Newsletter: October 2008

Newsletter 25: October 2008

If you have watched the news lately it seems like the world is coming to an end in the financial markets. There has been an unprecedented number of mortgage foreclosures, banks cannot obtain financing to stabilize their capital needs and several of the nation’s largest financial institutions have either filed for bankruptcy or have been taken over by the federal government. No one ever thought dislocations of this magnitude could or would happen.

Why has all of this happened and what does it mean?

Simply put, the balance of risk and return has been put on its head. This enormous disruption has been caused by the simple (or seemingly simple) mortgage. Up until about 35 years ago banks that issued mortgages kept the mortgages on their own books. There were no subprime mortgages back then nor were there adjustable, balloon or negative amortization (or “pick your payment”) mortgages. Because banks kept their own loans on the books they were more selective about to whom they extended loans and the terms of the loans. No one believed it was the birthright of every American to own a home (the home ownership rate until recently was far above the historical norm and is still much higher than in other first world countries).

In the last 15 years most banks except some smaller community banks stopped holding their own loans. Loans were sold to Fannie Mae and Freddie Mac who were “government sponsored” entities that were essentially public companies that were implicitly (now explicitly) guaranteed by the federal government. They were good in that they added liquidity and purchased what were considered conventional or prime (good risk) mortgages. By Fannie and Freddie buying these mortgages they gave banks and mortgage brokers (which did not exist 25 years ago) the ability to lend more money making the dream of home ownership more available and affordable.

As the market for mortgages became larger the creative financial geniuses figured that they could bundle together mortgages, cut them into pieces and sell them on the open market (securitization) like shares of stock. This is where the problem started. These securities were almost impossible to truly value because it was decidedly more difficult to determine the risk level or likelihood of default on the individual mortgages when they were bundled and then divided. Suddenly mortgages that were considered low quality by themselves were getting AAA ratings from agencies such as Standard and Poors when they were bundled and sold in pieces. The simple act of bundling a fixed rate 30 year mortgage did not suddenly make it more risky but the securitization boom included a large number of exotic mortgages that had rates that adjusted upward, negative amortization (if you did not make large enough payments the principal increased rather than decreased), failed to verify the borrower’s income (lots and lots of fraud) balloon payments and loans that required such low down payments that the likelihood of default was markedly higher than on conventional loans.

So how does all of this go from securitization of mortgages to the liquidation of Bear Sterns, the bankruptcy of Lehman Brothers and the government takeover of AIG, the largest insurance company in the world? Some of it was real and some of the downfall was imagined. First remember that investment banks were making huge amounts of money buying and trading the mortgage securities. In many cases the financial institutions originating these mortgage securities were also lending the money to others to buy the securities that they were trading.

At some point early in 2008 the toxic mortgages making up the mortgage security bundles started to go into foreclosure as the over leveraged borrowers started to default. This was because A. Housing prices were dropping and the low down payments many of these borrowers made meant they had no equity in their homes and therefore little to lose by simply walking away from the loans; and B. The interest rates on the adjustable mortgages were adjusting upward making the payments unaffordable.

Since these mortgages were being sold on the open market people started to realize that the risk of default on many of these mortgage securities was much higher than they thought and the market value started to plunge often by more than 50%. So what does that mean as long as you don’t try to sell the mortgages? Why not just hold tight?

Even though it does not seem like there were any rules regarding banks and insurance companies, there were. For the banks and investment banks there are capital requirements (whether demanded by the law or by contractual obligations). These capital requirements essentially say that for every $1.00 you borrow you must maintain a certain $ amount of assets in the event people want their money back. The assets of these large financial institutions that they thought were worth $10 Billion were now worth $3 Billion because of the now markedly reduced values of the mortgage securities they owned. The only way to avoid violating the law or other contracts was to raise more funds or sell assets. This caused the debacles in the markets.

AIG was forced to sell 80% of its stock to the federal government not because it was unable to pay its claims. It was forced into that position because it had bought too many securities whose value had plunged in market value and did not have the required amount of liquidity to meet the legal requirements for insurance companies.

In the end the market is working like it is supposed to. When there is too much money the market gets too high and people figure out there is no free lunch. The risk/reward balance was out of wack. When that happens, a bubble occurs and there is a correction. Do not misunderstand, this correct is a big one because the greed that got us here was historically huge. When housing prices are going up 10-15% per year but income for the average American is going up 2% per year there is going to be a problem. Housing, the largest part of most budgets, cannot continue to grow faster than income for too long or no one can afford a home. The average American did not see it and the financial geniuses chose to ignore it. We are all paying the price now.

For those who are retired and living off investments in the stock market, there is little comfort to be had as you watch your investments drop 25%. For those who have a few years until retirement things will get better. The excesses from poor regulation will deflate and the housing market will stabilize. Interest rates on mortgages now are likely to drop because of the poor outlook for the U.S. economy. Those drops coupled with the price reductions for homes from the last two years have made homes more affordable and hopefully a bottom will come in the next year.

We may never see primary residences increase in value like they did but they are likely to keep up with inflation as they have historically and people are less likely to use them as ATMs. The stock market will improve when this occurs as demand increases again and profits come again for businesses in the economy. Outside of real estate and the financial sector many parts of the economy are holding their own. So hold on and be patient, don’t cash out your retirement plans and put the money in your mattress, you will survive.

Rates are slightly lower than last month (low 6% range for a 30 year refi no point loan for excellent credit). Market rates for the 10 year T-Bill which determine mortgage interest rates, have dropped significantly. Mortgage rates have not dropped as much as would be expected. That may change given the significant drop in the price of crude oil and the likelihood of continued economic contraction caused by the financial and real estate sectors. With continued weakness expected for the US economy, mortgage rates should drop a bit going forward.

With the elderly population growing by leaps and bounds, families are struggling with long term care costs and worrying about Social Security. So what are the presidential candidates’ plans to address these issues? Below is a summary of the main party candidates’ positions on some of the issues that affect seniors and their families.

Sen. Barack Obama:

Sen. Obama has a section on his Web site devoted to seniors and Social Security. With regard to long term care, Sen. Obama’s Web site states that he “will work to give seniors choices about their care, consistent with their needs, and not biased towards institutional care. He will work to reform the financing of long term care to protect seniors and families. He will work to improve the quality of elder care, including training more nurses and health care workers.” His Web site also states that he will expand eligibility for Medicaid and ensure it continues to serve its critical safety net function.

In addition, Sen. Obama told the AARP he plans to propose tax code changes that would benefit family caregivers who often “are making substantial contributions without a lot of help.” He has also announced that he will eliminate all income taxes on seniors making less than $50,000 per year.

Other proposals include allowing the federal government to negotiate for lower drug prices for the Medicare program, just as it does to lower prices for veterans. Sen. Obama also supports allowing seniors to import safe prescription drugs from overseas and preventing pharmaceutical companies from blocking cheap and safe generic drugs from the market.

With regard to Social Security, Sen. Obama has called for a Social Security payroll tax on incomes above $250,000 a year to begin in 2019. Currently the tax is levied only on the first $102,000 of each worker’s income. He would not impose the tax on incomes between $102,000 and $250,000.

For more on Sen. Obama’s proposals for seniors, go to: www.barackobama.com/issues/socialsecurity/.

Sen. John McCain:

On Sen. McCain’s Web site, he states there is a need to develop a strategy for meeting growing long term care needs. His Web site mentions state based experiments such as Cash and Counseling or The Program of All Inclusive Care for the Elderly (PACE) that “are pioneering approaches for delivering care to people in a home setting.”

Sen. McCain’s Web site states that he wants to “reform the payment systems in Medicaid and Medicare to compensate providers for diagnosis, prevention and care coordination. Medicaid and Medicare should not pay for preventable medical errors or mismanagement.” To that end, Sen. McCain has proposed a major overhaul of Medicare’s payment system to pay health care providers by how successfully they treat their patients instead of by each individual service they perform. He has also suggested making wealthier Medicare beneficiaries pay more for their benefits. Specifically he has proposed higher Medicare Part D premiums for couples making more than $160,000 a year.

With regard to caregivers, Sen. McCain told the AARP that he believes that decisions about the care of older family members should remain within each family, and “any way we can help caregivers [offset costs through tax credits or other financial incentives] we should. But it needs to be part of an overall policy regarding health care.”

Sen. McCain states that he has said he would consider “almost anything” to help Social Security except higher payroll taxes. According to his Web site, Sen. McCain “supports supplementing the current Social Security system with personal accounts.”

A Pennsylvania appeals court rules that a durable power of attorney that allows the agent to “make gifts” does not accord the power to change retirement plan beneficiaries or to make large gifts of personal property absent specific authorization in the document. In Re: Slomski v. Thermoclad, et al (Pa. Super. Ct., Nos 1330WDA2007 & 1400WDA2007, July 29, 2008).

Ronald Slomski executed a power of attorney naming his mother, Rita Slomski, as attorney in fact. The document authorized the attorney in fact to “make gifts” but it did not contain further instructions regarding gifting powers. Shortly before Mr. Slomski died, his mother, acting under the power of attorney, changed the beneficiary designation on his retirement account from his step children to his siblings. She also used the document to distribute some $115,000 of Mr. Slomski’s assets to his siblings. Mrs. Slomski claimed that she was acting on her son’s instructions.

Mr. Slomski’s step daughters and his estate sued Mrs. Slomski, claiming that she lacked the proper authorization to make gifts. They argued that Pennsylvania law requires that a power of attorney specifically grant the authority to make unlimited gifts. Mrs. Slomski maintained that the statute grants an attorney in fact broad powers to manage bank accounts and retirement plans and that the change in beneficiaries should not count as a “gift.” The trial court ruled that Mrs. Slomski had the power to change the beneficiary designations but not to make the large distribution to the siblings. Both sides appealed.

The Superior Court of Pennsylvania finds that the power of attorney does not grant Mrs. Slomski the power to make unlimited gifts or to change the beneficiaries of the retirement plan. Citing the statute’s requirement that a power of attorney specifically authorize even limited gift making, the court says “if the phrase ‘to make gifts’ is insufficient to vest an agent with the authority to make limited gifts, it is clearly insufficient to vest an agent with the broader authority to make unlimited gifts.” The court also determines that “the legislature intended that any change in life insurance and retirement plan beneficiaries be treated as a ‘gift’ subject to [the statute].”

What this means is if you want your loved ones to have the maximum flexibility in making financial or medical decisions for you the power of attorney needs to be drafted broadly yet specify the authorities granted precisely.

New Law Makes Changes to Reverse Mortgages

In addition to addressing the current housing crisis, the Housing and Economic Recovery Act of 2008 makes changes to reverse mortgages, including higher borrowing limits and protections from aggressive marketing.

A reverse mortgage allows a homeowner who is at least 62 years old to use the equity in his or her home to obtain a loan that does not have to be repaid until the homeowner moves, sells, or dies. The new law, which goes into affect October 1, 2008, increases the borrowing level on reverse mortgages. The national limit on the amount a homeowner can borrow will be $417,000. The limit can be increased to $625,000 in areas with high housing costs. The amount a homeowner can actually borrow depends on the home’s value, location, interest rates, and the age of the borrower. Currently, the range in loan limits is between $200,160 and $362,790.

The new law also offers some protections for seniors. High fees and aggressive marketing have been cited as problems with reverse mortgages. Under the new law, fees will be capped at 2 percent of the first $200,000 borrowed and 1 percent on the balance, with a maximum of $6,000 in fees. In addition, the law prevents lenders from requiring borrowers to purchase insurance, annuities, or other products as a condition for getting a reverse mortgage. Lenders are also prohibited from working with other professionals who are trying to sell seniors financial products as part of the lending process.

The Pension Protection Act of 2006 enacted several provisions that affected Qualified Retirement Plans and also IRAs. Until that time, a beneficiary who was not the surviving spouse was not able to “rollover” retirement funds and had to pay taxes on these funds at their own income tax rate.

The new rule applies to distributions made on or after January 1, 2007 and now permits the beneficiary the ability to defer taxable distributions when received from a person who is deceased. They may have the funds rolled over to a Direct Rollover IRA and may allow the fund to grow while only taking out the annual required minimum distribution from this particular IRA. This has also been frequently called the “Stretch IRA.”

In these situations, if the person does not need the money, they may allow the funds to accumulate tax deferred (not tax free) which will hopefully be a greater amount earned on a yearly basis than the minimum distribution. In any event, the full amount of the principal of the IRA as of the date of death will not have to be withdrawn.

However, there are several specific requirements that must be met in order to obtain tax free rollover status:

• The 20% withholding requirement will not be required.

• The required minimum distribution is not eligible for rollover, but the current year distribution must be taken by the beneficiary prior to the qualified plan being transferred.

• The IRA Rollover account may be established for the benefit of the individual. If there is more than one specific beneficiary named, then the oldest Trust beneficiary must utilize their age for determination of the minimum distributions.

• The funds must be transferred directly from the prior IRA or account to the new one. The beneficiary may not request the funds himself/herself, receive them and deposit them with the new IRA custodian as they could do with their own IRA account.

Please note that this account should not be commingled with any other IRA funds, since a person’s own funds will not have to meet the minimum distribution requirements until at least age 70 ½. This allows the beneficiary another option as opposed to taking the funds in a lump sum and paying taxes or taking the funds out over a five year period. IRS Publications 575 and 590 are quite helpful in explaining the new requirements and options available under the Pension Protection Act.

In addition to Elder Law, our firm practices real estate law and originates mortgages. Please call us at (610) 940-0650 with any questions or for rate quotes.

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Robert Slutsky, Esq. has been practicing Elder Law for 15 years. He helps families in Montgomery, Delaware, Philadelphia, Chester and Bucks Counties. Mr. Slutsky has represented local Area Agencies on Aging, long term care facilities and was a member and officer on the CAPS Board of Directors for over 10 years. Home visits are available. You may reach him at (610) 940-0650, robslutsky@comcast.net or the website at www.slutskyelderlaw.com.

DISCLAIMER: The content of this Newsletter is for general information only. It is not intended to be legal, tax, financial, medical or other advice. The reader should obtain legal, tax, medical or other advice from a competent professional to address his or her specific needs. We do not endorse any particular service provider. If a service provider is mentioned in an article it is simply because we may have come across them in our travels and cannot speak to their quality of service or integrity.