401k Loans

There is a new, interest-free, penalty-free option if you need a quick $1,000.

 The Internal Revenue Service has now made it easier to take a limited amount of money out of a traditional retirement account penalty-free. While previously you could tap your savings without penalty in more limited ways, and often with more paperwork, you can now take out up to $1,000 of your funds for any self-defined emergency.

The change comes after the IRS spelled out what counts as an emergency personal or family expense under a 2022 retirement law that went into effect this year. The reasons can include medical care, funeral expenses, and auto repairs, but the key phrase is the catchall, “any other necessary emergency personal expenses.” 

The $1,000 provision is different from other retirement-account withdrawal options because you can just say that you have an emergency, without specifying what it is, so you can get the money faster.  

Exploding Deficit

U.S. National Debt crossed above $33 trillion for the first time just last week and another $100 billion in debt has already been added to that total.

What's different this time, as this chart from Bank of America shows, is that previous bouts of spending occurred during wartime or times of financial crises. Today's economy is growing, and unemployment is at all-time record lows. This is the environment historically where the deficit would be shrinking as the government stood back and let the private sector do the heavy lifting.

This shortfall has to be covered by the issuance of debt, and the cost of that financing has doubled in the past 18 months.

According to the U.S. Treasury, as of August, it cost the government $808 billion just to maintain its debt. That’s 15 percent of the total federal spending – and it's growing.

A report from the Peter G. Peterson Foundation (a nonpartisan organization dedicated to increasing awareness and accelerating action on America’s long-term fiscal challenges) points out that "the federal government already spends more on interest than on budget areas such as veterans’ benefits, transportation, and education."

This issue needs to become front and center heading into the election year.

Reprieve for Older Savers

Higher earners age 50 and up will get two more years to use pretax dollars for all of their retirement savings in 401(k)s and similar plans, after the Internal Revenue Service delayed a new requirement.

The IRS postponed until 2026 a law that was scheduled to take effect next year, and the agency gave more flexibility to older workers trying to decide how to plan their retirement savings.

The change enacted by Congress last year will force high earners to put so-called catch-up contributions into Roth-style accounts funded with post-tax dollars. The law applies to workers who made more than $145,000 in wages during the prior year and who contribute more than the general maximum for 401(k)s, which is $22,500 this year.

In a notice, the IRS said it was trying to create an orderly transition to the new system and postponed the requirement until 2026.

Under current law, contributions to 401(k) and similar plans are capped at $22,500. But savers ages 50 and older can make catch-up contributions beyond that into their 401(k) accounts each year, and eligible workers can put an extra $7,500 into their accounts, for a total of $30,000. Those catch-up payments can be made with pretax or post-tax dollars.

As part of a broader retirement law last year, Congress required that high earners make those catch-up contributions in post-tax dollars. The change was designed in part to raise money within the 10-year budgetary window that Congress uses. It thus helped to raise revenue for other changes such as a delay in the starting age for required minimum distributions from tax-deferred accounts.

Interest Rates and the Budget Deficit

The federal government's deficit nearly tripled in the first nine months of the fiscal year, a surge that's bound to raise concerns about the country's rising debt levels.

The Treasury Department said Thursday that the budget gap from October through June was nearly $1.4 trillion, a 170 percent increase from the same period a year earlier. The federal government operates under a fiscal year that begins October 1.

The shortfall adds to an already large federal debt — estimated at more than $32 trillion. Financing that debt is increasingly expensive as a result of rising interest rates. Interest payments over the last nine months reached $652 billion, 25 percent more than during a same period a year ago.

To finance the rising deficit, the U.S. Treasury is expected to issue a deluge of government bonds into the market. Interest rates most certainly will move higher to find willing buyers for this increased supply.

The above chart, which I think is an important one in the current environment, shows why this debt explosion is worrisome for all markets.

The spike in interest rates over the past couple years was one of the primary reasons stocks sold off during that time. The red line above is the price of treasury bonds going lower (which means interest rates are moving higher). You can see the Nasdaq moving lower at the same time. After heading lower in the first part of 2023, rates are back to the high point of the year. Stocks, however, have so far ignored what is happening to rates and have continued the rally. At some point, this gap will close as the higher yield in bonds becomes more attractive to investors relative to stocks.

With more than $1 trillion in new government debt being sold in the coming quarter to fund the deficit mentioned above, it is hard to envision bond prices moving higher as the mechanism of this happening.

Sticky Home Prices

Considering a 30-year mortgage has gone from approximately 3 percent to 7 percent over the past two years, simple math would tell you that home prices would have to come down. But they haven't for a couple reasons, and both are on the supply side.

First, if you have an existing mortgage, you are reluctant to sell because even a lateral move would nearly double your existing payment. Many potential sellers are staying in place and remodeling rather than move.

Secondly, there is an extreme lack of new homes. In the four decades leading up to the global financial crisis, nearly 26 million new homes were built in each decade. In the wake of the 2008 crises, which really came out of the real estate sector, only 5.8 million new homes were built. Sellers will continue to have the upper hand until rates continue to ratchet higher or the job market slows.

Mortgage Fees are Changing

Starting today, upfront fees for mortgage loans backed by Fannie Mae and Freddie Mac will be adjusted because of changes in the Loan Level Price Adjustments. These are the fees that vary from borrower to borrower based on their credit scores, down payments, types of home, and more. The changes relate to credit scores and down-payment sizes. But not in the way you think it would. 

In some cases, people with higher credit scores may end up paying more while those with lower credit scores will pay less. Huh?

The entire matrix of fees based on credit score and down payment has been updated. If you have a top credit score, you’ll still pay less than if you have a low credit score. However, the penalty now for having a lower credit score will be smaller than it was before May 1.  

For example, if you have a score of 659 and are borrowing 75 percent of a home's value, you'll pay a fee equal to 1.5 percent of the loan balance. Before these changes, you would have paid a 2.75 percent fee. On a hypothetical $300,000 loan, that's a difference of $3,750 in closing costs. 

On the other end, if you have a credit score of 740 or higher, you would have paid a 0.25 percent fee on that same loan. Starting on May 1, you could pay as much as 0.375 percent. 

These changes are part of the Federal Housing Finance Agency’s broader examination of fees to provide “equitable and sustainable access to homeownership” and shore up capital at Freddie Mac and Fannie Mae. That's all well and good, but the fact that people who have worked hard to build up their credit are subsidizing others who haven't strikes me as an overreach.

We're not talking about a small segment of the mortgage market. Fannie Mae's and Freddie Mac’s share of that market comprised nearly 60 percent of all new mortgages during the pandemic, up from 42 percent in 2019.

Bank Failure Follow-up

What an end to the month. Regulators seized control of First Republic Bank and sold it to JPMorgan Chase on Monday, a dramatic move aimed at curbing a two-month banking crisis that has rattled the financial system.

First Republic is the second largest U.S. bank by assets to collapse after Washington Mutual, which failed during the financial crisis of 2008 and was also acquired by JPMorgan. Add its assets to the previous two that failed earlier this year, and as the New York Times points out, it isn't pretty.

Regional banks play an important role in our economy. Small businesses, real estate developers, and consumers purchasing homes and cars typically deal with their local bank.

The recent bank failures and rising interest rates have forced banks to rein in lending, making it harder for businesses to expand and individuals to buy homes and cars. That is one of the reasons that the economy has been slowing in recent months.

These three institutions got caught in the trap of borrowing short-term to lend or invest long-term and then had interest rates spike. Let's hope First Republic’s travails were a delayed reaction to the turmoil in March rather than the opening of a new phase in the crisis.

SVB, WTH?

When three major banks fall in the span of a week, including the 16th largest by assets in the country, it certainly makes you sit up and take notice.

Thankfully, the Treasury, Federal Reserve, and Federal Deposit Insurance Corporation (FDIC) did as well, and together they implemented major policy changes intended to stabilize the banking system in response to these failures and the risk of continued deposit outflows.

We don't know how this will shake out going forward, but we do know that it is not the banking crisis of 2008. Back then, bank balance sheets were full of toxic worthless securities that would never regain their previous valuation. Because of regulatory changes made under the Dodd Frank Act in response to that crisis, banks hold much higher-quality paper, primarily government and mortgage-backed bonds. These bonds have gone down in value because of the rapid rise in interest rates, but they will all mature at 100 cents on the dollar.

So what happened?

Silicon Valley Bank’s failure boils down to a simple misstep: It grew too fast using borrowed short-term money from depositors who could ask to be repaid at any time, and invested it in long-term assets that it was unable, or unwilling, to sell. When interest rates rose quickly, it was saddled with losses that ultimately forced it to try to raise fresh capital, spooking depositors who yanked their funds in two days. (For those wanting more detail, this is the best I've read.)

There are certainly other banks out there with similar unrealized losses on their balance sheets. And the problem is global in scope due to central banks around the world suppressing rates for so long. It was just this past September when the UK's Central Bank had to bail out its pension system for a similar reason.

One of the biggest surprises for me is how quickly journalists and analysts have been able to reconstruct what went wrong. Where were the regulators while this was happening? The Dodd Frank act added hundreds of thousands of pages of regulations, and an army of hundreds of regulators. The Fed enacts "stress tests" in case regular regulation fails. Seems like gross negligence on its part. Let's hope that now that these issues are front and center, it will be contained to just these banks.

Should clients be worried about their accounts at OAM? Absolutely not. Accounts at our custodian, Shareholders Service Group (SSG), are covered by SIPC (Securities Investor Protection Corporation) insurance, which is similar to the FDIC insurance that protects bank account holders. While there are limits to its coverage, SSG has purchased additional insurance through Lloyd’s of London that provides excess account protection for held assets up to an aggregate limit of $1 billion, of which $1.9 million may cover cash awaiting reinvestment at the individual account level. This excess account protection is the highest level of coverage available in the industry today.

Additionally, SSG's only role is to provide custody services for independent fiduciary Registered Investment Advisors. It doesn't invest or take positions in any securities. It simply safeguards client assets.

Lastly, it would be rare for clients to have any kind of significant cash balance. While we often refer to money market funds, CDs, or treasury bills as "cash" when discussing allocations, all of those are securities, which would always remain protected safely in their accounts.

Tax Season Coming Up

In 2017, Congress made a landmark change by nearly doubling the standard deduction. As a result, the number of filers itemizing deductions dropped to about 15 million in 2021 from about 47 million in 2017, according to the latest IRS data.

The standard deduction is the amount taxpayers can subtract from income if they don’t break out deductions for mortgage interest, charitable contributions, state and local taxes, and other items separately on Schedule A.

The standard deduction is $12,950 for single filers and $25,900 for married couples filing jointly. In 2023, it bumps up to $13,850 for singles and $27,700 for married couples. Taxpayers age 65 and older receive an additional standard deduction. For most single filers, it is $1,750 for 2022 and $1,850 for 2023. For married couples filing jointly, it is $1,400 for 2022 and $1,500 for 2023, for each spouse age 65 and older.

About 90 percent of filers now take the standard deduction.

Looking Back, and Ahead

Our January 2022 newsletter was titled "New Paradigm" because we noted that the sudden shift in the Federal Reserve's rhetoric regarding interest rates was a game changer. Interest rates are the price of money, and that price was going to go up.

The consensus coming into last year was that growth would come in at three to four percent, interest rates would rise modestly as the Fed started a hiking campaign, and inflation would moderate as the supply chain got back online. Analysts expected stocks to rise roughly 10 percent.

None of that came true. Growth was negative in the first two quarters of the year and, while it did improve in the second half, it didn’t come anywhere near three or four percent for the full year. The Fed didn’t just hike rates, it raised them higher and faster than ever before. And, of course, stocks were down 20 percent for the full year (and 30 percent for the tech-heavy Nasdaq). Inflation ended the year at 7 percent, helping to push bonds down 17 percent.

This chart from Bianco Research shows clearly what an outlier stocks and bonds both being down together by that magnitude was. Note that the data goes back to 1802.

As unprecedented as the move in the bond market was, it leaves savers in a much better place than in the past few years. CDs, Treasury bills, and short-term bonds are yielding close to five percent after being around one percent this past year. And due to longer-term rates being lower than short-term rates, it is safer investments offering a better return that is a true anomaly.

We've talked over the past year about this situation of interest rates on longer dated bonds being lower than short-term rates, known as a yield-curve inversion. It's garnering a lot of attention because historically, every time this has occurred, a recession has followed (although the timing of that recession has varied--anywhere from three months to two years). Stocks and other investment assets do not perform well in recessions. 

Is it a foregone conclusion? Maybe not. The research linking the inverted yield curve to recession was done in the late '80s by Campbell Harvey for his dissertation at the University of Chicago. But today, everyone knows about the yield curve and that common knowledge may have changed people’s behavior so much that the curve is no longer as useful (h/t Alhambra Investments). Even Dr. Harvey doesn't believe it is viable in this environment.

It's also hard to see a recession with the employment numbers we've been seeing. Last week the government reported that U.S. employers added a solid 223,000 jobs in December, evidence that the economy remains healthy even as the Fed is rapidly raising interest rates to try to slow economic growth and the pace of hiring. The unemployment rate fell to 3.5 percent, matching a 53-year low.

Lastly, I would just point out that back-to-back down years in stocks are fairly rare although that did happen in the dot com bust when 2000, 2001 and 2002 were all negative. Before that, you have to go back to 1973-74, 1946-48, 1939-41, and 1929-1932. (Bonds have never suffered back-to-back annual losses.)

The caveat is that stocks didn't really begin to recover in those markets until the Fed stopped raising interest rates. In 2022, the Fed made seven consecutive increases to its benchmark lending rate, including a 0.5 percent hike in December that brought its rate into the 4.25-4.5 percent range. The first Fed meeting of 2023 takes place next month, and the consensus is that another increase is in the cards.