Too Much Moral Hazard…

Much of the financial mess we’re experiencing has been attributed to financial derivatives (like credit default swaps), or as Warren Buffet describes them – financial weapons of mass destruction.

But why are derivatives such a problem? Is it that they’re opaque and hard to value? Is it that they’re kept “off-the-books”? Is it that they’re a vehicle  for speculation? Well, maybe… But I think the bigger problem is that they led to moral hazard in the financial industry.

What is moral hazard? Moral hazard is essentially the premise that:

“An individual or institution insulated from risk may behave differently from the way it would if it were fully exposed to the risk.”

Would you buy the same expensive car if you didn’t have insurance? Would you speed if you knew there was a cop on every corner? Would you steal a million dollars if you knew the worst that would happen would be a week in jail? Balancing risk and reward plays a big part in our decision making process.

Why were all those banks giving away subprime mortgages to unqualified borrowers? Because they could… Derivatives can be used as a form of insurance. The banks got to reap all the rewards and the record profits coming from issuing those mortgages, and got to delegate all the risk to someone else through the use of credit default swaps. With such a system in place, it’s no wonder they indulged…

Now that the worst case scenario has come to pass, are all these institutions going to suffer the consequences? No, because they’re “too big to fail”. The government is taking billions of bad decisions off their hands – reinforcing moral hazard even further.

What’s the solution to this mess? Both U.S. presidential candidates are talking about more government regulation. But does that really stop moral hazard? Probably not… Bureaucracy and regulation don’t get rid of moral hazard – only full exposure to risk does.

Would the upper management of these financial institutions have been so reckless if they were personally responsible and accountable for the outcomes? No way. All the CEOs got paid their millions regardless of whether they drove their companies into the ground or not. What was their incentive to limit risk?

Why did our grandparents pay off their houses as quickly as possible, and save every penny they could? The prospect of literally being out on the streets with absolutely nothing was a scary proposition.

These days, we have unemployment benefits, homeless shelters, bankruptcy protection, and insurance on just about everything, leading to moral hazard that’s rampant not just in our financial industry, but throughout our society in general. I’m not suggesting we necessarily get rid of these things, but we need to understand the costs.

If we want to avoid future financial calamities, we need to take a hard look at the type of behavior we’re encouraging. Free markets can lead to a positive, self-reinforcing cycle, but only when there is full exposure to risk.

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

What’s The "True" Cost Of The $700B Bailout?

The dollar figures being tossed around with all of these financial “rescue packages” are staggering. A few dozen billion here, and few hundred billion there. Where is all this money coming from, and what are the costs of spending all this money?

Context

So far, the U.S. government has pledged to spend over $1.8 trillion to help stabilize the current financial crisis. That’s a BIG number. How big? $1.8 trillion is equal to:

• 75% of total 2007 U.S. government revenue
• 13% of total 2007 U.S. GDP
• $8,400 per U.S. worker

They’re going to spend the equivalent of 65% of the total cost to run the whole U.S. government for year, military and all, to bail out all these bone-headed financial institutions! Ouch…

And we likely haven’t seen the last of the bailouts yet either. None of the $1.8 trillion pledged so far helps the millions of homeowners who are facing foreclosure. Expect a trillion dollar homeowner bailout plan in the new year…

Currency

So where does all this money come from? Money doesn’t grow on trees, right? As I’ve been explaining to my son, money comes from helicopters…

One of the things that the U.S. government has been doing throughout this crisis is printing money. But printing money obviously has to come at a cost. In this case, the cost is devaluation of the currency; hence the declining U.S. dollar.

The effect is that each dollar becomes less valuable, and thus, each dollar has less purchasing power. So, even though U.S. wages have been basically flat this decade, they’re down significantly when compared to wages in other countries like Canada and members of the European Union because the currency has declined so much.

This is one of the reasons the cost of natural resources has appeared to have jumped significantly this decade. The cost of raw materials is increasing, but because oil and gold and other resources are measured in U.S. dollars, the price jump has been more significant. The result is inflation because everything appears to cost more to make, but in reality it’s as much about the fact that your money is worth less.

If printing money was the solution to financial problems, Zimbabwe would be the model financial system.

Debt

The other way the U.S. government can get money is by issuing bonds, but the government has to pay interest on these bonds every year until they’re repaid. The interest on current debt was about $239B in 2007, which is about 10% of government revenue, or $1,000 per U.S. worker per year, every year!

Issuing debt is essentially taxing your children. Not only do they have to pay the debt back, but they have to pay interest in the meantime. It’s essentially like everyone leaving $50,000 in debt to their children when they die rather than an inheritance.

I think Eric Sprott summed things up nicely when he said:

“Central banks cannot create wealth. Nor can they avoid losses. They can only convert one financial problem into another.”

Some are suggesting that these bailouts will be profitable for the government in the not-too-distant future. I’m not sure I believe it. I’d be surprised if the government got back more than a small fraction of this money.

In the end, I think we’ve been over-consuming with borrowed money for too long. At some point, we’re going to have to pay down our collective debts. That time appears to be now…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

The Crash of 2008 – Can I Open My Eyes Yet?!

Well, we officially have a stock market crash on our hands now… In the past two weeks, the wheels have finally come off, and there’s a definite sense of panic in the air. The first 20% drop in the market took one year, the next 20% took 2 weeks!

So what caused this sudden drop? The markets were falling at a nice gentle pace until recently…

Big Picture

The first thing to realize is that there are lots of interconnected, but not fully interdependent, parts to this puzzle – some of which I talked about in detail a couple of weeks ago.

The first shoe to drop was housing prices, which peaked in 2005 and have been falling ever since as they return to “normal”. Falling housing prices led to problems in the sub-prime mortgage market.  This, in turn, led to problems at the many financial institutions that were over-exposed to this “toxic paper”.

Problems and failures in some financial institutions caused them all to stop lending to each other, and to other companies, and to start hoarding their cash in order to increase their chances of survival – hence the credit crisis.

In order for our economy to function efficiently, companies need access to credit on a regular basis to function. But since their access to credit has dried up, the economy is being disrupted, which is causing it to slow down. Even the State of California is having problems accessing credit to meet payroll.

Falling house prices and rising interest rates have also taken a big toll on the economy because a big chunk of the economic growth since 2002 has been due directly to the housing sector and the wealth generated from increasing home equity.

The Crash

But back to the stock market. None of these problems explain the huge drop in the last two weeks because we’ve known about all these problems for a while. The economy hasn’t suddenly gotten significantly worse in the last two weeks, so what changed? What caused the great stock market crash of October 2008?

Well, the first big down day was September 29th, the day the U.S. House of Representatives attempted, and failed, to pass the $700B bailout package. Since that day, the markets have basically gone straight down. But, the same basic bailout package was passed later that week (with an extra $100B in pork). Why didn’t the selling stop? Because the failure of the bailout wasn’t the cause (or the solution!). It was aimed at the credit markets, not the stock market. But its failure triggered an unexpected chain reaction:

1) The bailout package was hyped up to be the “solution to all our ills” – which it was never intended to be. But in trying to get the bailout passed, people were predicting all sorts catastrophic problems if it didn’t get passed. This significantly raised the level of fear because such desperate action would only be required if we were in a truly desperate situation, right? Then, of course, the bailout didn’t get passed, and it added even more uncertainty to the markets.

2) September 29th was the second last day of the quarter, and many hedge funds need to honor redemption requests quarterly. I suspect there were many big hedge funds predicting a big rally when the bailout passed.  A rally would have given them a chance to sell and raise cash for all the redemption requests they’d received over the summer. But instead of a rally, the initial bailout proposal got rejected and the hedge funds (and many others) got worried and sold causing the Dow to record that famous 777 point drop.

3) This scared many average investors, who started pulling money out of mutual funds at record levels. Mutual funds don’t have the luxury of waiting for the end of the quarter like hedge funds; they need to fulfill redemptions within a couple of days. Since credit markets are frozen, mutual funds can’t borrow cash to tide them over, so they had to sell positions. This pushed the markets even lower.

4) As the markets continued to plunge, the hedge funds got margin calls.  This required them to sell even more positions, and the vicious cycle continued.

All of this forced selling drives the prices down very quickly because there are few buyers willing to be brave and try to catch the falling knife (or more accurately the falling piano!).

It’s ironic that a $700B bailout package that was supposed to help solve our financial problems may have triggered a $3 trillion+ crash in the stock market…

What’s Next?

It can’t go on much longer, can it!? The answer is: maybe…

The markets are now dropping on momentum alone, and all traditional ways to value stocks have gone out the window. But the longer this crash goes on, the bigger the bounce will be when we hit bottom.  This is because there are a huge number of people shorting the market that will have to cover their positions, causing a “short-squeeze”.

This is what, I think, we saw happening on Friday afternoon. After the markets were down 10% early, they rallied back. I don’t think this was buyers finding value.  Rather, I think it was mainly shorts getting nervous and not wanting to hold their positions over the weekend, especially with the G-7 conference going on.

But I suspect sometime soon (update: looks like today), we’ll get a break from the selling and a small rally as the shorts cover their positions. One sign the bottom may be near is that around midday Friday my boss said: “F***! I think I’m going to jump out a window! I’m down another 10% today!”  I’ve also seen some of the experts advising people to start covering their shorts.

But, this doesn’t mean the worst is over – the economy is still in big trouble. Some people are saying stocks are looking very cheap based on next year’s earning projections, but I think those projections are now based on an overly optimistic view of the next year’s economy.

During the tech bubble, it took 2 years for the markets to hit bottom – we’re only a year into this market decline. Some believe this crisis is much bigger than the tech bubble, which means it could take much longer than 2 years to work through all the problems…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]

When Will The Stock Market Carnage End?

The stock markets have suffered some “historic” drops this past week. For example, the Dow Jones Industrial Average was down 777 points last Monday after the $700 billion federal bailout plan failed to pass in the U.S. House of Representatives. Then last Thursday, when the same plan with a few minor tweaks got passed by the House and the Senate, the Dow dropped another 350 points. And to top it all off, at one point today the Dow was down another 800 points. The news seems to be all doom and gloom. When will the bleeding end?!

[And just in case you missed it, last week I talked about how we got into this mess in the first place.]

Putting Things In Context

The first thing to realize is, while 777 may have been the biggest one-day drop on the Dow ever, at 7% it’s not even close to the biggest relative one-day drop ever. That distinction goes to Black Monday in October 1987 when the Dow dropped 22.6% in one day! There have been 16 other times in the last hundred years when the Dow has had bigger drops than last week, which is an average of one every seven years. So was Monday’s drop gut-wrenching? Yes. Was it historic? No…

A number of comparisons have also been made to the Great Depression. While this may be the biggest crisis in the U.S. financial sector since the Great Depression (it could be, I don’t know, I’m not qualified to say), we’ve still got a long way to go before things get as bad the Great Depression:

	2007 – 2008	1929 – 1933
Drop in Dow Jones Industrial Average index	30%	90%
Unemployment	6%	23%

What’s Next?

So when will the decline end? The truthful answer is: I don’t know, and neither does anybody else. Not Ben Bernanke, not Henry Paulson, not Jim Cramer, not Warren Buffett, not anyone. One of the big myths of the investment world is that the experts can predict the future much better than everyone else. The reality is they can’t, especially in the short-term. They’re simply making wild-ass guesses just like the rest of us.

Take analysts ratings for example. Of the 17 analysts that covered Washington Mutual at the beginning of July, there was only one sell recommendation. The share price had dropped from $35 in January 2008 to $5 by summer, but it was still a “hold”. Hmm… Even at the beginning of September, only two of 14 analysts recommended selling. By the end of the month, Washington Mutual was bankrupt and their shares were worthless. Oops…

What about some of the big money players? Foreign sovereign wealth funds have been investing tens of billions into U.S. financial companies over the past year. Many of those investments are worth nothing today. The others are worth half of what they were when they bought. Hmm…

If you look at the news, some experts say the bottom is near, others say that this is only the appetizer. Jim Cramer likes to remind us that he called, within a couple days, the top of the tech bubble. What he doesn’t mention are the hundreds of other predictions he made that didn’t come true – selective memory wins again. Everyone’s right some of the time, just like a stopped clock is right twice a day. But guessing right is not the same thing as being right.

What Should I Not Do?

The average investor often makes terrible decisions because they’re making decisions based on emotion rather than based on some well thought out strategy. One thing I have learned about investing is that making decisions based on emotion is usually the opposite of the right thing to do. It seems like the times I feel most euphoric and invincible turn out to be the best times to sell, and the times I feel like giving up and selling everything turn out to be the best times to buy.

And research bears this out too. The average investor tends to significantly under-perform the experts because they’re chasing the hot sector or the hot mutual fund. They sell at the bottom and they buy at the top. In the end, they only earn a fraction of the returns of the indexes and most mutual funds.

So given that the news is so bad, we must be near a bottom, right? Maybe… Many of the investment newsletters are thinking the same thing. But this could be the smart money getting in at the bottom, or this could mean people are still too complacent…

What Should I Do?

The first thing you need to do is have a plan for your portfolio. And by the way, buy & hold is not a plan (at least not a very good one). Over the long-term buy & pray will do OK, but the markets can be flat for a decade or more. For example, if you bought and held the Dow, you’re down 10% this decade so far…

Over time, some investments will naturally do better than others. You need to prune the dead wood and let your best investments ride. Your investment plan should not only dictate what to buy, and when to buy it, but more importantly when to sell. For example, will you sell if your investments drop 10%? What about 25%? What about 75%? Knowing under what conditions you’re going to sell, before you buy, allows you to avoid the emotional traps of trying to figure it out during a crisis. This is the biggest difference between amateurs and professionals (the good ones anyway) – they manage (not micro-manage) their investments and they have contingency plans. So if your financial advisor only provides buy advice, but not sell advice, you probably need a new financial advisor…

The second thing you need is diversification. If all your investments rise and fall together, you’re not diversified. The point of diversification is to even out portfolio performance, and to avoid one catastrophe from doing serious damage to your portfolio. Even in markets such as these, there are some investments that are doing OK. You don’t want to put all your eggs in one basket, like many Enron employees who lost their jobs and all their retirement savings because they had everything invested in one place.

The third thing you need to know is: dividends are your friend. In the late 1990s people forgot about dividends because everyone was focused on growth companies. But over the last 100 years, dividends have accounted for 40% of stock market returns. Dividends allow you to get paid while you’re waiting for the markets to rebound.

The last thing you need to know is during turbulent times, you need to hedge your investments. There are several ways to do this, but the easiest way is through Exchange Traded Funds (ETFs). Many ETFs allow you to profit when the market goes down because they’re shorting the market. Some ETFs are inversely correlated 1:1 to the market, some 2:1. So, for example, if you had 10 – 20% of your portfolio invested in these bear-market ETFs, you’d have a cushion against any further big falls in the market.

So do I follow my own advice? Apparently not as well as I should have. I was busy plugging holes in my investment plan this weekend, hence the reason this post is a day later than normal. But it’s never too late to create (or fix) your plan. Burying your head in the sand (not opening your investment statements) isn’t going solve anything…

[Content © 2008 SorryToConfuseYou.com, All Rights Reserved.]