Category: Economy

End of the Line

Farewell, Bear Stearns. If it’s any consolation, a number of your colleagues will be joining you soon. Why? Simple: there isn’t enough money in America to save the financial system as we know it. It’s coming apart at the seams.

This is a good thing.

For sure, there will be lots of folks who will have to go through economic pain – heck, depending on the credit markets, there’s no telling how my current employer will fare, so I’m not at all exempt from this, either. It’s still a good thing overall, and here’s why. For the last 37 years, America has been living beyond its means. Our overall savings rate has dropped into the negative, and we’ve been spending like a drunken sailor.

Come to think of it, I’m fairly certain drunken sailors spend less. Because they typically don’t have access to leverage or derivative financial instruments, they can only spend what they have in port.

How much too much have we been spending? Warren Buffett warned in 2002 that derivatives – bets on bets, essentially – were financial weapons of mass destruction.

Charlie and I believe Berkshire should be a fortress of financial strength – for the sake of our owners, creditors, policyholders and employees. We try to be alert to any sort of megacatastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal. – Berkshire Hathaway Annual Report

According to the Bank for International Settlements, the total outstanding notional amount is 516 trillion (as of June 2007).

The annual gross domestic product of the United States of America – the goods and services that back “the full faith and credit of the United States” on which all of our bonds and other promises are made is…15 trillion.

Think about that for a second. If 3% of the derivatives in existence go bad (about the same amount that touched off the subprime bonfire last year), an unravelling could occur that would exceed all the goods and services the country makes, period.

All of this massive leverage – which is a fancy word for gambling, really – is catching up to the financial system rapidly, and all of the money in the world can’t bail out the system. It’s my hope that things unwind in a relatively orderly fashion, like a building evacuation, so the building can be torn down and rebuilt more soundly, but one way or another, the house of cards is coming down, and needs to.

Americans need to start saving again. Yes, the entire financial system incentivizes us to spend, spend, spend, but if you can resist the temptations of mass media, marketing, and incentives and put some money aside, you’ll be far, far ahead of your peers and colleagues.

In a downturn, cash is king. Save, reduce expenses, and batten down the hatches.

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I read with dismay this story on MSNBC about people breaking into their retirement funds to pay for housing and other debts they’ve accrued.

Now, understand that I work for a financial institution, a lending company. It is in my short term interest and financial welfare to recommend that people should always pay their debts, and for the most part, if you have the ability to repay, you should.

However, in cases like the story above, sometimes the responsible thing is to walk away.

Which is worse?

• Declare bankruptcy, default on your loans, and take a 7 year hit in which you pretty much are cut out of the lending world?
• Deplete your retirement, default on your loans anyway, and not only take a 7 year hit on credit, but also be wholly dependent on welfare and charity for the last 20 years of your life?

Which is worse?

The logical conclusion, the business conclusion, is to walk away from your debts. Don’t think that businesses don’t make that decision every day. Sallie Mae (ticker:SLM) lost a deal with JC Flowers – they walked away. There were consequences, but the consequences of walking away were weighed by JC Flowers and they decided that walking away made the most financial sense.

There’s a culture encouraged by financial institutions that there’s a moral penalty for walking away, and that moral pressure is one of the many forces used by companies to keep individuals in obligations, whether or not they have the ability to repay.

Here’s the problem with that. It’s short term thinking. For the citizens in the MSNBC story, it is in my long term interests as a taxpaying citizen of the United States for that borrower to walk away. Companies come and go, but that citizen, if he depletes his retirement, will be dependent on me and others for a subsistence lifestyle. Just as he’s trading his future for the present, so are financial institutions trading America’s future for the present if they continue to encourage debt holdings by consumers who simply cannot pay and will not be able to pay.

Conclusion: if you’re a financial institution with a consumer who cannot repay, that loan is going to decay sooner or later anyway. (unless it’s a student loan which can never be forgiven or written off by the consumer) Write it off now, preserve that citizen’s retirement and savings, and help them be able to buy your services later on down the road. Think long term, think big picture.

[youtube]https://www.youtube.com/watch?v=ETQj3a221EQ[/youtube]

The market crashes, turns to ashes that you’re dancing on
while some fat lady cues up for a song.

You just don’t panic, so they said
in all the good books that I have read.
You just lay back and feed your head,
but that ain’t clever, that never got nothing to
sell, hell, oh well, maybe we were
better off dead.

– Matthew Ebel, Better Off Dead from the album Goodbye Planet Earth, the best damn album you’ll buy today