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.


TS said...

I've been reading Ben Stein's book on retirement and it's truly frightening. Not for me as for our country.

He said that as of 2000 the average 45-54 year old has saved $23,000 in 401k. Yikes. Stein says it appears likely baby boomers will experience poverty in their old age. Everyone knows Social Security will be greatly reduced and yet the national savings rate is near zero. Go figure.

Maybe you could help me out as to what Stein means by this comment (although I'm sure context would help):

"Consider the fact that if everyone were to save equally, then this would confer no net advantage on anyone. We'd all be pitted against one another to exchange the same quantity of stocks and bonds for the same goods and services from younger Generations X, Y, and Z."

If the natural rate of savings was 10% instead of 1-2%, wouldn't that solve the problem? Sure there would be no net advantage for individuals, but it would seem to be an advantage for everyone. The saver isn't hurt by his countryman saving is he? Sure it dampens the economy but if the natural savings rate was 10% the economy would adjust over time. (Though I recall Japan had a tremendously high savings rate and for years their economy was in poor shape.)

Paul said...


Without the context, answering your question is a little tough, but Stein's comment does raise an interesting point.

I've been saying for years that the boom in the stock market was caused primarily by two things: a) the rapid increase of private money that had to be invested due to the creation of IRAs and 401(k) plans; and, b) the capacity of the equity market to create things to sell - namely new stocks created via IPOs.

All the .com IPOs came to be because really shrewd people figured out that if you could conjure up a little 'internet' company and tell a good story, you could sell boatloads of stock to the mutual funds trying to find a place to put all their new IRA/401 money.

Stocks rose so rapidly that it seemed like anyone could make money. In fact, the risk analysis came to be that cash, CDs and T-bills were the risky investments, because if you didn't have your money in the stock market you were being left behind.

In a very real way, stocks became viewed as a riskless instrument for storing wealth, akin to currency.

But supply/demand always eventually wins out. Stock prices went up as long as people were competing to buy shares (high demand, low supply).

Same thing happened with real estate by the way.

Forgetting whatever has been going on in the stock market lately, I think Stein was talking about the flip side of the IRA/401(k) story. If all of us boomers have been busily converting cash into stocks while we are working (which again, is what I believe is the primary cause of the price growth in the stock market), then eventually the day will come when all of us are doing the opposite - selling shares to raise cash to pay for our Geritol and Depends.

Who will be the buyers of all those shares? The reality is that it has to be our kids, who will be beginning to load up their own IRAs and 401(k)s. And they in turn have to hope their kids will buy their shares when their time comes to retire.

The trouble is that there isn't as many of them as there are us Boomers. Could be that we Boomers will end up on the street corners selling shares of Apple for a cup a coffee, like those guys who sold apples during the Depression.

I wonder how different things might have been had the rules for IRA/401(k) plans been that you could only buy T-Bills? Is such a plan that different than Social Security? I think so - the payout terms of Social Security can be changed much more easily than for a T-Bill.

By the way, we don't one share of stock. We've certainly owned stock over the years, and generally made some decent money at it. But starting about 1999, we converted everything to real estate, CDs and bonds. There is some risk in the real estate (and higher return so far), but the CDs are guaranteed by the FDIC and the Bonds by municipal taxing authorities.

By the way, a key problem with the school funding dilemma in Ohio is that with the diminishing industrial base and the aging of the population, the fraction of the budget that has to allocated to Medicaid and other social programs is increasing and taking money away from other - also important - funding needs like schools.

The proposed amendment is just the attempt of the teachers' unions to reserve some of the state money for themselves - no matter what.

TS said...

Yeah, much of investing seems an elaborate ponzi scheme. Good if you get in early (and then out), not so good if you get in late.

(Btw, Ben Stein makes a similar point as you with respect to dollar-cost averaging stock - what good is it if you're also dollar-cost averaging OUT of the stock when you retire? Then you get the reverse of the benefit of buying more stock when stocks are down.)

What I don't like about cash and cash equivalents like CDs is that there is nothing backing them. Gold seems so arbitrary to me, but at least the gold standard would theoretically offer restraint as far as the government just printing more money, as will be a tremendous temptation as we go forward into the future with so few workers-per-retiree.

Paul said...

Interesting viewpoint about currency and CDs. I guess I'm satisfied that they're backed by the government of the United States. That's sufficient for me, although I am beginning to investigate buying CDs issued by foreign banks in their currency - in particular the Euro. Not so much because I think the US government is going to fall, but because it's a way to hedge against inflation.

I've never really understood the gold standard. Once you accept that gold is a commodity like anything else, and its price goes up and down in response to supply and demand, then it's no better a way to store wealth than anything else. It certainly is not helpful to lock the value of your currency to gold when it has varying value on the world market, and that value is not necessarily a good representation of the state of our economy.

Ever see a Twilight Zone where these two guys steal a bunch of gold bars then lock themselves in a secret chamber and take a pill that makes them sleep for 50 years?
When they wake up, the site of their secret chamber is now in the center of a desert. They load up their bars, a couple of canteens of water, their guns and head off down the road to the horizon. Before long one guy, who has been guzzling water, runs out and asks the other guy for some. The other guy says sure, but it will cost you a gold bar. The first guys complains but eventually pays up. When the guzzler later wants more water, the other guy says it will now cost five bars. So the guzzler shoots him, takes all the water and all the gold bars.

He guzzles all the remaining water, and starts throwing away bars to lessen his load. Eventually he keels over. A couple in a futuristic car eventually pulls up, and finds the guy near death. He says he will give them all his gold for a drink of water. They give him the water, but he dies anyway. They drive away confused why the guy thought gold was worth anything since it was easily synthesized by the ton.

TS said...

Haven't seen that episode, but I've never understood the idea of the gold standard either since the supply fluctuates and it's not something you HAVE to have.

Seems like you'd want to fix your currency to something with a more stable supply, or at least something intrinsically valuable, like beachfront property. *grin* But the psychology of it is that gold goes up during times of inflation and uncertainty and we're sure seeing it lately.

I still think investors should be able to use psychology to their advantage, i.e. buy when everyone is irrationally averse to something. Like land/housing now.

Paul said...


I got to meet John Galbraith once, and he seemed like a good guy. Granted that you don't get to where he was in the commercial real estate business without being tough as nails.

I said that to a friend - that Galbreath seemed tough but decent - and my friend replied back that Galbraith was an asshole. Seems that during the Depression years when their family farm in Galloway went into foreclosure, Galbraith bought it. In fact he bought a lot of land in the area on the cheap, ultimately building the 3,000 plus acre Darby Dan Farms. He had cash when people were land rich and needed cash.

The folks who offered and underwrote the big IPOs of the last 10 years did the same kind of thing - figure out that people were cash rich (in their IRA/401(k)s) and in need of investments. The suckers were lining up at their doors.

The basis for wealth building has always been, and always will be: Buy low, sell high.

Unfortunately, many people get it backwards.