Bailout E-Book

John Waggoner

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 246

Veröffentlichungsjahr: 2008

Beschreibung

In Bailout, John Waggoner answers the essential questions surrounding recent market catastrophes--from the failure of Bear Stearns to the credit crisis--and reveals how you can protect your portfolio during these turbulent times. Waggoner offers a wide range of strategies to help your portfolio weather this storm, including rebalancing and using foreign currencies, and discusses how Treasury bonds, gold, commodities, and real estate can solidify your financial standing. With the expert advice found here, you'll quickly discover what it takes to achieve safety and success in today's volatile market.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Acknowledgements

Chapter 1 - What Just Happened Here?

The Herd on the Street

Bear Lessons

Chapter 2 - How Did It All Begin?

Bust to Boom Again

Push Me, Pull You

The Humble Mortgage

Package Them Up and Move Them Out

The Big Bear

Chapter 3 - Silly Season

Irrational Exuberance?

Banks Break out the Levers

Wall Street Adds a Few Levers of Its Own

Chapter 4 - Matters Become More Serious

The Pin that Bursts the Bubble

Default Comes to Wall Street

Death of a Hedge Fund

Meanwhile, at Bear Stearns . . .

Chapter 5 - Where Do We Go from Here?

Making a Wish

A Word about Risk

Match Your Investments with Your Goals

Bonds Add Income and Safety

Cash: For Money You Need Very, Very Soon

A Word about Mutual Funds

Your Greatest Source of Wealth

How to Put Your Basic Plan Together

Chapter 6 - What’s the Worst That Could Happen?

Downturns in the Upticks

Those Who Fail to Learn from the Past. . .

Your Mother (or Grandmother) Was Right

Step 1: Paying Off the Card

Step 2: Building up Some Savings

Which Card First?

No Debt Ever?

Chapter 7 - Fighting Depression

Drowning in Debt

A Lender Be

Leading the Charge: Utilities

Bargains for the Brave—and the Liquid

Exotica

Who’s Afraid of the Big, Bad Bear?

Chapter 8 - Creeping Inflation

The Spiral

When Prices Rise, Prices Rise

The Case for a Comeback

A Three-Pronged Approach

Gold

Take some TIPS

Foreign Currencies

Appendix - Take a Load off Fannie

Notes

About the Author

Index

Copyright © 2008 by John M.Waggoner. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty:While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation.You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data

Waggoner, John M. Bailout :what the rescue of Bear Stearns and the credit crisis mean for your investments / John M.Waggoner. p. cm. Includes bibliographical references and index.

eISBN : 978-0-470-44342-2

1. Investments. 2. Financial crises. I. Title. HG4521.W155 2008 332.6—dc22 2008032175

In memory of my parents, Miles Waggoner andDorothy Mundinger, and with love for my children,Nate and Hope Waggoner

Acknowledgments

First, I’d like to thank Debra Englander, my editor, and Kelly O’Connor, Wiley’s development editor, for their support and great patience.

When you work in a newsroom, anything you do is often the result of your interactions with your fellow reporters and editors. Sandra Block, Christine Dugas, and Cathy Chu are friends of the best kind:They can tell you when your ideas are good and when they’re bad, and in either case, you still wind up laughing about it. I can always talk about the markets with David Craig, Matt Krantz, and Adam Shell, and I always come away with help and encouragement. Nancy Blair, Fred Monyak, and Tom Fogarty can make me look much better than I am and they do it with grace. The folks who run the Money section—Jim Henderson, Geri Tucker, and Rodney Brooks—are one reason it’s so consistently good. And Mary Ann Cristiano’s love, encouragement, and patience helped me more than I can possibly say.

Chapter 1

What Just Happened Here?

If you have ever woken up in the lemur cage at the zoo—and who hasn’t?—you know that most true disasters start innocently enough. In this case, it all started with a night out with your buddies. You drank. You talked. You ordered a martini. It tasted good.

Pretty soon, someone suggested moving to Snickenfelder’s, where they have a list of martinis longer than the menu. Good idea! After all, Snickenfelder’s was just down the street. And when you got there, you were confronted with more alcoholic concoctions than you thought possible. You tried an apricot mango martini. Yum. An orange chocolate martini. Wow. On reflection, your mistake was ordering the Snickenfelder Schnocker, made with vodka, hazelnut liquor, amaretto, Irish cream, Kahlua, and more vodka.

You vaguely recall the karaoke contest, but you have to admit that you probably did not understand the rules when you got up on the stage. “Unbroken Melody” was probably a bad choice, given your state. At any rate, here you are, covered in peanut butter and surrounded by cooing primates.

In March of 2008, the world markets woke up with one of the ugliest hangovers in history. Bear Stearns, the fifth-largest U.S. investment bank found itself in the financial equivalent of the drunk tank: Sequestered with federal regulators and pitiless bidders for the remnants of its assets.

It was a nasty, nasty, bender that put Bear Stearns in the lockup, the sort of sudden decline that smacks of Victorian morality tales. Just two years earlier, Bear Stearns was a titan of finance, happily ensconced at its massive $1.3 billion headquarters at 383 Madison Avenue in New York. It had thousands of employees working around the globe, billions of dollars in assets, and a varied business in stocks, bonds, derivatives, and financial counseling for the very rich.

In short, Bear Stearns was a very big, very important company, one with tremendous earnings and global clout. And Bear Stearns remained a very big, very important company right up until the second week of March, 2008. On March 7, 2008, the company’s stock closed at $70.08—well off its 2007 highs, but nearly every financial stock had been clobbered in 2008.

The next trading day, Monday, March 10, the stock slid more than 10 percent and closed at $62.30. Tuesday, it fell to $55. After a slight rally on the 12th, it slipped below $60 again. Then, on Friday, the stock collapsed, plunging to $30 a share. But the worst was yet to come.

Late on Sunday, March 16, word came out that arch rival JPMorgan Chase had bid just $2 a share for Bear Stearns, and the company had accepted it. By the end of trading on March 17, 2008, Bear Stock was trading at $4.81 a share.The $2 price tag was just too low for Wall Street to believe—and rightly so, as it turned out.

“JP Morgan Bags Wounded Bear—Bargain-basement $235 million for Reeling Giant,” read the March 17 headline of the New York Post.1 JPMorgan Chase bought all of Bear Stearns for about a fifth of the value of its Manhattan headquarters alone. Later that week, bowing to threats of lawsuits, JPMorgan Chase upped the Bear bid to $10 a share—still, on its face, a tremendous bargain.

By the end of the Bear Stearns saga, there were plenty of ruined investors. Employees who had kept money in Bear Stearns stock were essentially wiped out. (Top management, who had many more shares, fared far better than the rank and file). But big companies fail all the time and, to be honest, they leave little mark of their passage, except for the holes they leave in the lives (and retirement accounts) of their workers.

When Bear Stearns collapsed, however, it nearly crippled the short-term money market, the lifeblood of modern finance. Bank lending ground to a halt. Municipal financing, which pays for roads, schools, and other daily essentials, evaporated. The company’s fall changed the way the government regulates Wall Street, and it shook the faith of investors to the core—and justifiably so.

The Herd on the Street

How did it happen?

Periods of intoxication generally begin with sobriety, and it is the nature of manias that they start out perfectly sane. So we are going to detail, in the next chapter, the relatively sober beginnings of the bubble that eventually bagged Bear. As you will see, things made a great deal of sense.

From 2005 until August, 2007 was the period of pure mania. Most of us are familiar with the boom in housing, but it is still interesting to recap, if only for sheer, eye-popping detail and shadenfreude. We will visit a small, somewhat representative town in suburban Washington to illustrate what soaring house prices can do to otherwise sober citizens.

But the real bubble—the one that took down Bear Stearns—wasn’t in the real estate market. It was in the debt market. We think of bonds as a kind of investment for Old Money, the folks who would visit the bank vault every few months, clip a few coupons, and redeem them for walking-around money.

In fact, the bond bulls had run on Wall Street for a very, very long time.The bull market in stocks ran from August 1982 and ended (according to some views) in March, 2002, propelling the Dow up about 1,200 percent. (See Figure 1.1.)

Figure 1.1 The Super Bull Market in Stocks, 1982-2000

But the bull market in bonds ran far longer.We will explain this in detail in Chapter 3, but bonds prices rise when interest rates fall. The yield on the bellwether 10-year Treasury bond fell from a high of 15.83 percent in September 1981 to a low of 3.35 percent in May 2003. For the past 10 years, you would have made far more money investing in bonds than you would have investing in stocks. (See Figure 1.2.)

We haven’t seen a bear market for bonds in many, many years—and what brought down Bear Stearns was not the stock market, but the bond market. Bear Stearns nearly went bankrupt because the bonds it packaged and sold to investors were so incredibly bad. Eventually, Bears’ creditors suspected that the company’s assets were virtually worthless—and lending to a company with worthless assets is simply throwing good money after bad. At the very end, when Bear Stearns could not even get short-term lending, the company was forced to a great reckoning in a small room—the sale of itself for the fire-sale price of $2 a share to JPMorgan Chase.

Figure 1.2 Stocks vs. Bonds, 10 years

Bear Lessons

The question, then, becomes what does the bear market in bonds and the demise of Bear Stearns mean for your investments? We can start with a few calming observations: For one thing, the system worked. We are not in a worldwide depression, the banking system is still functioning, and people get up and go to work every morning. The Federal Reserve did its job, and with some alacrity, too. All that’s for the good.

Once that is settled, though, we have to ask a few questions about how we save and invest. We must, of course, assume that somehow the world will muddle through. Otherwise, we may as well hunker down in a bunker, eating canned food, and cradling our rifles.

For that reason, your core plan for investing—using a mixture of stocks, bonds, and money market securities to meet your goals—should not be radically different. We’re not going to suggest you throw out decades of financial research and put all your money into gold or plastics or Irish punts. And in Chapter 5, we will give you some guidance on how to set up your basic plan of attack.

That said, we should also note that the world economic system is increasingly complex and precarious. For example, the use of derivatives among financial institutions is soaring. These are legal contracts between two parties: Their value is derived from the movements in various market indices, which is where the word “derivatives” come from. Currently, there are about $55 trillion in derivatives outstanding, which is roughly five times the value of all the goods and services produced in the United States each year.

Warren Buffett, CEO of Berkshire Hathaway and the world’s wealthiest man, knows a thing or two about risk. He had this to say about derivatives in 2007:

I believe we may not know where exactly the danger begins and at what point it becomes a super danger. We don’t know when it will end precisely, but . . . at some point some very unpleasant things will happen in markets.2

As investors, we have other worries, too. The U.S. debt now totals $9 trillion, close to a record in relation to our gross domestic product. The Treasury’s credit rating is the world’s gold standard. In times of crisis, in fact, people buy Treasuries, not gold, even though gold has been the world’s fallback currency since Nebuchadnezzar was in short pants.

Unfortunately, we are not working earnestly to repay those debts. We’re adding merrily to them, to the tune of $2 billion a day. A billion here and a billion there, as Senator Everett Dirksen once said, and pretty soon you’re talking real money.

Even worse, the U.S. doesn’t save enough of it to count on the public to buy them. It has to rely on other governments to buy our daily $2 billion of Treasury securities. So far, that has worked just fine—although it has put a great deal of pressure on the U.S. dollar. Should other countries say one day, “Thanks, we just need $1.5 billion today,” then the dollar could quickly fall from the gold standard to the silver standard. (See Figure 1.3).

Figure 1.3 Trade-Weighted Dollar Index

Investors, then, need to take a few precautions against catastrophe. One potential catastrophe is debt liquidation—the type we came perilously close to seeing when Bear Stearns collapsed. Debt liquidation simply means cascading defaults, which will ultimately lead to a Depression-like economic downturn. There are some schools of thought that this kind of event—which occurred with depressing frequency in the 19th century—is actually good for the economy, a kind of economic cleansing process.These are the same kind of people who giggle during horror movies, too.

In Chapter 6, we will start with the most basic way to protect yourself from deflation: Paying down your debt. You may recall your grandmother warning you about the peril of debt. And you know what? She was right. It makes no sense to plan a portfolio that returns 12 percent when you are paying 25 percent to your credit card company.

Once again, let’s not get carried away: Some debt is good. If you have a 6 percent mortgage and can afford the payments, then relax. That is cheap money—and you can probably earn better returns elsewhere than what you would get from paying down your mortgage early.

Your portfolio, too, can be clobbered by deflation. Although some stocks might weather deflation well—nasty businesses like payday lending companies come to mind—you might be better off by adding some high-quality bonds to your portfolio. Think of it this way: If you get $100 a month from your bonds each month and prices fall, your bond becomes increasingly lovely in the eyes of other investors—and they will pay you a premium for it.

Another solution to our massive debt problem isn’t much more palatable. If the government allows higher inflation, it can repay its debt with progressively cheaper money. But that means that the price of food, gas, and other essential rises too—which ultimately impoverishes everyone. Inflation has been called the cruelest tax, because it hurts those on a fixed income most—like people who live on pensions or periodic withdrawals from their savings.

Not too long ago, there was one hedge against inflation: gold. And it’s still an inflation hedge, albeit one that’s annoying to store and pays no dividends. But today you have several other options for fighting inflation, such as Treasury Inflation-Protected Securities, or TIPS. We will run through your inflation-fighting options in Chapter 7.

Finally, we must remember that booms and busts are part of the fabric of capitalist society. And it is fabulously easy to get caught up in the boom, and crunched in the bust. How can you tell if Wall Street has left the world of the rational and gone straight to the laughable? It is not easy, but there are signs, and good ones.We will talk about those in Chapter 8.

Kurt Vonnegut, author of Slaughterhouse Five, among other novels, once said that the only thing we can learn from history is to be surprised. He’s quite right. Somewhere along the way, the people at Bear Stearns—and much of the rest of Wall Street—felt that there was nothing to be surprised about.

As an investor, you can make intelligent guesses about what the future will be like. But there will always be surprises. For that reason, you need to cast your net far and wide to protect—as best you can—against the unexpected. There will be days when your small insurance positions in foreign bonds or commodity funds will make you feel like the village idiot. That’s ok. When you invest, making gains are just part of the game. The other part is keeping them. It is a lesson that Bear Stearns could have learned a little better.

Chapter 2

How Did It All Begin?

We like to think of the men and women on Wall Street as serious-minded, sober people. In fact, Wall Streeters cultivate this image. Nearly every ad for a brokerage house, mutual fund, or investment bank features a conservatively dressed man or woman in a wood-paneled room, arms crossed, glasses in hand, looking thoughtfully into the distance. (By law, they can’t show pictures of people rolling around in piles of money.)

Now, people who occupy the world of finance are, by and large, exceptionally smart people.They typically come from Ivy League colleges, sport advanced degrees, and have very nice taste in clothing.They take their work quite seriously.

Nevertheless, from time to time, people in the financial world go quite mad, no matter what their IQs. It’s a phenomenon that has been observed for centuries.

In his classic 1857 work, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, Charles MacKay noted, “Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper . . . Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

Manias, like that first drink at the bar, almost always start soberly. The South Seas Bubble, for example, was founded on the entirely rational notion that Latin America, in the early 18th century, had a vast store of natural resources that could be incredibly lucrative for a company to exploit, particularly if the company had the backing of the English government.

Investors simply got too carried away with that notion. Suddenly, no price was too high to pay for stock in the South Seas Company, or the many other new corporations formed during the South Seas madness. (One company raised money for a venture so profitable it couldn’t tell its investors what it was.)

The price of one share of the South Seas Company went from £100 to £1,000 in the course of 18 months. (For the curious, £1,000 in 1720 is worth £132,743 today,1 or, at current exchange rates, about $261,500. Isaac Newton, who was no dummy, lost a small fortune in the South Seas Company.When the bubble burst, Newton reportedly lamented, “I can calculate the motions of heavenly bodies, but not the madness of people.”

Similarly, to use a more recent example, it was entirely logical to think in, say, 1996, that the Internet was a pretty darn big thing and that it might have fascinating commercial potential. Why, you could order books online! And type messages to friends! And, perhaps, someday, even watch movies!

Technology stocks were also buoyed by the rather mad assumption that the Entire World as We Know It would be demolished by a computer glitch called the Y2K problem. In a nutshell, the Y2K problem was this: Back in the old days—the 1980s—computer memory was hard to come by. To save a bit or two, programmers used two digits rather than four. As the clock turned from 1999 to 2000, people feared that all computers would go haywire—not only messing up bank records and Social Security payouts, but electrical stations and nuclear power plants, too.

Many companies, rather than fix all their software bit by bit, simply bought new equipment that was Y2K compliant. You can only imagine the glee in an IT person’s eyes when handed a huge budget and told to replace everything in the building. All that wild spending went straight to the earnings of all manner of technology companies, from consultants to software and hardware manufacturers.

But investors simply took a reasonable assumption—that technology had good growth potential—and blew it all out of financial proportion. Yes, the Internet was capable of many wonderful things, but not in 1996. People paid too much for corporate earnings that were too far in the future—or for earnings that never materialized, which is one of the problems with technology in general.They get carried away.

The technology-laden NASDAQ stock index rocketed 110 percent in the 12 months that ended March 10, 2000. Some technology stocks sold for several hundred times their past 12 months’ earnings. Other Internet companies soared with little else but a CEO, three computers, and a name that ended in .com.

The bubble that took down Bear Stearns had three ingredients: houses, mortgages, and mortgaged-backed securities. All three, separately, aren’t usually considered a bubble cocktail. Stir them all together? Ummmm. Bubbly.

Bust to Boom Again

Manias, at least the financial types, are generally rare, occurring perhaps once a generation. But the mania that engulfed Bear Stearns had its roots, ironically enough, in the popping of the technology bubble of the 1990s.

By 2000, the tech boom had gone to bust. The tech-laden NASDAQ stock index deflated at a rate rarely seen for a broad-based market index. One year after its March 10, 2000 peak, the NASDAQ was down 62 percent—one of the worst bear markets in living memory. Even now, more than seven years later, the Nazz is still down nearly 50 percent from its 2000 highs.

But the NASDAQ—and stock prices generally—were not the only things deflating. The market for new stock issues, or initial public offerings, dried up entirely. Lenders no longer showered companies with millions of dollars for technological expansion.

And many of those people who worked for startup companies like Pets.com were suddenly out of work. Although no one knew it at the time, a recession had started in July 2000 and ended in March 2001. (The National Bureau of Economic Research’s Business Cycle Dating Committee, which works with great deliberation, did not declare the beginning of the recession until March 2001, the date when the committee later decided the recession had ended.) Unemployment, which was 3.8 percent in April 2000, nearly doubled to 6.3 percent by May 2003.

As unemployment crept up, prices slid down. By 2003, the producer price index, which measures inflation at the wholesale level, was trending downward. Cheap goods from China and elsewhere were pushing prices down. Suddenly, Wall Street—and, most importantly, the Federal Reserve—was worried about deflation.

The fed Chairman Alan Greenspan said as much in Congressional testimony in May 2003: Deflation “is a very serious issue and an issue to which we at the Federal Reserve are paying extensive attention.” Greenspan went on to say, “Even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative.”2

The worst outbreak of deflation in recent memory was, of course, the Great Depression. The specter of the Great Depression must haunt every Fed chairman’s mind.Who wants to be known as the Fed chairman who led the country into another Great Depression?

The Depression was a deflationary spiral. As the economy slowed, people lost their jobs. Prices fell because no one had money to buy things.You could cut prices all you wanted, and your inventory would still languish. As spending slowed, so did employment, creating a vicious cycle that would lead to the worst economic period in 20th-century history.

The situation in 2002 and 2003 wasn’t as dire as the Depression, but it was certainly worrisome. What truly terrified the Fed was the prospect of a Japanese-style deflationary slowdown. Japan’s deflationary recession ground on for more than a decade.

And, at least at first blush, Japan’s problems seemed a lot like our own. The Japanese deflation began when its stock-market bubble burst in 1989. (Their real estate bubble popped at the same time.) Their banking system was in shambles, primarily because of bad real estate loans. And waves of cheap Chinese imports kept prices falling.

Alan Greenspan summed up his worries about the U.S. economy in May 2003, during his testimony to Congress:

Once again this year, our economy has struggled to surmount new obstacles. As the tensions with Iraq increased early in 2003, uncertainties surrounding a possible war contributed to a softening in economic activity. Oil prices moved up close to $40 a barrel in February, stock prices tested their lows of last fall, and consumer and business confidence ebbed. Although in January there were some signs of a post-holiday pickup in retail sales other than motor vehicles, spending was little changed, on balance, over the following three months as a gasoline price surge drained consumer purchasing power and severe winter weather kept many shoppers at home.

Businesses, too, were reluctant to initiate new projects in such a highly uncertain environment. Hiring slumped, capital spending plans were put on hold, and inventories were held to very lean levels. Collectively, households and businesses hesitated to make decisions, pending news about the timing, success, and cost of military action—factors that could significantly alter the outcomes of those decisions.

Even more troubling was the fact that by the time of Greenspan’s testimony, the Fed had cut short-term interest rates 12 times, from 6.5 percent to 1.25 percent, and the economy was still puzzlingly anemic.

Normally, lowering interest rates is like throwing a pork chop into a grease fire. When rates fall, companies and individuals can refinance their debts at lower rates, reducing their monthly payments, and giving them more money to spend.

The economy’s sluggish behavior was even more peculiar because when the Fed lowers interest rates, it doesn’t just walk out and announce that, henceforth, short-term interest rates will be lower. (Actually, it does do that, and it is a big event when the Fed makes its announcements, but that is just for informational purposes.) Instead, the Fed vastly increases the amount of money available to lend, and its actions have what are called a multiplier effect.

To push rates lower, the Fed increases the amount of money in circulation. And money, to some extent, isn’t much different from fish. When six ships laden with scrod hit the docks, the price of fish falls. When there is a lot of money in the system, the price of money—interest rates—drops, too.

When the Fed lowers interest rates, it is like having an entire fleet of money-bearing ships arrive at port. To increase the money supply, the Fed buys government bonds from its primary dealers and credits the primary dealer with the purchase price. The Fed doesn’t pull that cash out of a wall safe. It simply creates the cash, in the form of an electronic book entry. Viola! The money supply is now larger. The dealers now have more money on their books than they need, so they lend the excess out to other banks. But the amount they lend can be far more than the Fed gives them, thanks to the wonders of fractional banking.

Banks have to keep a certain amount of money on reserve, so they can meet withdrawals. Let’s say the reserve requirement at a bank is 10 percent: For every $100 the bank lends, it must keep $10 in reserve. Now let’s imagine this on a grand scale and say, for the sake of illustration, that the Fed buys $10 million in securities from one of its member banks. The bank can then lend $9 million, assuming it keeps the $1 million in reserve.