troubles that will make the current troubles look like a walk in the park. Furthermore, broad-based declines in housing prices will start to wreak havoc on housing markets across the country.

The Cataclysmic Shift

The problem with the housing market bulls is that they are thinking within the framework of past housing downturns. The current downturn is unlike any other since the Great Depression. No other downturn has started with houses so overpriced relative to rents. Few downturns started with such reasonable interest rates. No other downturn saw double digit house price declines across the country. This downturn is different, and it is going to lead homeowners (or homedebtors, as the Irvine Housing Blog calls those who have little equity) to change their behavior in ways that only the pessimists such as myself anticipate.

The problem with most predictions is that they are linear extrapolations of the past into the future. Have global temperatures been rising? They will continue to rise at the same rate. Has crime been increasing? It will continue to increase at a similar rate. The problem is that significant change often comes suddenly. That is why no one who knows anything is worried about the gradual increases in the Earth’s temperature that will occur if global warming continues. What really scares people is the possibility (however remote) that the changes could accelerate or could cause something unexpected to happen (such as the jet stream moving or the ocean currents changing). A thorough review of the history of global temperatures reveals that such cataclysmic change is not unusual.

In the case of housing, the cataclysm will come within the next couple years. It will be fueled by two factors: option ARM mortgage recasts and house price declines. (Slate has a worthwhile take on what will happen, but its analysis is less detailed than mine.)

Why House Prices will Continue to Decline

House prices are elevated relative to rents and relative to incomes, especially in the hottest markets, such as California, Nevada, Florida, and Arizona. However, price increases in middle America have been no less astonishing. One example with which I am all too familiar is the house I just sold in the Saint Louis suburb of Maplewood. Zillow has a decent graph of the house’s value, although it is not completely correct. If you look at the county assessor’s website (and search by the address) you can see that the house sold for $100k back in 1997 and then for $188k in 2004. I just sold it for $165k. Over this period of time few renovations of note were done on the property and the neighborhood did not improve significantly. The employment situation in the area has not changed. So from 1997 to 2004 the house appreciated by 88%, while between 1990 and 1997, during great economic times, the house appreciated by only 25%. In relation to both rents and area incomes, the house is still probably 20% overvalued.

Housing Starts

Moving from the anecdotal to the statistical, we can see that this is not an isolated situation. The chart above shows housing starts and permits for the last 30 years. Over this period the population has increased at a fairly steady rate. Since 2003 there have been too many houses built. This will lead inevitably to falling prices.

Orange County Price to Income

If you look at the ratio of income to house prices in the above graph (from Piggington’s Econo-Almanac), you will see that house prices are way higher than they should be relative to incomes (while this graph is for one area of California, prices are elevated relative to incomes across most of the country). While creative financing can lead to a bubble in prices, there is no way for house prices to remain unaffordable indefinitely.

Price to Rent ratio

Another thing to consider is that house prices remain tethered to rental prices over the long term. If renting is cheaper than buying, people will choose to rent rather than buy and house prices will fall. House prices have never been so much higher than rental prices than they are now. Above is a chart of the ratio of the OFHEO house price index to the CPI-Owner’s equivalent rent.


Another factor weighing on prices is the increase in foreclosures. Banks that own foreclosed houses are motivated sellers and they will cut the prices so that they can sell their inventory. Increasing foreclosures will increase supply and decrease prices of transactions. Why pay $200k for a house when your neighbor but his out of foreclosure for $140k? Foreclosures are actually understated because banks often don’t have the manpower necessary to foreclose and sell delinquent properties.

The foreclosure problem will soon get much worse. Considering that it often takes over half a year (and can take much longer) between when a homedebtor falls behind on a mortgage and when the house is repossessed, the current wave of foreclosures began before house prices had fallen significantly. With prices now down 20% in many areas and 30% or more in some areas, the rate of foreclosures will increase drastically over the next year. Those that need to sell and who have little equity will be unable to sell for more than they owe. Short sales are difficult, so foreclosure will be the last resort for many who need to move.

Even though asking prices for houses have fallen dramatically already, they have not fallen nearly enough: witness the low volume of house sales relative to prior years. In the graph below we can see that the spring selling season in San Diego has been a bust, as it has elsewhere (image from the Bubble Markets Inventory Tracker blog).


Option ARM Recasts

Besides falling house prices, another factor in the coming mortgage crisis is the coming recasts of millions of option ARM mortgages. Most of you will be familiar with the problem of interest rate resets on ARMs (adjustable rate mortgages). This problem is well-known. Almost all ARMs have fixed rates for the first couple years and then the rates reset to market rates. Considering the current low interest rate environment, this problem is likely overblown.


The greater problem, however, is recasts. Option ARMs allow for the choice of the size of the payment. Homedebtors can choose to pay an amortizing payment (such that their mortgage balance is reduced), an interest-only payment, or a negative-amortizing payment, where their mortgage balance increases. Recent data from Countrywide indicates that 71% of borrowers with option ARMs are only making the minimum, negative-amortizing payment. Option ARMs have provisions such that when the mortgage balance exceeds the original mortgage by 10% to 15%, the loan converts into a fully self-amortizing loan. Considering that many of these loans were made over the last few years (beginning in 2005), we should start to see a number of recasts. When a mortgage recasts, the payment size can easily double or triple. Those who could afford their payments before will no longer be able to do so.

Option ARMs are highly prevalent, especially in the most bubbly markets. See the following map and click on it for a larger version (courtesy of the Irvine Housing Blog):


The Coming Crisis

The coming crisis will be caused by option ARM recasts, falling prices, and banks’ increasing reluctance to lend. The crisis will manifest itself in people simply walking away from houses where their mortgage is worth more than the house. Considering how many people have used home equity loans to remove equity, how many have had negative amortization in their loans, and considering how small down payments became over the last few years, very few homeowners will be left with equity in their houses. currently estimates that 9 million households have negative equity. That figure could easily double or triple as house prices fall by another 20% to 30%.

The assumption on the part of mortgage lenders, regulators, and housing market optimists is that as long as people can afford to pay their mortgages, they will. But homedebtors faced with 20% to 30% negative equity will be much better off going through foreclosure than they will paying off their debts. Helping them is the fact that in a number of states, purchase money mortgages are non-recourse debt, meaning that banks cannot sue to recover the money they lose. The sheer number of foreclosures will mean that banks will not have the manpower to go after domedebtors even when they want to do so.

The rising tide of foreclosures caused by people walking away from houses in which they have negative equity will act as part of a positive-feedback loop to increase the rate of price declines. The housing market is not getting better anytime soon and it will soon get much, much worse.

Buy my book!

Okay, well it is not my book, but I co-authored a chapter. Plus, it is an interesting book. Are We Free? Psychology and Free Will gives the opinions (and research) of some of the world’s top psychologists on whether (and how) humans have free will. I have not read any chapter but my own, but I am familiar with many of the authors, and their research is intriguing and sometimes disturbing. If you have ever wondered whether you were truly free, this book will be of interest.