Although I believe in taxing the employees of the companies using poor business practices and subsequently require the government to bail them out  (See my 16 Feb 09 Article), I don't like the 90% tax on bonuses of $250,000.  I was thinking about Mr. Liddy the CEO of AIG.  Here is a man that was asked to take over the reins of the company after all the damage was done.  I'm sure by now the company has already paid him $250,000 for this year.  Suppose this rule applies to him.  I put myself in his position and I'm thinking I'm sitting there in front of congress.  After the first congressmen tells me of this plan I'm going to look at him and say "Mr. Congressman, I was asked to take over this company after all the damage was done.  I've been paid $400,000 for the work I've done to this point in the year.  Do you mean for this law to apply to me?"  If the answer is yes then this man if he stayed would end up working the rest of the year for $0.  I don't know how rich he is but it doesn't make any sense to me that he would continue to stay in that job because this man could easily go somewhere else.  I suppose if he is rich enough he may do it for the challenge.  

So maybe he would do it for the glory but I'll bet there are 70 other people in that firm that already made more than $250,000 for the months Jan - Mar.  Would we really expect them to work for $0 the rest of the year?  Especially since I'll bet that even if they are in the division that caused the problem 10 or 20% of them probably have been there less than 1 year and did little to contribute to the problem.  Why would we include them in the "punishment"?

How the Financial Institution fix should have been conceived

I know I hinted at this a couple months ago but now I believe it more than ever so I will expand.  The problem was some banks made bad loans so all banks got scared and therefore they were not lending money.  The government should have stepped in and made the loans to those evaluated as good risks.  In other words the government should have established a bank funded it with the $800 billion dollars and made the loans to those companies and individuals that were reasonably safe loans.  If the government was in business and siphoning away all the good credit risks loans from the established banks the banks would soon realize they need to either compete for the good loans or else the only people left to do business with will be marginal credit risk entities.  It is hard to predict which of these the banks would chose but either way it is a win, win situation for the consumer, the banking industry, the government and the country.

Suppose they chose to compete for the good credit risk loans, this would free up the $800 billion so the government can work the margins.  Suppose they chose not to compete then they either chose not to make any loans or they start to make loans to the margins.  If they chose not to make any loans they don’t do any business and don’t make any money.  In this case the government makes money on the good credit risks and then has money to work the margins.  If they chose to make loans to the marginal credit risks then the marginal credit risk market is served.  It is obvious the public is served with this approach because the credit market is served.  The government benefits because at least initially they are lending to the best credit risk and thus likely to make a profit.  The banking industry is helped because the banks that are likely to survive after the process runs its course are those that practiced sound banking principles the past 10 years and will cull those that have not implemented sound banking principles.  After the badly managed banks have left the market the government can sell or privatize this financial rescue bank.

This method offers many solution to the problems we see caused by the poorly conceived and implemented TARP.  With the TARP we took the stress of possible failure away from an industry that has put the country at horrible financial risk.  This allows them to bunker down to ride out the storm while the rest of country flounders trying to make up for the service they are no longer providing.  With the method I propose here they have to get in the game to survive.  Not only that they would have to do it efficiently and at a competitive cost.  From what I understand the banks have traditionally calculated mortgages at 1.85% above a rate based on the sales prices of long term government bonds.  In order to keep their previous revenue they have recently begun adding a 3% premium above this rate instead.  This allows them to suck the money away from their best customer base and restrict access to the mid risk customer and still maintain their own standard of living.  So the only people that aren’t penalized are the banks.  If the congress created competition in the market place that was forced to loan with a premium of 2% above the standard for highly qualified borrowers then the other banks would compete for the best customers and we would see offers of cost + 1.85 traditional rate.  Now the banks will either be forced to control costs such as executive pay / bonuses, corporate jets and staff parties or they will have to pick the best mid level risk borrowers to make loans to in order to make that additional profit.

I’m going to add a little commentary here.  Whenever, I see the congress grilling the CEO’s of the major banks about the excesses  force them to commit to a salary cap and mock them for planning corporate get a ways I actually feel sorry for the CEO and other employees at Wells Fargo.  I can’t be sure but from all accounts Wells Fargo was and always has been in pretty good shape and appears to have followed good banking procedures when the rest of the banking world had gone a muck.  Yes they ended up getting forced to take some money in the original bail out.  But they pretty much did it at the barrel of a gun.  Now the CEO has to bite his tongue and Congressmen and Senators take pot shots at him.  The employees of a perfectly healthy bank had to cancel a traditional get away even though they as a team had the disciple to do things right while the employees at other firms were raking in money through unsavory practices.  What is worse yet when the government decided to save the other companies they took away the competitive advantage the well managed bank had and significantly weakened the ability the positive aspect of good banking strategy would have had on future banking practices.

Stated more simply if the government would establish my plan a well managed bank such as Wells Fargo would survive and become the dominant bank post financial crisis establishing the model for future banking practice.  With the current plan the banks that were able to become the biggest players during a period with no scruples get to keep their gains and will undoubtedly fall back into the only practice they know once no one is looking.

Oh, one last thought.  I know a lot of people are saying “That wouldn’t have worked because it would have taken to long to create this federal bank”.  This of course is wrong because if the government had let Washington Mutual or Citibank etc. fold and go into federal receivership there would have been a ready made bank infrastructure of buildings, employees and relationships to conduct banking business.  All that would have been left to do was fund the $800 billion and define the rules at which the loans would be made.  Whalah a federal bank.

NOTE:  I decided to post this without making sure all sentences were written to clarity.  I thought the subject to important not to get the discussion underway and will rely on your ability to understand more then my ability to convey until I have time to edit for clarity.

Financial Crisis Preventions

For months now as citizens of this nation we’ve heard and talked about the financial crisis and solutions but very little if any talk has been dedicated to future prevention.  When I started this expose’ I was a little concerned the reaction would be “why are you worried about future prevention when we are in the middle of a crisis right now  --  Lets fix this one before we worry about the next”.  After about 3 seconds of thought I realized the specific subject I wanted to talk about in this article if left uncorrected will significantly degrade our ability to get out of this financial crisis.  One more caveat before I start writing on the crux of what this article is about.  This particular article is meant to address only one point.  It is a critical point but one that is only 25 to 45 % of the problem and the solution I suggest is probably only 10 to 15 % of what needs to be done.

The problem I intend to address today is peer pressure, specifically the lack of it.  Maybe not the total lack of it, but certainly the failure of it to lead in a beneficial manner.   There has been a lot of attention on CEO’s and a little in bank regulators but the fact of the matter is it is the participation of the rank and file members of the organization that codify the destructive behaviors into company policy.  Revisiting the Ernon tapes again you see the references to Grandma Millie weren’t made by Kenneth Lay or any of the top brass.  These were mid level everyday people.  These were mid level everyday people that were sitting next to and working with people just like you and I.  If the people that were sitting next to the people making those comments and actually doing the market manipulation would have stepped up and put a stop to it then there would not have been an energy crisis in California.  For whatever reason those people that were just like you and me either started to participate in the same behavior or passively ignored it (but were still willing to participate in taking the profit).  Though most of these people ended up losing it the end anyway and the rest of the country in the rest of the industries should have learned from this you can see from this financial crisis the lesson did not take. 

Now in the financial crisis I am going to concentrate just on three of the players, the banks, the regulators and the appraisers.  Two other responsible parties I’m not going to spend much time on; the traditional real-estate agents and the buyers/sellers.  In my mind I give the real-estate agents a pass, it really is their job to get the best price for the seller.  For the most part the sales pitches they give are annoyingly optimistic but generally consistent with the morality code of the sales industry.  Buyers/Sellers are a different situation all together and desire a specific chastisement.  I can’t give banks and appraisers passes however.

I bought a house just before the bubble burst.  During the process my wife was all concerned about how much the house we wanted to buy would appraise for.  I laughed at her and told her “sweetheart, the appraisal is going to come back and it will be 3 to 7 thousand dollars above what we’ve agreed to in the sales contract.”  I continued, “ this would be the result whether the contract was $265,000 for this house or $165,000 for this house.  It would matter.  It’ll be 2 to 7 thousand above the negotiated price.  If the seller agrees to sell the house at this price, the buyer agrees to pay this price and the bank looks like they will give the loan, the appraiser will rubber stamp the deal and take his cut in the process”.  Since the stated purpose of the appraiser was to put some logic into prices and they totally failed to do this to ensure their own gain I include appraisers and their firms as candidates for my method to help prevent future financial crisis’s. 

However, it is the banks and the bank employees that fit the best candidates for immediate implementation.  Again when I bought my house the bank was telling me I qualified for loans in the $350,000 to $400,000 range.  I looked at my finances and I was thinking, “what kind of morons are these guys”.  I ended up buying a house financing about half that.  Even then I was uncomfortable.  Now I could kick myself and will spend a lot of time on how I messed up when I get around to the buyer / seller composition.  But part what led me to get this stretched out was factoring in how much the banks thought I could handle.  This was totally irresponsible of the banking industry and it came about largely because the people responsible for making the loans received their compensation based on a percentage of loan amounts.  Regulators really messed up allowing this type of compensation package to stay in place.  Regulators including the congress of the United States are prime candidates for participation in my plan to help discourage the next financial crisis.  But it was the rank and file bank employees that should have been the first defense for preventing this present crisis.  They were the first to realize they were making loans to people that wouldn’t be able to pay them back.  They devised the plans to shed those loans from their own company’s books and con other companies, governments, pension plans to assume the risk and they enriched themselves in the process.  Therefore, I think my plan is a must for banks that wholly participated in creation of these toxic assets.

So what am I proposing:  For those people that worked for companies that directly led to the financial crisis I propose for the next ten years we multiply the total income tax a normal person would pay given the same income and deductions and increase that amount by 20% and make that the amount they owe in income tax.  This plan would be relatively easy to implement.  Every W2 we get includes the employer tax number.  That means the employees of Washington Mutual, Lehman Brothers, Sallie May etc got a W2 that breaks out they were employed by these companies.   If the 2009 tax forms required people to fill in a line that includes the employer numbers of the places they work in the last ten years.  Everyone that includes numbers for Freddie Mac, Merrill Lynch, and AIG would do their taxes normally after they compute the amount a normal person would pay multiply that number by 1.2 to compute the tax they owe. 

The Bail-out Discussion - I've heard a couple discussions about buying mortgages.  The most quoted female's plan seems to offer too much of a guarantee to the holders of the loans.  The other talks about lowering the principle of loans for the home owners that may be "underwater" on their houses.  I believe it would stabilize housing prices better if they negotiated interest rates lower instead of lowering the principle amount.  For instance suppose the person bought the house for $300,000 and initially paid interest rate of 3.5% but then it adjusted so that now the interest rate is at 7.5%.  To pay off the house in 20 years the principle and interest payment is 2,097.64 (of course the principle should be less that $300,000 but for simplicity I'll keep this number in the example).  Now suppose the neighbors already went into foreclosure and people now are getting just $225,000 for similar houses.  Under the “reduce the principle plan” the home owners would get a new mortgage of $225,000 (at the current 30 yr rate?) say 6%.  Their new principle and interest payment would be $1,348.99.  Suppose though instead they just negotiated a new mortgage of $300,000 at 3.5%.  Then their principle and interest payment would be $1,347.13.  

This is a much better plan for the neighborhoods because with the higher principle balance the home owner still must get $300,000 out of the house in order to get out of debt.  This will keep the value of the houses in the same range as they had been.  This is a positive because you prevent the destruction of wealth of other hard working home owners.  Also, by lowering the principle balance to a level the family could afford chances are a lot of the rest of the neighborhood hasn't depreciated that far.  This would reward the home owner that mismanaged their finances and actually allow them to sell this principle adjusted house at a profit and pocket the difference.

Although I believe we must keep many of these potential foreclosure houses of the market I don't believe we should set up a process that allows bad financial managers to benefit more than those that acted responsibly.  I believe we as a society can and should help many of these people.  And if it can be shown these people were taken advantage of in the loan they took out, I believe the financial company should be out the possible ill-gotten gain.  However, if the prevailing interest rate is 6.0% and we have to get them into a 3.5% loan in order to make the house affordable.  I think we should be able to collect the profits of the sale to make up the difference instead of the family collecting it.  

Everything I need to know about today’s financial crisis I learned in the 5^th grade.

 After I got back to Ohio last year I was fumbling through some old boxes and found a cassette tape of me giving a report on Argentina .  I think it was from about the 5^th grade.  I remember the lessons we learned about inflation back then and how South American countries and before that other countries in Europe ended up destroying their economies by “printing money” during bad economic times.  Interesting how stupid the American public has gotten.  Instead of learning from the lessons of the past and demanding our politicians act responsibly JQ is placated by the politicians doing the worst possible thing because it at least gives the impression they are doing something.

 Hopefully if they are going to end up spending the money they get away from the current thinking of using it to make up for basic necessities.  That is I hope they get away from sending everyone $1000 checks or paying for road projects already “in the works”.  If they are going to spend it they should make sure they spend it on projects that will change the infrastructure.  The depression and “New Deal” projects did nothing to actually get us out of the depression however the TVA, Hoover Dam and road system allowed the country to gain exceptional wealth in the 50’s and 60’s.  If we have to spend the money now make sure we get things that will be equally beneficial when we come out of the recession.  Giving people $1000 check so they can buy their kids electric cars isn’t what I’m imagining; maybe a new power grid or a network of natural gas filling stations?  Right now I’m stuck on green technologies but there are other possibilities.  Perhaps we could get rid of “health and malpractice insurance” and the bureaucracy created by those systems and actually spend that money on health care.

The Stock Market  - I've begun to doubt the wisdom of the advice given to small investors to ride out the market for the long run.  Of course my realization is too late for most small investors but I'll record it for next time.  This last week or so the market has been  up and down between 8300 and 9200 and I've been tempted to throw some money into an index fund (note most index funds do not index the DOW).  But I keep thinking the bouncing occurs because other small investors also think they can judge the bottom and whala the big investors keep getting more of the little investors money.  I'm thinking my thought process from 11 Oct is probably correct and 8000 is where the market should be and will spend the longest amount of time before a sustained increase, I'm predicting it gets to the 7500 range after the small investors have been drained and bounces around there for a while.  After all of us that really have no business in the market should have lost all our money it should stay around 8000 for awhile before it starts to increase gradually.

Back to the first point.  I've long believed in the invest for the long term approach and I've only lost money with both stocks and mutual funds.  I started cost dollar averaging just a few months before the tech bubble burst.  I would think even with this down turn if dollar cost averaging worked I would have more money now than I've put into the funds.  I don't.  And I conclude the reason I don't is because others in the market are not there to for the long run.  They are there mostly to drain the value from the stocks and get it into their pockets. Since I believe long term investors benefit business to a much greater degree than temporary investors I believe there must be some sort of policy change in order to benefit the long term investor.  I might be simple but I'm thinking significant taxes for investments held less than a year and hefty taxes on investments held less than two years is the easiest way to stimulate the desired behavior.  If the rules continue to favor those in the market for the sole purpose of draining equity I think small investor like me should stay away from all forms of stock purchases even in the form of mutual funds.

Caveat - That doesn't mean I'm selling anything and it is likely the $50 a month I put into mutual funds will still go into those mutual funds.  It's just that I think its stupid and probably a waste of my money. i.e.  I wish I would have stuck with US Saving Bonds.  But of course if dollar cost averaging works, I'm kind of forced to keep buying now.  I guess I'm still hoping the "experts" are smarter than the "layman"

Why you may not be making money on mutual funds  Back in 1997 before I started buying mutual funds I had a work acquaintance who was claiming he was making tons of money with the funds he was in.  He based this on the claims the company that was selling him the funds was making.  I think they were claiming some funds were making 15% others maybe 20%.  But I sat down with him and looked at how much he put into the funds and found a single interest rate to cover all his deposits (based on how long each had been in the funds) and his return was just about 7%.  This was better than the rate I was getting on bonds but not by much.  

Anyway I've been doing mutual funds since that time and for quite some time my company would be advertising a rate of return of 10 or 15 % and I'd do the numbers and never be even close.  In fact for a while I was seeing an increase of 15% but that was when the company was advertising 20 to 30% increase per year.  Interestingly over the past few months my investments have fallen by over 30%.  A few months ago I looked into this a little and started to wonder if the day I picked to buy was making a difference.  It seemed to me that if a large number of investors were making their monthly buy on the same day then it is likely the price the mutual fund had to pay in order to get the stocks for the mutual fund may be higher on that day than say another day.  For instance if everyone had the 1st or the 15th as their buy date and the mutual fund carries GE stock.  Then (essentially) you have all these people buying GE on the 1st and / or the15th.  This means the mutual fund is probably actually more expensive on the 1st and the 15th.  Say in 2000 the price of your mutual fund was $15.00 almost everyday but on the 15th when you buy it was $15.50.  In 2001 the mutual fund was $18.00  almost everyday but you bought on the 15th of the month when it was $19.00.  you can see how the company could claim a 20% rate of return while you end up with significantly less rate of return.

The Stock Market   - Suppose I have a few thousand dollars in cash and I was wondering if I should take a gamble and put it in an Index Fund.  My initial thought  ---- before 2001 the stock market was about 9000 (I'm going from memory).  Taking into consideration the deficit, the transfer of our economy from producing consumer goods to producing war goods and unemployment figures etc I judge the "fundamentals" to be worse now than prior to 2001.  With that logic I conclude the 14,500 level the DOW was at last year was more a function of changes in rules, specifically tax rules, that tricked investors into valuing stocks more than they should have been.  So if our industry is in worse shape than prior to 2001 and the stock market was appropriately valued at 9000 points in 2001 than a level of 8000 is not all that out of line.  Unfortunately, with the herd mentality investors typically exhibit there is a strong chance it could go even lower.  The question to me then becomes do I invest at 8000 and get in at what the market should be at?  Probably not very smart for me.  Getting in where the market belongs means an expected return of 8 percent based on historical data.  I have loans at an interest rate of 7%.  Even though this is less this rate is guaranteed.  Of course, if the market gets below its fundamental value the potential for big gains is there. 

Sen McCain's Debate Proposal - I wonder if Sen McCain's staff or the subsequent reports did a serious math analysis to come up with a figure of $300 Billion to service the foreclosures or if they just used my numbers from 23 Sept.  I like Sen McCain talking like this.  Let me say one thing before getting into what I like.  Missed by both the reporters and Sen McCain is an explanation as to why if we could service all the bad loans for $300 Billion why is the package set up to spend $700 billion.

Things I like   - or at least things to consider.  The way I see it - the $300 billion McCain needs to do this really should be the same money the feds need to purchase the bad mortgage mutual funds.  What is good about his proposal is he is making a commitment not dump a bunch of foreclosures on the market.  The other thing I like about McCain is he is at least making people debate the best course of action.  The first proposal almost became another "we are the experts let us go on our gut feeling".  We all know how that has worked out for us the last 5 years.

Continuing the tax thought  -  For years now we have been trying to prop up stock prices and also house prices by taxing these items at a much lower rate than other types of income.  Many of the arguments for this approach are valid.  However, I think promoting stocks and real-estate at the expense of savings accounts, other real property and even labor has led to a unhealthy unbalance toward these instruments.  I've got about 3 pages worth of thoughts on this that hopefully I can get out to you soon.