Thursday, January 17, 2008

Greed Gets Us Every Time

The following is part of a dialog I've been having with a young friend who, like many people in our country, have come to realize that they must become increasingly savvy about investing if they want to have a retirement nest egg when they get old. There is no standing on the sideline and letting one's employer or the government take care of you in old age - you must invest and do so prudently.

The "Graham" I mention is Ben Graham, a legendary investor and mentor of none other than Warren Buffett. Graham wrote "The Intelligent Investor," which should be required reading for anyone thinking of buying stocks or mutual funds. "Schiller" is Robert Shiller, the Yale economics professor who coined the term "Irrational Exuberance" and has written a book by the same title.

You have learned well young Skywalker...

However, Graham was thinking about individuals when he observed that most people in the stock market are amateurs. In the case of the big financial houses, nearly all are MBAs and many have prestigious Ivy League degrees. The problem isn't education - it's just plain old greed. If anything, the folks in the financial industry are lemmings - once one of them starts running in some particular direction with a little success, the rest follow along, right over the cliff.

Reminds of the stories of the gold rush. The first guys to strike gold did okay, and some made spectacular fortunes (e.g. the father of William Randolph Hearst). Then came the 49ers en masse. The early ones who hit and got out did okay, but the early ones who just got a little taste of success and stayed for the long haul ended up spending their earnings on exorbitantly priced supplies just to stay alive.

The guys who came last never had a chance. In the end, the folks who did the best were the merchants who sold the livestock and supplies to the idiots.

The business of a bank is nothing more than buying and selling money. They buy money by soliciting deposits, and their cost is the interest rate they need to pay to attract deposits. They sell money by making loans, and their income is the interest they collect. A wise banker would try to match up the interest rate and term of their deposits to the interest rate and term of loans. In other words, if you want to be able to sell 3 year 8% car loans, you want to offer 3 Year Certificates of Deposit at say 5%. If there are no takers, you might have to go to 6%, but you'll push up you auto loan rate to 9%. A century ago, that's all there was to banking.

It gets trickier when you start talking about 30 year mortgages. It's pretty hard to find investors willing to lock up money for 30 years, so the bankers have to make some risk decisions. When a home buyer takes out a mortgage, the bank must immediately come up with enough cash to pay the home seller. That cash will come from their pool of deposits, some of which are savings deposits due on demand, some is from the stream of cash coming back as other loans are being paid off, and some is in long-term deposits like CDs. Managing the mix of this pool takes sophisticated financial skills, and a successful bank has to be pretty good at it.

Then along came the notion of Collateralized Mortgage Obligations (CMO). In the spirit of matching up the timing and magnitude of inflows and outflows, a bank can take a big bundle of its mortgages, and sell off ownership shares to investors. For example, a bank can take $10 million dollars worth of mortgages (ie the sum of their loan principles) and sell it off as 10,000 CMO certificates each with a face value of $1,000. When you buy one of these certificates, you receive each month a payment that represents 1/10,000th of the principle and interest paid by the mortgage holders the previous month. In 30 years, you would receive back your whole $1,000 plus interest. A CMO certificate can be bought and sold any time during its life, with its market price being a function of the interest rates being paid on the underlying mortgage vs the current interest rate on long term debt (be happy to explain how bonds are priced, and why bond prices go up when interest rates go down, and visa versa).

We've purchased a number of CMOs in the past decade. They have some interesting characteristics. The first being is that if you buy one when mortgage interest rates are high, they look very attractive - usually paying well above CD rates. But when mortgage interest rates go down, as they have, the people who hold 'your' mortgages pay them off and take out new mortgages.

I bought these CMOs thinking they were a long-term, premium interest rate investment. Instead, I got all my money back in a year or two - admittedly at a premium interest rate, but now I had to find another investment for that money, and with interest rates down generally, it ended up being a not so shiny investment after all.

And when mortgage interest rates go up, the mortgage holders are happy to pay out at a low rate and you end up getting stuck with an investment that takes years to pay out at a below-market rate. I have a couple of these now with only pennies/share of value, but I still get a tiny principle+interest check every month. It's not worth selling them because the transaction fee is more than they're worth.

The big money maker for banks for decades has been credit cards. When I was kid, it was relatively tough to get a credit card, but the interest rates charged were somewhat reasonable. For example, you build a $10,000,000 credit card portfolio of blue chip customers by charging 10%. You couldn't charge more because customer with good credit can find money for less than 10% elsewhere.

Then some bright MBA said that you could potentially make a lot more money by extending another $10,000,000 in credit at 20% APY to higher risk customers who you previously would not have considered giving a credit card at all. The math works out something like this:
  1. $10 million loaned out at 10% and completely paid off. At the end of the year, you have your $10 million back plus $1,000,000 in profit, or $11 million.
  2. $10 million loaned out at 20%, but 5% of the borrowers default. You get back $9.5 million of your money and $1.9 million in profit. That's $11.4 million so far. Then you sell the $500,000 in bad accounts to a collection outfit for $250,000. In total you get $11.65 million.

Then the other banks see what you're doing, and jump on board. The next thing you know everyone's mailbox is filling up with credit card offers at crazy high interest rates.

And then the mortgage bankers figure out that there's a game like this for them too. By extending mortgages to a higher volume of higher risk customers, they can crank up profits spectacularly. A few try, and everyone follows. But some interesting things happen...

One thing is that a lot of these high risk folks refinance their homes during the real estate boom and end up taking out a chunk of cash in the transaction. Their $100,000 house with a $75,000 mortgage gets reappraised for $200,000, so they take out a $150,000 mortgage, use $75,000 to pay off the old mortgage and walk away with $75,000 in cash. The lender feels secure because they have a $200,000 house for collateral. The homeowner feels rich with the $75,000 in hand (although he'll soon start making payments on it). Maybe he pays off the credit card debt, and uses the rest to buy a needed car and take a nice cruise vacation.

Then he runs up the credit card debt again, spends the cash from the refinancing, and hits the wall - too much debt and not enough income. The only way to raise cash is to sell the house. Except lots of people are in that boat and house prices start to decline. Eventually the price of the home falls below the mortgage value and the homeowner walks away and lets the bank foreclose.

Now the bank understands that high risk credit card debt is not the same thing as high risk mortgage debt. Credit card debt is very liquid, and can be sold quickly at a discount to someone willing to work hard to collect the money. Selling a foreclosed house in a weak real estate market is something else. Even at deep discounts, there aren't that many folks buying homes right now - not even speculators.

If all things that go up must come down, then I believe the slope of the line on the downside is at least double that of the upside. Maybe it's 10x. In other words, if it took us 10 years to build up to this crazy level of risk in the consumer credit market, that risk will be shaken out (by rapidly falling prices and foreclosures) in one year.

It is just one more brand of speculation disguised as investment, like the 49ers, or last decade's .com investor, or all those other boom/bust cycles Graham and Shiller talk about. And I think it's a mistake for the government to bail those folks out. We need to do a radical risk-ectomy in our economy and give folks a stern lesson about risk and reward. Seems like we have to do this about once every generation. Recessions and depressions happen when spending gets way out ahead of income, and when people fail to recognize risk because of the seduction of greed. The longer it goes and the more out of balance it becomes, the longer it takes to recover. It's going to be bad enough anyway.

Let's not make it worse with a government bailout.

Tuesday, January 1, 2008

Reading List


This may qualify as the most boring blog post ever. But I was thinking that it would be good to have an inventory of our books, and thought I might well put that list on the blog for safekeeping. So here goes (nothing implied in the order other than the arrangement on our bookshelves):

Books in our Library That I Have Read % = Kindle
Ambrose: Undaunted Courage
Sullivan: The Arts of China
Giannetti: Understanding Movies
Munsterberg: The Art of Japan
Rice: Islamic Art
Craven: Indian Art
Oster: The Mexicans
Rivera: Family Installments
Pettigrew: Prejudice
Morrison: Sula
Goodbird: Goodbird
Wideman: Sent for you Yesterday
Sandoz: These Were the Souix
Shenkman: Legends, Lies & Cherished Myths of American History
Bobrick: Wide as the Waters
Hawkins: A Brief History of Time
Burke: Connections
Clarke: Report on Planet Three
Gleick: Chaos
Barry: Practical Logic
Gould: Eight Little Piggies
Paterniti: Driving Mr. Albert
Gould: Questioning the Millennium
Sagan: The Dragons of Eden
Trotter: Coal, Class & Color
Dickens: A Tale of Two Cities
Poe: The Short Stories
Verne: Twenty Thousand Leagues Under the Sea
McCartney: Sold Out
Charpentier: How to Read the Bible
The Holy Bible
Borden: Hit the Bullseye
Fox: On Becoming a Musical Mystical Bear
Buechner: Telling the Truth
Thayer: Management of the Hanford Engineer Works in WWII
Sanger: Working on the Bomb
Nicklaus: My Story
Yeager: Yeager
McCain: Faith of My Fathers
Bamford: The Puzzle Palace
Cronkite: A Reporter's Life
Fuller: We Almost Lost Detroit
Cherniack: The Hawk's Nest Incident
Michener: The Source
Woodward: The Bretheren
Clarke: 2010
Crichton: Timeline
Grimwood: Replay
Asimov: The Martian Way
Vonnegut: Timequake
Asimov: Robot Visions
Heinlein: The Past Through Tomorrow
Heinlein: Stranger in a Strange Land
Hebert: Dune
Heller: Catch-22
Magriel: Backgammon
Lavigne: Hell's Angels – Into the Abyss
Pirsig: Zen and the Art of Motorcycle Maintenance
Thwait: Afloat on the Ohio
La Plante: Hog Fever
Miller: The Biker Code
La Plante: Detours
Fulton: One Man Caravan
Rogers : Investment Biker
The Boy Scout Handbook
McWhorter: The Power of Babel
Zumwalt: My Father, My Son
Keegan: The Price of Admiralty
Woodward: The Commanders
Ford: The Button
Clancy: Every Man a Tiger
Kernan: Crossing the Line
Rockwell: The Rickover Effect
Tyler: Running Critical
Waller: Big Red
White: They Were Expendable
Cosby: Time Flies
Fulgrum: Uh-Oh
Fulgrum: It Was on Fire When I Lay Down on It
Adams: Dirk Gently's Holistic Detective Agency
Adams: So Long and Thanks for All the Fish
Keillor: Lake Wobegon
Barry: Cyberspace
Luciano: The Umpire Strikes Back
Murphy: Golf in the Kingdom
Feinstein: A Good Walk Spoiled
Feinstein: A Season on the Brink
Warren: A Purpose Driven Church
Rogers: The IBM Way
Lansing: Endurance
Brehm: That Others May Live
Adams: Mostly Harmless
Adams: The Hitchhiker's Guide 'Trilogy'
Clancy: The Sum of All Fears
Clancy: Without Remorse
Clancy: The Hunt for Red October
Clancy: Red Storm Rising
Clancy: Patriot Games
Clancy: Clear and Present Danger
Coonts: Flight of the Intruder
Clancy: The Cardinal of the Kremlin
Gouillart: Transforming the Organization
Martin: The Digital Estate
Adams: Dogbert's Top Secret Management Handbook
Klass: UFOs Identified
Christensen: The Innovator's Dilemma
Doody: Reinventing the Wheel
Iacocca: Iacocca
Iacocca: Talking Straight
Collins: Good to Great
Shiller: Irrational Exuberance
Clarke: Profiles of the Future
Barker: Paradigms
Ambrose: Nothing in the World Like It
Sobel: Longitude
Friedman: Free to Choose
Marx: The Communist Manifesto
Wright: On a Clear Day You Can See General Motors
Clancy: Teeth of the Tiger
Bethany: The Smartest Guys in the Room
Kelly: Out of Control
Diamond: Guns, Germs and Steel
Grizzard: When My Love Returns from the Ladies Room…
Orr: Set up Running
Unwin: The Probability of God
Graham: The Intelligent Investor
Asimov: Foundation
Asimov: Foundation's Edge
Crichton: Airframe
Crichton: Sphere
Sagan: Contact
Orwell: 1984
Tammet: Born on a Blue Day
Rainer/Geiger: Simple Church
Shorto: Island at the Center of the World
Chaisson: Epic of Evolution
Wells: War of the Worlds
Wells: The Time Machine
George: Authentic Leadership %
Clancy/Franks: Into the Storm %
Miller: Blue Like Jazz
Jacobs: Getting Around Brown
Solis/Breakenridge: Putting the Public Back in Public Relations
Levinson: The Box

Books In Our Library That I Plan To Read (* = or need to finish; # = reading now; % Kindle)
Gottman: The Seven Principles for Making Marriage Work
Eggerichs: Love & Respect
Warren: Better Together
Kasich: Courage is Contagious
Ambrose: The Victors
Brokaw: The Greatest Generation
Keneally: Schindler's List
Davis: To Appomattox
Warren: A Purpose Driven Life
Nixon: Beyond Peace
McCullough: Truman
Auletta: The Highwaymen
McManus: An Unstoppable Force
Friedman: The World is Flat
Marx: Das Kapital*
Winik: April 1865
Goodwin: Team of Rivals
Alcorn: The Treasure Principle
Schroeder: The Science of God
Welch: Winning
Dreyfus: On The Internet
Bryson: The Life and Times of the Thunderbolt Kid
Singer: Writings on an Ethical Life
Alcorn: Heaven
Hemphill: Empowering Kingdom Growth
Eldridge: Wild of Heart
Lewis: Out of the Silent Planet
Lowenstein: Origins of the Crash
Mahar: Bull
Godin: Tribes
Bourdain: Kitchen Confidential %
Machiavelli: The Prince %
Tressel: The Winners Manual %
Doggett: You Never Give Me Your Money %
Riley: Ship's Doctor % *

Books I Plan To Read But Don't Own
Kozol: The Shame of the Nation
Rubin: In an Uncertain World

Books in our Library That I Have Resisted Reading
Morgan: The Oxford History of England
Bronte: Wuthering Heights
Hugo: The Hunchback of Notre Dame
Kipling: The Light that Failed
Bronte: Jane Eyre
Butler: The Way of All Flesh
Redfield: The Celestine Prophesy
Mitchell: Gone with the Wind
Doyle: Hound of the Baskervilles
Barnes: Brief Gaudy Hour
Phillips: How to Deal with Annoying People

Books I've Read But Are Not in Our Library (anymore)
Card: Ender's Game (Catherine nailed this one)
Ryan: The Adolescence of P-1
Clancy: Rainbow Six
Clancy: Into the Storm
Clancy: Submarine
Coonts: The Cannibal Queen
Naisbitt: Megatrends
Toffler: Future Shock
Blanchard: The One Minute Manager
Roberts: Leadership Secrets of Atilla the Hun
Asimov: I Robot
Clarke: Rama
Clarke: Rendezvous with Rama
King: The Tommyknockers
King: The Green Mile
King: Needful Things
Koontz: Demon Seed
Jones: Colossus
Jones: The Fall of Colossus
Huxley: Brave New World
Harris: I'm Okay, You're Okay
Covey: The Seven Habits of Highly Effective People
Kidder: The Soul of a New Machine



In the end, this list doesn't look very long. I know there are many other books I've read in paperback and have pitched in some sorting out of junk in our basement. And who knows how many I've checked out of a public library, read and returned without remembering them. But the truth is that I don't read as much now as I used to. Maybe it's because I have to wear reading glasses these days, or maybe that the reading lamp on our headboard has gone kaput and I haven't fixed or replaced it. Regardless, I've decided that Tuesdays are reading days, and will strive to work through the growing pile of books on the 'yet to be read' list.

Perhaps now is time for one of those hypotheticals: If for whatever reason, I had to live with only ten of these books to read over and over for the rest of my life, what would they be:

1. The Holy Bible
2. Adams: The Hitchhiker's Trilogy
3. Cosby: Time Flies
4. Asimov: The Martian Way
5. Wells: War of the Worlds
6. Clancy: Red Storm Rising
7. Fulton: One Man Caravan
8. Clancy: Hunt for Red October
9. Asimov: I Robot
10. Clarke: Rendezvous with Rama

I guess the thinking is that if the situation is that I can only have ten books, they had be ones that could serve to remove me mentally from whatever situation would bring about such a restriction. I suspect the list will change over time.