A lot of people don’t even know that Greece’s debt is a problem that is threatening to bring down the European Union. And of those that have heard about, few realize its significance and potential impact on the US. John Mauldin has done a fine job explaining that in his most recent newsletter. It’s written as a letter to his kids explaining how the current economic situation affects them.

Why is Greece important? Because so much of their debt is on the books of European banks. Hundreds of billions of dollars worth. And just a few years ago this seemed like a good thing. The rating agencies made Greek debt AAA, and banks could use massive leverage (almost 40 times in some European banks) and buy these bonds and make good money in the process. (Don’t ask Dad why people still trust rating agencies. Some things just can’t be explained.)

Except, now that Greek debt is risky. Today, it appears there will be some kind of bailout for Greece. But that is just a band-aid on a very serious wound. The crisis will not go away. It will come back, unless the Greeks willingly go into their own Great Depression by slashing their spending and raising taxes to a level that no one in the US could even contemplate. What is being demanded of them is really bad for them, but they did it to themselves.

But those European banks? When that debt goes bad, and it will, they will react to each other just like they did in 2008. Trust will evaporate. Will taxpayers shoulder the burden? Maybe, maybe not. It will be a huge crisis. There are other countries in Europe, like Spain and Portugal, that are almost as bad as Greece. Great Britain is not too far behind.

The European economy is as large as that of the US. We feel it when they go into recessions, for many of our largest companies make a lot of money in Europe. A crisis will also make the euro go down, which reduces corporate profits and makes it harder for us to sell our products into Europe, not to mention compete with European companies for global trade. And that means we all buy less from China, which means they will buy less of our bonds, and on and on go the connections. And it will all make it much harder to start new companies, which are the source of real growth in jobs.

And then in January of 2011 we are going to have the largest tax increase in US history. The research shows that tax increases have a negative 3-times effect on GDP, or the growth of the economy. As I will show in a letter in a few weeks, I think it is likely that the level of tax increases, when combined with the increase in state and local taxes (or the reductions in spending), will be enough to throw us back into recession, even without problems coming from Europe. (And no, Melissa, that is not some Republican research conspiracy. The research was done by Christina Romer, who is Obama’s chairperson of the Joint Council of Economic Advisors.)

And sadly, that means even higher unemployment. It means sales at the bar where you work, Melissa, will fall farther as more of your friends lose jobs. And commissions at the electronics store where you work, Chad, will be even lower than the miserable level they’re at now. And Henry, it means the hours you work at UPS will be even more difficult to come by. You are smart to be looking for more part-time work. Abbi and Amanda? People may eat out a little less, and your fellow workers will all want more hours. And Trey? Greece has little to do with the fact that you do not do your homework on time.

And this next time, we won’t be able to fight the recession with even greater debt and lower interest rates, as we did this last time. Rates are as low as they can go, and this week the bond market is showing that it does not like the massive borrowing the US is engaged in. It is worried about the possibility of “Greece R Us.”

Bond markets require confidence above all else. If Greece defaults, then how far away is Spain or Japan? What makes the US so different, if we do not control our debt? As Reinhart and Rogoff show, when confidence goes, the end is very near. And it always comes faster than anyone expects.

The good news? We will get through this. We pulled through some rough times as a nation in the ’70s. No one, in 2020, is going to want to go back to the good old days of 2010, as the amazing innovations in medicine and other technologies will have made life so much better. You guys are going to live a very long time (and I hope I get a few extra years to enjoy those grandkids as well!). In 1975 we did not know where the new jobs would come from. It was fairly bleak. But the jobs did come, as they will once again.

At least there is some good news in the end!

The underlying issue is the size of the country’s debt. At some point, either it becomes too big to service, or creditors get cold feet about the ability to service the debt and demand repayment – usually at the worst possible time. This is what happened to Iceland. They defaulted on $50 Billion euros of debt, not a large amount by US standards, but 488% of their GDP and a huge amount to their tiny population of less than 350,000. Greece, Portugual, Spain, Ireland and the UK are all in a similar situation.

Even the US isn’t too far behind. Currently our debt is nearly 400% of our GDP. At what point do our creditors stop lending us money?
USdebt-vs-gdp

Sir John Templeton, founder of Templeton funds is widely acknowledged as one of the greatest investing minds ever. He died in 2008 at the age of 95. His son recently released a memo found among his belongings that was written in 2005.

Apparently, Templeton predicted the coming economic challenges and it seems Greenspan was wrong – it isn’t impossible to predict financial bubbles!

John M. Templeton
Lyford Cay, Nassau, Bahamas

June 15, 2005

MEMORANDUM

Financial Chaos – probably in many nations in the next five years. The word chaos is chosen to express likelihood of reduced profit margin at the same time as acceleration in cost of living.

Increasingly often, people ask my opinion on what is likely to happen financially. I am now thinking that the dangers are more numerous and larger than ever before in my lifetime. Quite likely, in the early months of 2005, the peak of prosperity is behind us.

In the past century, protection could be obtained by keeping your net worth in cash or government bonds. Now, the surplus capacities are so great that most currencies and bonds are likely to continue losing their purchasing power.

Mortgages and other forms of debts are over tenfold greater now than ever before 1970, which can cause manifold increases in bankruptcy auctions.

Surplus capacity, which leads to intense competition, has already shown devastating effects on companies who operate airlines and is now beginning to show in companies in ocean shipping and other activities. Also, the present surpluses of cash and liquid assets have pushed yields on bonds and mortgages almost to zero when adjusted for higher cost of living. Clearly, major corrections are likely in the next few years.

Most of the methods of universities and other schools which require residence have become hopelessly obsolete. Probably over half of the universities in the world will disappear quickly over the next thirty years.

Obsolescence is likely to have a devastating effect in a wide variety of human activities, especially in those where advancement is hindered by labor unions or other bureaucracies or by government regulations.

Increasing freedom of competition is likely to cause most established institutions to disappear with the next fifty years, especially in nations where there are limits on free competition.

Accelerating competition is likely to cause profit margins to continue to decrease and even become negative in various industries. Over tenfold more persons hopelessly indebted leads to multiplying bankruptcies not only for them but for many businesses that extend credit without collateral. Voters are likely to enact rescue subsidies, which transfer the debts to governments, such as Fannie May and Freddie Mac.

Research and discoveries and efficiency are likely to continue to accelerate. Probably, as quickly as fifty years, as much as ninety percent of education will be done by electronics.

Now, with almost one hundred independent nations on earth and rapid advancements in communication, the top one percent of people are likely to progress more rapidly than the others. Such top one percent may consist of those who are multi-millionaires and also, those who are innovators and also, those with top intellectual abilities. Comparisons show that prosperity flows toward those nations having most freedom of competition.

Especially, electronic computers are likely to become helpful in all human activities including even persons who have not yet learned to read.

Hopefully, many of you can help us to find published journals and websites and electronic search engines to help us benefit from accelerating research and discoveries.

Not yet have I found any better method to prosper during the future financial chaos, which is likely to last many years, than to keep your net worth in shares of those corporations that have proven to have the widest profit margins and the most rapidly increasing profits. Earning power is likely to continue to be valuable, especially if diversified among many nations.

The Wall Street Journal had an article advising homeowners who were upside down on their mortgage to just throw in the towel and walk away from their mortgage. Here’s the abridged version:

Millions of Americans are now deeply underwater on their mortgage. If you’re among them, you need to stop living in a dream world and give serious thought to walking away from the debt.

No, you shouldn’t feel bad about it, and you shouldn’t feel guilty. The lenders would do the same to you—in a heartbeat. You need to put yourself and your family’s finances first.

If you are reluctant to give up on “your” home, realize that it isn’t “yours.” If you are in negative equity, it’s the bank’s home. You’re just renting it. And right now you may be paying way above market rates. You need to be ruthless about your cash flow.

Still, when it comes to the idea of walking away from debts, many people are held back by a sense of morality. They feel it’s wrong to abandon their obligations. They don’t want to be a deadbeat.

Your instincts, while honorable, are leading you astray.

The economy is fundamentally amoral.

Whether we like it or not, walking away from debts is as American as apple pie. Companies file for bankruptcy all the time, and their lenders eat the losses. Executives and investors pocketed millions from the likes of Washington Mutual, Lehman Brothers and Bear Stearns when the going was good. They didn’t have to give back one cent of that money when the companies went into bankruptcy.

Wow, I’m speechless. It seems the greed of Wall Street has permeated down to the lower rungs of society and it’s perfectly okay to socialize your debts and losses. (By socializing, I mean the bank or taxpayer or a large group of people who are not affiliated to you end up paying for your debts/losses/mistakes/greed). Apparently its as American as apple pie. Is this the change I didn’t vote for? If everyone in all sections of society thinks its perfectly okay to default on your obligations, logically, the next question is

How much longer until the US Government starts defaulting on its debts?

Of course, the US Government cannot default, since it can keep printing US Dollars to pay for its debt. Which it is already doing. The only problem is that this increases the number of dollars in circulation and causes the currency to devalue. Sooner or later, we’re going to see a large of amount of inflation. No we may not see hyperinflation like Brazil or Zimbabwe, but we sure might see 10-12% inflation for a few years.

But 12% inflation for only 6 years would cause the price of everything to double. If you don’t think that’s possible, just look at a country which isn’t currently in deep recession, like India. Inflation in India is currently running at 9%. And over the past decade it has been running at a similar rate.

So what’s the effect on the average Indian? Highly skilled workers saw their salaries jump 10 times, while salaries for unskilled labor is up about 5 times. So everyone is better off, right? Not exactly, people living on fixed incomes basically got screwed as prices for everything else went up 5-10 times as well. It was great if you owned real assets like real estate, gold and to some extent stocks, but terrible if you owned bonds or cash. Just make sure your investments are tailored towards those investments that happen to do well during inflationary times.

Just read this news article from the Associated Press:

Tue Feb 23, 8:17 am ET

MOSCOW, Ohio – An Ohio man says he bulldozed his $350,000 home to keep a bank from foreclosing on it.

Terry Hoskins says he has struggled with the RiverHills Bank over his home in Moscow for years and had problems with the Internal Revenue Service. He says the IRS placed liens on his carpet store and commercial property and the bank claimed his house as collateral.

Hoskins says he owes $160,000 on the house. He says he spent a lot of money on attorneys and finally had enough. About two weeks ago he bulldozed the home 25 miles southeast of Cincinnati.

bulldozed_foreclosed_house_moscow-ohio
Ok, there’s nothing really humorous about this. But I thought it was a great story about getting back at the bank. Banks are notoriously difficult to deal with and after accepting billions in bailout money from the taxpayers aren’t really modifying very many loans. If you think that people who default on their mortgages are scumbags and deserve to lose their homes and that banks are just faultless victims, check this link about a foreclosure attorney who tried to help a couple modify their loan. Actually, regardless of what you think about banks or borrowers  you should still read the article. It’s very interesting.

Bob Parsons is the multi-millionaire founder of Godaddy, probably the world’s largest domain registrar company. Here’s an interesting video about the top 5 rules for starting a business that they don’t teach you in business school.

#5. Start small

Don’t go all in when first starting a business. Get a proof of concept first and make sure you have a fallback plan. Parsons worked at a day job for 3 yrs while he started his first business, which he subsequently sold for $64 million.

#4. The best business partner is no partner

As opposed to conventional wisdom, two heads are not better than one. Having a partner or investor usually ends badly. You too much time discussing and negotiating than doing anything productive.

#3. Solve your own problems

Don’t use mentors and don’t copy what others do. According to the founder of Sony, Akio Morito, “You never succeed in business, technology or life by following the footsteps of others”. Indeed, a wise man keeps his own council. Speaking of Akio Morito, check out his highly acclaimed book, Made in Japan.

#2. Don’t fight fate

Keep eyes open to act on new opps when they arrive. For example,  Yamaha started out making pianos before they ventured in motorcycles, and Godday started out building custom websites.  You also need to be lucky. Strategy and planning are important but talent lies in spotting a a lucky break and taking action.  He gives the example of the first superbowl ad that got censored. The in-game censorship resulted in tremendous publicity and they jumped on it.

#1: Get and stay out of your comfort zone

Security is for cadavers!

You can watch the entire video below, but I’ve covered the main parts, except for the hot blonde! And speaking about wisdom that they don’t teach in business school, check out Never Wrestle with a Pig and Ninety Other Ideas to Build Your Business and Career.


Regular readers know I’m currently pursuing an MBA. What they don’t know is that I’m currently taking 6 classes plus an Applied Management Research project which is almost twice the usual workload. I’m a third of the way through the quarter and I’m already feeling burnt out.

To help take my mind off things, I decided to look at vacation packages. Once my quarter gets over, I might travel for a week.  I’ve been dying to visit South America or the West Indies for quite a while. Several packages look pretty good. And by  good, I mean from the aspect of being good value for money. Yes, I like to travel cheap, or as I like to emphasize, I’m a price-conscious consumer. Some of the places that had good deals were Costa Rica, Puerto Rico, and Mazatlan. Argentina also looked enticing, but the flights were slightly more expensive. One of the things I noticed was that my Discover Card was offering 5% cashback on travel booking until the end March 2010.

I don’t usually use my Discover credit card very much. It has a strange (but useful) rotational rewards program. Usually, you get 1% cashback, but every month (or sometimes for a whole quarter) you’ll get 5% cashback on a specific category of purchases. Each month its a different category. For example, it might be on travel (plane, hotel, car rentals or cruises), only restaurants, gas or maybe just groceries. This quarter, it just happens to be travel. Pretty useful if I actually end up traveling somewhere.

I typically use my American Express True Earnings Card instead of Discover. The rewards are more predictable. You get the typical 1% cashback on regular purchases, but you always get 2% cashback at restaurants and 3% cashback on travel. I paid my MBA tuition fees with it and got over $500 on it! While I don’t condone spending $50,000 just to get $500 back, it still makes for a nice Christmas present! (I would’ve actually preferred the American Express Starwoods Card since the rewards are great for taking vacations and the points are redeemable for stuff on Amazon, but I was coldly rejected).

So before making any major purchases, you should definitely go through your credit card rewards and see which one gives you more bang for your buck. If you don’t have a Discover card, make sure you sign up for it – the additional 5% might be worth it if you’re planning a big ticket purchase.

If you’re a student with limited credit history, you can sign up for the Discover Student credit card. It is a bit easier to get approved for it and it comes with the same set of rewards.

And if any of you have any vacation suggestions for the end of March, please let me know.

Detour Destinations - The Best Local Trips. Local Prices. No Hassles.

One of my favorite investors, Nassim Nicholas Taleb, founder of Empirica investment management funds and author of Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, was recently quoted on Bloomberg advising every single human being to short the US Treasury bonds. While this news is about a week old, I thought I’d still comment on it given the fact that it’s a pretty strong statement and that I recently exited a similar paired-trade.

Taleb said investors should bet on a rise in long-term U.S. Treasury yields, which move inversely to prices, as long as Bernanke and White House economic adviser Lawrence Summers are in office, without being more specific. Nouriel Roubini, the New York University professor who predicted the credit crisis, also said at the conference that the U.S. dollar will weaken against Asian and “commodity” currencies such as the Brazilian real over the next two or three years.

The Fed and U.S. agencies have lent, spent or guaranteed $9.66 trillion to lift the economy from the worst recession since the Great Depression, according to data compiled by Bloomberg. Bernanke, who in December 2008 slashed the central bank’s target rate for overnight loans between banks to virtually zero, flooded the economy with more than $1 trillion in the largest monetary expansion in U.S. history.

President Barack Obama has increased the U.S. marketable debt to a record $7.27 trillion as he tries to sustain the recovery from last year’s recession. The Obama administration projects the U.S. budget deficit will rise to a record $1.6 trillion in the 2011 fiscal year.

“The problem we have in the United States, the level of debt is still very high and being converted to government debt”, Taleb said in an interview with Bloomberg Television. “We are worse-off today than we were last year. In the United States and in Europe, you have fewer people employed and a larger amount of debt”.

Moody’s Investors Service Inc. said on Feb. 2 that the U.S. government’s Aaa bond rating will come under pressure in the future unless additional measures are taken to reduce budget deficits projected for the next decade.”.

Do I believe him? Absolutely. So why did I exit my highly profitable trade? Several reasons. During times of global economic uncertainity, there has always been a flight to quality. We saw this during the financial meltdown in 2008, where US Treasury prices soared and yields tanked. Right now, there is uncertainity in Europe regarding the debt of Greece, Portugal, Ireland, and Spain. People are worried this might have lasting consequences on the Euro as a viable currency. These fears are probably overblown, but until everything settles down and we have more clarity, there will be a flight to quality, which means that people will sell the Euro and flock to US Treasuries.

At least thats my hypothesis and I sold all my positions (except Berkshire Hathaway), shorted the Euro and also the S&P500. The one thing I didn’t do is go long the US Treasuries, since inherently I feel Nassim Nicolas Taleb is correct. At some point, I’ll most likely re-enter my short US Treasury trade, but in the meanwhile I happy to see how the European Union handles the issues of excessive debt.

Almost exactly a year ago, I mentioned a paired-trade investment between the long-term Bond ETF (TLT) and short-term corporate/sovereign bond ETF (AWF).  I went long AWF and shorted an equal dollar amount of TLT. Last week, I closed the position after holding it for just over a year.

When I entered the trade, AWF was trading for $8.29 and had a yield of 13.4%, while my short position in TLT was trading at $112.10 and had a yield of 3.5%.  When I close out my position a year later, AWF had a price of $13.10 and a yield of 8.6%, while TLT was going for $91.65 and yielding 3.9%.

I made about 63% on the long AWF position and 18% on the short TLT position. Coupled with the 9.9% net dividend yield, that trade made me ~91%. Not a bad return for a year and 4 days.  Bond yields don’t usually move 500 basis points in a year. No point being greedy. Time to bank some profit!

paired-trade-awf-tlt-returns

A drop in the stock market will cause the price of bonds to move up, since they typically are inversely correlated. Similarly a sharp rise in in yields would cause bonds price to drop. I expect a move in TLT to about roughly $96 at which point I might renter the position depending on the larger macro-economic picture.

Here’s an interesting article by Dominic Frisby about Venezuela’s devaluation, the effect on a country’s currency and the relation with gold prices.

Gold bugs are forever telling you to buy gold because it is ‘nobody else’s liability’. It’s become one of those hackneyed phrases that has almost lost its meaning.

But recent events in Venezuela give us a nice illustration of what that phrase really means. And there’s a stark, but important message for savers everywhere.

Inflation is currently running at 27% in Venezuela. That’s just the official figure. You can expect the real number to be considerably higher.

Earlier this month, the Venezuelan president Hugo Chavez, devalued the bolivar by half, from 2.15 per US dollar to 4.30 per dollar. There will be a second peg, subsidised by the government, of 2.60 bolivars per dollar for essential imports such as food, medicine and machinery.

This devaluation has effectively doubled the cost of imported goods and halved the Venezuelan people’s purchasing power in a single stroke. Savers – though I doubt there are that many given the country’s precarious situation – will have had half of their wealth effectively wiped out overnight.

Chavez is doing it, he said on state TV, ‘to boost the productive economy, to reduce imports that aren’t strictly necessary and to stimulate exports.’ But that won’t be the effect. All his actions will do is discourage people from working at all. Leaving aside the moral issue of whether government should have the power to do that (and, largely speaking, with our modern system of money and credit, they do), many Venezuelans will now ask themselves: ‘What is the point of my working at all, if the proceeds are going to be devalued so suddenly?’

But any Venezuelan who happened to have converted some of their wealth into gold would be protected from these government foibles – at least, as much as is possible under the circumstances. [LOD”s note: Not only gold and silver, but even real estate would hold its price in an event like this. Over the long term, real estate matches inflation, and to some degree population growth]. Chavez cannot suddenly devalue gold by half to ‘boost the productive economy’. So the proceeds of that individual’s labour would have been preserved. The purchasing power of gold against essential goods such as food, energy and shelter remains unchanged – in fact it’s probably risen.

I remember backpacking across South America in the early ’90s. Venezuela was one of the wealthiest, most advanced nations on the continent. It’s such a shame to now see the country on Hayek’s The Road to Serfdom, or, worse still, to Zimbabwe.

“Chavez”, writes Daniel Cancel on Bloomberg, “is trying to maintain spending for his 21st century socialist revolution as South America’s largest oil exporter fails to emerge from its first recession in six years. The government is seeking to stem its falling popularity and the highest inflation rate among 78 economies tracked by Bloomberg, ahead of parliamentary elections scheduled for September.”

Well, isn’t our own government doing the same thing? Haven’t they boosted spending over the last three years in an attempt to stem falling popularity ahead of an election? Isn’t quantitative easing an elaborate form of currency devaluation? The effect of their actions has been that sterling has been losing its purchasing power. It buys us considerably less food, energy, medicine, industrial goods and anything else you care to mention (except mass manufactured goods from Asia) than it did five years ago.

It even buys us less foreign currency, as the chart below – which shows sterling against a basket of foreign currencies – shows. (I’ve drawn on that white line highlight the market direction) The only reason sterling has not fallen further is that other foreign central banks have been doing the same things to their own money. It is a race to the bottom.

british-pound-against-basket-of-currencies.ashx

Our currency has devalued many times before. Anyone who remembers 1976 can tell you about the sterling crisis then. Financial markets were losing confidence in the pound. (I believe that loss of confidence is coming again. If sterling drops below $1.57 against the dollar, look out below).

The UK Treasury could not balance its books, while Labour’s strategy emphasized high public spending. The newly-elected prime minister, Jim Callaghan, was told there were three possible outcomes: a disastrous free fall in sterling, an internationally unacceptable siege economy, or a deal with key allies to prop up the pound while painful economic reforms were put in place. What will David Cameron be told should he win in the summer? The parallels to today are uncanny.

In more recent memory, we have had the sterling lows of March 1985 (when we almost hit parity with the dollar), then another crisis with ‘Black Wednesday’ in October 1990, when we were forced to drop out of the European Exchange Rate Mechanism.

What is worrying is that our current deficits, debts and spending are all at far greater levels than during any of the previous crises. So many toxic assets have been transferred from the balance sheets of banks to governments, that sovereign debt default – not just here, but throughout the Anglo-Saxon economies – is now a major risk.

You can read the entire article on moneyweek.

So Why should you care?
If you invest in US companies that do business with Venezuela, then your portfolio returns will definitely be adversely impacted. US companies that do business with Venezuela like Haliburton are likely to feel the impact of this currency devaluation. Haliburton CEO just announced that they may face a $30 million loss in the 1st quarter because of this.

While I liquidated almost my entire stock portfolio at the market open this morning (including Harvest Natural Resources which does business in Venezuela), I’m still keeping my gold and silver coins!  Talking the about market, its risen 50% since the March lows of last year. I might even go short some weaker stocks on any market bounces too.

Today the baby Berkshires (BRK.B) split 50 to 1. And it’s up 4%! This was to be expected. The stock is now affordable to many small investors and there is talk about it being added to the S&P500 index.

When the stock split was first announced, I had a brilliant idea to sell my baby Berks on the news and then re-buy them just before the split. I figured that the euphoria of the split news would push the stock higher and then the enthusiasm would die down and I could buy them back lower.  So the stocks that I bought at $2,550 (split adjusted price of $51) were sold at $3,500 (split adjusted stock price of $70).

My plan worked. The stock drifted down to $3,250. I would’ve been happy to buy them at $3,300. Especially since the current price is $72.25 or just over $3,600 pre-split price. Unfortunately, with my busy school schedule, I totally forgot to put in a buy order and ended up buying the stock back at $71.

Sometimes it better to not try and optimize everything! How many of you are buying BRK-B now that it’s more affordable?