Free-Market Economic Stimulus Proposal

Free-Market Economic Stimulus Proposal

 

Summary

 

Americans as a group have taken on too much debt that has led to significant economic problems.  Mortgage debt increased from 66% of GDP in 2000 to 102% of GDP by the end of 2007.  As real estate prices have fallen, much of this mortgage debt has become toxic and has led to significant liquidity problems in banking leading to a severe economic contraction world-wide.  In an effort to reduce the overall debt load of Americans, help stop the fall in home prices and provided needed liquidity to the banking industry, a simple free-market solution is being proposed.

 

The proposal is to provide a one year window in which people are allowed to transfer money from a pre-tax retirement account (401K, IRA, or 403b) account without penalty at a flat tax rate of 15% directly toward payment on a mortgage. 

 

Currently, there is a combined total of over $6 trillion located in 401K, IRA and 403b accounts.  A 20% conversion of this money to pay toward mortgages would result in a ~$1 trillion liquidity injection into banks while reducing the federal deficit by ~$180 billion.  The five key advantages of implementing this tax law change are:

1.     It allows for a reduction in the overall debt load of Americans, specifically related to mortgage debt.  $1 trillion in mortgage payments would reduce mortgage debt outstanding by 7% of GDP.

2.     It provides liquidity to banks while reducing outstanding loan balances. 

3.     It also improves the financial position of the United States government.  In addition to the initial 15% tax payments, it will eliminate/reduce the mortgage deduction for individual taxpayers going forward.

4.     It provides cash to consumers.  For those capable of paying off their mortgages from these funds, their disposable income rises sharply as their mortgage payment disappears. 

5.     For those without homes who have inadequate funds for a down payment but have pretax savings, this would allow them to access their existing personal funds toward the purchase of a home.

 

Existing plans to stimulate the economy typically attempt to boost the economy by increasing the federal debt load to inject money into the economy.  The substitution of one type of debt (federal) for another (mortgage) does little to reduce America’s overall debt load.

 

2/23/09b

 

 

Problem Statement

 

From 2000-2007, the debt load carried by Americans rose sharply.  The primary cause of this increase in debt load was mortgage debt.  Mortgage debt rose from $6.3 trillion (66% of GDP) at the start of 2000 to $14.3 trillion (102% of GDP) at the start of 2008¹.  Consumer debt from 3Q00 to 3Q08 increased by a much smaller amount – from $1.67 trillion (16.9% of GDP) to $2.58 trillion (17.9% of GDP) ².  The rise in mortgage debt helped fuel a rise in home prices.  This phenomenon was not unique to the United States and multiple countries throughout the world experienced similar debt financed housing booms.  Some others included Great Britain, Iceland, Spain, Australia, South Korea, Poland and Ireland³.

 

Many of these new mortgages were bundled into collateralized debt obligations (CDO’s) and sold to various financial institutions including banks, insurance companies, and pension funds.  Lending standards were also relaxed in many cases such that people with poor credit histories, inadequate down payments, or inadequate income for the debt level were given mortgages.  As home prices began to fall, many debtors started defaulting on their mortgage resulting in a sharp increase in home foreclosures.  As more homes entered foreclosure and entered into forced sales, it further flooded the housing supply and lowered home prices leading to a popping of the home asset bubble. 

 

As homeowners defaulted, banks and mortgage companies began to face losses on the CDO’s.  To maintain capital ratios and provide liquidity, many banks began to sell their CDO holdings.  With heavy selling and few buyers, CDO prices cratered and the investments became illiquid.  This further stressed banks and financial companies.  Overall liquidity dried up and spilled over into areas beyond the financial sector.  Due to the credit crunch, many consumers and businesses reduced spending and a sharp economic contraction occurred.  The contraction further reduced consumer confidence leading to a downward economic spiral.

 

Government responses to the crisis have typically involved borrowing money from the capital markets to inject liquidity into the banks or to consumers.  Unfortunately, this has had limited success as governments and the private sector compete for the same capital.

 

Based on the problems listed above, a solution is needed that will allow multiple improvements to the financial system including:

1. A reduction in mortgage debt outstanding.
2. An improvement in liquidity for banks and financial institutions.
3. A pricing improvement for the CDO’s
4. A reduction in government deficits requiring money from the capital markets.
5. A reduction in the excess inventory of homes to help stop the drop in home prices.
6. An improvement in consumer confidence and willingness for consumers to spend and invest more.

 

Proposal

 

The proposal is to provide a one year window in which people are allowed to transfer money from a pre-tax retirement account (401K, IRA, or 403b) without penalty at a flat tax rate of 15% directly toward payment on a mortgage.  The money would be paid directly from the retirement account to the mortgage holder with the 15% federal withholding taken out.  It would be similar to a rollover of funds from a 401K to a rollover IRA.  The money would not count toward an individual’s adjusted gross income.

 

Benefits of the proposal

 

While there is no way to be certain of the number of people who would participate in the proposed plan, assuming a 20% participation rate of IRA/401K/403b funds, approximately $1 trillion dollars of liquidity would be injected into the financial industry and approximately $250 billion would be paid to the federal government resulting in a reduction in the deficit.  At the end of 2007, there was approximately $4.7 trillion in IRA’s and $4.5 trillion in defined contribution plans such as 401K and 403b plans for a total of $9.2 trillion⁴.  Due to the market performance in 2008, the value of these investments has likely fallen to less than $7 trillion⁵.  Even at the lower level, a significant amount of money is available for reducing the mortgage debt outstanding.

 

By reducing mortgage balances outstanding, it would also provide an improvement to the loan-to-capital ratio for banks.  This is a key measure of bank health which has led to a number of bank failures.

 

The CDO’s which have become illiquid would also quickly increase in value and the injection of cash would speed up the cash payments from the CDO’s.  The higher value of the CDO’s would also serve to improve the loan-to-capital ratio of the banks.

 

The plan would allow individuals who do not currently own a home but have money in a pre-tax account to be able to have adequate cash for a significant down payment or outright purchase.  The current homeowner vacancy rate is 2.9% of homes⁶.   Historically, this number is around 1.2%⁶.  This means there is an inventory overhang of around 2 million homes that need to be sold to bring the supply and demand of homes back into balance.  Until the surplus inventory of homes is sold, home prices will likely continue to drop.  It would take about 3% of the people who have an IRA/401K/403b to purchase a new home to eliminate this inventory overhang. 

 

The flat 15% tax on the withdrawal from the pre-tax accounts would also serve to improve the financial position of the U.S. government.  During calendar 2008, federal debt to the public increased from $5.14 trillion to $6.37 trillion (+24%) ⁷.  The $1.23 trillion dollar increase in debt to the public represents a significant draw on capital markets.  In 2009, CBO federal deficit projection was $1.2 trillion prior to passage of the stimulus package⁸.  A $180 billion dollar reduction in the federal deficit frees up the capital for other purposes within the economy.  There is also a recurring benefit to the government as these people would no longer have mortgage interest to write off on their taxes.

 

On an individual level, those able to pay off mortgages would have more disposable income to use for spending or investing.  From a consumer psychology perspective, the elimination of debt would eliminate much of the fear currently causing people to spend less.  When you have no mortgage, you have no fear of losing your home. 

 

 

Free Market Philosophy

 

As previously stated, mortgage debt rose from $6.3 trillion (66% of GDP) at the start of 2000 to $14.3 trillion (102% of GDP) at the start of 2008.  At the same time mortgage debt was rising sharply, money at zero maturity (MZM) was also rising.  MZM is money in savings, cash, checking and money market accounts that can be immediately liquidated.  MZM rose from $4.3 trillion (46% of GDP) at the start of 2000 to $8.2 trillion (58% of GDP) at the end of 2007⁹. 

 

The obvious question is why have people been borrowing so much money at the same time they are increasing cash?  I need to look no further than my own balance sheet to answer this question.  I have both a mortgage on a house I purchased in 2003 and significant money market holdings in my 401K.  Because of the existing tax laws, I am not willing to use my own cash in the 401K to pay off my debt.  If I chose to use money in my 401K to pay off my mortgage, I would be subject to a) the regular income tax rate, b) a 10% tax penalty, c) a phase-out of child tax credits (5%), and d) a blackout period where I could not contribute to my 401K and the loss of my company matching funds.   The incremental tax rate would exceed 50%. 

 

The proposal is not a proposal to create new government regulations, but to temporarily suspend the existing penalties associated with a free movement of money. 

 

The second reason that the proposal is consistent with a free market philosophy is that it does not eliminate “moral hazard.”  Recent government actions on bank and mortgage bailouts have financially rewarded companies and individuals who made bad choices at the expense of those who made sound financial choices.  With this proposal, individuals who took out NINJA loans (No Income, No Job or Assets) would not be financially rewarded at the expense of others.  Likewise, those banks and mortgage companies who issued these loans would still be on the hook for their bad choices.  Banks that followed sound market practices would be rewarded with the extra liquidity. 

 

Potential Downside to Plan

 

There are three potential downsides I see to the plan:

 

First, the liquidation of $1.2 trillion in assets in 401K/IRA/403b plans could potentially create downward pressure on stock prices.  About 50% of existing holdings in these plans are domestic equity funds⁴.  The remaining 50% is in international funds, bond funds, money market funds, and balanced funds.  While $600 billion is a significant withdrawal from the stock market, it is equivalent to the amount that was injected in the S&P 500 in 2007 through stock buybacks¹⁰.  The $589 billion in 2007 only had a minor impact on the stock market values with the S&P500 index only gaining 3.5%. 

 

There are also adequate funds on the sidelines to purchase these shares.  Money at Zero Maturity has increase by $1.2 trillion since the start of 2008⁹.  Any dip in stock prices due to the liquidations should be limited in duration.

 

The second downside that may be mentioned is that this plan reduces retirement savings as people reduce 401K/IRA/403b accounts.  While this is technically a true statement, a free and clear home is a significant retirement asset.  A retiree with no mortgage needs less money on a monthly basis.  If needed, a free and clear home provides a retiree an asset that can be sold or produce income through a reverse mortgage.

 

The third complaint that may exist is that such a plan would be bad for the mutual fund industry.  A 20% withdrawal of assets from these plans would significantly reduce revenue (-20%) for mutual fund management companies.  While this is a true statement, government policy should not support these companies at the expense of the individual holders of these assets or the economy at large.

 

 

Data Sources

 

Any questions or comments about the proposal can be sent to:

 

Charles Musick

musickcd@bellsouth.net

 

Data references to follow.

 

1. Mortgage debt source: Federal Reserve (http://www.federalreserve.gov/releases/z1/current/z1r-4.pdf) Table L2, Row 10 GDP Data Source: Bureau of Economic Analysis: http://www.bea.gov/national/index.htm
2. Consumer Debt Data source: Federal Reserve: http://www.federalreserve.gov/releases/G19/Current/ GDP data source: Bureau of Economic Analysis: http://www.bea.gov/national/index.htm
3. Other Countries with real estate bubbles Source: Wikipedia: http://en.wikipedia.org/wiki/Housing_bubble
4. 2008 ICI Factbook: http://www.icifactbook.org/fb_sec7.html#7.1
5. 27% drop in average balances from L.A. Times: http://latimesblogs.latimes.com/money_co/2009/01/401k-wall-stree.html
6. U.S. Census Bureau data: http://www.census.gov/hhes/www/housing/hvs/qtr408/q408ind.html
7. U.S. Treasury Department: http://www.treasurydirect.gov/NP/BPDLogin?application=np
8. Congressional Budget Office: http://www.cbo.gov/doc.cfm?index=9957
9. Money at Zero Maturity Date from St. Louis Fed: http://research.stlouisfed.org/fred2/series/MZM GDP: http://www.bea.gov/national/index.htm
10. Forbes Magazine: http://www.snl.com/snlitn/scans/052008increfor.pdf

 

Wall Street’s 700 Billion Dollar Bailout

This weekend the Bush administration proposed a 700 billion dollar bailout of bad mortgage debt to unfreeze the credit markets in the United States.   Some members of Congress even argue that this bailout is not big enough.   Through all of the arguing between how big or small the bailout should be the talk has been minimal in asking whether this bailout is necessary.  Just because everyone is saying it is necessary doesn’t necessarily mean it’s true.

The fact of the matter is that the federal government does not have the money to buy up this debt.  Instead, the government will take on debt to buy faulty mortgage debt.   This bailout policy is putting more people on the line, not less as a bailout may imply.   To understand the bailout one needs to look at the nuts and bolts of what goes on behind the scenes to make this plan go into effect.

Being the United States is running up huge deficits and is heavy in debt we don’t have hard cash to bailout faulty mortgage debt.  In order to initiate the bailout, we will have to print money to bail out the firms.  The printing of more money leads to an increase in the money supply is the same thing as printing credit and money out of thin air.  Too much credit in the system without the proportional increase in real wealth was the cause of the problem in the first place and now we are trying to solve it by creating more credit and more money out of thin air.  The answer to inflation is not more inflation.

There are many ways to solve our current economic problems.  We need to balance our budget by simply living below our means, return to a sound monetary policy of low inflation and low borrowing rates, and lowering taxes.  This would make housing more affordable for more people and increase our standard of living.  We would have temporary economic pain of a year or two but the alternative of this bailout is we could have economic pain for the next ten to thirty years depending on how many band-aids they put on the system.   These economic band-aids are propping up prices, which only prolong the pain.

Looks Can Be Deceiving

When looking at a political issue whether it be oil, health care, or any other political issue that exists, there is always what appears to be going on and what is actually going on.

What I See

When I see oil prices are high, I have noticed gas prices rise and have noticed the average consumer and business feeling some sort of financial pressure directly related to the rising costs of oil prices. I also notice that many oil companies are making recording breaking profits.

In regards to health care, I notice health insurance premiums that are expensive to many people, pills would be extremely out of me and my families reach if it was not for their insurance policy, and I notice many people who cannot afford health care in this country.

What I Want

I want to see a United States that is energy independent, energy efficient, and can use every resource available to us without disrupting our way of life. I would love to see a United States where people are not starving because they cannot afford to drive to the supermarket because of high-energy costs and to see businesses flourish, innovate, and create technologies that change the world without energy prices being a sole factor it that not happening. I would also love to see families having enough money to pay for energy costs as well as other basic needs.

In Regards to Healthcare, I would love prices to be affordable to as many people as possible in our country.

How to Accomplish These Goals

This post is not to divulge into a debate about policy; that is for another article.

Most debates tend not to be about what we want but how we go about getting what we want. Noticing symptoms of a problem is easy and diagnosing the remedy is always the most challenging part. To have sound policy on any issue, the first step is to make an effort to understand the underlying problem or problems and asking ourselves how we got here.

If energy is rising faster than our standard of living and it was not always…why is that happening?

If health care costs are rising…what is causing the prices to rise?

With so many moving parts to what is really going on behind the scenes who are we to say that we are seeing the whole picture. If we can acknowledge what we notice may or may not be the whole picture, our solution to fix the problem may radically change or maybe the solution will stay exactly the same. If we assume our assumptions are right automatically and that the way we see it is the only side of the story, we risk making one or more decisions that could ultimately lead to a completely new set of problems we did not even anticipate.

Obama on Oil

John McCain’s support of the moratorium on offshore drilling during his first presidential campaign was certainly laudable, but his decision to completely change his position and tell a group of Houston oil executives exactly what they wanted to hear today was the same Washington politics that has prevented us from achieving energy independence for decades. Much like his gas tax gimmick that would leave consumers with pennies in savings, opening our coastlines to offshore drilling would take at least a decade to produce any oil at all, and the effect on gasoline prices would be negligible at best since America only has 3% of the world’s oil. It’s another example of short-term political posturing from Washington, not the long-term leadership we need to solve our dependence on oil. Instead of giving oil executives another way to boost their record profits, I believe we should put in place a windfall profits tax that will help to ease the burden of higher energy costs on working families, and we should invest in the affordable, renewable sources of energy that Senator McCain has opposed in the past,” said Barack Obama.

After reading this from the Obama campaign, I’ve got to say that I think Obama may be the most clueless politician around when it comes to economics; particularly the economics of oil. Where to start? While there are many issues I have with his statement, two in particular are especially horrible.

First, he complains that, “opening our coastlines to offshore drilling would take at least a decade to produce any oil at all.” This is the same argument Bill Clinton made in 1996 about drilling in the Arctic National Wildlife Refuge (ANWR) when he vetoed legislation allowing the drilling. It would have been very nice if oil from ANWR had started pumping in 2006. 500,000 barrels per day may not have solved all of our problems, but would certainly have impacted our economy in several ways. First assuming that drilling in ANWR didn’t impact oil prices, this would have reduced our trade deficit by almost $20 billion per year. The reality is that it would have also impacted oil prices, so the price of imported oil would have dropped which would have reduced the trade deficit even more. The irony of Obama’s statement is that he then calls McCain’s position “short-term political posturing.” It is amazing to me that Obama complains off-shore drilling will take too long so it is short-term posturing on McCain’s part in the very next sentence.

His position on off-shore drilling is bad, but not as bad as his support for the windfall profits tax, “I believe we should put in place a windfall profits tax that will help to ease the burden of higher energy costs on working families.” This is one of the dumbest statements imaginable and proves Obama has no clue on how the economy works. The windfall profit tax will not ease the burden on working families, but will put a tax directly on them. Here is how a windfall profit tax will work in practice:

You have a company like BP that pumps oil out of the ground in Russia with TNK. This oil is then refined overseas. Once they have products like gasoline and diesel, they then decide where to ship these products since there is a surplus of gas and diesel in Russia. Option 1 is to ship it to the U.S. Option 2 is to ship it elsewhere. If you ship it to the U.S., your profits will be taxed with a windfall profit tax. If it is shipped elsewhere, it will not. BP will ship the product elsewhere until U.S. prices increase enough for the NET profit of shipping it to the U.S. to equal the NET profit of shipping it elsewhere. In other words, pump prices will have to increase the amount of the windfall profits tax to make it worthwhile to ship to the U.S. I’m not exactly sure how this eases the burden on working class families.

The Politics of a Pump and Dump

mPhase Technologies, a developmental stage hi-tech company has some exciting products they claim to be working on. One of the featured technologies they proudly mention on their website is the magnetometer. The magnetometer is similar to something you would see in an unrealistic film sci-fi movie. Of course this technology is “real”. The magnetometer can detect different metals that management says will help future security threats in and other high security locations. What is baffling is the example they use to explain why the magnetometer is so great is that it was able to detect a crowbar from 10 meters away. This should lead to high skepticism.

One will not find this information in their 10-Q’s but in YouTube videos, which are also displayed on the front page of their website. Surly this is a way for management to pump the stock to show would be investors how great their technology is.

Senior management have a long history together. They used to run a company called PacketPort.com, which was a pump and dump from 2005. A simple search of the SEC Litigation page will return several hits.

“The Securities and Exchange Commission filed an enforcement action on November 15, 2005, charging six individuals and four companies with securities fraud and other violations in connection with a scheme to pump and dump the stock of PacketPort.com, a company based in Norwalk, Connecticut. The SEC alleges that three PacketPort.com officials and two stock touters, aided and abetted by a registered representative, executed the pump and dump, which obtained more than $9 million in illicit proceeds.”

Top management, Ronald Durando and Gustave Dotoli are certainly a management team shareholders may want to think twice about.

“The Complaint alleges that Ronald Durando, a 48-year-old resident of Nutley, New Jersey, privately acquired a majority stake in an insolvent public company, then called Linkon. His stake in Linkon consisted of restricted shares. With the help of his colleagues, Gustave Dotoli, a 70-year-old resident of Nutley, New Jersey, and attorney Robert H. Jaffe, a 69-year-old resident of Mountainside, New Jersey, Durando took control of Linkon and changed its name to PacketPort.com. Durando became president and CEO, and Jaffe and Dotoli became directors. Durando, Jaffe, and Dotoli laundered restrictive legends from Durando’s share certificates so that the restricted shares could be passed off to the public as “free trading.” Durando then paid IP Equity, Inc., a private California corporation that operated an Internet-based stock newsletter, and its principals, M. Christopher Agarwal and Theodore Kunzog, to publish false publicity and bogus recommendations about PacketPort.com in order to pump up the stock price. The share price more than quadrupled following the false publicity, rising from about $4.75 to a high of about $19.50.”

Durando and Dotoli also happen to be running mPhase Technologies. These crooks aren’t just unethical but from a very bird’s eye view downright stupid. Perhaps they should realize that committing similar crimes for something they have already been accused for in the past would hurt them in court; mPhase is PacketPort.com déjà vu. Unfortunately past litigation and investigations into management’s former affairs should lead one to believe they will never have the opportunity to use a magnetometer as it makes sense to conclude that this product is only an mPhase shareholder’s delusion created by a YouTube video.

Irresponsible Compensation at Societe Generale SA

Societe Generale SA is a prime example of how a corporate culture can lead people to make extremely poor financial transactions. Jerome Kerviel was the name of the futures trader who helped cover up some very large trading positions that led to a $7 billion loss. Kerviel’s trading results for the year had a direct correlation to his bonus. As any rational investor would know, a one-year performance by itself is not highly correlated on average to one’s long-term performance. In addition, the way one makes returns is just as important as the returns themselves. This is the reason many funds who make triple digit returns on high leverage tend to do poorly or blow up in the years to come. The average fund by definition must perform by the mean performance of all funds. One could also assume with high certainty that the mean return going forward will be in single to low double digits and certainly much lower than triple digits. Therefore, you could be 99% confident that if you take all the funds that use excessive leverage to make abnormal returns a reversion to the mean will take place. This is why a corporate culture that rewards for excessive short-term returns are only asking for disaster ahead. In Kerviel’s case, he succumbed to human emotion and not some sort of money laundering, which many thought to be the case originally.

Iran’s President Wants it Both Ways

The associated press came out with a staggering report out of Iran this morning. Iranian President Mahmoud Ahmadinejad declared $115 barrel oil “too low”. He said, “The oil price of $115 a barrel in today’s global markets is a deceiving figure. Oil is a strategic commodity that needs to discover its real value.”

He also claimed that $115 barrel oil was still below the inflation adjusted highs set in 1980. Ahmadinejad called the United States arrogant and selfish and said us Americans believe oil is a free commodity. He then went on to comment on the U.S. currency and called the dollar “a handful of paper” lacking global support. A website quoted Ahmadinejad as saying, “The dollar is not money and longer but a handful of paper distributed in the world without commodity support.”

Ahmadinejad’s points he was trying to make are right on the mark but the evidence he uses is certainly flawed making his credibility all but lacking. I must downright dismiss his remarks that the price of oil is still too low. While I believe oil is bound to go higher the current price of oil is the current price of oil with no questions asked. There’s no conspiracy to keep the price of oil low. Now a much more appropriate argument would to say that per cup oil is cheaper than bottled water and to go more in depth on the facts of oil depletion. Making the argument that global production is higher now than it most likely will ever be again it would be all but conclusive that oil is bound to shoot up higher than it is right now.

His inflation adjusted numbers do nothing to support his claim. If you adjust the 1980 high of $38/bbl you will get a number between $96 and $103 barrel oil. Even if the price is lower than it was in 1980 it certainly should be higher anyway as global production was still increasing even though the United States peaked nationally in the early 1970s. Whether the numbers are higher are lower by some a few percentage points is trivial and a moot point as it totally disregards the reason why oil prices are where they are today. It’s about the rate of oil depletion a topic Ahmadinejad didn’t mention once.

His bearish view on the dollar has no merit. He calls it a handful of paper with no global or commodity support. He is right the commodity support is not there but fiat currency is not backed by an underlying commodity but a faith in the nation which the currency is printed that their monetary and economic policy is sound. Global support is still certainly there. While it may not always be there the facts Ahmadinejad are stating are downright incorrect. The Chinese are still buying our debt and as long as this happens our dollar will remain somewhat propped up. Of course if this support ever went away our dollar would crash and would only be compounded by runs on the dollar and the U.S. banking system. Neither our gold reserves at Fort Knox nor our currency reserves would be enough to help keep our currency stable in that situation as our gold would last two days and our currency reserves roughly eight seconds.

Ahmadinejad seems to want it both ways as these assertions seem nothing more than Iranian PR. It is no surprise that high oil prices and a weak dollar would benefit Iran’s economy. Of course if the reason for high oil prices is an increase in the rate of global oil depletion than that would mean Iran and Iraq may certainly be in decline and would also assume their reserves may be less than what has been stated. This would give not only Iran but all OPEC nations less leverage in the world.

On a more rhetorical note, a crashing dollar crashed would not be a handful of paper but of cotton

Source: http://biz.yahoo.com/ap/080419/iran_oil.html

Seth Klarman at MIT Sloan

On October 27, 2007, Seth Klarman who manages the Baupost Group gave a speech as well as answered questions at the MIT Sloan Investment Management Conference. Klarman stressed tuning out daily market blips. He noted most investors can’t tune out the so called noise. I would tend to agree with this assessment. Even so called “Buffett Followers” who preach his mantra of never looking at stock quotes – many of them do, it’s just not in vogue. His conservative and somewhat boring approach to investing has given him impressive returns by any measure. Not only has he significantly outperformed the market but he has made money for his limited partners 24 out of 25 years. The key to this high yield investing approach is to first focus on downside risk before even considering the upside. He has also made his money without ever using leverage. Klarman makes the point that the market should not dictate you and using margin allows it to do just that. “It’s a slippery slope”, he said while referring to using leverage. “If you are on a small amount of leverage, why not use more?” Leverage is addicting.

“We are in an era of leverage,” he said to the crowd. Klarman noted that the last two generations of American have been using their homes as ATM machines and have been buying more goods on credit. He pointed out the problem wasn’t just amongst Main Street. Investment Banks have been pushing structured investment vehicles and exotic finances and the rating agencies have been labeling “toxic waste” as investment grade.

This situation has certainly become worse since October of 2007 and Klarman seems to have been very right on the severity of this theme which many pundits were calling trivial. Klarman noted last year that “Leverage is at record high levels…probably the beginning of a credit de-leveraging period.” He pointed out that the debt crisis is probably not near the end since people who owe money are taking out more debt to cure the problem. “This very ‘cure’ is what caused the problem in the first place”, he said.

In today’s environment credit receivables are ballooning. Perhaps the next round of defaults will take place in this arena. If you can’t take money out of your house anymore why not just swipe plastic? This type of mindset I believe is very prevalent in American society and while pundits such as Larry Kudlow will easily dismiss this rationale, I would be skeptical of this assessment.

Big Oil Once Again Abused by Congress

Once again as prices at the pump skyrocket big oil executives had to defend themselves against critics in Congress. These hearings aren’t a surprise though. Every time gasoline prices make a big move to the upside Congress howls in anger pointing the finger at an “Oil Company Conspiracy”. Of course any rationally minded human being would know gasoline and oil were all publicly traded commodities as is heating oil and natural gas.

One would think the chairman of the House Select Committee on Energy Independence and Global Warming would have some insightful remarks to dispute the “evil oil company” claims unless of course the one making the most foolish remarks was the chairman himself. Rep. Ed Markey of Massachusetts demanded, “The American people deserve answers and it is time for Big Oil to go on the record about these record prices.”

“Given that the largest contributor to the cost of gasoline is crude oil, this has translated into record-high gasoline prices,” Peter Robertson, vice chairman of Chevron said.

He also wanted to know why big oil hadn’t put more money into alternative energies. Perhaps it didn’t cross his mind that he was questioning “Big Oil” hence the word “oil”. Maybe he should ask executives at Pfizer why they aren’t putting more money into Vitamins or why Exxon Pays more taxes to the US Government then they have US revenue. Why not ask why we push fuels with negative energy yields such as Ethanol and Hydrogen which do even more damage to the environment than the usage of gasoline? As someone who should have vast knowledge on the subject of the oil industry as well as alternative fuels and their contributions to pollution or lack thereof, these questions are nothing but disturbing as they show the lack of competence in Congress to one of the largest issues to not only the United States but the world.

Dominion Homes Takes Buyout Over Bankruptcy

On September 10, 2007 I wrote an article about Dominion Homes, the struggling homebuilder based out of Ohio. The company was highly leveraged, had close to no cash on the balance sheet, and owned roughly 400 million dollars in land on the books. With tight liquidity in the housing market the company was having trouble selling off its inventory. With roughly 200 million dollars of long term debt on the balance sheet, the company was flirting with bankruptcy.

I suggested the company would make a fantastic buyout candidate as the company was trading for a mere fraction of the 200 million dollar book value. The reasoning behind a buyout was that a larger company with a stronger balance sheet could pay down its debt which would take bankruptcy out of the question as well as increase Dominion’s credit rating. The transaction would also allow for Dominion Homes to wait until the housing market rebounded to sell off its land instead of forcefully liquidate. While the company may get below book either way, there is no question Dominion Homes would get more for their inventory if they had the luxury of not having their lenders demanding payment. Of course the only way they could achieve that luxury would be paying down their debt and the best way to do that would be to have someone else do it for them.

On January 18, 2008 Angelo Gordon & Co., L.P. a well respected firm along with Silver Point Capital, L.P. decided to take the company over for the bargain price of 65 cents a share which would equate to about a 5.5. million dollar market cap. While Angelo Gordon and Silver Point are practically getting this company for nothing, shareholders of Dominion Homes faced two awful choices to make: Sellout at fire sale prices or go bankrupt and be left with possibly no equity. Bankruptcy was just an option they couldn’t afford so they had to do the next worst thing which happened to be the only other option.

Management made a press release that very day saying, “The homebuilding industry continues to be in a very difficult period,” said Mr. Borror. “This transaction will allow Dominion Homes to continue our 55-year tradition of building quality homes that exceed our customers’ expectations.”

The press release also hinted to one of the obvious reasons of the buyout saying , “The Company also announced today that it has entered into certain amendments to its existing credit facility with its lenders in anticipation of the merger transaction. The lenders have agreed to increase the Company’s borrowing capacity under the credit facility by approximately $3,500,000 and to forbear until the earlier of June 30, 2008 or termination of the merger agreement from exercising their rights and remedies under the credit facility.”

This deal could be no further from what was perfectly inevitable. While I did predict this several months prior, my feat was none other then logic and far from predicting the future. This is also a good example of why never to buy a company in hopes for a buyout. As the company looked cheap at 3 dollars which was where the stock price hovered at the day I wrote my original article. There is an arbitrage opportunity where one has to see whether the probability of the deal will go through. As I write this the spread is roughly 6.5% and levered up 2:1 that is a pretty nice rate of return within the amount of time the deal should go though, assuming it doesn’t fall through.