Back on the subprime/housing/credit front . . .

I’m still anticipating it to be worse than generally expected (even now). And, I continue to watch for the event that will drive us to the bottom.

As I described awhile back, I believe the final episode will be triggered when one of the involved parties decides to “make a run for it.” Hedge funds, securities dealers and financial institutions own huge amounts of bonds backed by weak mortgages. No one knows what these bonds are worth on the market because no one is willing to make an offer to buy them. So, the investors carry them on their books at what they claim are justifiable prices. For Merrill Lynch, justifiable prices required a $5 billion write-down earlier this month, but that grew to $8.4 billion this week (per yesterday’s Wall Street Journal).

Today’s estimated prices may, indeed, be reasonable approximations of the true economic value of the bonds if held to maturity. But, not if they aren’t held to maturity. If they were to be sold today, it would have to be at prices much lower than these book values.

And, that’s the risk. If one holder believes that this valuation charade is doomed and the market will soon be flooded with bonds in a sellers’ panic, that holder may decide to get out first -- take the best offer available today, then stand back and watch the rest of the market implode as more and more bonds are written down or actually sold at ever decreasing prices.

All the players, as well as their regulators and bankers, recognize the precariousness of this situation, and are doing all they can to prevent the dreaded sell-off. Mortgage lenders, for instance, are recasting loans to make them less likely to go into default. They’re giving up future income to avoid recognizing a current loss.

The nation’s largest banks are putting together a giant Structured Investment Vehicle (SIV) to buy some of the billions of dollars of bank- and broker-sponsored SIVs that are effectively insolvent due to losses in their holdings of bonds backed by weak mortgages. These premier banks will be putting over-valued, weak assets into a pool that they will carry on their books at full value. That helps?

The Federal Reserve is likely to make another cut in the Fed funds and discount rates – to send a signal that the Fed is there to help (no matter how irresponsible the financial services sector has been . . . again . . . and in spite of the fact that the price of money is not the problem).

Might these efforts succeed? Sure. But, I doubt it. Someone will make a run for it. Some investment pools, in fact, are required by their founding documents to liquidate if their value drops by a certain amount. Others must direct all mortgage payments received to only the senior-level investors once a specified value is breached, leaving the subordinated investors with a non-paying “asset” they might as well dump and get what they can while they can.

So, yes, I still think someone will bolt. Then we can get on with the real clean-up of this very messy situation.

Dreaming about retirement

I had the strangest dream last night. I had announced my retirement, and suddenly found myself standing on a stage in front of all my coworkers trying to explain what I was going to do next and how I felt about leaving my “home away from home” of the last 20 years. I fumbled through a few disjointed comments, got an overly generous round of applause, then shuffled back to my seat.

When I awoke, the prospect of retirement was more real than ever before. Then I realized that this dream was true. It had happened the day before.

Yes, I have made the tough decision – I will be leaving MEMBERS Capital Advisors at the end of this year. This in no way reflects negatively on MCA. In fact, the company is in the best shape it has ever been with more investment management talent and capabilities than ever before. And, the prospects look absolutely stellar from here. But, I have stayed “one more year” a couple of times, now. It is time for me to do some other things and live life more on my schedule awhile, before those options are lost.

I am planning to pursue a small investment-related project with some former associates on a very part-time basis, but mostly I’ll be free to do whatever I choose (or, as Michael Armour cautioned last week, whatever is chosen for me, which I will aggressively seek to minimize!). The rest of my list of potential to-dos is huge – way too long. And, I don’t want to spread myself thinly over a multitude of tasks-with-no-end as most of us do throughout our working years.

So, my plan for the first few weeks of retirement is to settle in to our cottage up North with Colleen, chop a little wood and move a little (?) snow, and focus on sorting through that ominous list of options . . . that we are so very fortunate to have.

Thanks for the advice!

I appreciate the ideas submitted by Mike Farner and Michael Armour (which you can see by clicking on “Comments” at the bottom of the prior entry) in response to my request of a few weeks ago. Each will receive a nice gift courtesy of MEMBERS Capital Advisors. (Guys, call or email me with your shirt sizes.) Their key points (paraphrased):

Mike – Don’t carry a lot of debt or frivolous spending habits into retirement, and don’t underestimate how long your money has to last (so you don’t outlive it).

Michael – Know what you’re going to do before you hang it up so that you are in control of your life, or others will make the decisions for you.

Some others shared their ideas, but were unwilling to go public with them. One of the most intriguing suggestions was to check out international living. Besides improving your climate, it can also improve your financial status with a much lower cost of living, including much lower (if any) taxes. Don’t move to Florida and avoid state income tax, move to Panama (among many other exotic locales) and avoid all taxes!

This idea has always struck me as unpatriotic – earning your fortune (?) here in the great U. S. of A., then running off to retire somewhere else, taking your nest egg with you. But, in a way, it is also a patently American thing to do. If emigrating will result in a significant improvement in your quality of life, get in the boat!

I personally am not anywhere near actually making this kind of move – we’re well set up with our condo here and cottage up North. But, I can’t help but poke around a little, out of simple curiosity and just in case the political/economic system here gets (how shall I say it?) . . . too Un-American?

Anyone similarly curious might start by taking a look at this website:
http://www.internationalliving.com/


CBS-1007-7D6D

A little help here?

Did you see this? Researchers have determined that two-year-old chimpanzees and two-year-old humans are essentially intellectual equals. So, why are we humans building computers and traveling in space while chimps are foraging for food and swinging from trees?

Because chimps are wiser? Maybe. But, the researchers attributed it to one area where the children were slightly more capable than the chimps. The children were better at patterning the behavior of others.

Give them each a lidded clear plastic jar with cookies inside and they’ll handle it similarly. They’ll hold it, turn it, bite it, and bang it on the floor, to no avail, of course. Then, if someone sits down with them, unscrews the top, takes a cookie, eats it, then puts the lid back on, their reactions are quite different. The child (once it stops whining, “MY cookie!”) is soon trying to unscrew the lid, and usually eventually succeeds. The chimp still holds it, turns it, bites it, and bangs it on the floor.

So, we humans have a greater capability than our closest relatives (we’re talking species here) to learn from others.

But, we don’t use this capability nearly as much as we could. Examples?

In its broadest sense, we don’t learn what we should from history. If we did, we wouldn’t keep repeating it (even after we’ve studied it).

On an individual level, it’s worse. We often don’t even pay attention. When we do, we don’t really listen. And, when we do listen, we are usually quick to discount the information coming to us.

One example I’ve experienced – raising those supposedly readily taught children. The single greatest disappointment in my stint as a parent has been (and still is) my inability to shelter my kids from most of the typical mistakes, pains and anguish of growing up. Part of this was the teacher, I’m sure. But, most of it, I really think, is because they, like all of us, weren’t very good at taking guidance.

A close second in the disappointment category is my own learning. I wish I had listened more to my parents, my bosses and coworkers, my spouse, my kids, and my many other well-meaning would-be teachers. As I gradually became aware of this deficiency over the years, I have tried to be better at seeing, hearing, feeling and understanding the many forms of learning coming my way. I still avoid or miss or ignore a lot, I’m sure, but I’m trying.

In that vein, I’ll be entering retirement one of these days. This may well be as difficult in some ways as growing up, maybe worse as it evolves into growing old. So, I have a request, especially of all of you who are already retired.

What are some of the common mistakes we soon-to-be-retired should try to avoid? What are some lessons you’ve learned – things you wish you had been told earlier? Or, things you did know, and are glad you did?

We’ll send a little gift to everyone who responds, and a medium gift to the best of the bunch. Just click “Comment” below. If you don’t want your name posted with your comment, or you don’t want even your comment posted, just say so. I’ll be out the next couple of weeks, but will look them over when I return and will let you know what I learned.

Here’s a retirement issue for you – income taxes.

First, a caveat. None of the following should be considered tax advice. If you need such advice, consult a tax expert.

If you do, you may find that many of these “experts” are expecting the next administration and congress to push through increases in personal income tax rates. The reasons – to shrink the ballooning deficit and spread the income tax load more fairly.

They may well succeed in raising the tax rates. But, I’m afraid they won’t get what they want.

First, I’m not at all sure higher taxes would reduce the deficit. This year’s deficit is now estimated to be $158 billion – a big number, but only 1.2% of GDP, and $217 billion LESS than the annual deficit before the most recent round of tax CUTS. (All numbers courtesy of the U. S. Treasury.)

Why? I assume it is similar to the effect of raising taxes on cigarettes or gasoline. It reduces their attractiveness. Taxing income more makes it less attractive, too, whether that income is from labor or investments. So, people and companies have less incentive to seek maximum pre-tax income. One way they evidence this is by deferring making changes in their investments because deferring gains taxes is more important at higher rates. Another is by aggressively seeking ways to shelter income from the higher taxes, like domiciling in lower tax locations. And, even if everything else stays the same, higher taxes mean lower after-tax income, which itself is a drag on a nation’s economy.

This impact of high or increased taxes is hard to refute. Ireland and some Eastern European countries are recent vivid examples of the positive effects lowered taxes can have on an economy as well as on the government’s total tax receipts. So, maybe we don’t want to raise the overall tax load on our economy. But, why not make it more equitable – raise the rates on the highest incomes and lower them on the other end?

This is probably doable. But, we need to be careful. We don’t want to disincentivize our most productive citizens, which make up a large part of the highest paid, or incentivize our biggest tax payers (productive or not) to relocate. Besides, we’re already getting a much higher proportion of our income tax receipts from the higher income groups than in years past. But, not by raising tax rates.

We’ve raised income tax receipts from the wealthy through other changes in the tax code, like allowing fewer deductions, or through the lack of changes, like not indexing the Alternative Minimum Tax to inflation. Our top tax rate was 70% in 1980, and the Treasury was getting 19% of its individual income tax receipts from the highest paid 1% of taxpayers. It was getting fully 49% of its receipts from the top 10% of income earners. The other 90% of its citizens paid in only about half of the total income tax receipts.

By 2004, we had cut our top tax rate in half – to 35%. But, even with these lower rates, we collected 36% (up from 19%) of tax receipts from the highest earning 1% of the population, and 68% (up from 49%) from the top 10%. I’m not sure we can push this much farther without killing or scaring off these geese that are laying all those golden eggs for the rest of us.

So, I’m not expecting lower income tax rates on my “middle income” in retirement. Nor am I hoping for higher rates on those with higher incomes. I’d say let’s not tamper with success, and focus instead on spending those tax receipts in ways that provide the most benefits, especially for our currently least productive citizens.

Retirement question!?

Occasionally, someone asks me a technical question about retirement. Can you imagine that!? As if I would know such things!!

This blog is intended merely to convey some of the investment and retirement-related thoughts that occur to me as I approach my own retirement. It was not supposed to be an all-encompassing factual resource for pre- and post-retirees.

But, I have to admit – I have been combing the Internet for just such resources, too. Without much success. The net is full of calculators and check lists and investment advice, but provides relatively little about the overall “project” of preparing for, entering, and living in retirement. But, I recently found a good alternative source of this kind of information.

If you’re willing to leave the net for awhile and employ a very retro-resource – a book – there are some that provide very helpful, broader views of the subject. A recently published, excellent example is The Wall Street Journal – Complete Retirement Guidebook (How to plan it, live it and enjoy it) by Gene Ruffenach and Kelly Green (Three Rivers Press).

This 300-page (small size, large print, lots of graphics), $15.00 paperback does a very good job of helping you define what you really want in retirement. It then provides practical guidance for what you need to do – before and after retirement – to get it.

So, read the book. But, check back here occasionally as you write your own retirement story whenever you need someone to commiserate with.

(Continued from last week.)

As we walked, recounting our day’s adventure, I began to wonder. When we were in the ditch and our pursuers were standing just across the fence considering their next move, did anyone (besides me) seriously consider making a solo run for it – bolting from the ditch and heading across the hay field? Doing so would divulge the location of the others, but even if they also ran at that point, they would be a few steps behind and were almost certain to get caught. And, that would occupy the pursuers, further assuring the success of my dash for freedom.

So, I asked. To a person, they all admitted to considering running. Most confessed that they almost did run. But, none did. They realized, even at that young age, that to do so would have cost them their “membership” in the group, and would have caused great pain and hardship for the others (and maybe even for themselves ultimately when the others turned him in). If we just stayed together and didn’t flinch, we would retain each other’s respect, and we would all have some chance, at least, of coming out unscathed.

And, that, as you know, was exactly what happened. The sheriff’s decision not to “lay down the law” extended our good fortune. We knew how lucky we had been, and we certainly learned a thing or two about life, and about ourselves.

We made it home safely, by the back roads and alleys. Once there, we suffered the expected parental wrath (muted somewhat by their recognition that “boys will be boys”) for nearly ruining our shoes “playing Army in the ditches.” We all promised never to do it again. And, we never did.

Why relate this story here? Because it has some striking similarities to what is going on in the investment markets. Some investors’ hunger for maximum returns (greed) got them into trouble. They had invested in high yielding subprime mortgage-backed investment pools, and with the housing market rolling over, the mortgages began to default – more and faster than they expected. The value of the investment pools declined. How much? No way to know. Until all the underlying mortgages are extinguished by normal retirement, refinancing, or sale of repossessed property, the amount of the decline can only be estimated. And, with this great uncertainty, no one has been willing to buy these mortgage pools at any price.

Initially, the financial pain could very possibly have been modest, and limited to these direct investors (and the strapped homeowners, of course). But, they had borrowed extensively to buy more and more such weak paper. They were up to their chins in leverage, and now mostly under water. So, as the problems grew, the concerns spread beyond the direct investors to their lenders and others, and they all wanted out.

But, they couldn’t all get out at once. And, they knew they shouldn’t even try. If nobody ran and they all waited patiently for the scenario to play out, the damage could be minimized. The investment fraternity could save itself a lot of money and avoid a lot of anguish if all its members could just stick together.

Nice thought. But, unlike our covey of pre-teen boys, the markets don’t work that way. In fact, they won’t work that way. For markets to function – to correctly (most of the time) price whatever is being traded – everyone in the markets must be trusted . . . to do whatever is in their own best interests. So, instead of sticking together, investors generally prefer sticking each other. It’s every man for himself (neutral gender intended). If running for the woods appears to be the best option, they’ll run for the woods.

And, then there are “the authorities.” Typically, well after the excesses have developed and the bubble is already leaking, they arrive to do what they should have done before the problems developed. By then, the “fix” exacerbates the problems, hastening and deepening the damage. Rating agencies, regulators, and the congress all seem to be particularly adept at this. Where is the wisdom of the county sheriff when you need it?

I do have to acknowledge that some of the players this time – besides the world’s central banks – have made valiant and partially successful attempts to limit the damage. The fraternity of big Canadian banks were the first to act by voluntarily extending due dates of loans to strapped borrowers. Some mortgage lenders are beginning to do the same. The prime motivation is not eleemosynary, however. They are willing to restructure the debt only because it improves the chances of getting their money back. If the problems are as extensive as they appear, though, this won’t prevent the inevitable; it will merely allow it to play out in slow motion.

So, when the Bear Stearns hedge funds were initially being kept afloat by another injection of capital and their lender’s good will (not immediately calling their loans and liquidating the fund), more and worse news was almost a certainty. Such attempts to make faltering investments look secure rarely work for long. Eventually, there is always someone unwilling to play along. They see the ruse and choose to save their own skin. In this instance, the authorities are doing their part, too, tightening lending standards just as thousands of struggling homeowners and hedge fund borrowers need to refinance their loans.

How bad will it get this time? How long will it last? The initial explosion of market volatility indicated that the ultimate outcome was very uncertain. The recent relative (and, I would say eerie) calm indicates a growing belief that market participants and regulators have been and will continue doing the right thing.

We’ll withhold our judgment. Just as boys will be boys, we expect that markets will be markets. Someone will bolt, or sneeze, or surrender. We’ll just have to await the next chapter to know who and how much pain and suffering their actions will trigger.