Handling Finances

On the radio a few days ago, I heard an interview with New York Times economy columnist David Leonhardt on the state of the economy. The interview centered on his column from March 19, 2008 called “Can’t Grasp Credit Crisis? Join the Club.” The first line of the column grabbed my attention: “Raise your hand if you don’t quite understand this whole financial crisis.”

In short, the stock market is jumping around like a caffeinated jackrabbit on a hotplate because nobody really knows what’s wrong. Subprime mortgages and other subprime loans got sliced up, packaged together and sold in so many different ways that it’s been nearly impossible to figure out which investments are losing how much. And when people don’t know how bad it is, they tend to panic. That’s what happened to Bear Sterns — the major investment banker that is being sold for a small fraction of what it was worth a year ago… or even a month ago! They didn’t just lose all their money investing in risky subprime loans, but when the market panicked, people started pulling millions of dollars out of Bear Sterns (and other investments like mutual funds) to protect their money from further losses. The more people sold, the more Bear Sterns was forced to sell more and more failing investments — right when they were at their lowest. After a few weeks and months of selling more and more of their assets at lower and lower prices (desperate to repay those who asked for their money back) they were finally forced to admit that they didn’t have enough assets left to cover all their obligations. It’s really similar to a run on a bank where too many people ask for their money back, but since the bank has loaned most of it out, they can’t repay it right away and end up in big trouble with it’s patrons (though in the US, there are protections to keep this from happening).

So what caused the credit crisis?

So some of the trouble — and certainly the speed and magnitude of recent market declines has been caused by fear and panic among investors. To understand what set it off requires a bit more understanding of recent economic history.

After the real-estate slump in the early 1990’s, mortgage lenders were becoming increasingly national and international in scale rather than simply local. Instead of developing long-term relationships with their borrowers, they competed for loans nationwide and lowered fees while creating new types of mortgages like ARMs — perfect for people who aren’t planning to stay in their house for more than a couple of years and want to save on interest.

Everybody was sure that home values could never drop nationwide, and with the federal funds rate held very low to ward off a second recession in the early 2000’s, everybody from homeowners who took out mortgages with little or no down payment, to big-time investing firms were increasing their returns by heavily borrowing at a low rate and investing in the high interest-rate subprime loans. When betting with borrowed money, even a relatively small drop in investment value can wipe out the investor which explains why so many groups went bankrupt all of a sudden. To make it worse, since the investing firms don’t always know how much exposure they have to the subprime loans (since they’re all sliced up and packaged in many different ways), they’re now holding onto cash to avoid the same fate as Bear Sterns by running out of money as investors ask for their money back. More cash means less investing which just compounds the problem as those trying to sell have an even harder time finding buyers and are forced to drop prices even further.

It’s a highly complex issue with all sorts of ripples affecting what would normally seem like barely-related investments. My main goal through this whole mess is to follow it closely and learn as much as I can — this kind of perfect storm doesn’t come often, but it’s always a potential danger and understanding how bubbles grow and burst is the first step to recognizing them in the future.

This weekend, Bear Sterns, a major mortgage-backed investment firm, announced that they’d lost a whole lot of money and had to borrow money from the government and J.P. Morgan to avoid becoming worth less than they owed.  Bear Sterns stopped returning investor money as they worried they didn’t have enough assets to cover redemptions, and they agreed to be purchased by J.P. Morgan for $2 per share — a huge drop from around $60 per share just day ago!  J.P. Morgan is paying around a fifth of the value of just Bear Sterns’ Manhattan office building so they must have invested a whole lot of borrowed money in sub-prime mortgages to reach this point!

What’s interesting to me is that Bear Sterns profited heavily from sub-prime lending, but ended up losing everything by leveraging, or borrowing money to invest in these mortgages.  Just like people who took out home-equity loans when home values were rising, Bear Sterns made a lot of money investing borrowed money.  Similarly, just as many people are now left owing more money than their homes are worth, Bear Sterns proved once again that investing borrowed money is inherently risky.

The lesson: don’t place bets with borrowed money!  At Rocket Finance, rocketc is doing something similar — investing the money from 0% credit card offers in the historically safe money market funds.  Money market funds are historically extremely safe, but if he’d put the money in a stock market fund, he’d be seriously risking his money.  If you’re going to need the money in 12 months (say to pay back your credit card when the 0% offer ends, or to pay off investors when they ask for their money back) playing with borrowed money is risky.  In my mind, it’s no better than a lottery — in an up market you have a good chance of making a lot of money, but you can neither predict when the market will turn on you nor how far it will fall when it does.

I was listening to NPR and learned something very interesting on why oil is so expensive

these days.  At well over $100, oil is now more expensive than it ever has been — even adjusting for inflation.  There are some obvious reasons like increased demand in China and India and the possibility of an American invasion of Iran, but these factors are not enough to account for the current high price.  I found it interesting that apparently investors are driving up the price of oil — it’s not just supply vs. demand any more.  The report noted that funds like pension funds and sovereign wealth funds are putting billions of dollars into funds that trade oil much like others trade currency and stocks.

These oil-trading funds had a total of $9 billion in 2000.  Now, the oil-trading market is well over $250 billion.  In comparison, the whole world uses about $8-9 billion dollars a day, so it’s no longer just a inflation-proof investment but a full-blown speculative bubble!

While the high prices are making many oil companies a whole lot of profits, they’re also hurting industries like airlines and trucking that are heavily influenced by the price of oil.  I’ve seen a number of reports lately of airline representatives talking about how they won’t be able to run much longer at current levels.

What does this mean for us?  Well, unfortunately, the price of oil is being driven ever higher as speculative investors rush in to be a part of the soaring profits, and there’s really no way to know when it will end.  On the plus side, the bubble is bound to burst and the price of oil will plummet, but again, it will probably hurt consumers again as speculators drive the price of oil lower than it’s really worth.

Just like the ’90s tech bubble and the recent sub-prime financial bubble, the oil bubble is going to burst some time and when it does, a lot of people will lose money (and a rare few will end up on top).  I’m going to try to avoid investing in oil-related stocks in the near future since I’m not interested in trying to carefully follow it to have a chance of pulling out near the top of the bubble.  Of course, that won’t change my investing much as I’m largely invested in index funds and ETFs.

In short, expect the price of oil (and gas) to continue to climb way further than makes sense.  Also expect it to plummet when it stops climbing and investors try to protect their profits.  It’s unfortunate that such basic staples are affected by this type of speculative investing (similar to the increase in grain prices, though that was more organic and driven by farmers than investors in my understanding) but it’s just the way our capitalist world works.  Just stay alert and watch for this type of speculative bubble and above all, stay diversified!