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January 31, 2010

Regulating Banks

This is one of those things like executive compensation where the folks in Washington hit the target but miss the mark.

What got us in the problem we are in is not the banks, but the products they offer.  It is not that banks are large, or that they trade for their own accounts, but that they create dangerous products that are completely untested prior to releasing them on the general public.

Credit default swaps may be 'out', but there are new derivatives, equally as dangerous, that are 'in'.  Average Joes now have access to leveraged ETFs and commodity funds that even the Big Boys don't really understand.  SKF, for example, is a 2X ultra short ETF that doubles down on the proposition that the banking industry is in trouble.  Trading at a 52 week low of $20 and a 52 week high of $375, it is a gambler's wet dream.  But I have to wonder how many Average Joes, who really can't afford the losses, have lost a pile "investing" in this ETF.  (The other thing that is scary about these ETFs is that they don't always function the way logic would dictate they should function and even experienced traders have been burned.)

We have the FDA, which regulates the drugs that pharmaceutical companies want to sell to the public to make sure they are fit for human consumption and not just snake oil.  And this is exactly the kind of regulation we need on financial products.  Every new financial product should be tested and retested before being disseminated to the masses.  


P.S. On February 12, 2010, Proshares began offering 3X leveraged ETFs.  With the ability to also leverage outside the fund by buying on margin, this means the potential for 6X the gains and also 6X the losses.  One of the leading causes of the Great Depression was the ability to borrow $9 for every $1 invested.  These new ETFs allow for the ability to borrow $3 for every $1 invested.  This is not a good trend in the markets. 




January 29, 2010

Political Finger Pointing

Ok.  So I listened to the State of the Union last night.  And I heard the President's frustration with the partisanship that is tearing our nation apart.  But what I would like to know is why we can't reorder our priorities to focus first on topics we can all get behind instead of stubbornly butting our heads together on the most polarizing issues out there.

Sure financial reform, health care, and climate issues are important.  But as important are the issues of joblessness and foreign-sourced energy.  

Last night Obama simply couldn't bring himself to say the words "natural gas".  Why?  Because T. Boone Pickens has been lobbying so aggressively for it?  Because Republicans want it?  Who cares? Natural gas is both plentiful and clean.  It is simply the quickest, cleanest way to reduce our dependency on foreign oil.  Isn't that what everyone wants?  EVERYONE?  And passing a very simple bill that encourages the utilization of liquified natural gas in government vehicles would not only keep our dollars at home but create a ton of jobs as well.  

Sometimes in order to get people to consider seeing things your way, you need to show them you are capable of seeing things their way first.  Depolarizing a relationship is as simple as finding an issue that the other side wants to talk about and then working together to succeed in finding a solution to that issue first.  Successful politics is not about grinding people into the dirt and forcing them to call "Uncle".  It's about being the bigger person.  It's about allowing a minority to feel they still have a voice.  Particularly when there are so many things this country needs to deal with that everyone can get behind.  Things like education (know how many of our children are stuck in portable buildings anyone?), and stimulating personal retirement savings (social security isn't enough!), and rebuilding our infrastructure (know how many dams in this country need repair?).  The list goes on and on. 

Seriously, it's time to stop pointing fingers and start earning America's respect.   Prove you can govern wisely, not just forcefully, and people will follow you anywhere.

Debt Lessons from the Big Boys

One of the things that troubles me greatly is the fact that neither Big Boys nor Average Joes are dealing proactively with the structure of their debt. 

This is most particularly troubling when it comes to mortgages.  Right now interest rates are as low as they will ever be, and yet people are not proactively doing what they need to do to take advantage of this opportunity to lock in low rates for a very long time.  Knowing the rate of interest you will ultimately pay on a debt is as important as knowing the total amount of the debt itself.

Average Joes with adjustable rate mortgages should be flocking to refinance their loans, even if they are currently underwater on the value of their homes.  Even people who are not out of a job or already in foreclosure should be proactively seeking a workout to create long term stability in their mortgage payments.  But when you talk to an Average Joe about converting his 3% ARM to a 4.5% 15 year fixed rate mortgage he balks at paying the couple hundred extra dollars a month that it would take to put him on the path to financial security (don't tell me there's not room in the budget...there is always room in the budget when you get your priorities straight).   

This is one of those teachable moments that executives everywhere should be pounding the table on within their companies.  Big Boys everywhere should be delving into their employees' mortgage status and helping their people understand the time bomb that is on the very near-term horizon when interest rates start heading upwards in 2011.

Most companies shudder at the thought of getting involved in the personal lives of their employees.  But this is a prime example of how what we do on a micro level seriously affects what will happen to all of us on a macro level.  Do we really want to see another default-driven recession?  Really? 

Why is it that Big Boys can see so clearly the corporate problem of borrowing at short-term rates to finance long term projects and yet they don't think it's their job to teach these same debt matching fundamentals to their employees?

The government is in the same boat as Average Joes, which is going to result in serious problems in another year or two.  We have borrowed trillions of dollars that we aren't going to be able to pay back any time soon, yet the average term of our loans is less than five years.  What happens when interest rates move upwards? A greater percentage of our revenue will go toward paying interest, that's what.  Politicians should be as concerned with the structure of our national debt as they are with adding to the deficit itself.  It is such a fixable problem, and yet we aren't even trying to fix it. 

The lesson here, whether you are the government, a Big Boy, or an Average Joe is that we must all learn how to borrow correctly.  We can't afford to just sit around waiting for another debt-driven crisis to hit and then say, "How in the world did this happen...again?"    



January 12, 2010

Our Rapidly Deteriorating Credit Quality

A couple of days ago I drove by the first house I ever owned.  Brand new in 1985, 25 years newer than the house I currently own, it is a wreck.  On and off the foreclosure rolls for several years now, the yard is overgrown, the roof is patched in places with black plastic, and the only reminder of what used to be the fence are the metal posts that dot the perimeter of the property.  The house that cost $95,000 in 1985 isn't worth $50,000 now.  Thanks to sub-prime lending, the entire neighborhood looks the same.

Because we fail to properly educate people on financial matters, first time homeowners mistakenly compare their prospective mortgage payment to their current rent and make a snap judgment about what kind of house they can afford.  With little to no money down, they have no skin in the game.  And so, when the realities of home ownership hit - "What????  I need a new roof? A new air conditioner? Carpet? Paint? Fence? Dishwasher? Plumbing?" - these folks are ill-equipped to handle it and usually don't.  (On average, a person must spend 2-3% of the value of their house on annual maintenance to keep it in good repair.)    

Homes that are not maintained fall into disrepair very quickly.  Banks that negotiate workouts with mortgage holders breathe a sigh of relief when a borrower makes a payment, not realizing that they are only delaying (and exacerbating) the day of reckoning.  Bankers don't hop in their cars and go around looking at the properties in their foreclosure pool to make sure their collateral isn't crumbling to pieces, and so they make the critical mistake of overestimating the quality of the credit on their balance sheets by overestimating the quality of the underlying assets.

Commercial property is the same, times thousands.  

Credit card debt quality is deteriorating so fast it makes my head spin.  With all the new fees and higher rates being rolled out as quickly as possible before the new regulations on consumer lending take effect, anyone who can pay off this kind of debt is doing so as quickly as possible.  And so, what looks like improving statistics on consumer credit is, in reality, simply the loss of the best borrowers and the collectible debts.

48 states out of 50 are insolvent and having to borrow to make ends meet.  And don't even get me started on the mounting national debt.

The stock market is pricing in a V-shaped recovery as if nothing else is remotely possible.  And in the meantime the quality of our debt (and the assets that secure it) just keeps getting worse and worse.   


P.S.  According to LPS Applied Analytics, for loans in forclosure, borrowers on average have not made any payments for 410 days but are still living in the houses in forclosure.  I would maintain that these squatters have been living in these houses a lot longer than that since, prior to forclosure, making a payment, any kind of payment, starts the clock ticking all over again.  




January 09, 2010

The Red-Hot Stock Market - Hold Your Nose and Jump

But make sure you have those puts in place!


Everybody everywhere is wondering how much longer this stock market can keep rising.  Professional bulls jump while professional bears hold their nose and jump, but everybody on Wall Street is still jumping.

It's about time for the amateurs to join the party.  Unfortunately, the amateurs won't have the tools in their kits to exit when the party stops.  Why?  Because the amateurs don't know how to use derivatives.

Option trading is now seeing volume of 14 million contracts a day.  Why so much?  Because in a rapidly increasing market a hedge is cheap to put on and offers the downside protection necessary for the professionals to stay in the market and still sleep at night.  This strategy works particularly well with commodity plays.

Let's say you want to buy US Steel (X) (which has doubled since this summer).  You go long the stock and buy short-duration puts.  The stock goes up 10%, the put costs you 2%, you net 8%.  Easy, risk-free money.

So the market keeps marching higher. No correction necessary because nobody is worried.

But what happens when the market levels out?  When the market levels out then the share price no longer appreciates enough to cover the cost of the put.  At this point, "smart money" covers his final contract by delivering in his long shares and, Voila, goes to cash.

At this point the market turns and begins it's downward correction.  Who is left holding the bag?  The amateur investor who isn't quite sure  - is a put an option to buy the stock or one to sell?  Too complicated for me!  I'll just buy me some Citibank stock - what the hell? - it's only $3.50/share!