“So with your higher salary, you should be contributing more to your 401(k), isn’t it?” I asked him. My understanding of the 401(k) is very shallow but I believe it is somewhat akin to the EPF we have here, or the CPF that’s in Singapore.

Yes, he replied but he sighed. More in his 401(k), he said, but he doubted his retirement savings would be enough for him to maintain his current lifestyle eventually.

That, unfortunately, is a fear that’s being faced by people everywhere: a fear that our retirement savings are insufficient to carry us on through the remaining years of our lives.

Inflation is the greatest enemy of retirement savings and just simply keeping our money in the banks without thinking about the best way to make money work for us means that the value of our savings gets eaten away.

Maybe, gold is still the best bet for anyone to make a good investment choice and in the United States, I hear that it’s now possible – or maybe it has been going on for a few years – to open a Gold Individual Retirement Account or Gold IRA. (It’s also known as Gold 401k.) What this means is that the contributions in the 401(k) are invested into gold and held there in the retirement account.

I hear that it’s also quite easy to sell off the IRA Gold or the 401k Gold and have the proceeds placed into other investment options such as stocks, bonds, mutual funds, and money market accounts. The Gold IRA transfer, one way or the other, should be effected quite fast, within days of initiating the process.

So I suppose this is what my relative should be looking at: maximising the returns on his 401(k).

Millions of savers may be worrying about falling interest rates – but, in fact, many already have hundreds or even thousands of pounds lying untouched in forgotten accounts or investments.

Many banks and building societies have stepped up their campaigns to reunite customers with lost cash before the Government pools dormant accounts for “community use” next year. Similarly, large companies increasingly are using specialists to track down shareholders who have gone off the radar.

Towards the end of 2009 the Government is going to pool the £1 billion lying in dormant bank and building society accounts – those in which there has been no customer-initiated activity for 15 years – and place the money in one FSA-regulated central reclaim fund.

This fund will then be “reinvested in the community”, particularly in youth services and financial inclusion schemes, across the UK. However, if someone later comes forward to claim their money, the fund will be used to pay account holders.

So while there is no urgent need to claim your cash before it is spent on disadvantaged youth, it is still a good idea to claim assets as soon as possible – after all, the money is yours.

Rachel le Broqc, of the Building Societies Association, says that there are many reasons why accounts become dormant. She explains: “People move house and forget to inform their building society or bank of their new address; childhood accounts become forgotten; or people pass away and their heirs may not be aware of the existence of such accounts.”

An amendment to the Banking Code this year meant that all banks now have to make an effort to reunite customers with their lost assets. Halifax, Lloyds TSB and HSBC have all introduced reunification programs recently. HSBC, which is writing to customers who have not used their accounts for more than two years, says that the average amount in a dormant account is £1,400, although it has 17 accounts with balances of more than £100,000.

However, you do not need to wait for your bank to contact you. Simply go online at www.mylostaccount.org.uk to search for lost accounts. The website covers 42 banks, all 59 UK building societies and all National Savings & Investment products. It was introduced at the start of the year and receives about 760 searches a day. Although the service is free, you could have to wait up to 12 weeks for a response to your search.

With the large number of takeovers and mergers of UK-listed companies, it can be difficult for shareholders to keep track of their holdings. And if you move house and forget to inform your stockbroker or the share registrar, assets may soon become “lost” and any dividend cheques may not reach you.

The Unclaimed Assets Register has a database of unclaimed life policies, pensions, unit trust holdings and share dividends drawn from many companies. It may be able to help if you vaguely recall paying into a policy in the past but have lost the paperwork and forgotten the name of the company. It can also help to track down policies of a deceased person.

The service, run by Experian, charges a one-off fixed fee of £25, regardless of the outcome of the search – only about 10 per cent of searches are successful. But when assets are found, the average payout is £6,000. Go to www.uar.co.uk, or call 0870 2411713.

Richard Hunter, of Hargreaves Lansdown, the independent financial adviser, says: “If you remember owning company shares but have lost your share certificate, approach the registrar of that company and request a new one – this costs about £25. If you find an old share certificate, either yours or that of someone who has died, contact the registrar named on the certificate. There are now only three registrars – Capita, Computershare and Equiniti.”

You may be contacted by an asset reunification company. These specialise in reuniting “lost” shareholders or beneficiaries with assets that are rightfully theirs. Many large companies have hired such specialists to track down lost shareholders. For example, BT, Southern Water and O2 have hired a company called Prosearch, which is owned by Equiniti, while National Grid, Alliance & Leicester and British Airport Authority have hired Capita Tracing Solutions.

Such companies are likely to contact you in writing and ask you to confirm your identity details, such as your previous address, before telling you what assets you can claim. Unfortunately, the asset reunification industry is unregulated – companies cannot register with the Financial Services Authority – so before entering into correspondence with any company that sends unsolicited letters, make sure that it is legitimate (see box, right).

There will also be a fee. For example, Prosearch charges about 12 per cent of the value of assets reclaimed. If there is a large sum involved, you may wish to do the legwork yourself.

Some companies, such as Fraser & Fraser and Title Research, specialise in tracking down beneficiaries of a person who has died without leaving a will and with no obvious next of kin. Fees can vary from 5 per cent for the recovery of cash in a bank account to 40 per cent for the recovery of a large and complicated estate from overseas.

In these cases, you may have never even heard of the family member who has died – so tracking down such assets yourself, without the help of a specialist, can be almost impossible.

Neil Fraser, of Fraser & Fraser, says: “If you have lost touch with a family member and think that you might be an heir, you can search for the will through the Probate Registry. For details, go to ancestor-search.info/NAT-Probate.htm or call 01904 666777. If no will was made or you are not aware of any lost relatives, then you will have to hope that we come knocking on your door.”

Caution is key

- Legitimate asset reunification companies rarely approach potential clients via e-mail. Never disclose personal information to the sender of an unsolicited e-mail. For general advice on avoiding internet-based scams, visit GetSafeOnline.org.

- A letter should include the company’s address and phone number – check that these are listed in the Yellow Pages and visit the company’s website, which should appear professional. All genuine companies are listed on the Companies House website at www.companieshouse.gov.uk.

- Be wary of any company that promises money in exchange for an upfront fee. The fees charged by legitimate companies are normally a percentage of the total assets reclaimed. However, this should always be discussed and agreed in advance.

- If a company claims to be owned by another, call the latter – on a number you have sourced yourself – to check.

- If you suspect a scam, do not respond. Instead, contact Consumer Direct on 0845 4040506, or report it online, using the “report a scam” form at ConsumerDirect.gov.uk.

CASE STUDY: Unexpected windfall

Frances Blackmore, a retired English teacher from Brighton, recently received £1,700 from “lost” shares in O2, the mobile phone company.

Mrs Blackmore, right, received a letter from Prosearch, the asset reunification company, asking for identity confirmation to reunite her with some unclaimed assets.

“The letter was quite vague and I wondered at first if it was a scam,” she said. “But after making some inquiries about the company I decided to go ahead and reply. I was then told that I held 1,026 shares with O2, which is now owned by Telefónica, worth £2,052.”

Mrs Blackmore thinks that her late husband held shares in British Telecommunications (BT), from which O2 demerged in 2001, and that these were overlooked when his estate was settled.

Prosearch charged Mrs Blackmore a fee of £256 for its service, 12 per cent of her holdings, which reduced her payout to £1,736 after VAT.

“I know that I could have tracked down the shares myself, but I decided to pay the company for doing the work for me. The process was very easy. Once I had agreed to the service, I completed a claim form and received the cheque within two weeks. It was an unexpected windfall so I’m pleased.”

And now you need a safe bolt hole

Given the financial crisis, it is likely that you will want to keep any reclaimed money as safe as possible, writes Mark Bridge. Finding a haven that offers a return can be a headache, though, especially when savings rates have tumbled with recent base-rate cuts. Here Times Money lists the options.

Savings accounts: Dennis Hall, of Yellowtail, the independent financial adviser (IFA), says that cash is the most obvious refuge in a credit crunch. He adds: “It is best to spread your money over the best-paying savings products on the high street.”

You can compare deals at comparision websites, such as Moneysupermarket.com, and in the best-buy tables in Times Money (see pages 10-11).

Kevin Mountford, of Moneysupermarket.com, says that the best rate for an instant-access account is now 6 per cent, from Tesco Personal Finance. This is an internet account, however, and the headline rate includes a 12-month 1.5 per cent bonus on a much less competitive underlying rate of 4.5 per cent. Note also that the bank is “reviewing” its rates in light of the latest cut in the base rate.

Mr Mountford adds that customers willing to lock in their money can secure a rate of 5.75 per cent for one year with Anglo Irish Bank’s fixed-rate bond. He also suggests a regular saver account, saying: “You have to put in money every month, but you can get rates of 6 per cent with Barclays and Halifax.”

When spreading money between accounts, remember that an individual’s savings are guaranteed up to £50,000 per financial group and that different brands may be part of the same group. For example, Halifax and Birmingham Midshires are both part of HBOS.

Isas: Mr Mountford urges savers to look at their tax-free Isa options. “Do not wait until the April deadline,” he says. “Rates may fall, so it’s best to get in now.”

He adds that Nationwide’s cash Isa options are the most competitive right now, paying up to 4.25 per cent.

Money market funds: These are sometimes considered the safest place after cash and bank deposits. Mr Hall says that they can offer a better return than the latter, but choosing the right fund is critical. “They are for those with significant cash – and seek advice,” he adds.

Premium Bonds: These offer the chance to win prizes up to £1 million in place of interest payments. However, the payouts depend on interest rates – and recent base-rate cuts mean that standard savings accounts are more competitive.

Gilts: Index-linked government bonds pay a set rate above inflation and can be purchased from the UK Debt Management Office (DMO.gov.uk) or through a stockbroker. However, Mr Hall says that they are currently overvalued.

Index-linked savings certificates: These products from National Savings & Investments offer tax-free returns and pay guaranteed interest at 1 per cent above inflation over three and five-year terms.

Gold: The most ancient safe haven has performed well in recent weeks, with the price per ounce climbing from less than $700 in late October to about $830 this week.

Investors can buy gold through exchange-traded funds (ETFs), which track the gold price and can be bought through a stockbroker and held tax-free in an Isa. Alternatively, you can buy bullion – kept in secure storage for a small fee – at Bullionvault.com. Mark Dampier, of Hargreaves Lansdown, the IFA, is “bullish” on gold and says that investors should put about 5 per cent of their portfolio into the metal.

These fallacies include the oft-repeated maxim that diversification reduces risk, and that risky assets such as stocks become safer as the holding period gets longer.

According to Zvi Bodie, Norman and Adele Barron Professor of Management at Boston University: “In the US, there is a movement towards consumer (financial) literacy which is completely misdirected. The idea is to make consumers capable of deciding how much to save for retirement over time, and how to invest money. But the professionals don’t even know how to do that. It’s silly and counter-productive and disingenuous. It’s a kind of fraud, an excuse for transferring risk from the corporate sector to the consumer sector.”

Prof Bodie singled out ‘target date’ retirement funds as flawed instruments that only further the fallacies and ultimately do little to provide investors with a secure stream of income in retirement. Target-date funds, also called life-cycle retirement funds, are designed to mature at a point in time that should coincide with one’s retirement age. Asset allocation and rebalancing are done automatically, so the allocation to equities reduces with age. In the US, such funds are a default option in retirement accounts.

They have, however, come under scrutiny since the financial crisis last year. Citing Morningstar data, Bloomberg has reported that target-date funds labelled 2000 to 2010 lost an average 23 per cent last year, with some dropping as much as 41 per cent. The average 2050 fund declined 39 per cent in 2008, while the Standard & Poor’s 500 Index fell 38 per cent. There are a number of target-date funds here, including those managed by Fidelity and UOB Asset Management.

Prof Bodie says target-date funds are a misnomer and misleading. This is because they are mutual funds, and some allocate money to other mutual funds, which do not have a maturity date. This is unlike bonds, which pay income regularly and at maturity will deliver an investor’s capital. “What consumers want and deserve is a pension, where they make contributions and the contributions can vary,” he said. “The end result at retirement should be a secure lifetime income that lasts as long as they live, with inflation protection.”

Prof Bodie contends that the technology exists to create such a product, but it will require active government involvement, and not just the private sector. “We have the technology to do the right thing to satisfy the requirement for at least some minimum level of guaranteed inflation-protected income at that stage in people’s lives when they are most vulnerable to risk,” he said.

Debunking investment myths

Prof Bodie cited three common investment fallacies:

1) Saving is for the short run and investing for the long run. But according to financial economics, saving means income minus consumption. Investment means selecting a portfolio of assets.

2) The only way to reduce risk is to diversify. In finance, however, the way to reduce risk is to hedge, insure or hold safe assets.

3) Stocks become safe in the long run due to ‘time diversification’. But if this were true, stocks would not carry a risk premium, says Prof Bodie.

An indication of how risky stocks are, the longer the horizon, can be gleaned from the pricing of put options. The price of such protection rises with the time horizon – a put option that matures in 25 years costs five times as much as a one-year option, says Prof Bodie.

He argues that conventional advice based on the mistaken principle of time diversification leads to portfolios that are riskier than consumers realise.

The starting point for a retirement portfolio should be 100 per cent inflation-proof guaranteed annuities, he reckons. This, however, is a big challenge in Singapore, where there are no inflation-linked bonds. Even CPF Life, the CPF’s new annuity scheme, fails to provide any inflation protection.

Even with US Treasury Inflation Protected Securities (TIPS), the real yield has dropped; on 10-year TIPS, it stands at about 1.3 per cent.

If you have ever been sold a financial product labelled ‘capital protected’ or ‘principal protected’ and did not know what the terms really meant, there is good news.

Singapore’s financial regulator has decided to ban their use because too many investors do not understand them.

What is more easily understood is ‘capital guaranteed’ — meaning the investor’s principal sum is fully protected – and this will be one of only two types of products allowed to be sold.

The other category? Everything else that is not capital guaranteed.

The Monetary Authority of Singapore (MAS) announced its decision yesterday as part of its response to feedback that it had received on a slew of changes proposed in the wake of the collapse of Lehman-linked structured products.

These proposals, first released in March, were mooted in response to controversy over the way complex investment instruments were sold to people, including elderly and lowly educated folk.

Some of the key changes include requiring financial institutions to provide customers with simple, user-friendly ‘product highlights sheets’ and providing ‘health warnings’ on complex investments in appropriately large font.

MAS had also proposed that bank tellers should not sell investments and there should be a seven-day ‘cooling off’ period during which an investor could change his mind and pull out of his investment.

In a 19-page document yesterday, the financial regulator outlined public responses it had received, and said that it would adopt most of the proposals.

The ban on the use of the term ‘capital protected’ will apply to mass-market products familiar to retail investors, including structured notes, unit trusts and investment-linked life insurance policies.

Some investors had previously raised concerns that they had difficulty understanding what those terms meant, MAS said.

A ‘capital protected’ product is where the principal sum is ploughed into investments like bonds which, on maturity, are expected to provide the 100 per cent capital protection.

But this is not a certainty. ‘The bonds could turn sour and affect the value of the investment, and people may not get back 100 per cent,’ said First Principal Financial’s chief executive Mohamed Salim.

This is to be distinguished from ‘capital guaranteed’ products where an investor is guaranteed to get back at maturity the money that he invested on day one.

Financial advisers told The Straits Times that many retail investors, even more experienced ones, cannot differentiate between the two terms.

MAS said yesterday that one way around the problem was for the industry to develop a standard definition for capital protected products.

But it had found that all the suggested definitions tended to be too lengthy or not easily understandable by investors.

Capital protected products were popular in the years just preceding the recent financial crisis. One banker told The Straits Times that ’30 to 40 per cent’ of retail investment products here carried this label.

This is why consumer advocates are lauding the move.

‘The term principal protected has never been understood by retail investors. Now they’ll understand the terms of sales better,’ said David Gerald, president of the Securities Investors Association of Singapore.

The change will make it tougher for bankers to market these investments. One banker said some product manufacturers will find it harder to sell structured products in Singapore in future because they cannot distinguish the safer products from more risky ones.

But Singapore will not lose its competitiveness as a wealth management centre, he acknowledged, since the measures as a whole will provide more transparency and confidence.

Seah Seng Choon, executive director of the Consumers Association of Singapore, lauded the full list of changes, saying that they go a long way in promoting a higher level of disclosure and safeguard investors’ interest.

MAS said that it will issue further responses to more proposals in the fourth quarter. That is because some of them need further study. — The Straits Times

Here is an interesting story that appeared in today’s issue of The Business Times in Singapore. It’s saying that owing to the global financial crisis Malaysians appear to be the most averse among Asians to higher risk investment products. They have become more conservative in their choice of financial instruments.

According to the Life Outlook Index released by AXA, 67 percent of Malaysians indicated a preference for insurance products that offer protection as well as savings. It’s a ‘dramatic shift’ from aggressive to conservative strategies, and this is reflected in a big jump from 26 percent in 2007 to 45 percent of those planning to purchase life insurance.

The response rate for dual protection-savings products ranged between 40 and 60 percent for the other seven markets AXA had surveyed, namely, China, Hongkong, India, Indonesia, the Philippines, Singapore and Thailand.

AXA Affin Life Insurance chief marketing officer Nicholas Kua said the switch from high-risk, high-return investment products to options combining life protection and long-term savings was quite consistent with the firm’s observations. “The financial crisis has made Malaysians and Asians more conservative,” he said, which was surprising because unlike Hongkong and Singapore, Malaysian investors were spared much of the pain associated with structured products and investments tied to the now defunct Lehman Brothers.

Here’s the rest of the Business Time story:

Even so, Kua said it was evident Malaysians are shaken up by the global economic gloom and more willing now to plan for their retirement. Instead of starting at an average age of 37 as was the indication in 2007, they now plan to begin at 34 — earlier than the regional average of 36.

Nearly a quarter or 23 per cent plan to increase savings for retirement while 43 per cent would maintain the current pace.

But most are still far from ready for retirement with only 38 per cent having a plan (36 per cent previously). More than a quarter or 27 per cent are “thinking seriously” but unsure how to go about saving while 7 per cent are non-planners — admittedly an improvement from 12 per cent in 2007.

According to the Employees Provident Fund — the country’s biggest pension fund and main source of savings for most workers — the average savings for a 54 year old member last year amounted to RM132,500.

Given that 70 per cent of retirees who take out their EPF savings in a lump sum exhaust it within 3-10 years, the concerns and fear are very real.

Indeed the AXA survey showed only 29 per cent of Malaysians think they can maintain their health post-retirement, most believing their funds would be insufficient.

The respondents also desired to retire at an average age of 54 — one year before the retirement age — but believe 57 to be more likely given the current economic conditions.

Kua said unlike the Indians who are “very realistic” and willing to either work longer or compromise their present living standards to save for their retirement age, the survey revealed Malaysians want to enjoy their golden years but not at the expense of their luxuries.

One area they were willing to trade-off current living standards is to provide their children a better education (57 per cent).

Although only 57 per cent still see opportunities in the future compared to 64 per cent previously, 60 per cent still plan to have kids, with half of them planning to have at least three.

The survey covered 2,400 respondents regionally, those in Malaysia having an income of RM4,000 to RM5,000.

Very few of us can be a Guy Ritchie or a Madonna or one of the several thousands of celebrities who have millions of dollars’ worth of assets to share among themselves or their lawyers whenever they get hitched or ditched.

For us, planning a wedded bliss together may require some pre-wedding financial planning as well. It’s always prudent to sit down with your spouse-to-be and talk frankly about money and expenses. What can you talk about?

1. The accounts you have. What types are they: current account, savings account, fixed deposits? How long have you had them? Start an inventory of the accounts you have and how you handle them.

2. The credit cards you have. How do you use them? What’s the balance in your credit cards? How do you repay them?

3. Bank loans. Do you have any bank loans to settle? Housing loan? Car loan? Study loan?

4. Should you have separate or joint bank accounts?

5. How will you make buying decisions? What purchase decisions should be made together and which should not? Should there be a limit to spending without joint decisions and if so, how much?

6. Who is responsible for the marketing, paying household bills, utility bills and preparing taxes? Should there be separate assessment or joint assessment?

7. Do you work benefits overlap? Do you have insurance: personal insurance, medical insurance, home insurance? How about investments: mutual funds, stock market? How about the degree of risk you are able to live with?

8. What are your money goals? Retirement planning?

Asking these questions early on and starting the conversation before you sign the marriage certificate will make it easier to revisit money talk, which may not be as fun as pillow talk but is certainly as vital to your relationship.

MENTION ‘unit trust’ and ‘insurance products’ now and most people are likely to shake their heads.

With the public avoiding such products in the current global financial fallout, it is not surprising that those who sell these items are taking hefty pay-cuts. Bank executives and insurance agents told The New Paper on Sunday that they have seen their monthly income drop by as much as 30 per cent.

A 28-year-old relationship manager who works in a foreign bank said that 60 per cent of her clients had stopped investing with her. This immediately caused her monthly pay of over $10,000 to drop by as much as $5,000. She said: ‘This crisis is worse than when the tech bubble burst in 2000 and tech stock prices took a plunge.’

Another relationship manager at a foreign bank, who wished to be known only as Goh, has seen 10 of his customers terminating their investments since Merrill Lynch’s collapse. Goh, 26, who has taken a $300 pay cut on his basic salary, said: ‘It is harder to do business these days. There is so much fear in the market, people keep getting edgier.’ One of his customers, he said, has split her $100,000 in savings among five banks as a precautionary measure. Despite this, he considers himself lucky as other managers have been sacked for failing to meet their targets.

Goh, who said that a relationship manager typically has a $1 million monthly sales target, added: ‘We are constantly pressured for numbers, such that there is a fine line between keeping to our morals and meeting targets.’ He said that, for example, in trying to meet sales volume, some in the industry may not provide customers with certain details or the full picture when they are selling financial products.

Kenneth Liu, 28, a relationship manager at a foreign bank, agreed that times are ‘very bad’. ‘It is difficult to even retain customers who make deposits at the bank.’ However, he has not suffered a drop in his income, because he is making up for the loss in revenue by focusing on other bank services such as loans and personal deposits. He is also working a few hours longer each day to keep earning the same commission as before.

Another business analyst at a foreign bank, who gave her name only as Miss Yeo, reckoned that her chances of getting a permanent position with the bank – she is on a temporary contract – were slim given the uncertain economy. The repercussions are not only felt by bank employees, but also property agents and insurance agents.

Jerlyn Ong, 23, an insurance agent with Prudential, has seen her income fall from $2,200 to $1,800 just over the last month, despite putting an extra five hours at work every day to meet her sales target of eight policies a month. She said: ‘These are really bad times. It’s very hard for us to sell products as even big companies like AIG can be in trouble. My colleagues have many clients going to them to pull out their policies, because everyone is saying that it is not safe to put their money in insurance.’

A veteran insurance agent, who wished to be known only as Tan, is more sanguine. Tan, 58, said: ‘Buying insurance is a must. People must prepare for disasters and mishaps. With so much uncertainty in the market, it is even more important for them to buy insurance.’

Property agents are also reporting ‘more cautious’ investors. Just this week, it was reported that private home prices in Singapore fell between July and September, the first time in over four years. PropNex’s director Mohamed Ismail said that many property investors are waiting to see how the situation in the US is going to affect Singapore. Ismail said that business at his company has taken an overall dip of 30 per cent compared to last year, with condominiums in the Orchard Road area down by 50 per cent in transactions.

But there are opportunities aplenty to do well during bad times too. Goh said: ‘I’ve received so many calls from worried customers who tell me that their relationship manager is not contactable. Now is the time when I want to put in that extra bit of effort to retain my customers. It is times like these when I can build trust with them, so that they can also trust me with big investments in the good times.’

This article first appeared in The New Paper on 5 Oct 2008.

“I can’t see it having a direct impact on Malaysia. Any impact is likely to be indirect,” said Wong Ming Tek, head of research at HwangDBS Vickers Research. Banks in Malaysia had in the last few months said they didn’t have any major sub-prime exposure, and as such, Malaysia is likely to be spared the direct fallout from the collapse of the two financial institutions.

News of their collapse will, however, affect investor sentiment. On Monday, it sent stock markets in Europe and Asia reeling. “This will inevitably affect our stock market valuations,” said Clement Chew, head of equities broking at JP Morgan in Malaysia.

However, there are concerns that the collapse will affect the American economy and consequentially, global growth. “A slower US economy will hurt growth forecasts in Asia and Europe,” the New Straits Times quoted Chew as saying.

Lehman Brothers, which Monday filed for bankruptcy protection in the US, does not have a presence in Malaysia but Merrill Lynch has a small research presence here.

It’s complicated, but here’s the 30-second version of what happened with Bear Stearns and Lehman:

People went to traditional banks and mortgage brokers and bought mortgages.  All of these mortgages carry different amounts (e.g. $100,000 mortgage vs. a $500,000 mortgage) and different risk levels. The ones that are more likely to default have a higher interest rate, so the bank stands to gain more money…but at a greater risk of the home owner defaulting on the mortgage.

The problem with this is it is very difficult to balance your risk-reward ratio.  So they created an investment vehicle called a mortgage-backed security (MBS).  This is referred to as a “derivative” because it is based off of the mortgage.  The way it works is the banks chopped up all these different mortgages into different securities that were worth different amounts and different risk levels.  They then sold these to other banks and investments firms.  The firms who bought these MBS then received a payment based off of the mortgages.

For the banks selling MBS, it helped them pool risk and generate capital, and for the firms who bought the MBS, it provided a source of cash flow with what was thought to be a very safe, secure underlying
commodity: real estate.

Since real estate was so “safe,” these banks used huge amounts of leverage (borrowed money to buy the securities) because they didn’t think they were that risky.  Some firms, like Lehman, were leveraged 30:1, meaning that for every $30 they borrowed, they had $1 of underlying assets.  That would be like you making $1000 a year but taking out a loan of $30,000.

While all this is going on, people are buying up adjustable interest rate mortgages (ARMs).  They offer a cheap introductory rate, but then skyrocket.  So all of a sudden, all these people discovered they couldn’t make their monthly payments.  The default rate shot through the roof.  The firms that had purchased MBS did so based on certain calculations of default.  In other words, X number of people could default on their mortgages, but they could still make a profit and have a positive cash-flow.  However, when the default rate shot up, this threw all of their calculations off.

Now the firms faced a real problem.  They had HUGE amounts of debt on their balance sheets, and the assets that were supposed to balance that debt were becoming worth less and less because of the rising default rate and the drop in housing prices.  These are the “write-downs” that you hear about.  The firms had to pay interest on that debt, but they did not have the corresponding cash flow to be able to pay the debt.  Lehman, for example, had $5.4B of debt obligations last quarter, but only had $2.3B in income.

When you can’t pay your debt obligations, that’s called being insolvent.  Many people think that bankruptcy is caused by having more liabilities than assets, but that’s not true.  It’s caused when you
can’t make good on your debts, so the repo man comes and claims your assets in order to make up for it.

When that happens, you have to file for bankruptcy in order to make sure that people get paid in the correct order because otherwise different creditors are going to be suing you to make sure they get what you owe them.

So that’s where we are now with Lehman.  They couldn’t pay their debts, so they had to file for bankruptcy.