Wednesday, October 8, 2008

Depression 2.0

It's almost inevitable at this point.

We've been out of the stock market since 2000, when we sold our last shares of Worldcom – just before the tech bubble burst. Our retirement nest egg has been invested in tax-free municipal bonds, bank certificates of deposit, Treasury Inflation Protected Securities (TIPS), and the occasional Collateralized Mortgage Obligation. Between investments, we held our funds in standard-issue money market funds. In the past few years, we've gotten involved in some real estate syndication deals with a fraction of our portfolio. 

Some have run their course and generated excellent returns. The rest are in various stages of development, and we'll see how they turn out. But we made those investments understanding the risk, and took care to diversify. Still, it's looking a little shaky right now. If we lost it all, it would hurt, but not be the end of us.

We invested this way because I've been convinced since the mid-1990s that stock prices had lost any relationship to economic reality. As I wrote in January of this year, as well as back in 2005, my belief is that stock prices were being run up because of all the money pouring into 401(k) plans looking for an investment to buy. While few 401(k) account holders were buying individual stocks directly, they were in aggregate turning over billions of dollars each year to mutual funds, who were in turn investing in the stock market.

I take a very conservative view of stock pricing, not that different than Warren Buffet, or his mentor, Ben Graham. You look at the actual company, how they're performing, what kind of plans they have for the future – and all that to figure out whether the company stands a chance to generate profits going forward.

Then you look at the price of the stock, and the dividends they pay. And you compare the dividend-vs-stock-price (dividend yield) to what we consider our most risk-free investment – US Treasury securities. 

And finally, you consider buying the stock only if the dividend yield is more than the interest rate you get on the Treasury security. In fact, you want the dividend yield to be a lot more than the Treasury yield, because the stock dividend isn't a sure thing – it's more risky.

That extra bit of yield you want on the stock dividend is called the risk premium. Each of us can decide how big that premium needs to be. For me, it's always been about double. In other words, if I can get 5% interest on a T-Bill, I won't be interested in purchasing a stock unless the dividend yield is 10%.

For years my friends, and even my stockbroker, have said I'm nuts – that I'm missing one of the best bull markets in history. The only thing I knew was it was bubble, and no one knew how big it would get before it burst. In fact, no one knew for sure what would cause it to burst.

Turns out it was the insanity of the consumer credit market.

Twenty or so years ago, you couldn't get a credit card unless you could convince a bank that you had the means to repay it. One reason is that usury laws prevented banks from charging interest rates above around 18%. That's a boatload, but remember that the interest you pay on a credit card is income to a bank. So a bank makes the same kind of risk-reward calculation that is discussed above, and will make loans only if they are convinced that the interest (revenue) they will actually collect on one product (e.g. credit cards) is better than an alternative product (e.g. car loans). They do that by adjusting the qualifications one must have to get credit vs the interest rate. So if federal or state usury laws require them to keep interest rates low, they can extend credit to only the most credit-worthy people, who will almost all repay the credit card balance.

Then gradually the absolute free-market types convinced lawmakers (via generous campaign contributions) to abolish usury laws. The banks had come up with a new scheme that they wanted to spring on the public: If they could make $x by offering credit at 18% to low-risk people, they should be able to make $x and more by offering credit to everyone at 36%. At 36%, twice as many people could default on their credit card debt as they were seeing at 18%, and they would still make the same amount of money.

But even bad credit card debt has value. Companies sprang up to be in the business of buying bad credit card accounts from banks at deep discounts, and then trying to collect. Let's say Chase Bank has $10 million borrowed on its credit cards that isn't being paid back. Along comes someone who pays Chase $5 million for that debt. Chase ends up with $5 million they didn't have, plus they keep all their other credit card accounts which are actually paying 36% - more than enough to offset the write-off of the $5 million.

The collection company puts their army of phone collectors to work, and over the period of the next year, manages to collect $6 million of the $10 million of debt they have purchased for $ million. That's a 20% return on investment. Even if they never collect the last $4 million, they've made good money.

This is one cylinder of the engine that has been pumping our economy over the last couple of decades. 

People were spending way over their head.

But it felt okay because their home values seemed to be going up. Little did they understand that it was another price bubble, just like the stock market.

What benefit is there in having your home value go up if you wanted to stay there? Besides, if you sold your home, you were just going to have to buy another one at a high price.

The way you enjoy your rising home value is to take out a home equity loan – borrowing against that artificially inflated home value. The appraised value of your home was an opinion (you never really know what it's worth until you sell it), but the loan you took out was very real. In the beginning, the banks took a low risk approach here as well. They made home equity loans only on good properties owned by people with good income streams and a reasonable debt load.

But there were sharks in these waters too. Unscrupulous appraisers and mortgage brokers got in cahoots, valuing properties way above reasonable values, then selling mortgages that the homeowners could barely pay. I said 'selling mortgages' because the brokers weren't actually loaning the money, they were getting it from plain old banks who were in turn gathering up bundles of mortgages and selling them as 'Collateralized Mortgage Obligations' – in essence shares in a pool of mortgages.

The trouble is that these CMOs weren't just being bought by individual investors like me, they were also being purchased by other banks and insurance companies looking to get in on the action.

As always happens, the greed got out of hand. Credit had been extended to folks who had no business getting it, and they started defaulting on both their credit card and mortgage obligations. Banks who needed the interest income from those credit card and mortgage accounts in order to pay their interest obligations to holders of savings accounts and CDs had to start borrowing money from each other to make those payments. Then the stronger banks started worrying that the weaker banks couldn't make their payments on this short-term (often days) interbank credit, and the stronger banks started shutting that off. That's when we started to see the first banks fail a couple of weeks ago.

The Federal Reserve stepped in and became the lender-of-last-resort, helping those weak banks stay afloat. However, that's not a long term solution, and what we have seen in the last couple of weeks is the Fed arranging marriages between weak and strong banks.
The bailout plan proposed by Treasury Secretary Paulson was designed to buy up that bad mortgage debt, and get these banks out of trouble. He and Fed Chairman Bernanke knew that it was much cheaper to keep these banks afloat that it would be for the bubble to burst, because the downward spiral begins when everyday consumers close up their purses and begin to hunker down for a tough time. Companies sell less of their product, and lay off workers as a consequence. Consumer spending goes down some more because there are fewer people working.

When the stock market crashed in 1929, a very very small fraction of Americans owned stock. Today, nearly everyone does through their 401(k) plans. When the market takes a big hit, it changes millions of lives. Folks who wanted to retire, or send their kids to college, can no longer do that.

I did something last week that I never thought would happen: we pulled all of our nest egg out of money market accounts and moved those funds into FDIC-insured accounts in several banks. The interest rates we're getting on those CDs is small, but at least the money is as safe as we can make it. We too are hunkering down. It might not help the economy, but we've got to protect ourselves. I know without question that this kind of thinking is the final nail that drives us into an economic depression. But I see where this is going, and I have to protect my family. Folks who have not seen this coming are completely unprepared, and are headed for a lot of trouble.

It really is all about confidence, and our national leadership screwed it up again. This isn't a Democrat vs Republican thing – it's been going on for decades across many administrations and many changes of control in Congress. The common factor was short-term greed. They unwound all the hard-learned lessons of the Great Depression and have brought us back to exactly the same place. And in the end, they took too long to act, and still couldn't resist putting insane pork-barrel spending into the bill designed to save confidence. All they did was give me confidence that they behave on a level of selfishness that I consider to be treason.

Our country might still be screwed up had World War II not happened. Why? Because of two things: a) we built up our industrial capacity to a scale never before seen in the world; and, b) we bombed the rest of the world's industrial capacity into smoking craters. Our economic dominance of the post WWII era wasn't because we were better or smart. It was because we won the war with our homeland unscathed (unlike the British and French). Ironically, Germany and Japan emerged as strong nations after the war because we helped them rebuild their factories, as our allies in the new Cold War against the Soviets.

So how do we get out of this one?

I think it's the same old way. We need the Federal Government to put people to work in a big way. It doesn't all have to be on national defense, although that's a good place to start. The infrastructure of our country, built mostly during the post WWII period, is crumbing and needs a major overhaul. And we need a significant amount of new energy sources.

So let's fix the roads and bridges. And let's build scores of nuclear power plants and hundreds of wind farms for electricity. Let's get the auto industry retooled to produce plug in electric vehicles by the millions, simultaneously eliminating our dependence on foreign oil and putting the foreign auto industry back on its heels.

The key is rebuilding the American middle class, and that means construction and manufacturing jobs that pay a decent wage, not more Wal*Mart and McDonald's associates.

And we need to keep the crooks out of the rebuilding effort. Profiteering should be a treasonous offense, punished by stoning in the town square.

I'm not kidding.