From the Mind of Trevor Stone

On Monday we're signing a bunch of documents and an escrow company will move a whole bunch of money around between accounts and we're going to move some essentials into a house and change the locks.

I would feel significantly less nervous about this if I'd received final amounts and money wiring instructions by now. I usually assume that data networks between banks are made of molasses, so moving a few bytes from one bank to another takes two days and COBOL code doesn't run on weekends. So I've had over a quarter million dollars sitting around in a couple accounts for a month and I'm getting nervous, because moving $250,000 from place to place is a lot harder than moving $25.

I remember thinking, in 2010, that the stock market was likely to rise for a while after falling precipitously in 2008 and 2009. I also had a significant chunk of cash (earning really low interest) from five years of living below my means. "I should do some research, figure out how to actually buy stocks, and invest a bunch of that cash."

With the exception of maximizing 401(k) contributions, I didn't do that research and didn't invest anything. Partly this was because I had a continual sense of "I might decide to buy a house in the next two years," so the chance of losing a bunch of money due to market fluctuations was unattractive. But mostly it was because I like to do a lot of research to understand significant decisions and financial research is both endless, in the sense that there are thousands of securities one might invest in and their prospects change frequently, and boring, in the sense that finance takes everything that's interesting and unique about companies and governments and human decision making and reduces them to a whole bunch of numbers about the past and present accompanied by verbose disclaimers that past performance is no guarantee of future results.

It turns out that not investing in the broad U.S. stock market in 2010 came with a significant opportunity cost: the S&P 500 has roughly doubled in value in the last 5 years. International stocks haven't done as well, with non-U.S. developed markets growing around 4% per year and emerging markets growing by less than 1%. Had I invested $50k in 2010 in half-U.S./half foreign indexed funs I would today have about $30k more I could spend on a house (which I'm still not ready to buy). [It's not totally clear that not investing was a terrible decision, though. I spent much of the energy I could have devoted to poring over financial data becoming a better software engineer and making friends and having fun. The total future outcome of these activities in terms of future salary and well-being may well be worth tens of thousands.]

In December I happened to be looking at charts of the S&P 500 over the last few decades and noticed that the shape of the graph has a recent slope comparable to the slopes leading to 2000 and 2008, but with a present value significantly higher than when the market crashed in those two years. I spend a lot of time at work looking at graphs of web traffic and server performance, so a graph shape that matched historic trouble zones looked worrying to me.

After a checkup on and a rebalancing of my 401(k), I set out to the book store in search of a sensible volume educating readers how to invest in the market. My selection criteria mandated a copyright date after 2009, figuring that a book without the lessons of the worst financial crisis in nearly 80 years would be an incomplete read. Fortunately, there's a new edition of A Random Walk Down Wall Street by Burton G. Malkiel. This book argues that investors (particularly average folks) can achieve no better return, over the long term, than to put their money in a low-cost fund tracking a broad stock market index. When the book was initially published in the early 1970s, one couldn't actually invest in the market as a whole (short of buying a few hundred stocks, which a person with modest means can't do). Malkiel's advocacy of this strategy led to the creation of mutual funds based on indexes like the S&P 500 and the Russell 3000.

The reasons for the primacy of an indexing approach to investing are several. Perhaps most fundamentally, the demand for securities which outperform the market exceeds the supply of such securities. With demand exceeding supply, prices will rise until the securities are priced so high that they no longer outperform the market.

More concretely, in order to outperform an indexed fund, the total returns of the security must exceed the index by more than the cost of maintaining the fund. This cost is expressed as "expense ratio" in mutual fund documents and represents both payments to the people responsible for selecting the components of the fund and the transaction cost of buying and selling the underlying stocks when they become attractive or no longer attractive. Index funds of U.S. stocks often have an expense ratio below 0.1% while actively managed mutual funds typically have an expense ratio between 1 and 2%. So to outperform the market, an actively managed fund must not do better than the average stock in the index but must do so by one or two points. Assuming an average return of 10% for the broad market, an active fund must provide a 11 or 12% return; in other words they must be 10 to 20% better than the average. Among professional investors, it would be surprising to find individuals who are consistently 20% better than their peers. And in years when the market goes down across the board, you lose more money the higher your fund's expense ratio.

In addition to the core point of index-fund investing, A Random Walk covers a fair amount of ground in financial education. Malkiel starts by explaining several historic periods of rapid growth and sudden decline in asset prices from the famous Dutch tulips in 1637 through the global financial crisis in 2008. He then explains two general approaches to investing: Castles in the sky, also known as technical analysis, is focused on figuring out what price people are likely to pay for something in the near future, even if it's much more than the asset is worth. Firm foundations, also known as fundamental analysis, focuses on determining an absolute value of an asset based on facts about it, like how much money the company earns. Malkiel then argues against these approaches, proposing instead the efficient-market hypothesis. He uses both the theoretical basis of EMH and plenty of academic studies and comparisons of historical returns to make the case that long-term, low-cost index funds are the best investment vehicles. You can't beat the market, he argues, but you can match the market. And the market, over any long period in history, has done significantly better than other types of investments. The market doesn't need to be efficient for indexing to be a good strategy.

A Random Walk also has several chapters of practical advice on how to go about investing in the market. Though the book is primarily focused on stocks, Malkiel explains how to understand other types of assets and create a diversified portfolio. He discusses how to plan for situations when cash flow is needed like retirement and major expenses. He also broadly covers the impact of tax on investment returns (essentially: invest as much as possible in tax-free accounts like a 401(k) or IRA to take full advantage of compounding and reinvestment of dividends). Finally, he gives his thoughts on the near-term prospects for investing: the stock market is unlikely to grow at the rate it has for the last several years but will probably continue at a modest growth rate, less than 10% total returns. With low interest rates (though the Fed is expected to slowly start raising them), most bonds will not be very attractive for a while.

Having read the book, I've spent much of my free time in the last several weeks working out an investment strategy for some of the pile of cash sitting in my bank account. There are a few tricky aspects to this. First, my high tax bracket as a well-compensated programmer combined with historic low interest rates means that income-producing assets like bonds in a regular brokerage account would produce returns only slightly better than a certificate of deposit in an insured bank, meaning that interest rate risk leading to a decrease in the value of a bond fund could lead to a loss of money. So much for diversification of asset classes.

The second problem I'm encountering as I scour available ETFs is that recent security valuation history seems somewhat at odds with global economic trends. U.S. markets have doubled in value in the last five years despite stagnant conditions for the median American household. As one would expect, foreign developed markets haven't grown much, with the slow-moving Euro crisis playing a large role. Yet with most of the world economic and population growth growth coming in emerging markets in the last ten years (leading to the creation of acronyms like BRICS), emerging market stocks haven't been rising accordingly. One interpretation of these trends is that "emerging market growth" is mostly about folks in the third world having more money they can spend on products made by multinational companies based in the U.S.A. Another interpretation is that a lot of this economic growth is occurring among companies not (yet) listed on stock markets. While I think that's a great trend that may support sustainable communities, as an investor it's much more difficult to take advantage of ("obtain exposure to") such growth. A third interpretation is that the Giant Pool of Money went looking for the next target after the housing, commodities, and debt markets collapsed and the Pool decided that U.S. equities had the best chance for returns. As the S&P graph flattens out, the Pool may head off on the next quest for above-market returns, leading to a decline in U.S. markets and unhealthy growth somewhere else.

So what am I going to do about it?
I'm contributing as much as possible to my tax-free 401(k) with a several-decades-to-retirement allocation. That's the easy part.

I still think it's likely that I'll buy a house in Boulder, with a target date of 2018 or later to allow my sweetie to establish a stable job, reducing the risk that we'll decide that we need to live somewhere else. Three years is too short a period to rely on positive stock market returns, so I'm going to keep most of my pile of cash invested in cash.

I'm planning to take some cash and sell some company-granted stock (which has grown in value but isn't well diversified and can only be sold at certain times) and invest it in a variety of index-tracking exchange-traded funds, which are much like mutual funds but requiring smaller tax payments when not held in a tax-free account. I've spent several dozen hours this month looking at graphs and numbers and portfolio distributions and holding lists and building a spreadsheet. And due to the paradox of choice and information overload, coupled with the uncertainty of returns of a random-walk market, I'm not sure my plan is much better off than it was before.

My plan so far involves investing 45% in U.S. markets, 25% in the "All non-US companies" index plus major developed countries (which make up the bulk of the all-world index), 20% in emerging markets, and 10% in real estate investment trusts. Typical investment advice for someone my age would suggest 20% bonds, but with low interest rates and high income tax, I don't think bonds will be a good investment for several years. This portfolio isn't going to generate much current income in the near future, so it's not going to contribute to the house-buying fund but instead be treated as a long-term investment; a general bet on overall economic growth, particularly in the third world.

So what should you do?
First, take any investment advice with a healthy dose of skepticism. Don't bother reading most short-term focused writings (articles with titles like "7 Energy Stocks that are a Strong Buy" or anything on CNBC). Read books and articles like A Random Walk Down Wall Street that are focused on long-term investing and don't make bold claims about beating the market.

Second, take full advantage of workplace retirement programs. In the absence of a robust welfare state, the two tools most folks have for surviving old age are tax-free investment accounts and kids with good jobs.

Third, carefully examine any investment opportunities for cost. The more money you have to pay someone to manage your money, the less money you get from investments. Index funds tend to be the best investment choices.

Fourth, live below your means. There are hordes of people who would be happy to lend you money so you can make poor financial decisions.

Fifth, if you've got extra money to invest, think carefully about how you want to approach investing. Know that you're not likely to make a huge profit in the near future and that your investments might suddenly shrink if the global financial system suddenly discovers that was again acting on incorrect or incomplete information on a massive scale.

Ignite Boulder 14 videos are up! You can watch my talk, Money and Other Useful Myths, at http://www.youtube.com/watch?v=8WnmVuglpTQ or you can watch the whole event at http://www.youtube.com/igniteboulder/
(If you're curious why I'm wearing a panda on my head, see the first talk, http://www.youtube.com/watch?v=cKyhVjxzN3I )

If you're already a fan of Ignite Boulder, you may have noticed my name on the speaker lineup for Ignite Boulder 14. If you're already a fan, you'll also know you should get your tickets now, because it'll sell out before the event three weeks from now.

If you're not already a fan, here's the pitch. Come see me and 13 other clever folks each give a five minute presentation consisting of 20 slides which auto-advance every 15 seconds. It's on March 3rd at 7 PM at the historic Boulder Theater. I'll be talking about Money and Other Useful Myths, explaining why money is fictional and how true value is people doing stuff. If you can't make it to the Boulder Theater, the event may be streamed live and the talk will be on YouTube later.

As readers of this journal know, I'm really good at being long-winded. So I'm impressed that in test runs, I've been able to say what I want in just three minutes. My second draft has to be longer? Whoa.

(Via this Coding Horror blog post):

This video is a fantastic illustration and explanation of motivation and reward. The speaker is Daniel Pink, author of Drive: The Surprising Truth About What Motivates Us. He says that money is a good motivator for mechanical tasks. If you pay people for each pound of tomatoes they pick, they'll pick more tomatoes than if you pay a flat rate each day. But if the task requires any cognitive skill, people do worse if there's a performance incentive. If you give people the freedom to do something interesting, you'll get much better results than if you offer an innovation bonus and tell them to work on something.[1] Money is a motivator, but to a limited extent: pay people enough to take the issue of money off the table.

This is a pretty good description of my motivations. My actual salary isn't particularly important to me; I'd probably be happy to do the work I'm doing for half the salary (but not a quarter of the salary, 'cause then I'd have to put a lot more focus into getting by on a tight budget). What motivates me at work is (a) interesting projects, (b) socially beneficial results, and (c) having fun.

Pink concludes that, beyond being profit maximizers, people are purpose maximizers. This jives with something I've thought for a while: economists study things in terms of money because it's easy to measure, but that lens is insufficient to capture a wide spectrum of human activities and motivations. "Purpose" isn't easily transferrable, it's hard to measure, it doesn't seem to follow mathematical rules, but it's how those crazy Homo sapiens sapiens work.

Maybe the problem with the Soviet system is that they wanted a very industrial society, but they applied a system that's suited to post-industrial creative jobs. For all Marx's focus on factories and industrial workers, he described a communist society "where nobody has one exclusive sphere of activity but each can become accomplished in any branch he wishes, society regulates the general production and thus makes it possible for me to do one thing today and another tomorrow, to hunt in the morning, fish in the afternoon, rear cattle in the evening, criticise after dinner, just as I have a mind, without ever becoming hunter, fisherman, herdsman or critic." [Idealism and Materialism]

[1] Even worse, if you offer huge financial incentives for easily-measured results to smart investment bankers, you can tank the world economy.

On First Amendment grounds, the Supreme Court lifted some bans on corporate spending during elections.

As I read that article, I'm not sure this changes a lot. Corporations and unions can pay for ads close to an election, so you could see ads where the announcer finishes with "Paid for by ExxonMobile" instead of "Paid for by People for Economic Advancement through Offshore Drilling, a 527 organization." Corporations may also be allowed to give to candidates, but unless there's something startling about this case of corporate personhood, each corporation would be limited to $2000 per election cycle, which is a drop in the hat for a major campaign.

With this decision, a corporation can essentially out-shout a candidate they don't like, and if there's a deep-pocketed corporation on the other guy's side, the month leading up to the election may turn into one big shoutfest. But national elections are already dominated by money spent on advertisements (particularly TV), so this is ratcheting up the problem more than creating a new one. My apologies to anyone who likes to watch commercial TV in October. Maybe things will get so annoying that people will flock to Change Congress and mobilize support for an election system that doesn't overwhelmingly reward the biggest spender.

House Republican Leader John Boehner of Ohio called the decision "a big win for the First Amendment" as long as donors disclose every dollar they spend on campaigns. Maybe we can get a law requiring political ads list the campaign's biggest donors just like Cialis ads have to spend half their time listing side effects. It's hard for a list of donors posted once every month or three to a website to compete for attention with twenty TV ads a day.

This is also an example of a generally-beneficial principle and right (freedom of speech) that in some cases is detrimental to society. Democracy works best when everyone is given a fair hearing. Big-market TV advertising is a poor medium for that.

On the bus from Antigua to Chimaltenango (the closest city on the Pan-Am Highway), a woman sat next to us on the school bus seat. I thought it was a little odd, since there was an empty spot or two still. "Maybe she's fascinated by my hair or something." She was silent through the ride, but as we approached the highway junction she said something I didn't catch. ¿Que? ¿Xela? No, vamos despues. ¿Panajachel? Sí, vamos hoy. She pointed at a bus parked on the highway, so I grabbed my bags and headed for the bus door. I was about to get off, but she and the ayudante (he collects the bus fares and puts people's stuff on top of the bus) indicated I should stay on until our bus turned the corner. I sat in the front seat, the women across the aisle, and Molly was behind me. A guy behind Molly was jostling her, she responded by telling him to have patience. In the span between waiting at a stop sign and pulling in front of the other busses, the woman unvelcroed and unziped my pants pocket and filched the wallet I bought two days ago to replace the one stolen in Poptún. Meanwhile, the guy had unzipped Molly's backpack and snagged my old camera that she was borrowing since hers broke.

So, to update the casualties list:

• My brand new Mayan weave billfold with Q250 (approx US$30), stolen by a middle-aged woman on a bus in Chimaltenango. With the money in the wallet, she can pay for 25 more round trips to Antigua.
• My five-year-old 3.1 MP Pentax Optio 33L with three weeks of Molly's carefully framed photos and visual memoranda, stolen by a middle-aged man on a bus in Chimaltenango.
• A $20 bill and two $10 bills, missing from Molly's small blue bag, departure date and location unknown. Oddly, several other bills remain in the same place.

Clearly, Chimaltenango is a wretched hive of scum and villainy.
Lonely Planet advised us not to leave our things unattended there on account of bag-slashing, but I didn't think through the scenario of theives robbing me before I got off the bus. We discovered the theft a few minutes into our ride to Lake Atitlan; too far to turn back and wrestle the theives to the ground.

We spent most of the ride making light of the situation:

• Now Molly won't get frustrated that my old camera doesn't do a good job taking the photos she likes to frame
• Now I have an excuse to get a better pocket-sized camera in the next year, saving shoulder stress from carrying an SLR hiking
• Maybe we should buy several decoy wallets, place them in easily-accessible pockets, and fill them with notes like "Aquí está su boleto al infierno. Es de ida, no más. ¡Disfruta el viaje!" (Here is your ticket to hell. It's one way only. Enjoy the trip!)
• The average time I've owned a wallet in my life is about 8.5 years. 17 years on the first one, two days on the second
• With the money from my wallet, the woman can fund 25 more round trips on that route
• Nathan's advice: "Frustration is a magician's misdirection, leading the audience's eyes toward a distraction while in otherwise plain sight the fraid is perpetrated"
• (In a discussion about the black plumes out the back of the '80s-vintage school bus) "It's a problem with the catalytic converter." "The Catholic converter is dirty, so it can't put the holy air into the high confession chamber, thus leading to sinful smoke."
• Things that wouldn't happen in the U.S. #2365: A guy opening the bus's emergency exit to climb on the roof to untie a box while the bus is doing 45 uphill on a curve. #2366: Passengers boarding and departing the bus through the emergency exit while the bus is not at a full stop.

Inventory of valuables still in possession:

• Two sane minds with senses of humor and knowledge of several languages
• Two relatively healthy and intact human bodies
• Two United States passports (with expired visas for China)
• Two Visa bank cards
• Two full camera memory cards
• A camera bag containing a Canon Rebel XT, a 4GB Compact Flash card (over half full and containing fantastic pictures of Molly kissing a horse), and a Garmin hand-held GPS device with the locations of all my photographs
• Two journals containing daily descriptions and observations
• One MP3 player/recorder with a few dozen sound clips to share what cannot be photographed

Everything else could be replaced or let go with a minimum of greiving and frustration.

While it's clearly to the immediate personal benefit of the thieves to steal petty cash and old camera equipment, in the long run it hurts their community, and in turn their chance at true prosperity. While I know that not every Guatemalan is a theif, others who hear stories of theft on busses may conclude that Latinos are untrustworthy. They then don't treat them with respect and pay them a poor wage when they work in the north, lowering the flow of remissions to the south. They may also think twice about traveling in "the third world;" if they do, they may choose to stay in expensive foreign-owned hotels and take direct shuttles run by companies that don't keep their money locally. I certainly wouldn't recommend anyone stay in a hotel or eat at a restaurant in Chimaltenango, a place tarnished by the actions of a few who deny respect to people because of the color of their face and the style of their luggage.

I just got my direct deposit notice by email and said "Huh, that's slightly more than it was two weeks ago. Did I get a very small raise for some reason?" Comparing side-by-side with last paycheck, I found the difference: federal taxes were about $20 less. "Oh yeah, a cut in payroll taxes were part of the stimulus plan." Maybe I'll celebrate by buying... uh... lunch?

I'd love to help the economy, but since I'm putting all my stuff in storage in a month, acquiring new things isn't very attractive. I suppose I could eat out more often, but then I wouldn't have a bowl of left over curry when I'm running short on time. One thing on my to-do list is to pick some non-profit organizations for donations, since they're probably hurting right now.

Over a month ago, clarsa asked

I figured, when the Freddie Mac/Fannie Mae thing hit the tarmac, the best place to be would have been in foreign currency, particularly the yuan which had been held artificially low for quite some time in order to facilitate international trade. But for the last few days, I've been reading that Asian stocks were flailing wildly and Asian currency is losing ground against the dollar. How can that be?

I've been late in answering in part because I was busy and in part because I haven't learned as much about currency markets in the past few months as I have about other markets. But here's a stab at an answer.

First, some background. Most countries have their own currency. When one country's economy isn't doing well, their currency doesn't buy as much of other currencies. Equivalently, people with currency from other countries can buy that country's currency for cheap. For example, in the middle of summer, one U.S. dollar could buy half a British pound and one British pound could buy two U.S. dollars. Today, one U.S. dollar can buy 67 pence and one British pound can buy $1.50. In the former situation (a strong pound, a weak dollar), American goods are cheap for Brits and British goods are expensive for Yanks. In the latter situation, Americans find it "cheap" to visit castles and Brits find it "expensive" to visit Disneyland. (Traveling in Western Europe and America is almost never cheap when you compare the price of food and lodging to third world countries, but in currency exchanges it's relative prices that matter.) The Europeans weren't particularly happy with their high-valued currencies this summer because it resulted in fewer U.S. imports of European products. So they could buy more stuff, but they had a harder time selling stuff.

Some countries use currencies which aren't freely traded in this way. In some cases, they use another country's currency directly; for the last several years El Salvador's official currency has been the U.S. dollar. In other cases, the country keeps their currency, but assigns a fixed (or barely-fluctuating) conversion rate to another country. For instance, the Hong Kong dollar is always worth 103 Macau patacas. (That way you don't have to change money when you go from Hong Kong to Macau for a day, but the Macanese merchants get a few cents advantage.) The Chinese currency* is "pegged" to the dollar. In the middle of the summer, one U.S. dollar was worth about 6.83 Chinese yuan. Last week, one U.S. dollar was worth about 6.83 Chinese yuan. China just recently announced it would lower the value of the yuan, making one dollar buy 6.88 yuan. Not a big gain, but a significant sign.

* There are several ways to refer to Chinese currency. Its official international name is the Chinese yuan (CNY). In China, the official name is the Ren Min Bi (RMB), "The People's Currency." But if you ask someone how much a half-kilo of fruit or a plastic dingle-dangle costs, they'll answer in kuai. "Kuai" is a count word meaning "units," so "Er shi kuai" is short for "Er shi kuai ren min bi," "Twenty units people's currency." A loose translation of "Er shi kuai" is "Twenty bucks."

So there's part of the answer to your question: Since the exchange rate of the yuan with the dollar is fixed, investing in yuan doesn't give you any advantages over investing in the dollar (unless you want to buy a lot of goods and services priced in yuan). It's sort of like betting on the weight of a sack of flour. You won't lose any bets, but you won't make much money either.

What about other currencies? Since every day we hear news about how terrible the U.S. economy is, wouldn't it have been wise to invest in some other currency in the middle of the summer? Not really.

The U.S. dollar is sort of the de facto world currency. Barrels of oil, for instance, are bought and sold in dollars. And remember all those mortgage-backed securities and collateralized debt obligations that blew up earlier this year? They were all in dollars. When Lehman Brothers went bankrupt, everyone who'd sold (the equivalent of) an insurance policy against Lehman going bankrupt had to pay the policy holder. That meant they all needed dollars they could spend. They sold off oil and other commodities and foreign currencies so they'd have dollars to cover their investment positions.

Furthermore, the U.S. economy is seen as the most robust in the world. If the U.S. Federal Reserve collapses, the world will be near the point where we need to start trading cows for beans and searching our hard drives for funny pictures. So while holding pounds and euros was sensible when the U.S. economy was falling alone, now that the whole world's economy is collapsing, dollars are seen as the safe bet.

That's the theory anyway, but I wanted to be sure. Are there any currencies that have done better than the dollar lately? I grabbed data for 13 currencies vs. the dollar and graphed their value against the dollar. (Values are normalized so the currency's value on the first day of the graph, July 30th, is 1. That lets pounds at 0.5 to a dollar appear on the same graph as yen at 100 to a dollar). The Chinese yuan held steady (I skipped other currencies pegged to the dollar). 11 currencies lost value, ranging from the Thai baht which is 94% of its previous value to the Brazilian real and Australian dollar which are 67% of their previous value. The lone winner was the Japanese yen, now at 116% of its late-July value.

I don't know why the Japanese yen is doing well while everything else is tanking. Japan went through its own fiscal crisis in the mid- to late-90s so its financial system has some recently-created safeguards that Obama's economic team is probably studying. There are probably other factors too, but I've heard very little about Japan lately (other than references to their 1990s collapse).

( 54K graph )On the plus side, now would be a great time to visit Australia or Brazil. It's even summer!

mackys asks

What is a reasonable estimate for the ACTUAL value of the mortgage-backed "junk" securities that $810 billion of my tax dollars bought?

The answer to that question has fluctuated every few days recently, so note that everything I say could be wrong soon.

First, a timeline.

1. US Financial System: OMG! We paid way too much for all these mortgages and nobody wants to buy them from us! O noes!
2. US Treasury Secretary: You guys are too big to fail. I'll save you!
3. Lehman Brothers: Save us, Henry!
4. US Treasury Secretary: Wait, not you, Lehman.
5. Lehman Brothers: <is dead>
6. US Financial System: OMG! Did you see what just happened to Lehman, guys?!? I'm not going to give you any of the money I don't have in case you're the next Lehman.
7. US Treasury Secretary: Ruh roh.
8. US Treasury Secretary: I has a 3-page plan; let me show you it! Let me offer you a $700 billion "bailout" by buying all your "toxic waste." No oversight, no accountability. Sounds great, huh fellas?
9. US Taxpayers: WTF?!? You're bailing out a bunch of bankers by buying toxic waste?
10. Karl Rove: What happened to the Bush administrations public relations team after I left? That's the worst sales job ever.
11. Senate Banking Chairman: Hey, I've got an 8-page better idea. The government should buy shares in banks. They'll get a liquidity injection and the government will make money when the banks do.
12. US Financial System: <flail wildly>
13. John McCain: In my many years in Warshington, I've fought wasteful government spending. And as president... Wait. For the next two days, I don't want to be president. I need to rush off to help the government hastily approve $700 billion in spending.
14. Political Pundits: You're not a maverick. You're a loony.
15. US President, US Treasury Secretary, Federal Reserve Chairman, Speaker of the House, Committee Heads, Attention Whores Presidential Candidates: Buying $700 billion of toxic assets sounds great. Here's a 100-page proposal.
16. House Representatives in Tight Races: O noes! Our constituents found our phone numbers! Halp! I want to get reelected, screw this bailout.
17. US Financial System: Well shiiiiiit.
18. Emergency Conference Meeting: You know what people think is tasty? Bacon. Let's add 350 pages of pork.
19. Somebody In The Meeting: *psst* Let's slip the stock purchase option back in there.
20. US Senate: Tastes great, we're willing!
21. US House of Representatives: Okay, I guess...
22. Financial Commentators: So... the government is going to invent a price for a bunch of stuff which has no market value because nobody wants to buy it.
23. Economists (some): Something must be done. This is something, therefore, it must be done.
24. Economists (others): This is a terrible idea.
25. Economists (still others): This might work, but I've got a better idea.
26. US Financial System: I'm going to drink heavily for a week and then turn on MTV and the radio at the same time.
27. US Treasury Secretary: I know I said there might not be an economy by Monday, but I'll need five weeks and some Wall Street executives on staff before I can do anything.
28. Germany: Scheise! Now our banks are in trouble. Immediate action! Your money is safe in German banks!
29. Europeans: Hey, now we have to guarantee our banks!
30. Economists: Hey... that sock purchase plan is in the bailout plan. Let's try that.
31. United Kingdom: Bollocks! Now our banks are in trouble. Immediate action! We'll take major shares in you chaps. kthxbai.
32. World Financial System: Whoa... I think I'm still drunk.
33. World's Major Central Banks: All together now: lower interest rates! That usually works!
34. World Financial System: Crap! I mean Great! I mean... maybe?
35. Iceland: We're melting! And not just because of global warming.
36. US Treasury Secretary: World leader huddle!
37. World Financial Leaders: Okay... we're not making progress running straight into the line. Let's run the option.
38. US Treasury Secretary: But I hate the option. My fans always boo.
39. World Financial Leaders: Henry... you can run the option or you can lose the game.
40. US Treasury Secretary: Fine! I'll run the stupid option.
41. World Financial Leaders: Okay, everybody. I know we've all trumpeted the wonders of the free market system for years. But the free market is having trouble, so we need to save it. Our plan is often called "nationalization." We're going to become part owners of major banks so they'll have money they can use to lube the wheels of the economy.
42. Financial Commentators: Wow. The best option is socialism.
43. John McCain: I'm gonna go ahead and NOT mention that in my campaign.
44. US Financial System: Well... okay... I guess. But I won't move until everybody else moves too.
45. US Treasury Secretary: Dear diary... the last month has sucked ass. But I think we're going somewhere.

So... what's the value of what taxpayers are buying? Like most questions in finance, the answer is "That depends on the future market." What are the pieces?

Henry Paulson (Secretary of the Treasury) wanted to solve the problem by spending $700 billion to buy mortgage-backed assets. (Essentially, that's a bunch of assets tossed in a pile. Except then somebody pulled pieces out of each mortgage and stuck them into other piles. It's like everybody in a neighborhood having spaghetti, but each noodle is really long and is on everybody's plate.) What would the value of these assets be? In some approaches to value, something is worth exactly what someone else is willing to pay. So in a sense, we'd be buying $700 billion of mortgage assets because we're willing to pay $700 billion. But then they'd be immediately worth much less because nobody else wants to pay $700 billion for them. In fact, nobody wants to pay much of anything for them. Part of the problem is that, under mark-to-market accounting rules, if nobody wants to buy a bank's piles of mortgages, banks can't pretend they have a bunch of money instead. And if they can't pretend they have a bunch of money, they have problems doing their normal bank activities like borrowing and lending money.

Under other approaches to value, the piles of mortgages are worth significantly more than nothing. Some percentage of the people who mortgaged their homes are making monthly payments, so the piles of mortgages are earning income. But investors don't think they can make a good guess about how many people will keep paying their mortgages, so they aren't willing to gamble on invest in them. If the U.S. government owned them, they wouldn't have to worry as much about accounting rules. The government would get the money that homeowners pay each month, meaning they'd have some real value. After a few years, once the economy settled down and investors felt like buying stuff again, the government would sell the piles of mortgages back and recover some of the taxpayer's money. In the mean time, the federal government would be the country's biggest landlord and end up owning a bunch of houses. I'll come back into that in a bit.

The main problem with the Paulson plan (aside from the world's worst marketing job) is that it put the government in the role of a really dumb investor. One of the main goals of the "OMG, save the banking system!" plans is to inject liquidity (i.e., money that's easy to spend) into financial system. If the government drove a hard bargain (what a private investor would do), they'd get a bunch of really cheap mortgages (great for the budget when the market improves later!), but banks wouldn't get much money they could spend. If they paid enough to get the money flowing (what a government would do), they'd probably end up losing a bunch of money in the end. The government has some smart people working out some rules for a reverse auction The federal government is good at losing money (call it an Investment Portfolio to Nowhere), but a lot of economists looked into the proposal and thought it wasn't very good.

Finally, Paulson bit the bullet and followed the European lead to the government buying major shares in banks. Some key things to note:

• The government gets "preferred stock." That means that the government gets company profits (from dividends or sale of assets in case of a collapse) before normal shareholders.
• The Treasury has said, on their honor, that they won't use the shares to influence the decisions of the bank.
• This provides an immediate infusion of liquid cash (technically it's electronic, which is kind of like liquid... there's electrons flowing through wire instead of water flowing through pipes...)
• Nobody has to make up a price for the piles of mortgages. The government's buying shares which currently have a market value.
• If the banks get better, the government makes money when they sell the shares.
• If the banks fail, the government gets a chunk of their assets.
• This guy thinks there are some devilish details the banks can twist to connive with the sudden infusion of taxpayer money. (He lists "rotisserie baseball" as an interest. I hope that doesn't involve hitting a chicken with a stick.) Listen to the Planet Money podcast for his points. (As usual, Adam Davidson does a better job than I do at explaining this stuff.)
• I think Treasury is still planning to buy "toxic assets," but their total available cash for toxic waste and bank stock is around $350 billion and the latter will take about $200 billion.

So what's the real value of the mortgage-backed securities taxpayers are buying? Hard to say. But we aren't spending $700 billion on them. What's the value of the bank stock we're spending $200 billion on? Hard to say, but if things get better the value should be more than $200 billion. The bankers don't really like the stock plan, but their collective overvaluing of the market got us into this mess, so tough cookies.


A caricature of the Soviet economic system is that everybody gets an identical place to live (owned by the government) and gives most of their money to the State. America, these caricaturists say, is better because we let each person decide what house to buy with their own money. But in the end, everybody ended up buying a house that looked just like all the other houses in their subdivision. And under the Paulson plan, the government would've owned a bunch of them and everybody would've paid their mortgages to the State. Under socialism, government men start with a plan to exploit their fellow men. Under capitalism, it just ends up that way.

Part of me thinks it would be really interesting for the government to own a whole bunch of suburban real estate. They could embark on projects to create local centers of employment and commerce, reducing the distance people would have to drive and thereby reducing dependence on foreign oil. They could turn vacant McMansions (in Denver lingo "Prairie Palaces") into housing cooperatives. The other part of me thinks housing cooperatives and local community development must grow bottom-up to have a chance of success. The federal government is good at doing big things like running national parks. A half-dozen hippies are good at doing small things like organizing a house inhabited by a half-dozen hippies. But I think there's a chance that the anonymous sprawl suburbs will become the new ghettos while former industrial buildings (aka lofts) become the hip expensive places to live. Centennial will be a really swank ghetto, but it'll still be a ghetto. Maybe we'll be listening to rap songs entitled "Straight Outa Rancho Cucamonga."


I've come to understand some interesting things about macroeconomics in the last few years, but hard-core capitalism still bothers me. At its root, it's a bunch of people doing stuff in exchange for imaginary pieces of paper. The main advantages of money are that you can do math with it and it can be exchanged multiple times. If you give me $10, I can later give the $10 to somebody else. Or I can divide it in half and give $5 to two people. But money isn't the only thing that can be exchanged. Much of the time, it stands in for time, effort, or information. If I give you an afternoon of my time and energy moving all your stuff from one apartment to another, you can't necessarily give that afternoon to somebody else. If you and I have sex for ten minutes, it has no (necessary) impact on your ability to have sex with somebody else for ten minutes... or two other people for five minutes. If I tell you a funny story and you want to tell it to two other people, there's no need to tell each only half the story.

Money is a tool to enable zero-sum games. But a very effective path to success is for multiple individuals to team up and play a game that's not zero-sum. Maybe that's why society gets so skittish about prostitution: it tries to mix a zero-sum game (paying money) with a non-zero-sum game (two people helping each other have an orgasm).

Remember that investing is essentially gambling with two important differences: Nobody's quite sure what the odds are and the house doesn't always win in the long run. When you invest money, you might get more of it back or you might get less of it back. When you invest time (hanging out with friends, playing games, having sex, relaxing in the sun on the porch) you know that hour of time won't come back, but you also know it won't suddenly turn into just half an hour. Remember that money isn't the only thing in the world worth exchanging with another person.


So that's all the economics questions I was asked on my original post. If I didn't bore you to tears and you didn't learn what you want to know from Planet Money, ask more questions!

dr_tectonic asks

If I were informed about the situation at more than a casual level, are there actions I could take that would have a substantial impact on my current or future well-being? (I have some retirement funds, they're all TIAA/CREF and not easily accessible to do anything with them, and I'm not really planning on trying to do anything with them for another three decades.)

My current assumption is that the answer is "no", and that this is a situation, much like 9/11, where more information has at best a marginal benefit, and could do significant (emotional) harm by making me all upset about something I really can't affect, and so, like the dangers posed by nearby supernovae, asteroid impacts, random spree killers, rampaging sewer alligators, and the like, it's really best to just ignore it for the most part.

Short Answer:

I think "no" is the correct answer. Retirement plans are kind of like trees: make sure it's planted in a place that will, in general, get the right amount of light and water and then don't worry about it. If you start panicking about a drought and try to micro-manage your tree's growth (like digging it up and moving it to the other side of your house), you've got a good chance of doing more harm than good. Periodically check on your trees to make sure they're growing the way you want, but don't do so when you're panicked. Humans often make good short-term decisions when we panic (like "Oh no, house on fire, grab the cat and run!"), but we rarely make good long-term decisions in a state of panic.

So don't make any rash decisions, but make sure your investment portfolio is aligned with your investment goals, is diversified, and has low management fees.

Long Answer:

If TIAA/CREF works like my 401(k) plan, you've got a dozen or two mutual funds you can distribute a portion of your paycheck to. You can also log on and move money from one fund to another. Broadly, there are three types of funds based on what they invest in: stocks, bonds, and income. You don't know which particular stocks, bonds, or income investments are currently held by a mutual fund, but the prospectus of the fund will often provide a focus like "We will invest about 75% in technology stocks."

Stocks are small bits of ownership in a company, traded on a stock exchange. Stocks are the most volatile of these types of investment. They have the potential to increase value quickly, but they can also drop like a rock. (The Dow Jones Industrial Average, an index of a certain segment of the New York Stock Exchange, dropped to almost 8000 yesterday compared to its high above 14000 last July).

Bonds are less risky. Companies and governments borrow money in exchange for a promise to pay it back at interest over a period of time, typically several years. These aren't likely to suddenly drop half their value like stocks, but they also won't suddenly double in value. A specific bond will be worth nothing if the issuing company goes broke and can't pay it back. The value of a bond fund will drop if there are lots of people who want to buy bonds, driving down the interest rates.

Income investments are generally short-term loans at small interest rates. For instance, the commercial paper market lets companies borrow $1 million to cover payroll. They'll pay it back the next day for $1 million plus $10,000 (1% interest) the next day after they've processed sales.


In the case of retirement funds, like TIAA/CREF and 401(k) plans, paying attention to the current value of your investments is rarely a good idea. Since you and I aren't planning on doing anything with the money in those accounts for 30 years, we've got plenty of time for them to earn back the losses they've made this year and much more. The Dow Jones is the lowest it's been since we invaded Iraq in 2003, but it's still 10 times what it was 30 years ago. So your retirement plan is probably worth less today than it was a year ago. But in another year or five it'll probably be worth quite a bit more than it was a year ago and it will probably get back to that point faster if your money is in high-growth funds (stocks) rather than safer funds.

I've heard that the best approach to take to a retirement fund is to check on it every year or two and make sure you still like the risk/reward situation you're in. As you get close to retirement, you probably want to reduce risk (shifting from stocks into bonds and income funds) so that a big crash on your 65th birthday doesn't take out half your savings. But in your 30s, you can take a big loss and still end up in good shape.

If you'd had perfect foresight, you could have moved your high-growth investments at their peak (perhaps the middle of last year) into something safer (bonds or income) and then switch back once the stocks hit the bottom, assuming you can guess when that is. However, the current financial situation is largely a "credit crisis," meaning banks and investors are very reticent to lend money right now, since they don't trust it will be paid back. This fear is so pronounced that commercial paper trading stopped cold until the Federal Reserve stepped in. If banks are unwilling to lend each other money over night because they think there's a significant chance of failure, I'm not sure any investment is particularly good.

Also note that in addition to gains and losses due to the market, you're charged a significant fee. If the share price of the fund increases slightly, you can actually lose money if there's a large fee associated. If the share price decreases, you'll lose even more money. It can therefore be wise to invest in an index fund (the S&P 500, say) with a 0.1% expense ratio than in a fund with a 1.5% expense. In the latter case, you're hoping the fund managers are good enough to do significantly better than the S&P (which isn't always easy). If you've currently got high-fee mutual funds, now might be a good time to consider moving them to a lower-fee fund with similar risk and potential for growth.

If you have stock in specific companies (rather than through mutual funds), this would be a great time to look into their financial situation. If you're worried the company won't survive the current financial crisis, you might want to sell that stock. If you think it'll make it out, you probably should hold it until the price goes up after investors regain confidence in the market.


Further reading: Is My Money Safe? from the New York Times via TheMoneyMeltdown.com. Gotcha Capitalism, a book about hidden fees by Bob Sullivan.

I've been mentally working on a post with a title like "What's Going On In The World: A Summary" lately, but I haven't made time to write it all down. One thing it'll touch on is the "Global Credit Crunch," which grew out of the "U.S. Housing Crisis" stemming from the "Subprime Mortgage Collapse." I don't have any formal education in economics, but I often find that I can construct a decent sense of the key issues by listening to the language of people who do know what they're talking about. But despite all the news references to this major financial current event, I could tell I was missing key pieces of the puzzle.

Fortunately, This American Life is really good at sharing a full story in a way that's easy to understand in human ways. Episode #355: The Giant Pool of Money looks at people involved at each level of the house of cards which has now foreclosed. They define key terms, explain why otherwise sensible people made bad decisions, and what factors came into place for everything to fall apart. The whole episode will be available as a free download on their podcast for the next week; even if you don't want to listen to everyday people's stories about weird stuff every week, be sure to listen to episode 355.

One thing they didn't really touch on is the question "Where did all the money go?" They said "It's just gone," but money doesn't just disappear; it goes somewhere. Somebody class of people came out on the winning side. I think the answer goes something like this:
Global investors (the giant pool of money) bought shares in mortgage-backed securities offered by investment banks on the assumption that payments would be regular, producing dividends.

Investment banks bought loans from mortgage brokers and commercial banks on the assumption that they could sell shares to big investors.

Mortgage lenders gave money to people (many of whom shouldn't have gotten a loan in the first place) on the assumption they'd make regular payments (or on the assumption that someone would buy the loan before it would matter).

Some people took out mortgages to pay other debts on the assumption that the going interest rate was better than their other interest rate. So creditors are one set of winners. And not entirely coincidentally, creditors like the financial megalith JP Morgan Chase Manhattan were major players in the shenanigans we're now seeing fallout from. So they may not have lost as bad as their current numbers look.

Some people took out mortgages to pay for big expenses like college for their kids or trips to Mexico on the assumption that American housing prices would keep going up and they could use the equity in their home as an ATM. So smart spenders are one set of winners. If someone took out a mortgage, paid for college, then lost the house in foreclosure, they at least funded a good education for their kid who can find a good job (even in the current economy, they hope) and get a house with some extra room for their parents. Of course, dumb spenders are one set of losers. If they bought a big screen TV and took a trip to party on Mexican beaches and then lost their house in foreclosure, the best they can say is "The real titties looked better than the high def ones did."

And, of course, some people took out mortgages to buy houses. For several years, American home construction was a booming industry. So one set of winners is home builders. But then they became losers as they discovered they had vast tracts of cookie-cutter subdivisions ready to sell just as everyone started losing the houses they shouldn't have purchased three years before. But before the home builders moved to the loser category, they paid a lot of money in wages to construction crews. American construction work these days is largely done by Hispanics. A lot of Hispanics send a significant portion of their income to family members in Latin America.

So the flow goes something like this:
American consumers buy cheap goods at discount retail stores -> discount retail stores buy cheap goods from China -> China invests dollars in U.S. mortgage bonds -> mortgage bonds create a demand for unsound loans -> unsound loans promise American consumers the dream of home ownership -> dream sellers build ostentatious subdivisions -> frugal carpenters send their share of American consumer money to poor Mexican families.
It's not so much trickle-down economics as it is Gordian-hose economics. The flow doesn't start or stop where I've outlined, but it's interesting to see how two groups (Chinese factory workers and Mexican subsistence farmers) who at first seem to have nothing to do with $500,000 houses on Shady Hills Lane are beneficiaries of the complex transactions of the American housing market. Of course, with major increases in the prices of food and oil, those benefits may rapidly dissipate. I wonder how much of that increase has come from investors fleeing poor assumptions about the U.S. housing market in favor of assumptions about commodities markets...

Remember kids, when investing or making other important decisions: The past is not necessarily a good predictor of the future. Life is one big Hume problem.