Is a Depression Coming?

We know how we got into this mess, but where are we going? One potential route has been described by Hayman Adivors. The firm's managing partner J. Kyle Bass wrote a scary letter (below) in mid October. He says we're "experiencing the global deflationary bust of all time."

Some of his points are:

  • Don't trust financial stocks' book values. They're making it up. They are incredibly over-leveraged. For example, if we look at assets to tangible equity, Bank of America's leverage ratio is 134x!
  • It's not that banks are scared to lend. They just don't have any money left to lend.
  • Losses (from mortgages, credit cards, personal loans, auto loans, credit default swaps, corporate bonds, etc) will total in the trillions of dollars by the time we get through this.
  • The total credit market debt as percentage of Gross Domestic Product is the highest it has ever been. As of the end of June 2008, total debt was 356.5% of GDP. Heading into the Great Depression, this figure spiked at 260%. This percentage will come down, whether we like it or not. The government, meanwhile, is trying to re-lever the economy.
  • Home prices will bottom around 34% off their highs, and the economy will decline for at least two and a half more years.
  • Unemployment will hit as high as 12%.
  • Stocks will potentially decline 70% from their highs, or more. That's around 4,200 on the DJIA and 470 on the S&P 500. Warren Buffett is not infallible, says Bass.
In anticipation, Hayman's equity portfolio is only 20% long, and 50% short. Their bond portfolio is all short. They are also shorting currencies that they think will decline most against the dollar.

I don't know how they fared this past week, when the markets soared and the dollar weakened, but they've been bearish at least as far back as 2007. I've been unsuccessful in finding any kind of track record for Hayman Advisors. All I found was that they owned stakes in Express Jet (XJT) and Genesco (GCO) (I'm pretty sure they're losing money on these).

So far, LIBOR rates have been falling, a sign that the interbank lending freeze is thawing. This puts into doubt the "it's not fear, they have no money to lend" point. While mortgage rates have been on the rise (according to Bankrate.com, rates are once again at the highest levels they've been this year), a counter indication of sorts, it could be fear rather than having no money to lend.

These are tough times for investors. If you believe Bass, cash is the safest place to be. But the possibility of inflation is here too, in which case, as Warren Buffett wrote, cash is a sure loser.

Perhaps the best way to go is to buy shares of good companies and hedge them with puts?

Here's the Hayman Advisors letter:

Disclosure: At the time of writing, I had no position in any securities mentioned above.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.


How Madison DuPaix "Retired" at 29 -- A Rant

Of all the things to get worked up about, personal finance articles should probably not be on the list. But this article made me angry. [Update 11/4/08: that link is now dead, and the article seems to be missing from Laura Rowley's page. Fortunately, I took screen shots. Email me if you want them.]

There are what I think of as "inspirational personal finance stories." Various magazines and blogs publish them. Like feel good movies, they tell us about a regular person, working an ordinary 9 to 5 job, being able to retire early through a frugal lifestyle. We like reading these stories because they give us hope and motivation. Retiring early is possible, they show us. It just takes some hard work, planning, and discipline. If this person did it, I can probably do it too.

Maybe I'm angry because that's how I expected "Meet the 29-Year-Old Retiree" to go. The first paragraph sets it up thus: Madison left her job back in February. When asked what she does for a living, she feels uncomfortable explaining "how she managed to stash away enough to retire from her full-time job at age 29."

My interest is piqued. How did Madison save all that money?

Well, she's been investing in index funds for a while, and started her IRA when she was 16. Madison also tries to find the best deals she can when she buys things.

Hey, that's pretty good. What else did she do?

She bought a condo with an adjustable rate mortgage and had the good luck to sell it when the housing market peaked.

Ok, but that's not exactly saving is it? That sounds more like speculating with other people's money.

So how did she retire?

In February and March Madison sold some of her stocks, getting two to three years worth of her expenses in cash. The rest of her money is in stocks.

So she's able to live off that cash?

Yeah. She's also getting some extra money from blogging three times a week and doing credit card arbitrage. She also writes for About.com.

Blogging on a consistent basis can be kind of hard. Isn't it at least like a part time job? And is she, like, an employee of About.com?

She's retired!

Ok...So she has enough money to meet all her living expenses?

Of course! Madison is able to stay at home and take care of her kids (except when the part time nanny is necessary). Her husband's job takes care of a big expense, health insurance. He tried out retirement while he was on paternity leave, but he prefers to work.

She has a spouse who works?

Maybe I should have mentioned the husband's job sooner. But Madison is retired.

So let me get this straight. Madison quit her full time job, and now supplements her income by blogging and writing for About.com. Her husband further supplements the household income by working full time. They meet their expenses with this income and by drawing down on 2% of their savings. Besides the two to three year money, everything is in stocks.

Yes! That's how Madison retired.

What happens in three, five, ten, fifteen years if stocks stay flat or go down like Japan's did when they had a credit crisis?

Madison is retired!

She's 29 now. Let's say Madison lives until she's 80. Will her money last her another 51 years? She has kids. Will she be able to pay their education expenses? Although her husband works, they're taking out 2% of savings. What happens when he "retires" (i.e., blogs and writes for About.com)?


I wish Madison all the best. But I find the article about her infuriating because she hasn't retired, and, unless she's lucky, it seems that sooner or later she will have to find a full time job.

I think I'd be happier with an article that went like this: Meet Joe. He retired at 25 after he won the $50 million lotto jackpot. While not very inspirational, we can say that Joe is retired. That is, he doesn't have to work for a living another day in his life.

Laura Rowley's piece also makes me angry because it doesn't tell us about something that we all can do. "Meet the retiree" articles are supposed to show us how regular people can save enough to retire on with as little risk as possible. The most risk we should be taking is investing in the stock market (and credit card arbitrage if we're organized enough).

If you don't agree, consider whether it is appropriate to write a saving for retirement article about someone who borrowed money, went to Vegas, and won a couple of rounds at the poker table. Does it help anyone? It should rather be about all the people who tried this and are now deep in debt. It should be an article about what not to do. Madison made money by borrowing and gambling on housing prices going up. If she had worse timing, she might've been one of the millions of people about to lose their homes.

I'm happy for Madison. All the power to her. But don't make her a role model, or an example of "a throwback to the post-Depression era, when socking money away for the future was both a core value and a way of life." Don't say she's part of "a new generation of savers as the golden era of leveraged living comes to a crashing halt."

I'm 26. I'm a retiree too--for the weekend.


Negative Bond Yields

I received a great question from a reader. He noted that a few weeks ago, news articles about the financial panic stated that short term Treasury Bills had negative yields for a brief time. He could not quite understand this, and thought perhaps that it was a mistake. Take a dividend paying stock, he said. The yield you get on it is the annualized dividend payment divided by the purchase price. The lowest it can be is zero, and that's when the stock doesn't pay dividends. A negative yield means you're paying someone else money, and that just doesn't make sense.

The reader is absolutely right about stock dividend yields. They cannot be lower than zero (ok, so this isn't necessarily true either. Example: you own a business. It gets into some trouble and is sued. The court rules against you, but your business doesn't have enough capital to pay the judgment. In certain cases--when the judge is angry, basically--the court can "pierce the corporate veil." The shareholders can be held liable and be forced to pay up. I doubt this would ever happen with a stock you buy on one of the major exchanges. Another example is just a vocabulary distinction--it depends on what you mean by yield. I discuss this below.) With bonds, on the other hand, yields can be negative and you end up losing money, even when you hold to maturity.

There are two types of bonds, those that have a coupon and those that don't. The coupon is the interest the bond pays. The face value of the bond is the sum the bond holder will receive when the bond matures. So, for example, when a bond with the face value of $1,000 matures, the debtor will pay the bond holder $1,000.

Bonds without coupons are typically sold below face value. For example, a bond with the face value of $1,000 is sold for $900. When the bond matures, the bond holder receives $1,000. He gets a return of $100, or an 11.11% gain. The yield on this bond, we can say, is 11.11% (if you factor in time in years when calculating the yield, you may get a different answer. Suppose you get that 11.11% gain in a month. Your annualized, non-compounded return is actually 133.32%. Or say you get that return over two years. Your yield on that bond is 5.55%).

But suppose the bond is in great demand (because of its safety, etc) and investors are willing to pay more than $1,000 for it. When it matures, they get $1,000. Since they paid more, then end up losing money, and the bond has a negative yield. Suppose they paid $1,100 for it. The yield is negative 10% (for a holding period of a year).

The short term Treasury Bills (maturities range from a few days to one year), or T Bills, have no coupon and usually sell below face value. Their return, upon maturity, is the difference between purchase price and face value. Panic striken investors were willing to pay slightly more than face value, recently. They preferred losing a known amount of money in the safety of Treasury Bills than possibly lose everything if the financial system suddenly collapsed. The newspapers were not in error when they reported that yields on short term Treasuries were slightly negative.

Bonds that have coupons, that is, bonds that pay interest in installments, can also have a negative yield. Suppose a bond with a face value of $1,000 will pay $60 in interest before it matures. If you buy that bond for $1,000, you'll get a yield of 6%. But if you pay more than $1,060, you'll get a negative yield if you are unable to sell it for more than you paid and end up holding it until maturity. That's because when the bond matures, you'll be paid $1,000.

As this may be confusing, it might be helpful to distinguish between the different types of gains and losses you can get with a bond, and thus different types of yields. The above makes no distinctions.

Bonds can produce capital gains and losses. If you sell a bond for higher than you bought it, you get a capital gain. If you sell a bond for lower than you paid for it, you get a capital loss.

Bonds can also produce income gains and losses. These are the interest payments bond holders receive. While it is possible that investors might be willing to pay the bond issuer interest payments, this is highly unlikely. So, generally speaking, bond income can only be positive. If you take "yield" to mean interest payments paid before the bond matures, then a bond's yield cannot be negative. We can call this "current yield." It is distinct from what we can call "yield to maturity," which is face value minus purchase price plus interest payments.

But didn't I just say that yields can be negative, as in the example of short term Treasuries? Yes. I guess it's only a vocabulary distinction. On T Bills, the yield is the difference between face value and purchase price. That is to say, current yield and yield to maturity are conflated when short term Treasuries are discussed. Perhaps we can think of our returns on them as short term (less than one year) capital gains or losses. This is the same as ordinary income. So it makes sense to say that the yields on these bonds can be negative.

Please email me or leave a comment for further questions or to point out any mistakes above.


ING Direct Electric Orange Review

If you're looking for a Sharebuilder review, it is here.

Relatively recently, ING started offering an all electronic checking account, Electric Orange. Intrigued, I decided to try it out. While Electric Orange has some uses, it is probably not worth the trouble of moving your money there.

Online-only banking is becoming popular with people looking to maximize the interest their bank deposits earn. HSBC Direct, ING, Emigrant Bank Direct, and a few others have had online only savings accounts for a while now. As these involve less costs for banks, they tend to offer interest rates well above ordinary brick and mortar deposits. For example, at a time when regular HSBC savings accounts yield almost 0%, HSBC direct offers 3%. A couple of disadvantages that come from this low cost structure often include a limited number of transfers per month (as far as I know it's six) before an online-only savings account starts incurring fees and may be closed, and the way you make deposits.

With this in mind, here's what's good, not so good, and bad about ING's Electric Orange.

The Good

1. ING's Electric Orange, being a checking account, gets around the transaction limit issue. If you make a lot of electronic deposits and withdrawals (e.g., you sell things online and transfer funds back and forth through Paypal), this account might be worth considering.

2. The account earns interest.

3. Unlike other similar accounts, like HSBC's online payments account, you can send paper checks. You write the amount, what it's for, and the payee's name and address. ING sends out a paper check the next day. You incur no postage fees. If the check needs to get somewhere the next day, ING offers this option, but you have to pay extra. If you don't want to send a paper check but have the payees account information, you can send money electronically.

4. What's convenient about writing checks online is that you know exactly what your balance is. It's hard to bounce a check by accident.

5. Like some other banks, ING offers a line of credit (should you want it). Instead of insufficient funds charges, when you draft a check for more than is in your account, you take out a loan from ING. The last time I checked, it was around 7% interest, and the maximum you could borrow was $1,000.

6. The layout is very easy to use. You also have fast access to ING's other products, like the savings account, certificates of deposit, and Sharebuilder.

7. Signing up is quick and easy. ING requires less documentation than other banks (this may have identity theft risks, but I prefer having to provide as little information about myself as possible).

The Not So Good

1. When you write a check, ING deducts that amount from your account. You do not earn interest on this deducted amount. If the check isn't cashed within 90 days, the money is placed back into your account.

2. The paper checks are pretty much useless. We use checks to pay our credit cards, tuition, loan payments, and at places like the doctor's office. We also give checks to family members and friends, as well as contractors, repairmen, supermarket clerks, and the like. We can divide these into two groups: payments that can already be done electronically, without paper checks, and payments where we present a physical check.

Credit card bills and some tuition and loan payments can be done online. If you're already using an online-only checking account, you already know how to pay for these things online. Sending a paper check from ING can result in lost or late payments, and you don't earn interest on the money removed from your account when you draft the check.

Tuition and loan payments that require payment coupons (those things that you're supposed to include with your check--they state your account number, how much you owe, etc) cannot be made with Electric Orange. This is because you have the coupon at home, while the checks sent from ING are in South Dakota. This is all to say that you can't send payment coupons (or letters, etc) with your checks.

The ING check also comes in a difficult to open envelope that looks like junk mail. People working at billing processing centers might discard the envelope. If they succeed in opening it, they may wonder who the payment is from and what it's for. The space in the memo is limited. As no letter or payment coupon accompanies the check, there are potential problems here too.

While Electric Orange has some uses above (it can be improved, for instance, with an add a letter function), it is useless for "bring your checkbook with you" situations. If you want to pay for your doctor's visit with a check, give a last minute cash birthday gift, or pay for groceries, you can't use Electric Orange.

I wanted to see if I could get around this limitation by having the check sent to me, so that I could then give it to the payee. The payee's address is on the check. If I want to receive the check intended for the payee so that I can later give it to him, my address will be on the "pay to the order of" portion instead of his. Some payees and banks will not accept this.

Moreover, say you don't know who to make the check out for or for how much. With ordinary checks, you just take your checkbook with you. With Electric Orange, you can't send the check to yourself to fill out later (and anyway, imagine sending a blank check through the mail--not a good idea). An improvement here would be having the ability to print the check at home.

The Bad

1. No physical location to make a deposit. You need an existing bank account from which to transfer your deposits to ING. Unless all your funds come from direct deposits, this is inconvenient.

2. Five day holds on deposits. Given #1 above, you can't deposit cash directly into ING. Say you have to make a payment today, don't have enough in your account, and don't want to use your line of credit. With a regular bank checking account, you simply deposit cash, write your check, and mail it. With ING, you have to wait for funds to be transferred into Electric Orange, and then wait five days to use them. If you want to deposit a check into ING, it takes even longer, because you also have to wait for it to clear your regular bank. Since you need a regular checking account anyway, there's no point in using Electric Orange. Yes, Electric Orange earns interest, but

3. The interest rate is not very high.

4. Apparently, ING sends electronic payments instead of paper checks when it has the payee's account information. This can lead to problems, as Joe recently found out. His rent payment was canceled because ING tried sending an electronic payment instead of a paper check. Joe points out that this can have disasterous effects. Credit card companies, for instance, often make their interest rate higher if there's a late or missed payment. This sort of thing cannot happen with regular checking account.

Bottom Line

While innovative, Electric Orange is not very practical. As far as online only accounts go, its only advantages are that you can send paper checks (which work best in situations you don't need paper checks and work worst when you do) and you don't have a transaction limit. There is lots of room for improvement. Extra features, like being able to attach a letter or a scanned copy of a payment coupon, would go a long way to making Electric Orange useful. You might want to consider the account if you like the idea of an online only account and usually have lots of electronic transactions.

If you're looking for a free checking account that earns interest, you might consider Charles Schwab. Just recently it yielded 3%, but as of 10/27/08, it pays 1.75%, which is still pretty good.

This Electric Orange review will be updated every six months or whenever I become aware of changes to the account.

Feel free to leave a comment about your experience with Electric Orange. Please let me know if anything above is inaccurate.

October 30, 2008