Fast forward to 2005. Merck, already down from a rough year in 2004, gets hit with a scandal regarding Vioxx. Its stock price went from a high of 64 to a low of 27. It lost over 50% of its stock price at the time. I was paying close attention to it at at the time and I was pointing out to my friends that it was to be strongly considered. They thought I was crazy! With looming lawsuits and a loss of revenue, how can someone make this case? It was simple. The decrease in stock price was not comparable to the more modest decrease in revenues. I bought the stock at $33 in early 2006 and sold it at the end of the year for $42. It was a substantial gain. Looking back, I could have made more. The stock doubled within two years of its low in late 2005.

That brings us to today. Who is getting “beat up” now, and what stock price is dropping more than it should? I’m taking a close look at the major banks who have been writing off huge amounts due to the sub prime mortgage crisis. Many of these banks are still in the black, barely making profits, yet still trending downwards in their stock price. Why? Future expectations and a poor understanding of market forces. I’m paying close attention to these companies and their core businesses and whether or not they are doing well without including the one or two time write offs they are experiencing. My belief is that these companies will have a strong rebound. Citigroup, for instance, has lost over 50% of its stock price in a little over a year. For what? One quarter of record losses which followed 4 or 5 years of record profits. All write offs it experienced and the money it lost in the process was recuperated through foreign capital and the company still holds assets of close to 2 trillion dollars in which to garnish profits from.

So I’m making a prediction here. I’m betting on the belief that the big banks who have been battered lately will begin to go up this summer and will rebound to an equilibrium within two years. I’m not only making a prediction, I’m putting my money where my mouth is. I have transferred a respectable amount ($5,000) to my brokerage account for the purpose of investing in one or two of these stocks. And in two years time, I will link back to this blog to see how my prediction held up.

Prosper.com description
One of the descriptions used for Prosper is “eBay + PayPal + Match.com”. Lenders find bidders based on credit score, personal story, history, and motives. They bid on interest rates and get paid a premium at the end of the terms (typically three years).

Borrowers
People looking for cash sign up for Prosper and a profile is automatically created. Their personal credit history is for everyone to see: Approximate credit score, debt to income ratio, history of delinquencies, amount of revolving credit, etc. Using this data, Prosper assigns borrowers a letter Grade. AA, A, B, C, D, E, and HR (huge risk). The grade has an impact on the interest rate that is expected to pay.

This is a breakdown of Grade based on Credit Score

AA- 760+
A- 720-759
B- 680-719
C- 640-679
D- 600-639
E- 560-599
HR- 520-559

Lenders
Prosper let’s you purchase a portion of a loan by funding it with a minimum of $50. The idea is that instead of lending a single person $1,000, you can lend 20 people $50. This type of diversification let’s you minimize the risk of non-payment, more common with users on the lower end of the credit ranking.

Take a look at this sample listing for an idea as to what to expect when checking out a listing. “Borrowers” are completely anonymous, referred to using their screen name, and each has a story to tell and a reason for borrowing. In addition to credit data, lenders also see the borrower’s group membership, if any, friendships with other Prosper members, endorsement from those friends, past listings and prior Prosper loans.

Average results

Using the Prosper.com data, annual Return on Investment goes as following:

Lending to AA borrowers: 8.48%
Lending to A borrowers: 6.78%
Lending to B borrowers: 5.85%
Lending to C borrowers: 7.03%

However, I saw this statistic on Wikipedia: As of November 8, 2007, the median estimated return on investment (”ROI”) for Prosper lenders with more than 20 loans and an average loan age greater than 6 months is 4.89%.^[13] — after taking into account Prosper’s servicing fee charged to lenders (1% annual fee on A-HR loans).^[14]

A return on investment of 5%, on average? That’s comparable to a savings account at ING. Is Prosper.com really worth it, and is money really to be made? I’m not so sure. It’s an illiquid investment. You need to wait 3 years before you get your money back, if the borrower doesn’t default, and that leaves you with your hands tied if the money is needed in the future. It might be worth it if you could guarantee rates of 9-12%, but not 5%. I think a careful study of the borrowers and some investigation of their credit history is important. Mostly importantly, I think their personal stories leave us with a good idea as to how risky they are. Some people are borrowing to fund real estate properties, businesses, and college education. Some are looking to pay off large amounts of credit card debt. Who would YOU trust with your money?

Right now I am contemplating whether or not to transfer my money back into my bank account and focus on something a little more worthy of my greenbacks.

This isn’t new. Japan has accumulated over a trillion dollars in reserves over the past half century and has kept the dollar strong in times of weakness by buying up extra reserves. The difference is, Japan is a major ally and friend of the U.S., and it’s in the interest of the Japanese to ensure the dollar is considerably strong because of close links to the American economy.

China’s different. Historical mistrust and our friendship with Asian rivals assures us that the Chinese view the USA as a potential enemy and not a competitor. China is accumulating dollar assets not just to gain wealth but to gain a bargaining chip over the world’s lone superpower. In China it’s called their economic “Nuclear option“. Essentially, the Chinese know that they are increasingly in control of the dollar’s value and that the moves they make can alter the value of it drastically.

How would this work? Let’s pretend that China disagrees with global U.S. policy and decides it wants to act. With military options off the table it decides to wage economic warfare. It starts a massive sale of U.S. bonds. This causes a drastic spike in treasury yields, pounds the housing market, and throws the economy into a guaranteed recession. The USA, which has run a budget deficit for 35 of the last 40 years, would have trouble finding buyers for its U.S. bonds since the dollar’s value is volatile and decreasing. In addition, the price of gold and oil would skyrocket and the rest of the world would become unstable.

Sound far-fetched? Well, its happened before. The United States pulled the same stunt on Britain during the Suez crisis in order to get the British to withdraw from the region in 1956. As written in Wikipedia: “Part of the pressure that the United States used against Britain was financial, as President Eisenhower threatened to sell the United States reserves of the British pound and thereby precipitate a collapse of the British currency. ”

The situation is rather similar today: A world superpower (Britain) is heavily indebted to an emerging superpower (USA) due to war (World war two). Fast forward to 2008: A world superpower (USA) is heavily indebted to an emerging superpower (China) due to war (Iraq & Afghanistan). When another nation controls you physically or economically your sovereignty is threatened, at risk, and exploitable.

This isn’t a doomsday post and I’m not a conspiracy theorist. I am merely concerned as a citizen of this country. Having looked into this a lot, I’ve reached some conclusions about this and I like to think that times are different and the risk isn’t there for a number of reasons. First, China’s wealth is entirely Dependant on the price of the dollar and the overall state of the U.S. economy. A recession (or depression) in the USA threatens the trade imbalance China enjoys with the USA and possibly prevents it from accumulating more wealth through its exports. Second, and more importantly, China’s wealth exists because of the price of the dollar. A massive sell of dollars would take time as there simply isn’t a buyer for $1trillion in greenbacks. That means as China begins to sell off its reserves, the value of the unsold reserves will decrease. A 20% drop in the value of the dollar means that $1trillion China holds is now worth $800billion in purchasing power. It is in China’s best interest to ensure a strong dollar in order to preserve its new-found wealth. Any sudden moves to destabilize the dollar would inadvertently wreck China’s gains over the last 15 years.

Rather than using its “Nuclear option”, I would expect China to do two things going forward. First, it diversifies its reserves into two other currencies: The Euro & the Pound. It then uses its vast pool of reserves to buy up key assets in western nations. The Chinese Sovereign wealth fund, which is actually controlled by the government, will buy up ports, energy assets, and technologically important assets in western nations to continue its long standing tradition of economic espionage. Western nations will continue the upward trend of having foreign-owned businesses. Lastly, economic influence will be more evenly spread out between traditional superpowers and emerging nations like China and Russia.

• Watch your money grow before your eyes as each second ticks away
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• How much are you paying to live an average life? Find out.
• This picture shows where the oil is in the world

Here are a few ideas to get you started

Revver.com
A video sharing website that hosts user-generated content. Revver attaches advertising to user-submitted videos and shares all ad revenue 50/50 with the creators. Uploading a video to Revver has the potential to bring in passive income if it’s watched often. Many videos are passed around through social networks and office e-mails. Some videos reach millions of people around the world. Having a few videos uploaded can bring in some side change. In this case you are uploading the video once and enjoying the benefits many times over.

Dividend income
This is probably the most common form of passive income. It takes an initial investment on your part and you would need a pretty respectable amount of money to make this a big impact to your income. But this article isn’t about finding large streams of income. Even modest investments can net you hundreds of dollars a year in dividends. That’s extra money in your pocket that you didn’t have to work for.

Affiliate income
It requires a bit of know-how on your end, but it’s very possible and quite common for people to get supplemental income through affiliate programs. This requires you to sell products and get commission off of the sales. Starting up a successful website enables you to advertise and sell the goods of another company. Since you are doing work for them they are willing to pay you a percentage of the income. There are many companies out there. One of the bigger companies is Amazon. You can get about 4% on sales simply by redirecting traffic to their site. Many blogs review products and link to them on Amazon, taking a cut of the commission.

Real Estate
A much bigger investment is a rental property. It requires cash up front and maintenance at any given time. The benefit of real estate is that you primarily invest with other people’s money (OPM). In this case you would borrow money from a bank and pay the loan back with income from your tenant(s). When the home price appreciates you make money off your initial investment plus the entire amount provided by the bank. If the property is profitable enough you can get a property manager and truly turn this into passive income.

Conclusion
There is no ‘get rich scheme’ that’s instantly going to make you wealthy. Focus on the small things that add up to the bigger things. Passive income is like a snowball getting bigger in size as you roll it in more snow. Accumulation of income over time will make those small things you do a much bigger benefit. That’s how wealth is developed and sustained.

“Mind Your Business” is not just cheesy text added to the earliest coins minted in this country but a motto every person should live by. Your life should be looked at as if it’s a business. Everything you do affects how this business is run. You want to make sure you maintain organization in your life to eliminate wasted time and resources. You want to keep your expenses low to preserve cash. And of course, you want to maximize your income.

You should always be looking at ways to improve your situation and your business. Money is always to be made outside of work. There are ways to glean income from side jobs with your unique talents. There are income generating assets that can supplement your salary. There are rental properties that can bring in large amounts of cash over time. The important thing to do is to look at your life as if it was a business. Where can you improve, what can you do better, and how can you expand?

Who will this affect, and how?

The picture I link to below, courtesy of the Wall Street Journal, illustrates how each party is effected. It mentions an earlier rate cut but all of the factors remain the same:

Click to see an enlarged picture

Now, here is where I decide to rant for a bit.

Part of the reason we are entering troubled economic waters is the availability of money in the last 6 years. The mortgage industry issued money to whomever it deemed worthy without doing better checks into whether or not they could get repaid. They did this because much of the money being issued was now being raised through mortgage bonds instead of their own cash reserves. They weren’t risking their own money so it was more advantageous. Historic low interest rates meant homeowners could cash out enormous amounts of home equity to pay for goods and services. That helped our consumer economy stay strong while the underlying fundamentals in the economy were adequate at best. When the mortgage well ran dry and consumers were tapped out of disposable income to help fuel the economy, stock markets began to shake. In the last few weeks, they rattled. And around the world in the last few days, they dropped. The move by the federal reserve is an attempt to lower borrowing rates by banks, which theoretically pass the savings onto consumers, and thus allow people access to “cheaper” borrowing. The idea is that the more Americans can borrow, the more they will spend. That’s the exact reason we got into this mess to begin with. Most Americans now have a negative savings rate. That’s correct, we borrow more than we save! Our indebtedness to banks and credit card companies can only fuel the economy so long before massive waves of bankruptcies and foreclosures halt the unparalleled economic growth we have seen in this country over the last 50 years.

While it’s not doomsday, we have serious problems and too many wrong answers.

But why not do both?

I was in the minority in this debate and I argued for something different. My stance was this: If you are looking for added comfort and a little less weight on your shoulders, work to pay off your mortgage early. If you are looking for the best investment decision, invest the excess money.

Before I present my case, let me present an example.

John doe has $100,000 left of mortgage to be paid off at 5%. He expects this to be paid off in 10 years and 2 months. He is paying $1060 a month but has extra cash to spend. He decides that he can pay out $3,000 a month, paying off his mortgage in 3 years. Doing this will save him $19,450 in interest over the life of the loan. Traditional financial planners would tell him that this is a wise decision. For most Americans, it is. But what is the better investment choice? Can John get a better return for his excess money by using it elsewhere? The answer is yes.

To compare and contrast investing vs. paying off mortgage early, let’s assume averages. The stock market has historically returned 10% to investors and therefore we will use that as our benchmark.

Paying off mortgage early:
-Savings in interest: $19,450
-Loss of interest writeoffs in tax season assuming a 30% tax rate: ($5,835)
-After John pays off the house, let’s assume he invests for the remaining 7 years that he would have been paying off his mortgage. He invests $3,000 in the stock market each month. After 7 years of investing his contribution at 10% would yield $375,691

Total cash at the end of ten years: $389,306

Investing excess cash
- John invests the excess $1,940 in the stock market instead of paying off his mortgage early. That equates to $23,280 a year in investments and once again we assume a 10% return.

Total cash at end of ten years: $408,125.57

Conclusion
John would have made almost $19,000 more by investing his money instead of paying off his mortgage.

Comments
The example was basic and interest rates are closer to 6% than 5% these days. However, It is a fundamental fact that using historical returns as a guide, you can make more money by investing your excess cash. Debt is not a bad thing to have if you can manage it.

What most people base their decision on is this: What’s safer?

I truly believe investing your money is safer than paying down your mortgage.

If you put all of your extra reserves into your home you are SEVERELY restricting your capital in the case of an emergency. In order to take care of a catastrophe or a dire medical need, you will need to BORROW against your home through a HELOC or you will need to refinance. Even worse, let’s pretend you lose a job in year two and cannot afford to pay even the MINIMUM amount of your monthly mortgage. You still owe the bank a monthly check, no matter how far in advance you are in principal payments!

Each person’s scenario is different. If you aren’t cash strapped and you are making your decision based on economics and rate of return, consider this article. It can help guide you in the decision making process.

The file: Mortgage calcultor for investment purposes

One word sticks out when buying an investment property: cash flows. That’s the single most important word you need to know when trying to value a property. Will it make a profit? Is it worth the investment?

To answer these questions we need to find out two things: Revenue and Expenses

Expenses
It’s quite easy to figure out expenses ahead of time. There are only a handful of factors to consider and each one can be inserted into the excel spreadsheet that was attached.

Purchase price: how much will the home cost?
Real estate taxes: public knowledge. can often be found on Zillow.com or sites like www.propertyshark.com
Interest Rate: ask your bank what rate you can get for a loan
Insurance: call your insurance company or check online for an estimate

Knowing those four attributes and using the attached calculator, you can come up with a very accurate and realistic assumption of the expenses you will incur with your target property. Enter in each of the four values to come up with your “Monthly mortgage”, the total amount of cash you will send out monthly to the bank.

Revenue
Finding out the average rents has become easier over the years thanks to sites like Craigslist. If your not familiar with Craigslist then your local paper and a Google search for your area can accurately give you average rents in your area. These averages are typically based on the size of the home or the number of units/rooms. If you are renting out a single unit, put a conservative estimate into the attached rental calculator and compare it to your expenses from above.

The idea is to bring in more cash then you send out. The mortgage calculator will help you find properties that will instantly bring you a profit.

Here is a real life example of how to use this file
I am going to randomly choose a university in Philadelphia, an Urban city not so far away from where I live in NJ. I’m choosing Philadelphia because it has a large college presence and a not-so-inflated real estate market. It’s also a renter’s market.

Step 1: Find a target market. I’m going to pick “Temple University” in Philadelphia.
Step 2: Find out average rents “per room” in this area. I’m going to search the Philadelphia section of Craigslist and type in “Temple” for a keyword. As you can see, this brings up housing near Temple University and the rates being advertised.
Step 3: I have concluded that the average rent is about $450-$500 per room. Buying a 3 bedroom house could therefore net you at least $1350-$1500 in revenue.
Step 4: I searched realtor.com for homes near Temple University and picked a random four bedroom house that appeared to be in good shape (For Philadelphia standards). I came across this one. It’s a 4BR house selling for $209,000. My conservative guess is that I can get this for $200,000.
Step 5: Put figures into calculator.

Expenses:
Purchase price: $200,000
Down payment: 10% ($20,000)
Interest rate: 6.25% (the highest I think I would have to pay)
Insurance: I entered in $600 for the year, which is an educated guess on my end

Revenue:
I put in $475 for all 4 bedrooms

Total Expenses: $1,324/mo
Total Revnue: $1,900/mo

Total profit: $575/mo

This is the mentality I have when I am considering an investment. What are my expenses, and what can I expect my revenues to be. It took me ten minutes to scour free internet resources to find a property that can net you a $575 profit instantly with only 10% down. If you change the formulas and put 0% down (which isn’t generally allowed, but let’s pretend) you would still get $450 a month in profits.

Questions about this? Want to apply it to your local renter’s market? Let me know!

To straddle, we need to make a simultaneous purchase of an equal number of both calls and puts on the same stock with the same expiration date. You’re looking for a significant move of the stock price before the options expire. If the movement in stock price results in the option or put having a premium more than the amount of the combined premium paid for both options, you would realize a profit. If only a small movement in price occurs, then a loss is realized.

Here is an example using an imaginative company, “Walrus gas company”.

Example
Walrus gas is selling for $40. You have a gut feeling that a recent investment in arctic drilling is going to yield a gas field worth billions of dollars. The results of this investment will be evident in a month’s time, give or take. You decide to buy 100 call and 100 put options with an expiration date a few months ahead. Both the call and the put options cost $5. The put is for $35, the call is for $45. The straddle in this scenario takes place when you purchase a put option, hoping the price drops, and a call option, hoping the price increases.

Scenario #1: price drops to $20
The news was bad, and the stock tanked. You make money on your put option and sacrifice the premium on your call option. Take the original strike price of $35 and subtract the new market price of Walrus gas, which is $20. That’s a $15 profit. However, you must subtract out the premiums paid for both the call and the put at $5 a piece, $10 collectively. Your profit is now $15-$10 = $5. Your total investment was $10 and your profit was $5. That’s a 50% gain on investment.

Scenario #2: price soars to $80
The news was excellent and the stock price soars. You make money on your call option and sacrifice the premium on your put option. Take the new market price of $80 and subtract out the original strike price of $45. That’s a $35 profit. Now you subtract out the premiums paid for both the call and the put at $5 a piece, $10 collectively. Your profit is now $35-$10 = $25. Your total investment was $10 and your profit was $25. That’s a 250% gain on investment.

So where is the risk? Assume the stock price doesn’t change much. You would sacrifice the $10 in premiums paid for the call and put options and essentially lose 100% of your money. Risky investment? Of course. But it’s an adequate investment strategy to use and practice in times of volatility and it could bring you nice rewards if used properly.