Handling Finances

With recent worldwide food shortages causing riots, the scarcity and price of food is a serious issue.  Our food prices have increased significantly from flour and rice prices up 13% this year to eggs that are now 30% more expensive than last year!  While increasing prices are squeezing some who are just barely making ends meet, the truth is that the vast majority of us can easily absorb this kind of price increase simply by occasionally biking to the store or canceling our internet access or cell phone contracts.  The truth is that we’re not in danger of starving as in many countries.  I was surprised, then, to see an article from the Wall Street Journal advising readers to stockpile food as an investment (note: I linked to the Yahoo Finance page since it’s freely available to everyone)!

Be honest — how much money do you actually spend on rice every year?  I eat rice once a week or so, and I suspect I could “invest” $60 in a year’s supply of basic white rice.  Even if price increases accelerate (and they probably will), earning 20% on this investment will gain me $12 a year.  Yes, 20% is a lot, but thinking clearly for a moment, how much space am I willing to invest along with my money?  I’ve got to be honest, emptying out a closet for my food stockpile is not worth the $200 or so I could save a year.  And that’s not even counting the fact that I’ll eat a lot more of these stockpiled foods if they’re so easily available.

What Should We Do?

Are you really worried that food prices will continue increasing?  I sure am!  But instead of throwing out your kids toys to make space for bags of flour and rice, consider investing that money in companies that will profit from increased food prices.  Farmers will certainly make more money, and in turn they will buy more farm machinery and have more money for fertilizer and irrigation etc…  Of course, you could also invest in funds that buy wheat, corn and rice directly, but I find that pretty immoral — essentially you’re hoarding much more food than you could ever use and driving up the price at a time when people around the world are starving and rioting due to the scarcity of the food.

Also, I don’t see a problem with keeping your pantry full.  Don’t buy as little flour as possible because it’s more expensive, keep your flour bin full and as long as the prices continue to increase, you’ll always have some food at lower, pre-increase prices.  This strategy also gives you a bit of a buffer in case the locals go a bit crazy and buy all the rice in your town for a week or two.  While you won’t be contributing to the panic buying, you’ll also have plenty of food to last until new shipments come in and demand drops to more reasonable levels.  We’re not going to run out of anything — it’s just going to get a bit more expensive!

Why are Prices Increasing?

It’s really pretty basic supply and demand.  Countries like India and China are becoming much more wealthy, and as their citizens rise from poverty, they start to purchase more and more high-quality food.  At the same time, the global demand for bio-fuel like corn-based ethanol drives the prices of some specific crops.  When certain crops become more profitable than others, farmers abandon other crops, decreasing the supply of ALL crops and raising prices across the board.  Add in the occasional local drought or flood, and mix in some institutional investing (i.e. pension funds buying wheat futures for profit) and price increases aren’t all that surprising.

Stop Complaining and Give!

In the end, it’s no use complaining about it.  Some Americans will have to tighten their belts and maybe even give up high-end foods like porterhouse steak.  A few will have to choose between staples like clothes or food.  Most of us will simply have to accept that inflation works in cycles and be grateful that we’re wealthy enough that we don’t have to worry about whether we’ll survive the riot when we go to the supermarket.

Look at your rising food costs and instead of feeling sorry for yourself, consider those around you that truly can’t afford the increase.  Increase your giving to food shelves that are hurting badly at the double problem of rising prices and lower contributions in a slowing economy.  Consider donating to charities that specialize in bringing food to the neediest on our planet.  I’m particularly fond of CARE as they try to purchase food locally instead of dumping cheap food in a country and potentially harming local farming, but the issue is not one-sided, and in a time of crisis like this, any well-run charity that fights poverty will make good use of your money!  Check out Charity Watch for information on charities that use money responsibly and to weed out the scams.

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.