Tuesday, 23 February 2010

Investments and morality

The concept of moral spine, when taking investment decisions, usually neglected, is strongly emphasised in principles of Islamic banking. It seems it is one of sparse significant examples when ethics affects financial system on a level of banks, brokerage firms and other entities that are involved in large-scale banking operations. Their codes of practices forbid earning (excessive) interest, investments in shares of companies whose core business is deemed to be unethical, or trading in derivatives which are said not to be a real money. As you drill down in the superficial description from wikipedia, you will see the system is full of loopholes that enable to get round the rules.

And in our non-Islamic world, are there any rules? I worked out a short (and subjective) list of investments I would refrain from. I wouldn’t list there derivatives as Muslims do. Those financial instruments have been conjured up for three purposes: to hedge risks, take risks and speculate. As long as you don’t beg anyone for help because you have lost your capital this investment is ethical, but if try to socialise the losses or shift the costs of your flawed decision to someone else, who is not guilty, you are a typical product of modern “distorted capitalism”, “remnant of what used to be capitalism”, or whatever we have witnessed during the last financial crisis is. This stance can be described shortly: as long as your business goes well you tell the state and regulators to mind their own business, when your house of cards collapses, you seek their protection. A fine example of hypocrisy…

The first type of what I find unethical is not even an investment, because what I disapprove of is a pure speculation on real estate. If you buy a house or a flat to live in it, everything is alright, even if its price soars. If you buy a flat to pass it on to your child who is now in a nursery school, you do not do anything wrong, even if you will be subletting it for twenty years. But if you buy it only to sell it in a few years and take profits, I denounce your investment. By taking such a decision you contribute to rising real estate prices and make flats less affordable for other people, who will become slaves of mortgages for next thirty years. Dwelling is after all one of basis needs of a human being. Speculation deprives many individuals of their chance to have their own one.

Your own flat or house is your biggest financial asset, so it is an investment, but I wonder what would happen if mortgage became almost totally unavailable. How much would flats in Warsaw cost? The scenario doesn’t bring a picture in bright colours – flats would be bought be rich people who would let and the rest would have no choice but to rent it, rents would go up then. Not a good future prospect anyway.

The second type is a pure investment, unfortunately very common and used as a benchmark of risk-free rate of return. The government bonds. You keep your money in a bank, bank pays you interest from what it has earned from other clients – customers whose folly made them take out consumer loans or enterprises which had taken out loans to develop their businesses and have a higher rate of return than interest paid on the credit. This system of brokerage works well, mostly as the bank is the institution which takes a risk. Meanwhile you pay taxes and your neighbour buys government bonds. Interest he earns is financed from taxes you pay on what you earn as a worker as well as from your capital gains tax.

If you want to invest your money, do it on the market, let it work for a private business, don’t sponge on fellow taxpayers. State is not a saving bank, it’s role is to maintain law and order, provide public goods, depending on you economic views its role should be limited to minimum or cover a spectre of spheres like education, health care, social security. But it should not be a participant of financial markets. Another story is that it also should not spend more that it can afford to and consequently issue bonds. But as a balanced budget idea enthusiast I can talk my head off and I bet the day I die some of my neighbours will have their money invested in gilts. Damn it!

If I have touched upon taxation, I cannot leave out the new popular method of tax avoidance – antybelki – bank deposit which are constructed in a way that you don’t have to pay capital gains tax – either it is an insurance policy or the interest is paid daily and if it doesn’t exceed 2.50 PLN, calculated tax is rounded down to 0 PLN. It is absolutely legal, but if moral? You will save some money, but state budget will lose its revenue. Who will lose? A monster called “State” who lives in a cave and gobbles poor taxpayers? No, your neighbours will lose, your friends will lose, your family will lose, you will lose and the next generations will lose. They will have to pay higher taxes, because current lower revenues means higher budget deficit in the future. I realise the workings of Polish state are far cry from perfect, costs of maintaining bureaucratic apparatus are tremendous, but many public goods are finance from public purse, if you want to consume them, you shouldn’t evade paying taxes. (though the rational decision is not to pay taxes, because you’ll get them anyway).

My apologies to my readers. In the second year of blogging posting frequency will not be as high it used to be. But I pledge to try to focus on quality and publish at least two concise posts each week. I’m simply more busy this term and have less time for writing (what doesn’t mean less time for musing about politics, economy and society).


Island1 said...

Hang on, I'm not on board with the disapproval of property speculation. Particularly the phrase "other people, who will become slaves of mortgages for next thirty years." Most individuals who invest in property with a view to improving it and selling it for a profit in the short term are also operating on mortgages. It's a, potentially, shrewd way of using one's personal wealth. I've never understood the idea that a mortgage is a kind of slavery. It's not, it's a highly convenient way of paying your accommodation costs. Instead of paying rent for your whole life you make an agreement with a bank that amounts to promising to pay your rent for the next 30 years. Sounds like a good deal to me.

How else do you propose that people are housed, build your own, on free land?

Michael Dembinski said...

Beat me to it, Jamie!

The difference between slaves of mortgages for 30 years and people who rent is that the 'slaves' end up with a heap of capital, while the tenants have just pissed away a significant proportion of all the money they ever earned.

Where I do agree with you Bartek is the effect that second homes have on local communities. Take picturesque North Wales, which I know very well. Wealthy holidaymakers from Manchester and Liverpool fall in love with the place, and seeing the attractive property prices, buy a second home for holidays and eventual retirement. The result is villages where half the houses stand empty for most of the year, and the local young people have been priced out of the local property market. Now that is wrong.

student SGH said...

Guys, thanks for challenging me, do it more often. And sorry for the belated response, yesterday I got home late and I think I wasn't capable of expressing my thoughts in English.

Jamie, you are asking why slaves of mortgages? Whatever happens, you have to make monthly repayments, a bank is not interested whether you have some troubles or not, it asks you for a next installment. I worked in a debt collection department and I know how badly some people struggled after they had got into financial troubles, not necessarily because they had lost their jobs, but because of illnesses and accidents. Can you tell me why none of my colleagues from the department would take out a mortgage? They were scrimping and saving and pickling in small flats before they bought a better one for cash. Any guesses why?

And another aspect. As I have heard it "on a grapevine", big companies often encourage their employees to spend more money and run up debts, because they know an indebted employee is an obedient employee. Someone who has financial commitments is more afraid of being sacked so they will execute all orders, including unethical ones. I heard it in the context of business ethics, the method they use are the same as secret services used in communist countries - "we know you're in a certain situation, if you don't collaborate with us, you'll regret". I don't imply it's a norm, but sometimes it happens.

Most individuals who invest in property with a view to improving it and selling it for a profit in the short term are also operating on mortgages. Jamie, if somebody buys a property, then revamps it to sell it later, they raise the intrinsic value of it, so they are fully entitled to take profit. Yes, they take mortgages and it's fully justified. They use leverage to increase their return on equity. The whole economic point of going into debts is that the rate of return on your investment is higher than interest you have to pay on your debt.

You are both right that a joined ownership (bank is a co-owner of your property until you pay it off) is a much better way than sinking money in renting. Moreover, taking out a mortgage is justified when the rise in property prices is higher than yields on your savings.

Any other proposals? In my books people should generally support the next generations. Unthinkable is for me when young people whine in a newspaper that they credit application was rebuffed because they didn't even have 10,000 PLN for a down payment. My colleagues from the bank say if someone cannot put aside any one is not credible for a bank because how they will be able to repay it (the error in the reasoning is that they won't have to pay for a rented flat what will generate a cash surplus and they will have to pay unless they want to face a foreclosure).

Back to the thread of parents. From the moment a child is born it is enough to pay 100 PLN into a saving account every month. Given the the compound interest works on our favour and the annual REAL interest rate is 1,2% per year (0,1% per month), after 25 years, when your child becomes self-supporting, it will get 100*[(1+0,001)^300-1]/0,001 = 34,965.65 PLN in today's money! If you pay in 200 PLN, the capital will total to almost 70,000 PLN. Nice sum for the beginning of adult life. Parents can also save more for their children by changing cars once in 10 or 15 years instead of once in 3 or 5 years and buy a compact car instead of SUV.

student SGH said...

The capitalism in the Western Europe was built on accumulation. Fortunes were made on saving, not running up debts. In the same time Poland's income was consumed. Now we are lagging behind the West.

What we would need is a shift from financing our own future into financing a future of the next generation.

Yes Michael, after the finally pay off their mortgage they have a heap of capital. The only question is how much they had paid for it (adjusting to the changing value of money in time).

If those are second homes for real living it's just a half of the misery. In Spanish property bubbles some of the owners have never seen their flats. They were bought just with a view to sell it later at a higher price. Now many of those speculators are at a loss when the property bubble burst and they are left with unrealisable big asset, but serves them right, folly is sooner or later punished ;)

Michael, a report for you. Still flats in Poland are too expensive, I think they should drop by 20% to be reasonable. In Berlin, one can buy a 60 m2, 3-room flat in panel building block for 40,000 Euro = 160,000 PLN. Find a flat in Warsaw for 160,000 PLN, even 10m2 smaller, in poor location and dilapidated and I'll be leaning over backwards to get that mortgage to buy it...

Looking forward to your responses... Greetings...

student SGH said...

once again sorry, but an error has crept into my calculations. When working out the value of regular payments of 100 PLN per month I mixed real and nominal amounts. To get 34,965.65 you would have to pay inflation-adjusted amount of today's 100 PLN, so given that inflation will be positive less than 100 PLN and less every next month. Paying in as much as current value of today's 100 PLN would require higher payments but the final amount will be also higher.

Michael Dembinski said...

I worked in a debt collection department and I know how badly some people struggled after they had got into financial troubles, not necessarily because they had lost their jobs, but because of illnesses and accidents...

And the landlord's rent collection man is more lenient? The procedures for repossessing a house from a mortgage payer in default are complex (read article on foreclosure on Wikipedia).

Protection of tenants' rights vary from jurisdiction to jurisdiction, but at the end of the day, whether a mortgage-payer or a tenant, non-payment of mortgage or rent will result in you being thrown out onto the street.

But if you do pay (and the vast majority of us do, even in hard times), the home-owner does better in the long term.

Consider this: After working for 45 years, my father has a monthly pension of £743. After paying off the mortgage for my first house (in London) after just 15 years, I'm receiving monthly rental income from this property of £840.

And have been doing so for the past 12 years.

Michael Dembinski said...

Disparity of property prices between Warsaw and Berlin: Germans are a nation of renters not buyers. German property prices are too low, rather than Polish ones being too high.

The report in your link cites property price to earnings ratios for Poland and being between 5.9 and 7.3. This is indeed very high, even compared to over-priced England (4.3 times for UK, 6.5 times for London).

This might suggest that at some time in the future, Polish prices might soften.

But anyway, the tough answer is a) get a well-paid job, paying multiples over the average wage and b) get married to a girl with a well-paid job then c) find a property in an up-and-coming part of the city (Praga Pólnoc, Wola for example). And in the long term you'll do well enough to move into a big house on the leafy fringes of town when the sprogs come along!

student SGH said...

A bank is a better owner is can turn you out of a flat only if you default on your debt. And a mortgage payer should feel much more secure than someone who sink their money in renting. And law offers a better protection than in the case of landlord.

And when we speak about a mortgage usually even if a bank acutions off your property it will take only as much as you owe it. The rest will be handed to you (in a normal situation, not like it looked in the USA when bank didn't manage to recover the original amonut they had lent).

We should learn from others' mistakes. My parents sold their flat in Piaseczno for 170,000 PLN in 2005 to pay off the mortgage they had taken to buy and finish our terraced house in NI. They did because they wanted to pay off their mortgage. Had we known the flat prices would almost double within two years we'd have waited and sold it in 2007 to a fool who'd pay over the odds. Until today I feel those 170,000 PLN was a fair price which reflected intrinsic value of the flat. We could have had more, but a better deal was buying a house which is now worth around 50 per cent more than what was invested in it.

And rents in turn are exorbitant in Germany. My friend pays 350 Euro for a room in a Wohngemeinschaft in a mid-sized town in former GDR. Can you imagine paying a rent of 1,400 PLN for a room in Olsztyn and havin the pleasure to put up with flatmates and sharing kitchen and bathroom with them?

My scenario for Poland is that in the next decade prices in the big cities will be declining by three to five per cent a year. This will boost our purchasing power.

Have you read the comment under the report? Look at what people think - they reiterate it - "flats are too expensive". The more sound buyers we will have, the more likely it is that the prices will drift onto normal levels.

And in reply to your tough answer:

a) times when university graduates would get much over the avarage as they were starting off their careers are gone. For those multiples you have to wait for a few years. Until it happens, your creditworthiness is lower. Back in 2008 bank were reluctant to grant loans to yuppies who earned 15,000 PLN (net) and didn't have any savings. Their spending habits (they could pay for a rented flat and cover costs of living in Warsaw for 6,000 and save easily 100,000 in a year) made them incredible as borrowers or they got mortgages with higher margins.

b) For me, a better idea is to marry a clever girl, who will not throw our money around and with whom I'll stand a chance to grow rich. Potential, not current earnings is what matters. And of course toghther we'd sooner be able to afford to buy a flat that alone.

c) Indeed in some parts of the city flats might be undervalued. But I'd consider a different strategy. Have some cash and look out for bargains. Sometimes someone want to sell a slick flat very quickly becasue they are in urgent need of cash. If I don't have to apply for a mortgage and I buy the flat right away (after checking if there's no catch).

Suburbs. I may come back to suburbs when commuting will not be a nightmare like it is now. No matter what you use - train, bus or car. I'm impatiently waiting for the spring. I'll finally take my bike and I'll be riding to Metro Ursynów P&R, there I'll leave it and take the Metro to school. It will be teh fastest way to get to school. Ul. Puławska is unbearably clogged.

PS. News from the junction next to metro track. Land east of Puławska has been cleared. When the works start there and the road is narrowed to two lanes it's going to be really harrowing