Moral Hazard

Recently a friend of mine told me that – “he didn’t care what they (government) did, they should just fix it (the economy)”.

I was amazed at his conviction that “they” could fix “it”.

When I was in school – one of the dominant right wing political parties in India was trying to alter History textbooks to show a certain historic incident in positive light.

That became a huge controversy and I was really peeved at the – Historians for not telling “History”, as it is. It is much later that I realized that there is no History, as it is. It is the reconstruction of past events and is full of human biases.

I am fairly certain that my friend too will someday realize that no one has any certain answers to fix the economy, only opinions; but that will take time.

They Should Fix It

The real import of this statement hit home much later in the day.  My friend viewed the recession as a problem created by someone else and which needed to be solved by someone else.

I am fairly certain that all the bailout packages – whether banks or homeowners, have at least one side effect for sure, and that is – Moral Hazard.

Moral Hazard is when someone knows that they will be safeguarded from a certain risk, and therefore they alter their behavior.

For example, If homeowners know that the government will bail them out if home prices fall, they will take on more risk than they would have otherwise taken.

Similarly, banks who know that they are “too big to fail” will take more risks than they can handle, because they know that if something goes wrong the government will have to bail them out.

When the CEOs of the car companies first asked to be bailed out, they basically said – bail us out or the whole industry will collapse.

I am fairly certain that no one took the taxpayers hostage in such a way at any time other than the current recession. It is creating a – Moral Hazard so big that it may end up pervading the consciousness of a whole generation, who may learn that it is okay to make mistakes as long as every one else makes the same mistakes.

That can’t be the foundation of a healthy society, but some would argue that – hey, you need the bailouts to have any form of society to start with.

Will We Remember?

I think that despite the good intentions and nobility of all involved, the current approach is going to fail. The question is how many people will remember that the current approach failed when the next recession comes up?

The housing bubble was not the first bubble and it certainly is not the last bust. Something tells me we will not learn from this chapter of history, but then I guess that is just how humans are wired and there is nothing we can do about it.

Obama’s Help for Homeowners

President Obama unveiled his “Homeowner Affordability and Stability Plan” today which aims at helping stem the tide of foreclosures, and bring respite to hapless homeowners.

The NYT puts a price tag of $75 billion on it, however this is just an estimate. The actual cost may turn out to be much higher, but whats a few billion dollars, if it helps an estimated 9 million homeowners to keep their homes.

The plan lays out the following:

Refinancing

1. If you are current on your mortgage, but are unable to refinance at a lower rate because of a drop in the value of your home, you will have an opportunity to refinance into a 30 or 15 year fixed rate mortgage.

2. In order to be eligible for refinancing – you should owe less than 105% of the current market value of your property.

3. If you have both – a first and second mortgage; the amount due on the first mortgage should be less than 105% of the current market value of your property to make you eligible.

Modify Existing Mortgages

1. If you risk foreclosure, there may be a chance that the terms of your mortgage are modified by your lender. This plan provides incentives to mortgage lenders to modify existing mortgages.

2. It is not necessary to be behind your mortgage in order to qualify for a modification. There are three criteria for eligibility:

  1. You occupy your house as your primary residence
  2. Your monthly mortgage payment is greater than 31% of your monthly gross income
  3. Your loan is not large enough to exceed current Fannie Mae and Freddie Mac loan limits.

The final details of this plan are expected to be released on March 4. At that time the detailed and final plan will be declared.

If you have more questions about this program you can visit this link which has useful information about this process.

How much Free Market can you take?

When I was giving job interviews during my MBA – one incident changed my whole outlook on – Free Markets. Most MBA schools have a few “Placement Days” in which companies are invited to interview and recruit students. Normally this lasts for three or four days. The whole process is loosely described as “Placement Process” or just “Placement”.

The first day is called – Day Zero and during my Day Zero, we didn’t have any Placement Rules. Students were allowed to sit in as many interviews as they liked and there was no limit on the number of job offers they could accept.

As a result, at the end of Day o, we had several people who had multiple job offers; while many others had no job offers at all. At the end of Day 1 – the situation worsened. It seemed that a large number of people were getting no job offers at all, while a few had multiple offers.

Since a student can’t do more than one job at a time, this was turning out to be a disaster. If things were allowed to continue in the same fashion, we would have had a lot of recruiters who may have had – five accepted jobs, but no one would have turned up at work. And at the same time we would have students who had up to five job offers while others didn’t even have one.

The Free Market would have ruined us.

That was when our Placement Coordinators intervened and did a fine job of regulating the market. They made a few simple rules that were easy to execute and proved effective.

They mandated that every student will have to select his “Dream Company”. If he didn’t have a job offer, he could apply to as many companies as he liked, but once he had a job offer, he could only apply to his Dream Company.

If he got accepted to his Dream Company, then he would be automatically out of the Placement Process. That meant that each student could waste a maximum of one single job.

It also meant that the competition for those people who didn’t have a job reduced and they were also able to secure a job.

For me, the Placement Experience was the defining moment of my education. I have never seen such selfishness, greed, double speak in my life, as I did in those days.

People were wasting jobs in order to boost their egos and serve their vanity.

That also changed the way I looked at Free Markets.

Free Markets are great, but, how much Free Market can you really take? There needs to be regulation and there needs to be supervision.

There also need to be decisions based on facts and needs of the hour; rather than principles and ideologies. I feel a lot of the current – Bank Nationalization debate is based on ideology and not the need of the hour.

Nationalization of insolvent banks seem to strike a certain disgust in people. When in fact such a thing has been happening through the FDIC for years now.  It is also something that other countries have been able to do successfully and so if you are against this – On Principle, then probably you need to rethink reality.

Japan finance minister resigns

It is only today that I laid out my thoughts on why US will not go the Japan way, and I think I can safely add one more reason to it.

Just today Japan’s Finance Minister has resigned after he was alleged to be drunk at the G – 7 conference!

He has of course denied it, but I have found these two videos based on which you can make an informed decision:

Video 1

Video 2

So I add one more reason to – Why US won’t go the Japan Way – They don’t have drunk finance ministers!

On the other hand, I’d also like to point out this article from the Economist, where they basically say that US is in a much bigger soup than Japan.

I think he does look like he’s had one too many, what do you think?

Where Will You Invest If US Goes The Japan Way?

Japan’s Economy saw the worst quarter since 1974. In the last quarter – the economy fell at an annual rate of 12.1%. In comparison, US just fell at 3.8%.

The situation today in US is quite similar to Japan’s situation about a decade and a half ago. There was a massive housing boom and an equally massive bust, coupled with a troubled banking sector in which there were a large number of zombie banks that were kept alive on artificial support.

There are a lot of indications that US may go the Japanese way. If US goes the Japanese way – then that raises serious questions about investors who are invested (or investing) in stock markets.

To put this problem in perspective, consider the fact that its almost 18 years since the real estate bubble bust in Japan and the Japanese Nikkei is just about 20% of its peak levels.

The Japanese investors found out the solution to their problem by borrowing cheap Yens and then investing them abroad. And then keeping those investments as collateral for further borrowings, which they reinvested again to create what is commonly called as Yen Carry Trade. By virtue of being such a fancy thing – I don’t think a lot of common American investors will have the Carry Trade option.

So, Where Will You Invest if US Goes the Japan Way?

This is a really tricky question and one that has no “right” answers. The best bet would probably be to remain diversified across asset classes.

If you seriously believe that US is going to go the Japan way – then you are better off invested in commodities like Gold and stocks of emerging economies.

At the same time you need to have a lot of ultra safe bond investments that provide capital protection and insolvency protection. Not your insolvency, but the insolvency of your banks.

The current economic meltdown means that a lot of Japan’s bank’s loans will go bad now, and their situation will further worsen – leading to a lot more bank-ruptcies.

I don’t know when was the last time you planned your investments around your bank’s bankruptcy but I’ve certainly never did it.

If US goes the Japan way – there may well be no place to hide. If the top two economies in the world suffer from a prolonged slump, there is not much else that can drive global growth.

Will the US go the Japan Way?

The short answer is – No (at least to my mind).

The long answer is that Japan’s problems are well documented and everyone is well aware of them. If US goes down the same path for a few years – policy makers will recognize the same patterns and act.

The IMF has been giving the advice of  “shock – treatment” to developing economies for years. Now, when it came to US – this same advice was not heeded. Eventually, it will become clear that the current mess can’t be overcome without cleaning out the banking system and starting afresh. That may happen one year from now or a few years from now, but will certainly not take a decade and a half to play out.

Since history is there to act as a guide – US will not head the same way as Japan. Don’t sell off your Googles and Microsofts yet.

Stock Market Tips

A warm welcome to readers of Old School Value. If you like what you see here, please consider subscribing to our RSS Feed.

What follows is one of my earliest articles, submitted to Ezine a long time ago.  It was written during the stock market boom, but the number of times it has been republished during the bust,  far exceeds the number of times it was republished during the boom itself. When you go through the full text – you will realize why.

The stock markets are at all time highs and just like the last time around – when the market was at its previous high – every one thinks that nothing can go wrong, and there is just one way the market can go – UP.  Nothing could be farther from the truth and this will be clear from the way the market behaves in the next few months.  Here are a few tips that would hopefully save you from losing a lot of cash in the current frenzy.

Time and again investors have burnt their fingers in the markets and here are some tips to you so that you do not end up burning your fingers in this market.

The number one tip at this point would be to sell if you have stocks and not to buy them if you have cash. The golden principle in the markets is “Buy when everyone else sells and sell when everyone else buys”. Simple enough right? Not really. Why? Because of  ‘peer pressure’,  pure and simple. When everyone else around you seems to be having a ball at the markets, you would feel like a fool if you didn’t participate now.

OK, so you can’t resist buying at this time – then at least do yourself a favor and stay away from unknown Penny Stock and hot tips that your barber gave you. True, that the stock has tripled in the last fifteen days, but that was before people like your barber started buying the stock. Chances are, that the Promoter of the company has started buying into the stock and has spread rumors like an acquisition or a big export order to fool investors – and will sell out to them at a later date.

Another tip that would serve you well is – to value a stock based on its future growth and not its past performance. For instance, many investors say – I will not buy stocks of X company because it has doubled in the last year. Well it may have doubled in the last year, but that should not be the thing you should be telling yourself. Rather, you should ask yourself why has this doubled in the last year and can it do so again?

There should be a solid answer to your question – like the launch of a new product or reduction in the prices of raw material. And indeed, if the answer is in the positive – then by all means go ahead and buy that stock regardless of what has happened in the last year.

Another tip would be to – remember what you are buying. Quite simply, investors often forget – that when buying a stock, they are simply buying ownership in that company. Most of you would know that nothing spectacular would happen in the company that you work for, in a month’s time. They are not going to double their revenues, and certainly not double your salary every month.

Then why expect anything different from the companies that you invest in?

Why expect the prices to double in a month or two? Give time to your investments; don’t reduce it to a gamble. Only when you invest in fundamentally sound companies and then give them sufficient time to grow, will you see some healthy returns on your investments. Ideally, a minimum horizon of one year is a good time.

Hope these tips will prove helpful and you will make a lot more in the stock markets than you have already been making. Happy Investing!

Interesting Reads – 14th Feb

Happy Valentine’s day everyone! Have a great time.

Some interesting stuff I read over the week:

1. 30 Components of the Dow Jones Industrial Index by Investing School: The Investing-School explains the nuances of Dow Jones.

2. Discounted Cash Flow and Stock Valuations by Old Value School: This is a formula that is designed to help someone calculate the value of a business based on the cash flows that it is expected to receive in the future.

3. Job Hunting Tips by The Smarter Wallet: This is practical and useful advice for tough times.

4. Taking Income Tax Deductions? By The Digerati Life: I was quite surprised (and then surprised at my surprise) to learn that the iPod can be used to help with taxes too.

5. Winning the Lottery – A Two Way Road by Striking Up: I hope you win a lottery and hope you heed this advice after that.

6. Savings Series: Save Money with Brown Bag Lunches by Richer and Slimmer: I always like advice that is easy to follow and rewards instantly.

7. How Will The Government Pay For the Bailouts by Own The Dollar: A question that a lot of us are looking answer for.

8. Stop Thinking about True Value and Just Buy What You Need by MoneyNing: Although this may be counter-intuitive to a lot of people, I find that this is a good way of thinking about things.

9. Reduce Spending Without Sacrificing Lifestyle by My Wealth Builder: I was thinking about frugality in the same way a few months ago.

10. The Dividend Guy Investment Process by The Dividend Guy: The Dividend Guy talks about the things that he won’t do while investing.

Finance and Investment Carnivals:

1. Money Hacks Carnival #51

2. Millionaire Mind and Making Money Online

3. Festival of Stocks

4. Festival of Frugality

5. Moneyhacks Carnival – Frugalista Style

When Numbers Stop Making Sense

A few months back – Rogue trader Jerome Kerviel hit the headlines when he made massive trading losses (about 3.5 billion pounds) for his employer – Societe General Bank.

The hearing for his case has not yet begun and he was interviewed recently, here are some things that he said:

“There is a certain disconnection from reality when you are trading.”

“The huge numbers stopped meaning anything any more and I let myself get sucked into a self-perpetuating spiral. With hindsight I can see that I went a bit too far and got carried away.”

In another interview he said:

“I stopped recognising the vast sums I was dealing with and started taking insane risks.”

“And sometimes when I made enormous amounts of money, it gave me an almost orgasmic pleasure. It was all a bit like playing a video game, winning or losing millions in just a few seconds.”

This reminds of me of a political scientist who was analyzing the victory of an Indian politician just after the politician perpetuated a scam worth thousands of crores of rupees (a few billion dollars).

Basically, the analyst said that while news channels are flashing the large numbers on their screens to drive home the enormity of the scam, the numbers are so large – that the electorate doesn’t have any frame reference to understand them.  And since public memory is quite short, they will very soon forget about it, as something that happened in a distant world.

I face the very same problem that the Indian electorate faced or the French trader faced, while thinking about the current stimulus and bailout packages. The numbers are so large that there is absolutely no frame of reference to understand them.

It is hard to visualize what will happen if Citigroup – with its balance sheet of about 2 trillion dollars (slightly larger than the Russian GDP) goes bust.

It is equally hard to comprehend where 2.5 trillion dollars (only slightly less than the GDP of UK) will come from for rescuing the financial sector.

789 billion dollars (a figure easily remembered) seems a trifle to stimulate the economy, when seen next to the rescue package. Is an amount slightly higher than the GDP of Turkey enough to do this?

Why eliminate a paltry 16 billion dollars sought for school construction from the stimulus package, when you are talking of trillions?

It looks really paltry when you compare it with the whole package.

A few billion here and another few there; and pretty much all of this has stopped making sense.

Gold Mutual Funds – Expense Ratios and Minimum Investments

Gold is a popular hedge against stock market and dollar declines and there are several ways in which you can invest in gold.

A popular way of investing in gold is through gold ETFs and gold mutual funds. Even if you don’t believe the dollar is going to decline or need a hedge against the stock markets, you may still be interested in gold, and this gold mutual fund list can prove useful.

Here is a compilation of a few leading Gold Mutual Funds and Gold ETFs along with their:

  • Expense Ratio
  • Front Load (In case of Mutual Funds)
  • Minimum Investment (In case of Mutual Funds)
S. No. Name Ticker Expense Ratio Front Load Min Investment Category
1 SPDR Gold Trust ETF GLD 0.4% NA NA ETF
2 iShares COMEX Gold Trust IAU 0.4% NA NA ETF
3 Market Vectors TR Gold Miners GDX 0.55% NA NA ETF
4 Vanguard Precious Metals and Mining VGPMX 0.28% None 10000 Gold Mutual Fund
5 US Global Investors World Prec Minerals UNWPX 0.97% None 5000 Gold Mutual Fund
6 U.S. Gbl Inv Gold and Precious Metals USERX 1.27% None 5000 Gold Mutual Fund
7 USAA Precious Metals and Minerals USAGX 1.19% None 3000 Gold Mutual Fund
8 Tocqueville Gold TGDLX 1.43% None 1000 Gold Mutual Fund
9 Rydex Precious Metals Inv RYPMX 1.27% None 2500 Gold Mutual Fund
10 ProFunds Short Precious Metals Inv SPPIX 1.55% None 15000 Gold Mutual Fund
11 ProFunds Precious Metals UltraSector Inv PMPIX 1.46% None 15000 Gold Mutual Fund
12 Oppenheimer Gold & Special Minerals A OPSGX 1.05% 5.75% 1000 Gold Mutual Fund
13 OCM Gold OCMGX 1.93% 4.5% 1000 Gold Mutual Fund
14 Midas MIDSX 1.87% None 1000 Gold Mutual Fund
15 Jennison Natural Resources A PGNAX 1.14% 5.5% 2500 Gold Mutual Fund
16 ING Global Natural Resources A LEXMX 1.45% 5.75% 1000 Gold Mutual Fund
17 GAMCO Gold AAA GOLDX 1.46% None 1000 Gold Mutual Fund
18 Franklin Gold and Precious Metals A FKRX 0.89% 5.75% 1000 Gold Mutual Fund
19 First Eagle Gold A SGGDX 1.21% 5% 2500 Gold Mutual Fund
20 Fidelity Select Gold FSAGX 0.81% None 2500 Gold Mutual Fund
21 Evergreen Precious Metals A EKWAX 1.05% 5.75% 1000 Gold Mutual Fund
22 DWS Gold & Precious Metals S SCGDX 1.2% None 2500 Gold Mutual Fund
23 RiverSource Precious Metals & Mining A INPMX 1.34% 5.75% 2000 Gold Mutual Fund
24 American Century Global Gold Inv BGEIX 0.68% None 2500 Gold Mutual Fund

What is Fractional Reserve Banking?

Fractional Reserve Banking is the banking system, where, banks lend more money than they really have. In fact, banks just have a small fraction of what they lend out. Fractional Reserve Banking is followed by every modern economy in the world, and even though it sounds scary to people who hear it for the first time; it works pretty well.

At the heart of – fractional reserve banking – is the fact (or idea?) that every bank depositor will not ask for his money back at the same time. Fractional Reserve Banking assumes that only a certain percentage of people will ever demand their money back at the same time, and the rest of the money is free to be utilized productively.

How does the Fractional Reserve Banking system work?

For example – let’s consider that this percentage is 10%, and there are two banks in an economy – The Jeeves Bank, and – Bertie Bank.

Now, suppose that I have $100 and go and make a deposit of $100 with the Bertie Bank. Since, The Bertie Bank, is required to keep just 10% as reserves, it loans out $90 to Ms. Agatha, who wants to start a business, but doesn’t trust the – Bertie Bank enough to bank with them.

So, she goes and opens an account with – Jeeves Bank and deposits her $90 there.

So, now the situation looks like this:

  • Ms. Agatha – $90 with Jeeves Bank
  • Me – $100 with Bertie Bank

Notice, that with the initial $100, now there are deposits worth $190 in the economy, and what is more – there is still plenty to go around.

Since, Jeeves Bank has got deposits worth $90, and they just need to have a reserve of $9, they can loan out the remaining $81 to Mr. Psmith, who wants to start a – Consultancy Business. Mr. Psmith – then promptly goes out and deposits his $81 with – Bertie Bank, as he doesn’t share the same suspicions as Ms. Agatha.

So, now the score stands at:

  • Mr. Psmith – $81
  • Ms. Agatha – $90
  • Me  – $100

Notice, now that the initial $100 has grown to $271.  But, this is not the end of it, as now – Bertie Bank has an additional $81, which it didn’t have before and can lend out 90% of that to Pongo Little, who needs a little something to start his Onion Soup business.

This cycle could go – on and on, till a 1000 dollars are created in the economy with the initial 100. If the Central Bank was to reduce the reserve required to – 5% – an additional 1000 dollars can be created in the economy.

Pros and Cons of Fractional Reserve Banking

All modern economies use the Fractional Reserve Banking system, and it works quite well as it gives a lot of control in the hands of the central bank to add or reduce the money supply in the economy, and keep a check on excessive liquidity or overheating of an economy.

The disadvantage of using such a system is that a financial crisis can spread elsewhere and panic and rumors can become true in a self-fulfilling prophecy causing bank runs. Bank Runs can occur and financial system be destroyed just by the loss of trust alone.

For example, if one day Ms. Agatha and Mr. Psmith decide that the – Bertie Bank is not to be trusted, and it is better for them to bank with – Jeeves Bank – that would be the end of the Bertie Bank. Since it has loaned out more than it actually has – just the crisis of confidence can cause a systemic crash.