The Secrets of Successful Investing
Two recent headlines encapsulate the current financial wreck—the mortgage crisis that has ensnared the markets across the globe and may threaten the economy of the entire world:
OVER THEIR HEADS: Small Investors, Too, Get Nailed by Arcane Trades
—The Wall Street Journal, August 14, 2007
INVESTORS MULL HOW TO GET OUT OF HEDGE FUNDS: Market Turmoil Highlights Notoriously Tricky Rules for Redeeming Shares.
—The Wall Street Journal, August 15, 2007
The words “over their heads” and “tricky” caught my attention.
Investors are being hosed these days by Wall Street sharpies that have come up with highly complex, tricky and incomprehensible schemes that are over everyone’s head—including those that dreamed them up.
You and I are being hosed by these sharpies, too. They cried “WOLF”—just as they did in the 1980 Savings & Loan Crisis—and the federal government and central banks have injected billions into the markets. As taxpayers, we are bailing out the greedy, incompetent bastards.
If you read nothing else this week or this month (or this year), commit to memory the following advice from Peter Lynch, the retired wizard of Fidelity Investments:
Never invest in any idea you can’t illustrate with a crayon.
A Quick History of the Subprime Mortgage Mess
In the August 15 edition of The Wall Street Journal, Aaron Lucchetti and Serena Ng reported the spark that ignited the worldwide economic conflagration that we are seeing today:
In 2000, Standard & Poor’s made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a “piggyback,” where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage.
While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a movement that transformed America’s home-loan industry: a boom in “subprime” mortgages taken out by buyers with weak credit.
In other words, it was okay for people with no money that wanted to buy a home to borrow money for the down payment and then borrow more money for a mortgage.
To encourage home ownership—the great American dream—the patriotic mortgage companies came up with the idea of a very low “teaser” fixed rate that automatically turned into a variable rate mortgage after a year or two. Thus a starting rate of 6.6% winds up at 9.6% in a few years.
An example of what can happen is the sad tale of Mario and Letitia Montes of Fullerton, California, in the August 16 edition of The Wall Street Journal:
“My wife and I make pretty good money,” says Mr. Montes. Mrs. Montes works as a school secretary. Together, they earned nearly $90,000 last year. But they already pay about $38,400 a year on their home loans, even before taxes and insurance. In December, when their primary loan “resets” to a higher rate, that cost will rise to about $50,000 a year, Mr. Montes says.
Fifty grand a year for housing (before taxes and insurance) out of a total household income of $90,000 makes for an unsustainable lifestyle—by a lot.
Strapped homeowners like the Montes family who can’t afford the monthly payments are forced into default—millions of them. This past Tuesday, AP Business Writer Alex Veiga reported that in July alone, 179,599 homeowners defaulted and were thrown out onto the street—a 93% increase over the same period in 2006. According to RealtyTrac Inc., that’s one foreclosure for every 693 households in America.
Meanwhile, these mortgages had been bundled into giant funds and then sold by the slice to a vast network of hedge funds and individual investors. The various investment vehicles are so incredibly complex that nobody really understands them.
Suddenly the great real estate Ponzi scheme has been exposed. Panic has hit the credit markets. Not only are home mortgages difficult to get or refinance, but also businesses are being squeezed and cannot get loans, which means the economy will stagnate. The New York Stock exchange lost 1,000 points in three weeks and the sickness is contagious, affecting the markets and economies of countries throughout Europe and Asia. When America get the sniffles, the expression goes, the rest of the world catches cold.
The Sad Saga of an 81-year-old Widow
A lady I have known for more than 50 years was widowed 32 years ago and never remarried. On the death of her husband—who was 25 years her senior—she was left roughly $300,000, plus she owned a house in Connecticut that she sold for $300,000. Total nut: $600,000. She knew nothing about money—not even how to write a check or balance a checkbook, let alone how to invest her money. She entrusted her money to an old family friend who managed it pro bono. He died many years ago. Since it was a pro bono account, the firm gave it minimal treatment and it languished.
Two years ago her older brother took a look at the account and discovered that it gone from just under $600,000 down to $300,000. If she continued living the high life in Manhattan—taking expensive cruises and trips around the world, enjoying membership at an exclusive club and taking taxis everywhere—he told her that she would be a bag lady in not too long a time.
Working with an investment firm that specializes in corporate bonds, the brother—whose own seven-figure capital is primarily in these vehicles—managed to eke better than a 10% return on her money. At the same time, he moved her down south to be closer to her family and put her on a very tight budget. With $30,000 a year plus a bit of Social Security income, she would have been able to live out her days within her means in relative comfort. He actually got her little fund up to $375,000.
The Widow and the Wall Street Sharpies
What happened next was not pretty. At some point in the late winter, the riverboat gambler side of the widow’s brother reared its ugly head and he saw a bargain. He bought stocks for himself—and the widow—in a company called New Century Financial.
In the March 11, 2007 edition of The New York Times, Gretchen Morgenson wrote:
On March 1, a Wall Street analyst at Bear Stearns wrote a surprisingly upbeat report on a company that specializes in making mortgages to cash-poor homebuyers. The company, New Century Financial, had already disclosed that a growing number of borrowers were defaulting, and its stock, at around $15, had lost half its value in three weeks.
At the beginning of April, New Century Financial filed for Chapter 11. As of this writing, the widow’s $375,000 fund is down to $217,000. Her brother’s wife is secretly slipping her money to help pay for groceries and an occasional hairdo.
The story does not end there.
Even Losers Are Big Winners
Bear Stearns—the giant investment banker that upgraded New Century back on March 1—saw two of its mortgage-related hedge funds tank. The result was a multibillion loss to investors, whereupon the company’s stock tanked, dropping 27% in 2007. The co-president of Bear Stearns, Warren Spector—the person most responsible for this investment catastrophe in subprime mortgages—was fired. In his August 8 story in TheStreet.com, Brett Arends wrote:
And every investor who has watched the [Bear Stearns] stock collapse from more than $172 to just $117.78 in a few months is probably kicking himself for not selling at least some back at the peak, before the crisis hit.
Four savvy investors did just that.
Step forward, Alan Greenberg, Sam Molinaro, James Cayne and Warren Spector.
Who are they?
Top honchos at … Bear Stearns. (Or they were: Spector has now left in a management shake-up. The others remain.)
Between them, the four quietly cashed out more than $57 million worth of company stock before the crisis hit.
The executives saved themselves nearly $16 million by their astutely timed sales, which were disclosed in a series of public filings.
Those losses got passed on to the unlucky outside investors who bought the stock.
Bear Stearns declined to comment.
Connecting the Dots …
This is a newsletter about connecting dots. Here are the dots:
* Two giant Bear Stearns hedge funds, based on subprime mortgages—loans to cash-poor home buyers—started tanking.
* The four top executives of Bear Stearns cashed out $57 million in company stock close to the high.
* On March 1, Bear Stearns analysts issue an upbeat report on New Century, the largest subprime lender.
* Based on the optimism of Bear Stearns analysts, investors bought New Century.
* On March 8, New Century—owing billions to creditors—ceased accepting mortgage applications. A criminal investigation into its practices was announced and the stock fell to $3.57, from a high of $50 in May.
* On March 11, trading in New Century Stock was suspended.
* New Century declared bankruptcy on April 3.
The widow and her brother were wiped out.
You have to smell a rat.
Are not the Bear Stearns executives who sold company stock near the top and then sanctioned an upbeat report on New Century just days before it went under guilty of something?
Why will NBA referee Tim Donaghy spend 25 years in jail for cashing in on basketball games that he manipulated while the four Bear Stearns execs—whom it seems to me did essentially the same kind of thing—won’t be prosecuted?
In a word, Wall Street stinks.
A few insiders—like the big dogs at Bear Stearns—make their millions while millions of homes are sitting vacant and millions of middle class Americans have joined the ranks of the homeless.
According to Bloomberg Data, 60 mortgage companies have “halted operations, gone bankrupt or sought buyers since the start of 2006.” On August 17, The Guardian reported that Countrywide, which wrote more than $400 billion in mortgages a year and employs 54,000 workers, is teetering on the brink. This past Monday, Capital One closed its GreenPoint mortgage division and will take an after-tax charge of $840 million. Yesterday Lehman Brothers announced that is was folding BNC Mortgage, its subprime unit, and firing 1,200 employees in 23 cities. This morning, the AP reports that the mortgage industry job loss has been 40,000 since the start of the year with many more to come.
Waiting in the Wings?
And this past Tuesday in a Wall Street Journal story titled, “After the Tumult, Is It Buffett Time?” Karen Richardson surmises that the “Sage of Omaha” may be ready to make some serious moves now that stock prices of the mortgage companies are in the gutter and it’s a buyer’s market. She reports that Buffett is sitting on a war chest of nearly $50 billion cash. Citing the former Philippines’ first lady, Buffett told an interviewer, “I can spend money faster than Imelda Marcos when things are right.”
Buffett and Marcos are alike—judicious spenders. “I did not have three thousand pairs of shoes,” Imelda said huffily in 1987. “I had one thousand and sixty.”
Where’s the Outrage?
An occasional reader of this cranky little e-zine—such as my former client Steve Warsaw, a savvy direct marketer and crack sailor now living in Phoenix—weighed in on the subprime crisis. He writes:
Where are all the talking heads, Wall Street pundits and editors who so earnestly proclaim the virtues of a free capitalistic economy? Today, they are sitting on the curb with their begging cups in hand. Stand by, Mr. & Ms. Taxpayer. After all, we cannot expect these moguls of finance to be forced to sell their 200’ yachts or one of their three or four 12,000 sq. ft. offshore or Belle Haven mansions. Once again, for the third time in recent memory, you, Mr. & Ms. Wage Earner or fixed income retiree, will be forced to pay for the miscreants’ malfeasance, mistakes and mismanagement.
I’m old enough to remember when companies sold stock so that they could build their businesses, employ more workers and make the world a better place to live in. Wall Street and its peers all over the world are no longer performing their “honest broker” obligations—but they fully expect us to bail out their sorry asses when things go sour.
Will the Wall Street gamblers—for that’s what they are—learn anything from this experience? It’s doubtful. Almost certainly, their unrepentant avarice will kick in again before long. History has proven that whether it’s the tulip craze or railroad ‘deals,’ non-existent gold mines or fraudulent financials, the insatiable quest for quasi-legal materialistic gain will again rear its ugly head. Whatever the next scam, you can be certain it will wear a different face, be presented with different script and packaged in an unrecognizable wad of pretty tissue paper.