The United States of America

I'm not a Democrat

I'm not a Republican

I'm not a Tea Partier

I am simply concerned about the direction that our country is headed in right now. Since I'm also not a syndicated columnist - I decided to write this "Op-Ed" style piece and post it on Facebook. Sorry if you find it more boring than a video of a badger being bitten by a snake.

Since the great recession started in 2008 we have had 2 stimulus packages, 3 rounds of Quant. Easing, guaranteed ZIRP (zero int. rate policy) through 2013, a bank bail out, an auto industry bail out, lingering wars in Afghanistan and Iraq, and a “conflict” in Libya. That’s a hefty and unprecedented dose of fiscal and monetary stimulus - it’s really remarkable that we still have a ~9.2% unemployment and anemic growth. Either Keynesian economics has failed or we would have been sent back to an economic stone age if it wasn’t for the government's capacity to spend – which by the way, is mainly fueled by our ability to borrow – an ability enabled by our reserve currency status around the world. (Even after the S&P downgrade)

It is evident that two things need to happen - 1. Short run growth must take us out of this prolonged economic hardship (according to the government, the recession ended in 2009…so we’ll use the term hardship instead); 2. Longer term deficit reduction mainly focused on the substantial unfunded liabilities - 35.3TT Medicaid; 22.8TT Medicare; 7.9TT unfunded pensions (Source: USA Inc by Mary Meeker, Summary by William Gross here: (http://www.pimco.com/EN/Insights/Pages/Skunked.aspx)

To bring our friend Keynes back into the conversation, here is his greatest contribution to economics –

In the long run we'll all be dead.

That beautiful economic fact makes the aforementioned liabilities a bit less daunting - we can and probably will kick the can down the road until Keynes’ wisdom kicks in. Delaying pain is something that politicians are unequivocally adept at doing.

But wait, what if we decided that we wanted actual change though?
What if we wouldn’t settle to simply transfer our parent’s and grandparent’s debt to our children and grandchildren?

What would we do then?

Currently in the short term we need to do what we can to stimulate real economic growth. If we can make the assumption that government spending is even nearly as efficient as private sector spending - then through the multiplier effect – wars and stimulus should help fill the vacuum left by the housing crash, and general economic drawdown. (Multiplier Effect = the govt. pays $1 to Halliburton, who then spends x% of that money, the recipients of that x amount of money then spend y% of x and the money keeps flowing through the economy- so for 1 dollar spent by Barrack - hopefully $5 worth of economic activity takes place...)

As you likely now assume from my setup - I do not think government spending is anywhere near as efficient as private sector spending. Therefore, I think our government should be focused not on using the money to stimulate the current quarterly GDP number, but instead on policy that will act to revitalize our hegemonic political and economic structure. How to do that? I'll let the Catholic Church's deadly sins guide me -


1. Wrath. We are currently involved in two wars and forced to maintain an enormous military presence globally to protect our energy supply chain. It would be interesting to see what the price of Gasoline would be if we privatized all military forces needed/currently used to secure this resource - and made big oil foot the bill. If that was the case, would we be so slow to develop alternative and renewable energy sources? The best short run solution here seems to be nuclear energy and electric cars. Although I'm neither an engineer nor a scientist, I'm pretty sure we can build nuclear power plants in tsunami / earthquake / hurricane / tornado free zones, that are much safer than they were in the past. I find it frustrating that there is no political appetite to discuss this issue. That's the quick fix, a longer term, better solution would be to have a “Manhattan Project” like effort to build a renewable energy source.

2. Hubris. We’ve grown complacent and it's time that we take a close look at our tax code, and business environment. Whenever I hear people (Politicians, CEOs, the dude pouring my Peet’s iced coffee, ...) speak about how this is America and we'll always be great, I worry. China is here in a big way, they're gobbling up resources around the world from Africa to Costa Rica. Eventually they'll decouple from our economy, and when that happens - Game On. Right now we are lucky that they are so dependent on our consumer base for their economic growth trajectory. We need to make it as easy and efficient as possible to do business in the United States, or business will move elsewhere as it has been for the last 20 years. While I will concede that labor is cheaper in other parts of the world, improving the efficiency of the business environment here should be a top priority.

3. Sloth. While our University system, with the exception of the strain currently on public institutions such as my alma mater, is the best in the world - our prep schools are terrible compared to almost any other western nation. We need to take a page out of Germany's book and offer more trade school like training programs where people can choose to learn an actual craft. Vocational training will increase our economic efficiency in the long run because we'll have a workforce trained to work, and not trained to recite Shakespeare. An example of this is in the San Francisco Bay Area where there is a shortage of programmers and engineers. Say whatever you will about efficient markets dictating labor supply, there is a multi year lag between a demand imbalance and a wave of newly trained workers reacting to that imbalance. Although there are thousands of talented coders and engineers in India as a result of the said vocational training philosophy, the value of having talent in-house is undisputed. Unfortunately, there are deep socioeconomic forces at play here as well, and I see no single policy based cure all. In general though, more money needs to be efficiently allocated towards education in order for our future to be as bright as our past. As our economy continues to shift from being production based to service oriented, our government's "research and development capital" needs to be invested in training tomorrow's workforce.

4. . Gluttony. Let’s take a look at the biggest economic problems - unfunded Medicare / Medicaid liabilities. We need to start focusing on preventative health care and attack the obesity epidemic in a meaningful way. I have been studying the work of Dr. Robert H. Lustig at UCSF medical school - he purports in a very convincing manner that the obesity problem started in 1982 when the government came out with the food pyramid - emphasizing a low fat - high carbohydrate diet. A strong case could be made that demand side public policy supporting the highly subsidized corn industry is a driving force here... His thesis is that the increase in sugar consumption and specifically fructose / high fructose corn syrup are causing obesity because they block the body's natural satiety response after eating. I’m not a biochemist but basically the hunger causing response is similar to that of alcohol consumption (Fructose, Sucrose and Alcohol are all very similar chemically – so liken it to the drunk munchies) What's sugar causing the muchies have to do with the current economic environment? Well - if we could decrease obesity in our nation through public policy - the 35 and 23 Trillion dollar health based liabilities could potentially decrease in a very material way. Imagine that!

- http://www.nytimes.com/2011/04/17/magazine/mag-17Sugar-t.html?pagewanted=all
- http://www.youtube.com/watch?v=dBnniua6-oM


So...there are a few things I think we could start spending money on with a longer term perspective. While politicians may not want to shelve the pork ridden "shovel ready projects" - the longer term fruits will be much sweeter than the small, short term sugar high enjoyed by the shotgun stimulus approach we have seen thus far. As citizens we must take pride in our nation’s past economic greatness. Although we have been an economic world leader for the last 50 years, we must not feel any sense of entitlement to this status. Entitlement breeds complacency, and complacency will certainly lead us to a less desirable future than we are capable of earning for ourselves.

The Rescue Bill Explained

Our financial system currently faces a severe crisis created by years of lax lending standards, and inaccurate predicted default rates for borrowers.

When a borrower takes out a loan to buy a house, their creditworthiness is analyzed by the bank to see what their risk of default is. Prime borrowers pay the lowest interest rate for borrowed funds while subprime borrowers, who bear the highest risk of default, pay the highest interest rate.

Borrowers pay down part of their mortgage each month. Mortgage backed security bonds take thousands of mortgages from similar credit demographics (think prime / subprime) and bundle them together.



With bundles of mortgages, the law of large numbers diversifies the risk of default to mirror historic levels. In other words, historic default rates for various credit demographics can be used to predict how many people will be unable to pay in the future. Based on this information the buyers of the bonds can know how much cash to expect, and pay an appropriate price for the bond.

A bond is a security which pays a fixed amount of money to the holder. Bonds are sold to the holder in order to raise money. In this case the money is raised to finance real estate purchases.


Like many things in life, the system always works perfectly- except when it doesn't. The recent decline in housing prices has led default rates, especially on subprime mortgages, to skyrocket. When people don't make their monthly payments, the owners of the mortgage backed security bonds don't get paid as expected.

Currently defaults are climbing at unpredictable rates causing many bondholders to sell. In what seems to be a mirror image of the “irrational exuberance” fueled dot-com boom, fearful sellers are driving prices of these bonds down. Many experts believe the bonds are trading well below intrinsic value.

In terms of a bond, the intrinsic value is the present value of all future cash flows. Another way to look at it is today’s value of all the checks which the bondholder will collect over the life of the bond.


Market value is simply how much money you can sell your bond for at a given point in time. In a world with perfect information, where cash flows are accurately predicted, intrinsic value equals market value. In our world, market value does not equal intrinsic value since people have no idea how many defaults will actually occur.

Banks previously saw these bonds as safe investments, and used them as collateral to borrow excessively. When the value of their mortgage backed securities declined sharply, many banks were unable to pay all of their liabilities.

In the wake of Bear Sterns, Lehman Brothers, AIG, Freddie Mac and Fannie Mae ect… all having severe liquidity issues, the credit markets have frozen up and loans are very hard to come by. Since borrowed funds are crucial to business being done in our financial system, lack of liquidity in the credit markets threatens the stability of our economy.

The bailout package currently being pushed through congress will use $700 billion to buy distressed bonds from banks. With the toxic securities removed from their balance sheet, banks will be able to pay off their debts and start lending more freely again. Some experts believe that a financial meltdown will ensue if the bailout is not executed. As Warren Buffett put it last week, failure to pass the plan would trigger "a financial Pearl Harbor."

The government can buy this stuff because, unlike banks, they don't need to pay off any debts in the near term. Checks from the bonds can be collected over time, making (irrational) market prices irrelevant.

In a worst case scenario defaults may continue to spiral out of control leaving the value of these bonds below the price paid by the government. In this case the taxpayer will not be hit since the bill states that the president must call for legislation which charges the financial industry for the loss.



While losses are possible, many experts believe that fear in the marketplace is currently driving prices below intrinsic value. In a best case scenario the bailout will result in taxpayers gaining a return on their investment. If the government collects checks for more than the bonds cost in the open market, tax payers will be making money.



In any case, banks will hopefully be freed of their toxic waste and able to once again drive our economy by lending.

First day of class

The class is in C325 up at the Business School.

For the first session please bring a typed paper with the following information:

1. Name, SID, Year, Major
2. Why you want to take this class
3. What you can contribute to this class
4. One stock you think will go up in 1 year, and one stock you think will go down in one year.
4.1. More importantly why one will go up and one will go down.

Class will start tomorrow at 7:15.

See you then,

Michael

Stocks Simplified is designed to give students a basic understanding of finance and stock market investing. The course will cover the following topics:

-Differences between debt and equity
-A look at compounding and inflation
-Risk + Return / Bond Pricing
-Historical returns of stocks
-Stock payout policy
-Stock valuation
-Stock Picking
-Options and shorting

Many of these topics are covered in 103, and therefore if you are focused on finance and accounting my course might be too basic for you.

Grading will be based on class attendance, participation and a 1 page paper at the end of the course. (easy) Success will require light reading pared with heavy class participation.

There is no class today because it is a holiday.

I can only take 34 students in the class, I think more than 34 people want to take the class. To help weed out people who are not interested in the material I am creating an assignment due on the first day.

The assignment will be posted on this blog by 6pm on Sunday night. (it will not be hard)

Class begins on Monday night at 6:30.

Hope to see you there and thanks for the interest.

Best,

Michael