The Freedom Factory

Today in the Wall Street Journal, Peter Wallison of the American Enterprise Institute proposes the Treasury purchase bank’s troubled assets at their net realizable values. Currently, these assets are priced at market value, which is below their net realizable value. (See diagram below.) Although there is a risk that the taxpayer might pay too much for these assets by buying them at net realizable value, the benefit is that these purchases would help to boost bank’s depleted capital. This in turn, should “eliminate doubts about banks’ solvency and free up their ability and willingness to lend again”. Continue Reading

Does anyone in government follow the laws that they pass? Or is it only the common man, who lacks access to power, that is expected to follow the rules?  Numerous scandals over the past several months have surfaced, in which our elected officials have been tripped up for not obeying the laws that they are supposed to uphold and enforce. The worst part is that these same officials influence policy or create new laws that further impose government’s power over the people. Continue Reading

One recent frustration of mine is the lack of gratitude that many military members exhibit toward the tax payers of the United States. I know there are many fine men and women serving our nation- especially those fighting in Iraq and Afghanistan. However, I do not feel that many understand or appreciate the lavish benefits that they receive in the military.

Benefits for active duty soldiers, in my opinion, are quite generous- just as good (if not better than) in the private sector. Soldiers receive base pay, and tax-free allowances for food and housing (if housing or a government dining facility is not provided).

For example, base pay for the most junior enlisted troop is $18,000 per year; for college graduates, a junior officer will earn $30,000 a year. Housing allowance is based on rank and location (click here for rates) and the food allowance is around $200 per month. Thus, the gross salaries for soldiers are competitively priced to local wages with base pay roughly equivalent to a soldier’s net pay amount- subject only to taxes. Again, I stress that these are starting salaries, which would increase with each promotion and time in service. (As a reference point, the median household income in the US was $50,233 in 2007.)

In addition to pay and allowances, soldiers and their families also receive low cost, if not free, medical and dental care. Other benefits include tuition assistance for education, 30 days paid vacation, all Federal holidays off, and any commander directed ‘training days’. Training holidays usually coincide with 3-day weekend holidays, giving personnel a 4 day weekend. Pretty sweet, huh?

Perhaps the greatest benefit a soldier receives is rarely discussed- the retirement package. By far, the retirement package for the military rivals that of CEOs and upper management. After 20 years of service, a soldier is eligible to receive 50% of their average pay during their last 3 years of service.

The chart below provides a snapshot of the retirement benefits that a typical military member receives. The middle column is the present value of an annuity similar to what military would receive on their first day of retirement. The far right column is the ‘annual’ payment (or additional compensation) that a military member would need to save or invest to equal the value of their pension. (Note: I tried to be conservative in my assumptions, so these figures would represent the LOW end of the annuity valuations; put another way, this chart is the starting point for the value of military pensions.)

Assumes 25 years of service, 30 year life of annuity, and 3% annuity growth rate.

So let us quickly review. Military receive salaries that, by design, are comparable to prevailing market wages including time off and other benefits. The chart above shows that military members also receive a great retirement plan, which would tack on an additional $10-15,000 in compensation per year. Even with these benefits, I still do not begrudge the military their retirement. They enter into a contract with the government for the retirement, and thus the government should honor these commitments. (Essentially, the military pension could be considered a ‘forced savings’ plan, in which the soldier is never given access to his retirement savings. Many Americans would probably consider this a blessing, rather than a curse!)

Where I do question veterans is on their perceived entitlement to Veterans Administration (VA) benefits when their disabilities are not service related. I do not dispute disabilities resulting from combat or action in the line of duty (ex. parachute training jumps). However, many disabilities that the VA also approves are for ‘disabilities’ caused by aging, pre-existing conditions, and off-duty activities.

For example, many retired military that I work with have been diagnosed with ‘sleep apnea’. The primary causes of sleep apnea are: obesity or excessive weight, large tonsils or adenoids, other physical attributes, nasal congestion or blockage, and relaxed throat or tongue muscles. As a second example, a friend of mine was granted VA benefits for his knee, which he hurt playing flag football. I am baffled how military duty could cause or is related to these conditions? If diagnosed with sleep apnea, veterans can receive up to 50% disability. As a result, the military member could potentially receive up to $1,000 additional compensation per month- tax free! If you’re curious, you can look at the VA disability payment rates here to get a snapshot of these benefits.

Two common defenses I have hear when I question retired military about their abuse of the VA benefits are: “Well, we were government property for 20 years and are thus entitled to these benefits”, and “Don’t blame me… Congress granted us this benefit.” To the first point, the VA administration has provided individuals with machines to help them sleep at night. However, the people I have spoken with do not use them; they’re only interested in the cash compensation. If ‘government property’ can be fixed, should they still receive the cash compensation? To the second point, I seriously doubt that Congress intended to pay these benefits for non-duty related injuries, or a pre-existing condition such as sleep apnea. Where should the line ultimately be drawn?

It infuriates me that benefits Congress passed to benefit legitimately disabled veterans are being abused. Fact: very few veterans ever see combat. The ratio of combat troops to support personnel is still 1 to 9- roughly where it was in World War II and Vietnam. Although support personnel in combat zones are still in harm’s way, their bodies are not being ‘damaged’ in the same way. Perhaps I am naïve, but I would suspect performing a support role in logistics or similar function does not damage the body to the same extent as kicking down doors or throwing yourself to the ground to protect against mortars and small arms fire. Additionally, support personnel are compensated with the same Hostile Fire Pay and tax-exemptions (CZTE) that the combat troops receive.

I apologize for this rant, but it really disappoints me when I see this ‘entitlement’ mentality for several reasons. First, it steals from the many veterans who legitimately deserve these benefits. How many veterans have returned home from World War II, South Korea, Vietnam, or Iraq and failed to receive proper attention because these resources were being inappropriately consumed by these other veterans. If you need proof, Secretary of Defense Robert Gates fired the commanding general of the Walter Reed Medical Center for not addressing deficient facilities and care for wounded troops. The problem is not lack of resources, but of the allocation of those resources. For a quick overview of the size and amount of money spent by the VA, visit their website.

Second, it steals from the American taxpayer. If the median household income is $50,000 and subject to a 25% federal tax rate, roughly $12,500 in tax is collected. If all of that money is used to support the military, it would take at least two households to support one junior enlisted troop, and three households to support one junior officer. Now consider this- there are over 1.4 million troops in all branches of the US military. Thus, approximately 10-15 million households are required just to support our troops- not including veteran benefits. How many of these households that labor day-in and day-out to support the military have (at least) a $700,000 retirement? 5%, maybe?

Third, it precisely shows why socialist systems fail. People are greedy and act in their own interests because they do not feel the repercussions of their actions. Give an entitlement to a small group, and suddenly there is a line of people waiting to receive the same handout. The TARP and similar bailout programs that are being passed are no better.

Ironically most of the veterans I know vote predominantly Republican and seem to favor fiscal conservatism. Frequently I challenge them on this contradiction: the military and its benefit package resemble something more socialistic than the traditional Republican beleifs. There is no pay for performance and the government provides a safety net from cradle to grave. However, when the government seeks to promote a new social program, their response is, “Why should they deserve that benefit? They don’t pay taxes!” In my opinion, that is like complaining about government without voting in any election. Unless you have paid more in taxes than you have received from the government, you have zero right to complain about how your taxes are spent.

My hope is that Barack Obama drastically cuts the defense budget and decreases the size of the armed services. The United States has become trapped in the ‘industrial military complex’ which is draining resources needed to prepare the nation for the next century. Prior to World War II and the Cold War, the United States never had a large standing army. If it were not for conflicts in Europe, it is unlikely that we would have fought any war. If it were not for the fact that we have a million-man standing army, would we have ever been involved in the many foreign conflicts of the past 15 years: Iraq, Bosnia, Somalia, Afghanistan, and Iraq (again)? In spite of conventional wisdom, it seems it IS difficult to build goodwill by continually exerting our military influence.

In summary, if a soldier is receiving food stamps, it’s because of his (her) own poor financial planning, not because he (or she) isn’t being paid enough. Second, there are many veterans who abuse the system, receiving benefits that far surpass those intended by Congress or equivalent to the private sector. Due to the wars in Iraq and Afghanistan, it is unpopular to question these military entitlements. However, I firmly believe that we must examine these benefits because of the strain they (will) put on the system. Could the incident at Walter Reed be precursor for other large, government run entitlement programs such as Social Security, Medicare, or universal health care?

Every gun that is fired, every warship launched, every rocket fired, signifies, in the final sense, a theft from those who hunger and are not fed, those who are cold and are not clothed. The world in arms is not spending money alone. It is spending the sweat of its laborers, the genius of its scientists, the hopes of its children. – Dwight D. Eisenhower

Who could have possibly seen the severe credit crunch and subsequent market crash this past year? And, if someone saw the impending crash, why did they not caution against it? Like it or not, there were several modern-day Cassandras that tried to warn us about the impending collapse; unfortunately, just like the citizens of ancient Troy, we failed to listen. Continue Reading

It seems like everyone is looking for someone to blame for the economic crisis. Congress blames the banks for risky lending practices and corporate greed. Banks blame lawmakers for relaxing regulatory standards, keeping interest rates artificially low, and using Fannie and Freddie Mac to increase homeownership. Both groups also blame hedge funds for manipulating markets and distorting asset prices.  So, who’s to blame?

In isolation, one group might be responsible for our current difficulties. However, it does not work like that. The U.S. economy is a complex system that involves hundreds of millions of participants that interact in trillions of symbiotic transactions. Consumers lend to banks, who in turn lend to businesses and other consumers. Government provides oversight and takes a cut of every transaction. As you can see, there is no single entity to lock in the stockade for all to tar-and-feather.

The more meaningful question everyone should be asking is: how did I contribute to this crisis? Since the problems are rooted in the housing market, let’s start there. If you bought, sold, or refinanced a home in the past 7 years, like it or not, you contributed to the housing bubble. Granted, Mr. Greenspan facilitated your transaction by keeping interest rates too low too long in an effort to spur the economy following the dot-com bubble and 9/11 attacks. But nonetheless, your transaction had a direct impact on the ‘market’ and drove up home prices.

If you consumed beyond your means and carried a balance on your credit card, you contributed to the credit bubble. With access to cheap, short-term funding, the banks profited from your excessive spending habits and made a nice profit charging a 15% APR. Additionally, the banks probably increased your credit balance, adding more credit and leverage to the system. Plus, all the goods you purchased were probably manufactured in China, increasing the U.S.’s foreign trade deficit, which in turn fueled more lending to the banks.

Finally, if you invested in any type of managed investment that had exposure to sub-prime mortgages or leveraged financial instruments, you contributed to Wall Street’s greed. Although you are not directly responsible for the decisions of others, your capital enabled institutional investors to gamble with your money. This is one of Robert Kiyosaki’s primary complaints about managed mutual funds. They always collect management fees, pay themselves ‘performance’ bonuses in good times, but the investor bears all the downside risk. In short, always perform due diligence and understand what you are investing in. Just because it appears safe, does not mean it is.

All of these transactions were made possible by debt, cheap capital, and leverage. Before looking to blame someone else for the economy, first consider how you contributed to the problem. As the saying goes: every time you point a finger at someone, remember there are three fingers pointing back at you.

In summary, the economy will only begin to recover after each American accepts responsibility for and rectifies their individual actions. The force of the market it much greater than any program the government can create. Even the $700 billion bailout, impressive as it is, only represents about 5% of the United States’ annual GDP.  The economy created this problem and should be allowed to resolve it. Placing blame and looking to government to solve our problems will most likely only prolong the pain.

To fully appreciate what is occurring in the financial markets, I recommend reading two articles: Deleveraging: A Fate Worse than Debt from The Economist and The Question of Our Age by Tony Crescenzi.

The theme of both articles is the same- cheap credit for the past 20 years has fueled economic growth. Now that credit has dried up, can the system deleverage without causing economic contraction? The coordinated effort of the U.S and other governments is meant to prevent (or at least slow) this deleveraging process. So far the governments have added liquidity to credit markets and injected capital to expand lending and revive economic growth. Continue Reading

Everyone seems to be asking the same question- is this the bottom? Personally, I don’t think so, but we are close. The basis for my conclusion is three-fold.

First, the credit market is still largely frozen and there is a lack of confidence between banks. Although LIBOR dropped significantly last week, the TED spread is still quite high. Until interbank lending and confidence is restored, I will continue to remain bearish on the market. Once the credit market thaws, I believe the market will rally significantly because sophisticated investors are using the credit market as a signal to reenter the market. Currently, the institutional money is sitting on the sidelines and is unwilling to risk money to ‘catch a falling knife’.

The second reason is based on technicals. During the Dot-com bubble, the S&P topped at 1,550 and dropped to about 800 two years later. The S&P topped out again at 1565 on October 9, 2007, and yesterday (October 15, 2008), it closed at 908. If one directly compares this situation to 2002, the S&P could fall another 10%, or about 100 points. Secondly, economic downturns typically last about 18 months, which means the market should suffer for another 6 months (or so). Granted, I do not place much faith in technical analysis because it is not correct to compare today to historical events. For example, there has not been a terrorist attack like in 2001. But, it does help to use history as a gauge for approximate price ranges.

Finally, the fundamentals of the S&P 500 appear appropriately priced. The current P/E ratio is about 13.5. If corporate earnings start to decline, the price must also decline to maintain this ratio. The big question is by how much earnings will decline? If you have knowledge about this, I encourage you to blog about this article. It would be great to know what the historical P/E ratio has been at ‘bottoms’, or the average amount that earnings have decreased in recessions. Either piece of info would give great insight into possible market behavior.

To play this market, my recommendation is to make three equally spaced purchases. (See my previous article here.) One thing is certain- you will never be able to catch the exact bottom. Over the coming months dollar cost averaging is the best approach to take advantage of these bargain-basement prices. The market has already lost a lot of its value. How much lower can it really go?

There are several reasons to wade back into the market this week – the Dow is down 20% for the year, the S&P 500 fell 8% on Monday, and Warren Buffet is buying.  Although there is blood on Wall Street, there is not yet blood on every street- especially Main Street.  In short, I think the economy will get worse before it gets better, but it’s time to start buying. Continue Reading

Twice this past week, I have found myself explaining what happens when a bank goes bust. With weakness at Wachovia, Lehman Brothers, and other banks, I figured it would be a good time to assuage investors’ concerns. Two of the recent questions were: Are my investments protected, and what happens to the cash in my account? Continue Reading

I highly encourage anyone invested in the stock market to read Fooling Some People All of the Time because it explains the value that ‘shorts’ provide in the stock market and highlights potential pitfalls to consider before investing in stocks.  At the very least, I would recommend watching David Einhorn’s speech, here, to find out if you are interested in the subject, and to get a flavor for the book’s content.  (Link: http://foolingsomepeople.com/main/ ) Continue Reading