Thursday, October 09, 2008


The facts in regard to the way our world economy works have not fundamentally changed. The attitudes of many people have.

DEBT IS NOT EVIL. Right now, large numbers of people believe that debt is evil. A foolish thought. It is the same idea that knives are evil. A good chef can put a good kitchen knife to great use and kitchen knives help billions feed families daily. The amount of help people have received through the use of debt is about a trillion times greater than is commonly perceived. In the same way that a lot of children have benefited from kitchen knives while never having used one, people who avoid debt, receive benefits from it daily. Without debt our world would be a poor place. Debt is a valuable tool and not one that is going to be thrown away.

Over the past three years, we have been through a tightening phase. The use of debt by the inexperienced was encouraged. The problem is that when the inexperienced cut themselves, they cut the rest of us. Drowning men have threatened the lives of good swimmers. The retired owner of Wachovia Bank shares, one who has no debt outstanding, has been a great beneficiary of the system of debt but this person did nothing wrong and is currently suffering greatly.

Banks in the USA still operate off the same system today as the one of last week or last year. Basically, a bank with $8 on deposit is allowed to borrow another $92 and to lend the entire $100. Since $100 lent ultimately shows up as new deposits in banks, an initial deposit of $8 is "multiplied" many times. The leverage built into the worlds banking system has not gone away, but a few rule changes caused this de-leveraging of assets to be very violent and indeed very painful. Those who have cash to invest are making out like bandits. In times of economic crisis, "cash is king" but even so one must have the fortitude to put cash to work during tough times if one expects to benefit greatly from it.


As a college student in 1974, I reached the conclusion that the real estate recession was much worse than it had to be. It was clear that government officials purposely made a tough recession very tough. In 1991, I reached the same conclusion. It was clear that the US economy could have been guided to a "soft landing" but the politically powerful turned a de-leveraging process into a crash. Those who knew in advance how forceful the government would be, made a killing by buying what others were forced to sell. The current "crash" is no different. Those few who knew that new government rules would be used to force banks such as Wachovia to sell, are collecting assets for as little as a penny or two on the equity they invest.

More could have easily been done to cut back on wild speculation when the market was going up, eliminating the need for a super crash, and even after the excesses of the past many years, this crash could have been softened. My attitude about debt has not changed but the importance of using debt at the right time is all the more evident. Those who have the resources and willingness to make levered purchases now are likely to experience extraordinary profits over the next several years.


An age old question has risen to the top. Must we suffer, to experience joy? Without having the deep recession, millions of people who paid far too much for their home, would never know the error committed. They would gradually be bailed out by the long term growth in real estate values. They would live in a fine home while never having saved a nickel toward the initial purchase and while experiencing monthly payments less than their prior rental rates. With no pain in this round, the next bubble might be much greater.

I believe we are all called to give sacrificially. We should all love our neighbors enough to live frugally. One friend of mine tries to "live simply so that others can simply live". However, the investor who invests wisely helps his neighbors too. Jobs are created by the smart use of assets. Where is the proper balance? In any event, it is important to use our funds wisely. We should not spend excessively. Not an easy trick given that we live lives of great wealth relative to 99% of the people in the world. It does not matter if the funds we use are borrowed or not, we and our government should use our money wisely. It is not the federal debt that is creating this problem, not in any way. It was the misuse of government money that was the root cause. Had Fannie Mae and Freddie Mac not had about 5 trillion each with which to buy over priced loans, this event would not have happened.


Market mavens are talking about the "final capitulation" as if someone is going to ring a bell to say that the end of the down draft is over. All the while the sense of capitulation is in the air. Last night, I listened while men who have been hurt severely by this "crisis" expressed their concern for the retirees who might not have the opportunity to "make it back". The words of concern for others was touching but they also were words of acceptance. Acceptance that times will be tough for many a family for a long while. People will once again save, just at the right time to be aggressive investors.

There has already been a change in attitude but there has also been very real changes in the financial environment. In only 5 or 6 days, the rates on the 30 year Euro Bund has fallen from 4.85% to 4.16%. This means that trillions of euros of cash flows have suddenly increased in "real value" by about 15%! It means the payment needed to support the trillions of euros of debt have fallen by 15%! Yes, a lot of sales and refinancing must occur to realize this 15% of Trillions but it will filter into the worlds economy in the months ahead. In less than 4 months, the rate on the 5-year guilt has fallen from 5.4% to 3.9%. The "safe money 5-year return" in England has fallen 27% in less than 4 months! Capitulation has been going on for weeks.

The average price of a gallon of gas is about to fall to about $2.60 in America. Having predicted these lower prices for a long time, it is painful that they come partly as a result of a tough recession. However, we must not be fooled into believing that prices will "go right back up" when the recession is over. Yesterday, several articles suggested that OPEC is about to have an emergency meeting. One theory is that OPEC will attempt to support an $80 price target. Pundits need to put themselves in OPEC's shoes so they can get a taste of reality. OPEC knows that $80 per barrel is still well above the marginal cost of finding and producing new oil and even the marginal cost of producing energy through a large number of alternatives. They therefore know that if they defend the $80 price, they will simply encourage expenditures to produce energy via other means. No matter what they do, the price is going to settle down to the level where the marginal cost of the last barrel produced is equal to the market price of oil. My current best guess is that this number will be below $50 within three years. It is my belief that the "new nuclear power equivalent price" is lower than $40 per barrel but it will take 5 years before nuclear start ups pick up the pace.

Under the circumstances, OPEC, after making a little noise, will continue to sell as much oil as they can, until the price is at least close to the cost of production in marginal fields. In other words, new tar sand fields in places like Canada may not be developed as soon but they will not stop selling oil from Canada that only cost $35 to $45 to produce. Certainly Saudi Arabia will not stop selling oil that only cost $5 to $18 to produce.


An oft repeated myth is that lending has dried up. In truth, banks, credit unions and others are making loans daily. Highly leveraged companies are desperately conserving cash, in order to hold onto assets that will produce enormous returns on equity over the next couple of years, but most banks and credit unions are not involved in the highly levered transactions.

The returns on extremely levered assets of just a few percent are compounded into massive returns by the leverage. This morning there are clear indications that the large sums of money being pumped into the banking system are starting to relieve pressures on the highly levered. This all before even the first purchase of mortgage backed securities by the TARP (or whatever name the $700 Billion bail out fund now has). It will take months to run the bail out program but the price of the average bank stock will not fall during the bail out.

Even the person who is not inclined to speculate should not use this "crisis" as the reason to procrastinate. For example, homes have seldom been so affordable as they are today. Low prices, low mortgage rates and deals to be had. Now is a great time to buy a home or a second home.

Again, in 1991, under very similar circumstances, my wife and I purchased $200,000 beach condos by agreeing to take over payments. If we were young, we would go to Myrtle Beach now and buy a couple of hundred million dollars worth of property. Coming lower oil prices will release pent up vacation demand. Rents at the beach will increase as will the the value of beach homes. OLD FACTS -- NEW ATTITUDES?