Bad for Banks, Good for You

People hate banks.  Especially US banks.

In 2008, when President George W. Bush signed into law the biggest corporate bailouts in history, banks became the enemy.  They are retirement killers, staffed by toga-party heathens.  They are social pariahs.  Few mutual fund managers dare to buy them.  And this is what makes them great.

The Frost Report has been recommending bank stocks during every dip in the market since 2008 (which has been a great strategy), and things only look better for the future.

As of Oct 3, 2012, the six largest US lenders - including Bank of America, Citigroup, and JP Morgan - earned a combined $63 billion in profits.  In Q2, Wells Fargo had its most profitable quarter in 160 years.  Despite this, many bank shares are still trading at below book value, and at single-digit PE ratios.  In other words, despite sustained earnings, US banks remain ridiculously cheap.

Enter the complainers.

Wall Street hates regulation.  There is a natural tension between the motives of short-term profit and long-term sustainability.  Without regulation (and sometimes despite it), the creative minds of Wall Street regularly devise new ways to make vast hordes of money before self-destructing.  It is the loathsome job of government to prevent the latter by preventing the former.

When bankers are complaining about downsizing and frugal compensation, complaining about low leverage (which reduces risk, but also the opportunity to profit), complaining about high capital requirements and complaining about trading restrictions, you know that your money is both profitable and safe.

The greater the number of people who live in fear of bank stocks - while those banks continue to earn excellent profits - the better.

____


"The future looks very dim."

Michael Greenberger, University of Maryland, regarding US Banks

____

Time Machine - 1111 and the US National Debt

INVESTOR PSYCHOLOGY

Recency Bias is the tendency for people to remember recent events more than past events, and to believe that the most recent situation has always been so.  Put another way, people tend to frame their memories based on recent events, and to remember what they want - and likewise, to forget what they want.

I mention all this because it seems like lifetimes ago that the US national debt was not only in control, but people were actually talking about paying it off.  That moment was 11 years, 1 month, and 1 day ago today.

Bill Clinton had just finished his term in the White House, stained by political scandal (ie. the Monika Lewinsky affair).  Many viewed Clinton as a very unpresidential, even embarassing president.  Yet, no one could deny the positive economics of his term.  At the end of the Clinton presidency, the National Debt stood at 5.73 trillion dollars - a relatively small sum for the massive US economy.  After three straight years of budget surpluses, economists were estimating how long it would take to pay off the National Debt completely.

Presidential hopeful Al Gore, for example, outlined an economic plan that would eliminate the National Debt by the year 2012.  When candidate George W. Bush was asked if he had a similar plan, he said that although he agreed with paying off the debt in principal, he would not commit to a specific date.

Soon thereafter, Bush was elected as President.  He immediately began a series of tax cuts for high-income families, which he (and his economic advisors) believed would stimulate the economy so much that the end result would be an overall increase in tax revenues (known as "trickle-down economics."); unfortunately, it didn't work .  Tax revenues declined drastically with each cut.

Bush ran a budget deficit (increasing the national debt) in 7 of his 8 years in office.  In 2003,  he set a record for the largest annual debt increase in US history.  Due to a combination of tax cuts and expensive foreign interventions, by the end of the Bush term the US National Debt had nearly doubled - from $5.73 to $10.69 trillion.

People now talk about the National Debt as if it was meant to be, always was, and always will be.  Many cannot remember the time - not so long ago - when there was talk of the United States of America having no debt at all.

____


"I've abandoned free market principles to save the free market system."

George W. Bush, 2008

____

Culling the Sheep - again

This week marked the single biggest wave of selling by retail investors ever recorded.

On Monday Aug 8th 2011 alone, Swiss bank UBS recorded retail outflows of 1.3 billion dollars! No wonder the markets crashed.

In The Intelligent Investor’s Mind, I speak about "myopic loss aversion" – the tendency for people with long-term goals (such as retirement) to focus on short-term events, especially the gyrations of the stock market. Myopia literally means “shortsightedness.” Such shortsightedness typically beds with "recency bias" – the tendency to think that the current situation (good or bad) will last forever. This week’s market activity shows just how strongly these cognitive errors can destroy people’s financial well-being: usually their own.

If you doubt the intensity of this week’s retail investor freakout, check out these choice quotes:

"Investing in U.S. Markets is DEAD....DEAD… and it is NOT COMING BACK!!"

"Yeah, it's different all right, as in it is ALL coming down."

"Their plan is to get rid of paper currency and go to digital currency so they can make you a slave."

"666, whatever you'd like to call it is coming."

Yet the market rollercoastered, showing that as much as retail investors were frantically selling, professionals and value investors were swooping in to pick up the spoils. Bloomberg reported that insider buying by S&P 500 company executives reached levels not seen since March 2009.

This week also revealed some great moments in calm and cool leadership. First was Barack Obama’s matter-of-fact speech regarding the S&P debt downgrade, where he basically said (I’m paraphrasing), “I didn’t need a downgrade by S&P to tell me that our government had a dysfunctional moment. We need to fix the way our government works.” The second was from Federal Reserve chairman Ben Bernanke, who said that he would keep interest rates low (which makes it easy for businesses to expand & develop), but other than that, the markets just need to grow up and get on with it. The final moment was an interview with Bank of America’s Jamie Dimon, who demonstrated the sensibility of long-term thinking (see video below). Interestingly, all of these great moments were regarded negatively by the public, who just wanted their leaders to DO SOMETHING!

As usual, the counterintuitive nature of the stock market is at work: those who are fearful of losing their money are losing their money; those who are unafraid of losing their money are making more.

____


"There is no comparison between fear and greed. Fear is instant, pervasive and intense. Greed is slower. Fear hits."

Warren Buffett, Aug. 11, 2011

____

US Home Prices Drop Again

But is that bad?

In a story on CNBC, Home Prices fall for 8th straight month, David Blitzer, chairman of the Index Committee at S&P Indices, is quoted as saying, "There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing." When I read the same statement, I thought it was good news. Why the difference?

Everyone uses mental models in their daily life - whether they are aware of it or not. A mental model is a way of thinking, usually learned from the culture one grows up in, but often changed by education. A clear example is that in the West, most people believe that the mind/soul and body are separate. University educated individuals tend to use the scientific method to discover things, rather than logic or meditation.

Fictional character Sherlock Holmes famously uses “deductive reasoning” to solve crimes. Deductive reasoning is eliminating anything that must be false in order to find the last remaining item, which must be the truth. It is said that Sherlock Holme's author, Sir Arthur Conan Doyle, learned this technique from his university medical professor, who used it to diagnose patients.

Warren Buffett’s business partner, Charlie Munger, commonly uses “inversion.” Inversion is looking at every problem from the opposite direction from the normal one: for example, instead of asking, “How can we improve customer service?” Munger might ask, “How can we have terrible customer service?” The opposite of that answer is the way to have great customer service.

In Iraq, US soldiers and politicians often become annoyed because the Iraqis do not think of the relationship between cause-and-effect the same way we do. That is, they view the relationship between cause and effect as weak. If Iraqis take a day off to play cricket instead of building a new water pipeline, they don’t necessarily see the connection to having no clean water later that month. This difference in thinking is so frustrating for American troops that there is a whole series of military intelligence "lessons learned" documents devoted to it.

Now to examine David Blitzer’s comment: "There is very little, if any, good news about housing. Prices continue to weaken, trends in sales and construction are disappointing." Under normal circumstances, this statement would be perfectly logical. In a normal economic cycle, all these things indicate a weakening economy. David is inferring that low sales, low construction, and falling prices are bad – the traditional economist’s view. But is it truly bad? Or is David using a “fossilized mental model” – one that is not relevant for the situation?

The US had a housing bubble: that means there were unrealistic prices, oversupply, and sales to people who were not qualified. The remedy for a housing recovery is therefore lower prices, no new construction (until excess inventory is gone), and low new home sales (since foreclosures will be sold first). In other words, today's statistical weakness is exactly what the housing market needs to recover. At this point, strength in any of these numbers would be negative.

The banks can only release foreclosures onto the market at the same rate as the market is ready to absorb them. Since the banks control the flow of this inventory, new home sales and price stats are meaningless: any increase in market strength will be met by the release of foreclosures to match.

Prices are low enough that when the housing market does return, it will do so with a roar. Just like the bubble on the upside, the longer US housing numbers stay weak the more sudden and dramatic the recovery will seem.

Several months ago, I wrote that it was a good time to buy US real estate. Since then, in most cities home prices have fallen by about 3%. I do not apologize for this imperfection.

No one knows exactly when the market will recover, yet one thing is certain – buying quality real estate at a time of low interest rates and low prices will never prove to be a bad investment. Don’t try to catch the exact bottom.

____

"Don't try to buy at the bottom and sell at the top. This can't be done - except by liars."

Bernard Baruch

____

The US Federal Budget (and my 10th Grade teacher)

No, John Maynard Keynes was not my 10th Grade teacher. But it was in Grade 10, from my history teacher, that I learned about famous economist John Maynard Keynes.

It was Keynes who first proposed that markets move in cycles - in repeating booms and busts - and that the best way to lessen the impact of these booms and busts is to implement countermeasures.

Prior to Keynes, governments taxed less and spent more during good times (when they could afford to do so), and taxed more and spent less during bad times (when they couldn't). It all seemed very straightforward. After the Great Crash of 1929, for example, the US government cut back on myriads of projects and social services in order to save money.

Keynes argued that such seemingly sensible measures only worsen recessions. Instead, he argued that in bad economic times we need to cut taxes, cut interest rates, and increase government spending in order to “stimulate” the economy back to life. Then, in boom times, we need to increase taxes and curtail spending (since the economy is sustaining itself), and pay back that debt.

My 10th grade teacher pointed out that Keynes was foolish and that his ideas would never, ever work. The problem was not with Keynes' theory, but rather that his plan ignored human psychology and the reality of politics.

In bad economic times, people enjoy having their taxes reduced and interest rates cut, even though this leads to the large government deficits that these same people become angry about (rather like being pleased to receive expensive presents from your wife, then complaining that she spends too much).

As the economy improves, it gets even harder for the government to implement Keynes’ ideas. Despite being angry about large government deficits (“debt for our children!”) people are nonetheless unwilling to pay more in taxes to reduce it.

In the United States, any proposed tax changes are complicated by the remarkable fact that low-income earners have been led to believe that rich people need lower taxes, but that they personally don’t need them! Yes, only in America, prefabricated home owners and squirrel hunters can actually be seen protesting against higher taxes for the rich, even if that results in higher taxes for themselves.

The US budget promises to be a Frankenstein-like creation. The US Democratic Party hits walls of opposition because they propose ideas that only economists can appreciate. The US Republican Party is politically successful because they propose simple and intuitive economic ideas, no matter how unworkable those ideas may be.

Like John Maynard Keynes, Barack Obama expects people to be as logical and practical as he is – except that they aren’t. Even my tenth grade teacher knew that.

____


"The avoidance of taxes is the only intellectual pursuit that still carries any reward."

John Maynard Keynes

____

For an example of the class divide in America see:


____

The FDIC - Combating Stupidity Since 2011

Those who understand behavioral finance know that sometimes you have to protect people from orchestrating their own financial doom: in The Intelligent Investor’s Mind, I devote a section of every chapter to it. Financial quants and investment professionals (who should know better) are no exception. In fact, great genius is required to create a truly phenomenal financial disaster.

On March 29th, the Federal Deposit Insurance Corporation approved new rules for mortgages – essentially “anti-greed, anti-laziness” rules - that align the interests of homeowners, bankers and investors.

Under the new rules, banks will not be able to repackage and sell a mortgage (ex. Mortgage bonds, CDOs), unless the borrower puts down a 20% or greater down payment. If the borrower puts down less than 20%, the bank will be forced to keep some of the risk on its own books - known in the industry as “keeping skin in the game.”

Effectively, these new rules force banks to care about the quality of the loans they receive from mortgage brokers, and care how those loans perform. Prior to this, a mortgage broker could underwrite a loan from someone they knew couldn’t pay, sell it to a banker who didn’t care if the owner couldn’t pay, and in turn sell it to an investor who didn’t bother (or didn’t have the skill) to check to see if the owner couldn’t pay.

The National Association of Mortgage Brokers will undoubtedly hate the new rules. They are already fuming about the Federal Reserve’s new “Truth in Lending” regulations in general. Despite pushback, however, the matter will be put to vote this week and is expected to pass.

The days of dreamers with bad credit and no cash, walking into a mortgage broker's office, getting approved, then sitting on their new sofas & waiting for riches through equity appreciation are truly over - even if the market comes back.

People will always find new and ingenious ways to ruin themselves financially. Even so, it’s nice to see the old gaps being closed.

____

"If investing is entertaining, if you’re having fun, you’re probably not making any money. Good investing is boring."

George Soros
____