Archive for September, 2007
The 2001 rate cuts caused the bubble that is now a crisis. Here we go again
The right decisions are usually the hardest ones: they often require enduring short-term pain for the long-term gain. We learn this as parents early into the job.
The Federal Reserve under Mr. Greenspan’s leadership faced a tough decision in 2001. The post dot.com bubble had burst, the terrorist attacks followed and the economy was slipping into a recession. Instead of letting nature (i.e. market forces) take its course, Avuncular Al chose an easier, less painful (at least the short-run) road - he lowered interest rates at levels we have not seen in decades and kept them there for a long time.
Mr. Greenspan retired and wrote a book blaming the bubble on “global forces”, but “global forces” is probably his alter-ego as short-term interest rates followed the Fed Funds Rate every step of the way.
The Fed torch is now in Mr. Bernanke’s hands, he faces a new but old dilemma: to provide a temporary “fix” to the economy that is suffering a severe hangover from being overdosed by low interest rates set by his predecessor. This will guarantee a need for future “fixes” and eventually will lead to a larger crisis down the road. Or he can do nothing, let market forces work things out and let the economy go through a painful but needed withdrawal. In this article I wrote for Business Week I am arguing for doing the latter.
September 21st, 2007
Don’t compound them with bailout for mortgage ‘victims’
By Vitaliy Katsenelson
The housing bubble that was fueled by multidecade low interest rates priced many people out of their dream homes. But instead of settling for less or renting, people went after their American dream with a vengeance - taking out adjustable-rate, interest-only or, even worse, negative-amortization loans. Good things end, and great things end with a big bang; the burst of the nationwide housing bubble has left many with shattered homeownership dreams and financial despair.
And now the blame game starts. It must be the builder who charged too much for the house, or the “blood-sucking” mortgage broker who facilitated a loan, or the bank for extending credit we should never have had. Now, there’s a new extreme - the investors who purchased our mortgage with thousands of others from financial institutions.
The blame falls on us and none of the above. Though we want to blame the financial institutions for coming up with these products, as long as loan terms were fully disclosed, it is our responsibility to make the right financial decisions, not theirs. Any product can be dangerous if not used responsibly. Even a hair dryer, if used while taking a shower, could lead to untimely death. The financial products (i.e. mortgages, home-equity loans, credit cards) are electrified by compounding, and if not used appropriately, could lead to financial distress.
Though some would like to - and many will - pleading ignorance is disingenuous. With the exception of outright fraud, buyers knew they were biting off more than they could chew. They knew interest rates would reset and mortgage payments could increase, or at least it was their job to find out before they committed to the biggest purchase of their life. But that was in the future, and they lived in the now. The future is today, and there is a price to pay. We need to stop blaming everybody but ourselves and own up to our mistakes.
We hear sad, heartbreaking stories of eviction, broken families and pecuniary anguish resulting from people losing their homes all over the country. Of course, we want to help these folks in trouble. Our first instinct is to look at our almighty government for help. Though government sounds like an ambiguous third party, it is not - it is you and me. Should you and I carry the burden of those who made irresponsible or simply bad decisions? Money is a finite commodity, thus for the government to bail out the victims of this housing debacle, it either will have to raise taxes, cut spending or both. Yes, you and I will be paying higher taxes and/or money will be diverted from cancer research or other social programs because your neighbor elected to live in a larger house, better neighborhood or to have a greener lawn.
But that is just the beginning. The largest cost of a government bailout is the one that is not apparent at first - the moral hazard. In a free economy, incentives are set up in a way so that decisions made in our best interest also benefit society,or the system as a whole. Introduce moral hazard into the equation and individual decisions can benefit participants but hurt the system. The unintended consequence of a government bailout could be catastrophic.
The politician will tell you that only victims will be assisted. They’ll make sure not to call it a bailout. It is close to impossible to identify who the true victims are. Were they the ones with bad credit who took out subprime or Alt-A loans? Or the ones who are facing ARM resets? Maybe the ones whose house value declined because their neighbor foreclosed on his?
Politicians will come up with creative definitions of victim, but the result will be the same - the number of people who fall under the victim umbrella will mushroom exponentially, far exceeding original expectations - the unintended consequences. Homeowners who had all intentions of paying on their mortgages will ask for the government’s (now available) assistance. The ones who could not afford their house in the first place will get a couple years of free rent out of the system, ultimately defaulting on their mortgage a couple of years down the road.
In addition, the bailout will introduce an asymmetric payoff for current and future homeowners: Owning a house will become a risk-free endeavor. If your house price goes up, great. If it goes down, you claim to be a victim and society compensates you for the risk you’ve taken. A risk-free, utopian paradise, isn’t it? This will set the stage for an even greater next housing crisis.
The next couple of years will uncover more fraud committed by some unscrupulous mortgage brokers and banks. Some small elements of fraud are uncovered at the end of each boom: the junk bond boom of the late 1980s, S&L crisis of the early 1990s, the Internet bubble of the late ’90s, and it will happen again. Our economic and legal systems are equipped to deal with these people - they’ll go to prison. And politicians, like vultures, will feed on our misplaced anger. Like superheroes, they stand up to protect the little people (us) against the evil empire by creating “housing reforms.” But you cannot legislate common sense. With freedom comes responsibility. Do we really want to give up freedom and have government bureaucrats decide who should or should not get a loan? Instead, lawmakers should focus on making the lending process simpler and more transparent, where the terms of the loan are clearly spelled out on one page.
Doing nothing is the hardest thing to do when you see people in distress. We are a compassionate people, and we want to help. But there are times when we have to restrain ourselves and do as little as possible because by helping some you’ll hurt many others. This is one of those times. The current crisis will pass, as have many before. Let’s not escalate the magnitude of the next one by irresponsible actions.
Vitaliy Katsenelson, CFA, is a portfolio manager at Investment Management Associates in Denver. His book ,Active Value Investing: Making Money in Range-Bound Market, will be published by John Wiley & Sons at the end of September.
This article originally was published in the Rocky Mountain News
September 15th, 2007
I just came from a week-long trip in London. I got to tell you, London (and probably all Europe) is tremendously expensive. The numbers on price tags look very familiar: Starbucks (SBUX) Chai Tea Soy (okay, I do like those things) is 3.80, a breakfast (two eggs, a toast and a coffee) in your typical diner around the corner is 7.00… these prices sound okay if they were quoted in dollars. The only problem is that they were in British pounds.
At the end I basically convinced myself that prices were not quoted in pounds but in dollars. This way when I paid $7.60 ( 3.80 pounds x 2) for Chai Tea Soy or $14 for breakfast it did not drive me crazy. Of course, I’ll get my credit card bill in the mail in a couple of weeks and my little deception will come to the surface. Oh, well. On the other side of the coin, the US is 50% off for the Europeans.
I’ve been a believer in long-term dollar decline (and positioned portfolio accordingly), but I do ask myself - what will the dollar decline against? I don’t know the answer.
Scandinavian countries? Japan? The unintended consequence of the weak dollar – we travel less outside of the US and export more (since our goods are cheaper). The only problem is that we have a trade deficit, so we buy more than we sell – this where a weak dollar hurts us the most. But the weak dollar should work to lower the US’ trade deficit.
September 8th, 2007
I’ve been a big fan of First Marblehead’s (FMD) stock for couple months now, and it looks like an incredible value today, trading somewhere around 7-8 times earnings. Though I have to mention this stock is not for the light hearted, as it has a lot of myths surround it.
Tom Brown, who I am very proud to have as my book endorser, wrote a harsh but wonderful piece today dispelling a lot of myths surrounding FMD. In addition, the company has no debt, 15% of its market cap is in cash and it has been growing earnings 30-50% a year. Its margins will likely compress going forward, thus its growth may decline from its past levels, but it should be in double digits.
Oh, did I mention FMD just raised its dividend to 3% yield?
September 7th, 2007
By Vitaliy Katsenelson
We live in the society where, to our detriment, being politically correct is often more important than being correct. So I am going to come out and make a politically incorrect statement - social investing is an oxymoron.
There is nothing social about investing. Investing is not about making popular, socially approved choices. It is about allocating capital from a less efficient use to more efficient use. Touchy-feely types of choices make us feel good about ourselves… well, until we have to retire and have to start paying for things.
It is hard enough finding good investments, and adding more very subjective criteria to the mix only makes it more difficult. In fact, if you scrutinize any company long enough it won’t pass the “social” test.
- Political donations: A company is giving money to the wrong (another very subjective criteria, unless it is something black-and-white like Al Qaeda) cause or party.
- Treatment of employees (very subjective): Does Wal-Mart (WMT) treat its employees fairly? Do you start looking at employee compensation of every company you invest in? One should only care about how well a company pays its people if it impacts company’s fundamentals.
- Labor practices (for example, use of child labor): Do you avoid companies that use parts made in China or manufactured in China? If you did this in your personal life, you’d be walking around naked as textile manufacturing for the most part has migrated to China and other low wage countries where labor practices may not meet your standards.
- Charge too much – this is a big category, ranging from pharmaceutical companies (companies that save millions of lives a year) to payday loan companies, college loan providers and so on.
- Environmental citizenship – Do you avoid oil companies and refineries? What about auto companies who make gas-guzzling SUVs?
Some companies are trying to capitalize on the social investing idea to make you feel good about their “socially conscious” businesses. British Petroleum changed its name to BP (BP) and advertises on CNBC with a slogan “BP – Beyond Petroleum”.
So you don’t have any illusions about BP, it is only 4% beyond the petroleum. 96% of its sales come from petroleum products. If BP focused instead on running its business, its stock would perform a lot better than “petroleum-behind” Exxon Mobil (XOM).
I probably missed a dozen categories, but you get the idea. When social investing is taken to the extreme it turns into a very taxing exercise and substantially limits the ‘investable’ universe.
Avoiding sin – socially irresponsible - stocks (i.e. defense, tobacco, gambling and alcohol) doesn’t severely limit an investor’s stock universe and is not very taxing on time and effort, as sin stocks are easily identifiable. However, this may prevent you from following attractive opportunities.
In fact, I’d argue that this is the time to own these anti-social sin stocks as demand for their products is not closely tied to economic prosperity (they have a cycle of their own) and they’ll be a place to hide if the economy takes a turn for the worse.
Neither my company nor I own many anti-social stocks. I wish we owned more. We own Diageo (DEO) – the largest spirits maker in the world, that owns brands from Johnnie Walker to Bailey’s. As baby boomers age, they switch to higher grade liquors – higher margins for Diageo.
Also, liquor has got to be one of the most exportable goods after bubble gum. As the developing world develops – yes, you guessed it right - it’ll speak Johnnie Walker’s language. Also, as we get older we tend to drink more hard liquor and less beer – this is main reason why I own Diageo instead of Budweiser (BUD), not because drinking hard liquor is more socially responsible than drinking beer.
Adam Smith’s invisible hand did not wear a social glove and for a good reason: social criterions only add inefficiency to the system of capitalism.
I’d like to conclude by quoting Larry the Liquidator, a character from my favorite movie, “Other People’s Money”:
“Take the money. Invest it somewhere else. Maybe, maybe you’ll get lucky and it’ll be used productively. And if it is, you’ll create new jobs and provide a service for the economy and, God forbid, even make a few bucks for yourselves…”
September 7th, 2007
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