Wise Money Decisions

Some interesting California statistics:

Domestic migration outflow: 49th highest out of 50 states. 

According to ”Rich States, Poor States” by economists Arthur Laffer and Stephen Moore, the Californians leaving for elsewhere are our ”highest achievers and those with the most wealth, capital and entrepreneurial drive.” 

Highest maximum tax rate: 2nd highest out of 50.

Highest corporate tax rate: 15th highest out of 50.

Highest taxed population: 12th out of 50.

Best business climate as ranked by the Tax Foundation: 47th out of 50. 

Most expensive state to do business according to CNBC: 3rd out of 50.

Best state to do business according to Forbes magazine: 40th out of 50.

State requiring special credentials or licensing of most occupations: 1st out of 50.

California has credential or licensing requirements for 177 occupations.  Including mine.

Highest workers’ comp costs: 2nd out of 50. 

Highest gas taxes: 1st out of 50.

Highest unemployment rate: 3rd out of 50.

Highest foreclosure rate: 1st out of 50.

Housing affordability: 50th out of 50. 

Highest average public school teacher salaries: 1st out of 50.

Highest average compensation for state employees: 1st out of 50.

Highest welfare grant level: 2nd out of 50.

Highest state and local government spending per capita: 4th out of 50. 

Highest eighth grade math scores: 42nd out of 50.

Highest eighth grade reading scores: 45th out of 50.

Highest fourth grade math scores: 46th out of 50.

Highest fourth grade reading scores: 48th out of 50.

Highest level of violent crime: 10th out of 50.

Worst traffic: 1st out of 50.

Highest cost to repair and expand transportation infrastructure: 1st out of 50. 

Depending on your political leanings, you may find a few of the numbers encouraging.  But most of them are discouraging no matter which side of the aisle you’re on.

The statistics come from an article by Dave Cogdill, the Minority leader in the California Senate.

This AP article by Mitch Weiss points the proverbial finger at unscrupulous appraisers, lenders, brokers and others:

To be sure, there are many causes of the housing crisis - lenders who allowed people with spotty credit to buy homes with little or no money down, mortgage brokers who focused on selling loans without regard to the borrowers’ ability to repay, investment bankers who bought and sold risky mortgage-backed securities.

But wait a sec….. isn’t someone missing from the list?

How about the borrowers that didn’t exercise enough common sense to avoid biting off more than they could chew!

I don’t think that bad appraisers, lenders, or bankers should escape scrutiny.  But why give bad borrowers a free pass?  They’re just at fault.  If there were no bad borrowers, there would be no bad appraisers or lenders either. 

He made more money with the blog.  Seriously.

I’m not sure whether to laugh or cry:

“A California man who has defaulted on nine homes and expects banks to foreclose on all of them, forcing him into bankruptcy, says he now considers it a mistake to have invested in the real estate market.” 

It’s good that he now realizes it was a mistake.

The Story

The story goes that Shawn Forgaard was once a wealthy man.  He received $800,000 from stock options in his software company.  He began buying properties. 

He was putting anywhere from 10% to 40% down.  It wasn’t the down payment that caused him problems. 

What sunk him is the type of loan.  He was using negative amortization loans.  That’s the type of loan with a balance that can actually grow from month to month. 

A negative amortization loan doesn’t cause problems if the borrower pays the interest off each month.  But if the borrow fails to pay the interest, the deficit gets added to the balance.  The balance grows until the bank decides the loan is too risky and pulls the plug. 

As with any investment strategy, buying property in this way is not “risky” unless the borrower doesn’t have the ability to make the monthly payments. 

My guess is that Shawn had enough money in his bank account to pay the mortgages for a while.  He was counting on being able to refinance after the value of his properties went up.  He would be able to pull money out of each property and use it to continue to service the nine mortgages. 

The value never went up.  He wasn’t able to refinance, he ran out of money, he couldn’t make the payments, and kaboom!

If he had cash flow from another source, like his job or other investments, he may have been able to hold on long enough and make a killing when the market recovered.  His strategy was very risky because it required the market to behave in a certain way and he didn’t have the funds to hold on when the market didn’t cooperate.

Long Term Capital Management 

It reminds me of Long Term Capital Management (”LTCM”).  LTCM was a company started by brilliant people that figured out a way to arbitrage government bonds.  They borrowed incredible amounts of money and implemented their strategy.  For three or four years they made tremendous returns.  Then all hell broke loose.

The Asian financial crisis in 1997, along with other global financial events, led to tremendous losses for LTCM.  To make a long story short, the Fed organized a bailout of LTCM on behalf of various creditors. 

Bear Stearns declined to participate in the bailout.  They must not believe in bailouts.

The Moral of the Story 

Here’s the key point.  By the time they got around to liquidating LTCM’s positions, the global financial crises had abated.  Not only had LTCM’s positions recovered from their tremendous losses, they were actually liquidated at a profit!

As Jeremy Siegel indicates, if LTCM had not leveraged to the extent it did it may have had sufficient liquidity to weather the crisis and turn a profit despite the serious problems in the marketplace.

The Two Requirements for Successful Long-Term Investing

Here’s my short list of the requirements for successful long-term investing:

1) A winning long-term strategy

2) Sufficient liquidity to give your strategy time to weather any downturns.

Both Shawn Forgaard and LTCM obeyed the first rule but flunked the second. 

Jeremy Siegel is the author of one of my favorite investing books, “Stocks for the Long Run.”  In this 18 minute video he discusses the recent rate cuts, his concern that the Fed isn’t sufficiently concerned about inflation, and the Bear Stearns acquisition. 

If you’re not interested in macroeconomics then the only interesting part will be the Bear Stearns discussion.

The part I found most interesting is the comparison of Bear Stearns and Long Term Capital Management at about the 7 minute point.  Talking about mortgage-backed securities, Siegel says that Bear Stearns:

“Thought this stuff was great, they were buying it all the way down, with leverage…. It looked like a double down strategy on the part of Bear Stearns….

The truth is, had they had the liquidity to hold on, the Bear Stearns positions might have turned out to be very profitable. 

Just like Long Term Capital Management ten years ago, had they been able to hold on, those positions became profitable.” 

For those unfamiliar with the story of Long Term Capital Management, you can read about it here. 

The lesson that I take from both Bear Stearns and Long Term Capital Management is that you need to retain enough liquidity to withstand a temporary drop in your portfolio.  It doesn’t help to be right in the long run if you have to liquidate before you get there. 

Or as the famous quote says, “The market can stay irrational longer than you can stay solvent.”

It’s been widely reported that Joe Lewis’ losses in the Bear Stearns collapse amount to $1 billion. 

However, investors that hold large positions in a company are able to use derivative instruments, such as forward contracts or swaps, to hedge their risk.  It’s possible he has lost significantly less than $1 billion.

I haven’t seen any reports on whether Mr. Lewis had a hedging strategy in place.  But I have to believe that every investment bank would have tried to sell him a hedge product after he bought up a large stake in Bear Stearns over the last several months or years.  After all, that’s what investment banks do.  They find someone with money and talk them into buying a product.  It’s good honest work (as long as it’s done legally and with the client’s informed consent).

I had never heard of Joe Lewis before yesterday.  But I’m learning a little more about him.  Here are a few interesting Joe Lewis facts:

• He had an estimated fortunate of $5.6 billion.  It’s a little smaller now.
• He made his fortune in foreign exchange.
• He is buddies with Tiger Woods and Sean Connery.
• He lives in the same Bahamas resort as Sean Connery.  I understand it is the setting for some scenes from the 2006 James Bond movie “Casino Royale.” 
• Besides his Bahamas property, he owns property in Orlando and Argentina.
• In 1999 apparently there was an attempt on his life in Argentina.
• He is the 369th wealthiest individual in the world according to Forbes magazine.
• He owns all or part of several European soccer teams.
• Apparently he avoids the spotlight.  He is well known in Britain because of his soccer teams, but he is not well known in the U.S. (until today).

Today it is being announced that JPMorgan will acquire Bear Stearns for $2 per share.  To provide a little perspective on the stunning collapse of Bear Stearns, you need to know where Bear Stearns has been.

A Little History

Bear Stearns is the country’s fifth-largest investment bank.  Its stock was trading as high as $172 in January 2007.  Last summer two of its hedge funds collapsed in the beginning stages of the subprime mortgage crisis that we are still going through.  Its stock began a downward slide that became a freefall last week as investors began to doubt its viability as on ongoing business. 

On Friday its stock plummeted nearly 50% and ended the day at $30. 

We Don’t Know the Extent of Bear Stearns’ Problems

Now we have the news that it is being acquired for $2 per share.  Clearly we have no idea of the seriousness of Bear Stearns’ problems.  JPMorgan is willing to pay only $2 per share despite help from the federal government in funding the deal.  We might suspect there was a fair amount of prodding from federal authorities to convince JPMorgan to do the deal.  Without federal intervention I suspect JPMorgan would have offered considerably less.

At $2 per share JPMorgan will be paying $270 million.  Bloomberg is reporting that the Bear Stearns headquarters in midtown Manhattan (pictured to the right) is likely worth several times that.  Reading between the lines, Bear Stearns’ problems are much deeper than we know.

Poor Billionaire

The second-largest shareholder in Bear Stearns is a billionaire named Joseph Lewis.  He paid as much as $150 per share as recently as September.  He obviously believed in the company and wanted to help it succeed.  His shares are now worth $2. 

I feel bad for him just a little.  But he’s still a billionaire.  He’ll be okay.