The Bookmaker of Business: A Financial Tale (3 page)

 “But here’s something even more shocking,” David said.
“What if I told you that home ownership was an illusion?”

“How’s that?”

“Society teaches us from an early age that home ownership is
one of the pinnacles of achievement. And most people believe it. Mortgages are
marketed aggressively as a result. But the truth is that you do not truly own
property until you have clear title to it. Whoever is in possession of the
title, they are the real owners. Paying on a mortgage does not equal
ownership.”

“Why not?”

“It’s sort of like motor vehicle loans. When you buy an
automobile on credit, you may take physical possession of the vehicle, but it’s
the finance company that possesses the title to it. You are finally given title
when the loan balance is completely paid off. It’s more complicated with real
estate, but a homeowner is not truly the owner until all liens have been
satisfied and removed.”

“Are you saying that no one should ever get a mortgage? Then
how could people ever buy a house?”

“Getting a mortgage is not necessarily bad. The problem is
most homeowners only keep their homes for a short time, and during that time,
most of their mortgage payment goes to interest instead of equity. The mistake
most homeowners make is they never own their homes free and clear. Throughout
their working lives they continually roll their mortgages over, buying bigger,
more expensive homes but never paying off the balance of the loan. This is what
I call the revolving mortgage. A sobering fact is that most homeowners end up
paying more in interest throughout their lives than the entire purchase price
of their homes! Another big mistake homeowners make is not having a home
completely paid for when they retire. Many older homeowners lose their homes
when they can’t service the mortgage after they stop working.

“The prospective home buyer needs to calculate if their home
purchase including all interest, insurance, maintenance and taxes is less than
what they would pay in rent during the same amount of time. If it’s
significantly less and you can keep up the payments, then by all means, do so.
And if the value of your property increases you are even more fortunate. But if
not, and you fall behind on your payments, the bank will take possession of
your home. If that happens you will lose your down payment plus any equity
you’ve built up.

“But instead of getting a mortgage, what if you turned the
whole idea completely around and bought your home outright? Even if the
residence was ultra cheap, you wouldn’t have to worry about losing it due to a
sudden loss of income, like a layoff. And since you owned the home free and
clear, you could always trade up to a bigger, nicer home as your income and
savings increased. This way you would save all that interest
and
own the
equity. Wouldn’t that make more sense?”

Sean stared at David in disbelief.

“I understand that some of this may be difficult to hear.
Truth can have that effect sometimes, especially when it conflicts with a
person’s belief system. But truth can also be liberating. You shall know the
truth and the truth shall set you free.”

“So are there any good uses of debt?”

“There is no good debt. At least not from a borrower’s
perspective. It all fattens the purse of the lenders. So it’s not a question of
good versus bad, but more like necessary versus unnecessary. But the best use
of debt by far is for legitimate business purposes. Interest becomes a cost of
doing business that is factored in with other expenses. A great example of this
is the Ford Motor Company. I was part of the consortium that extended credit to
Mr. Ford to build his assembly line. The interest that Mr. Ford paid was minor
compared to the money he made off his idea. The Ford Motor Company was not only
a great success, but it was beneficial to the public too, in that the assembly
line lowered the cost of production to where more people could afford to buy
automobiles. It was a win-win situation for everyone involved.

“However, even business debt can be detrimental if too much
is issued. It can be a double-edged sword. If business conditions are good and
there is great demand for a company’s products, then the use of debt was a wise
decision. But if business conditions deteriorate, like they have over the past
several years, businesses must still service that debt and pay the interest
specified in their contract. For many companies this has become too much to
bear and they declared bankruptcy. If they had never issued those bonds, they
probably could have weathered the storm and stayed in business during these
lean times. But then again, debt is not the only way to finance an enterprise. The
company could choose equity financing, or selling shares of stock instead. When
a company floats a stock offering, there is no fixed interest cost, unlike
bonds. Instead, profits are divided among the shareholders. This is better when
business conditions deteriorate, but unfortunately, predicting business cycles
is next to impossible. Basically, debt financing is more profitable during boom
times and equity financing will lose less money during a depression. But if
your goal is to remain in business indefinitely, equity financing makes more
sense because you never know when the next depression will strike.

“Education loans can also be a wise use of debt, since
education increases your earning capacity. But then again, it can also be a
double-edged sword. Students should be very careful before taking on debt,
since they could be stuck with it for the rest of their lives. They should shop
around for the best education at the cheapest cost. Also, the curriculum they
choose should be in a field where wages are high. The prospective student needs
to determine if their lifetime wages will be more than their tuition cost plus
interest. If not, then they were better off not going into debt in the first
place.”

“What about automobile loans? Should people take on debt to
buy a car?”

“That’s a good question. Sound transportation is vital to
making a living. In cities with good mass transit systems, like New York,
having a car isn’t as important. But that’s not the case everywhere else.
Ideally, it’s better not taking on debt, but if you have no money and a loan is
your only recourse, then you must do it to survive. In that case, you should
shop around for the best interest rate.”

David then said, “But if you want to become wealthy, it’s
not enough to just stay out of debt. You need to start saving your money and
investing wisely.”

4

“What should I invest in?”

“There are plenty of investments open to the general public
like stocks, bonds and real estate that anyone can buy. Stocks are probably the
best investment right now.”

“Are you kidding? I lost all my money playing the stock
market three years ago. It’s a terrible investment.”

“That’s your emotion talking. I believe that 1932 is the
best year in the history of our country to buy stocks. There are incredible
bargains available right now. Investors with cash reserves are buying stocks at
fire sale prices. For example, over the past several months, I’ve been buying
other bank stocks at a fraction of their true worth. When the market recovers
I’ll make a handsome profit.”

“I don’t think the stock market will ever recover.”

“Once again that’s your emotion talking. Some people who get
burned in the stock market vow to never again put their money in stocks. This
is a mistake because the stock market has proven to be the most lucrative
investment over time. All investments go through boom and bust cycles. The
stock market is in a down pattern for the moment, but that doesn’t mean it will
stay there. Many stock traders make the mistake of getting completely out of
stocks during a bear market. The problem with this is that the biggest market
advances always occur soon after a market bottom. Investors who exit stocks
miss out on these major rallies. This is why investors should always have some
money in the stock market regardless. In fact, putting your money into a
diversified portfolio of stocks and bonds is much safer than depositing it into
highly leveraged banks.”

“How’s that?”

“I’ll get to that later, but for now I’d like to know how
you lost all your money playing the stock market.”

“I don’t know. I guess I bought the wrong stocks.”

“But every stock lost value during the crash, didn’t it?”

“I guess so.”

“Then you can’t say you bought the wrong stocks since they
all went down. Isn’t that correct?”

“I dunno. Maybe.”

“Did you invest in anything other than stocks?”

“Not really.”

“Did you buy on margin?”

“Huh?”

“I mean, did you borrow money from your broker to buy
stocks?”

“Well, yeah. But everybody buys stock that way, don’t they?”

“Maybe. So, how much margin did you use?”

“As much as I could.”

“So you maxed out your margin loans?”

“Right.”

David rolled his eyes at Colby while he poured himself some
more Scotch. Sean noticed the reaction.

“Why? Was that a bad move?”

David smiled as he took another sip. He then asked.

“Did you own any bonds during this period?”

“No.”

“Why not?”

“I guess I don’t know that much about them.”

“Did you know that government bonds increased in value at
the same time stock prices were plummeting?”

Sean shook his head. “No I didn’t. How’d that happen?”

“Well, when interest rates go down the value of bonds go up,
and our bond holdings are large. When interest rates dropped four percentage
points, we made a 50 percent gain on our bond portfolio.”

“How’d ya know that would happen?”

“We didn’t.”

“Then how did you know to keep your money in bonds as
opposed to stocks?”

“We didn’t know. Otherwise we wouldn’t have lost money in
stocks.”

“You lost money during the crash too?”

“Of course we did.”

“Then how did your bank survive?”

“Because we keep positions in both bonds and stocks and we
don’t trade on margin.”

“Why is that?”

“Because we understand that markets are uncertain and that
no one can predict them. So, we keep money in stocks and bonds to protect us
from this uncertainty. And using margin only magnifies your losses.”

“But doesn’t it magnify gains too?”

“Yes. But the problem is that big losses hurt you more than
big gains help you. That is why buying on margin should be avoided.”

“How come?”

“Well, when the stock market corrects, as it does from time
to time, there is a transfer of wealth away from the margin speculator and
toward the balanced investor.”

“How so?”

“Think about it. If you bought stock on 50 percent margin,
and the underlying price declines 50 percent, then that is a 100 percent loss
in your account. When that happens you’re busted. At first you get margin
calls, but when you can’t meet them your broker will arbitrarily close out your
positions. It is this forced selling that causes the market to crash. Whereas
the balanced investor who hypothetically has half his money in the same stock
and half in cash will only take a 25 percent total loss, but better yet, will
have cash in reserve to buy stock at depressed levels. That’s when he swoops in
and buys your abandoned positions at very low prices. When the market recovers,
the balanced investor makes a large profit. That is the transfer of wealth.”

“Wow! I never thought of it that way.”

“But that is how institutional investors have been playing
the game all along. While individual speculators take on heavy margin hoping
for big gains, they usually end up with big losses instead. In this game, the
margin speculator becomes the bettor and the balanced investor the bookie.”

“How’s that?”

“It’s very simple. Like a bookie who doesn’t know which team
will win, the balanced investor buys both stocks and bonds because he realizes
that he doesn’t know which will do better. As the markets fluctuate up and
down, the balanced investor will profit similar to how a bookie profits through
odds-making. Balanced investors not only earn dividends and interest, but also
capital gains when they rebalance their portfolios. The balanced investor is
not interested in predicting the direction of the markets, but instead bets
that they will fluctuate. Investors who play the markets like this cannot lose.
It is guaranteed that they will profit over time.

“On the other hand, speculators who play the markets with
leveraged positions are betting on the direction of the markets. Sometimes they
get lucky and make a big score, but it’s only a matter of time before they
choose wrong and take a huge loss. And if they are leveraged too much, they
will be wiped out. The only way leveraged trading will succeed is if the
speculator can pick market tops and bottoms accurately. I’ve been around long
enough to realize that this just isn’t possible. He might pick some of them all
of the time or all of them some of the time, but he will never pick all of them
all of the time. What the trader believes is skill is really just luck. Like
the sports bettor, the leveraged trader may make big gains for a while, but
eventually he will incur the big loss. It’s just a matter of time. It is a
mathematical certainty that he will lose. The odds are against him.”

“What is leverage? You use that word a lot.”

“Leverage is using money you don’t have to trade the
markets. Buying stocks and commodities on margin is an example of leverage.”

“Interesting. So then should I keep part of my money in
cash?”

“Yes, but bonds are even better since their yield is higher
than cash and their prices fluctuate independently of stock prices. This makes
bonds ideal to complement a stock portfolio.”

“So what bonds should I buy?”

“Government bonds are the safest bonds available. They are
safer than corporate, real estate or even municipal bonds.”

“Why is that?”

“There are many reasons. But the most important by far is
the fact that they’re supported by central banks. As commercial banks create
money by making loans, central banks create money when they buy government
bonds.”

“Why do they buy government bonds?”

“To adjust monetary policy. They can buy and sell as much
government debt as they deem necessary to control the nation’s money supply.”

“Why do they want to control the money supply?”

“Because somewhere down the line some government bureaucrat
believed if they could control the money supply they could effectively manage
business cycles.”

“What are business cycles?”

“All free market economies go through boom and bust cycles.
When business conditions are good, the demand for loans goes up. This pushes
interest rates higher. When more loans are made, the money supply and inflation
increase because of the new money created. But when interest rates get too
high, businesses cut back on borrowing. This slows down the economy, thereby
causing a depression. This slowdown reduces the money supply, which causes a
deflation. The policy makers believed if they could control a nation’s money
supply they could eliminate the inflationary boom and bust cycles of free
market economies.”

“And how did that turn out?” Colby asked with a wry smile.

“I’ll let you be the judge of that. So you see, a nation
with a central bank will never default on its bonds because it can simply buy
them up with money it creates out of thin air. Corporations and municipalities
do not have this luxury, which is why their default risk is higher.”

“But if that’s true, why doesn’t the government buy all its
own debt? That way it won’t have to pay any interest at all.”

“Well, if they did that it would cause a hyper-inflation. We
saw this in Germany after the Great War. This is called monetizing the debt
whereby the national currency becomes worthless. Central banks around the world
are constantly adjusting monetary policy through buying and selling government
bonds.”

“But are government bonds really that safe? What about the
massive war debt that America took on during the Great War? What if the debt
gets so big that they have trouble making interest payments?”

“Those are very good points. But remember what I said
earlier about central banks being able to buy their nation’s bonds. If a
country’s debt becomes too difficult to service out of tax revenues, then the
central bank will step in and buy some of those bonds to reduce the debt
burden. The only consequence is that this bond buying causes inflation. In
other words, governments make their debt more serviceable by devaluing their
currency.

“A great example of this is Great Britain. The UK has
incurred war debts dating back before the Napoleonic Wars, yet they have never
missed an interest payment on their bonds. This is because the Bank of England
has the same power as the Federal Reserve and can buy their own bonds when they
see fit. So it really doesn’t matter how much debt a nation incurs. They will
never miss an interest payment because the central bank can buy it for nothing.
This is why commercial banks are so heavily invested in government bonds. They
are highly liquid and incredibly safe.”

“That makes a lot of sense. OK, so if an investor follows
this plan, how much should he keep in bonds as opposed to stocks?”

“That is the million dollar question. It’s really up to the
individual depending on how much risk they’re comfortable with, but fortunately
I know a talented money man who has determined the most profitable combination
of stocks versus bonds. That is, if you have the fortitude to follow it
long-term.”

David continued. “The bucket shops of years ago are another
example of the dangers of leverage. Bucket shops were wire houses that instead
of buying and selling stock for their clients, they took positions against
them, or in other words, took the other side of their customers’ bets. They
allowed their customers massive amounts of leverage, sometimes 100 to 1 or
more. The reason they allowed this is because they knew that minor fluctuations
in stock prices at massive leverage would wipe out their clients’ accounts.
Sometimes clients would make a big score, as in any gambling operation, but
over time they knew they had the advantage over their clients. In this way,
bucket shops were more like casinos than investment firms.”

“But don’t equal sized gains and losses cancel each other
out?”

“Not on a percentage basis.”

“What do you mean?”

David opened a desk drawer and rummaged through it. He
pulled out a binder and turned to a page with the following diagrams inscribed.

“Let’s say you have a thousand dollars and you buy a stock
that combines a 7 percent loss with a 7 percent gain. You would end up with
$995, or a total loss of less than 1 percent.  But what if you carried this
same position at ten times the leverage? This would cause a 70 percent loss
followed by a 70 percent gain. In that case, your original thousand dollars would
be reduced to $510. Almost a 50 percent loss!

“Brokers also charge interest on their margin loans. It’s a
win-win situation for the broker in that they earn interest in addition to
their commissions, but not so for the trader. Not only do most traders lose
money on their leveraged trades, but they must also pay interest charges to
their broker.