Retirement As Never Before

The March 2007 issue of Financial Advisor magazine includes an article about "The Exponent of Life Expectancy" that underscores the notion that "retirement," as we've begun to experience it, is a new thing...something never before attempted.

Nick Murray observes that when King Tut, "the boy king," died at age 19 in 1325, the average life expectancy at the time was only 25 years. In fact, it book about 3,000 years for life expectancy to advance to age 30 (in Europe during the year 1400 AD). That sad rate of advance, 1 year of added life expectancy for every 6 centuries, would mean that today's average life expectancy would be only 35. But obviously advances in health and civilization have improved.

Between 1400 and 1800, life expectancy lengthened so that during the lifetimes of Thomas Jefferson, John Adams, Tecumseh, Lewis & Clark and Aaron Burr, the average life expectancy was 37 years of age.

By the end of that century, in only 100 years time, life expectancies increased by 10 years to age 47. During the next century, life expectancies increased by another 30 years to 77. Murray writes that "seventy is the new 50," and then goes on to speculate, "what if 100 is the new 70?"

When Social Security was created, it promised lifetime income to everyone over age 65. At the time, the average life expectancy was 63 years. Less than half of the population even had an opportunity to retire, and for most it was a short-lived season of life. Now, Money magazine has cover stories focused on "early retirement," say around age 55, which for some folks means that they will live almost half of their life "in retirement."

Is there any wonder why the Social Security numbers don't work? Does it really make sense that workers pay about 15% of their income to underwrite this grand new social experiment called "retirement?" Should poverty-stricken working parents be forced to cut back on food and healthcare for their children so that able-bodied workers have the means to spend more time on the golf course?

Retirees need to realize that the whole notion of a retirement portfolio is relatively new, primarily because the notion of "retirement" has probably been around for less than a century. Folks nearing retirement need to make provisions to take care of themselves until age 100, because that might just be where the average life expectancy resides in a few more decades. And everyone might want to think long and hard about just how "entitled" we ought to feel about Social Security, which has been a wealth transfer program since inception, despite the bluster and promise claimed by the politicians.

All that money you gave to Social Security? It's already spent.

Workers need to take care of themselves, and Social Security would function a lot better if it once again functioned as a "security blanket" for those folks who live much longer than expected as the average life expectancy moves inexorably forward.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Sub-Prime Hits the Fan

Problems with Subprime loans (loans made for too much money against too little collateral to people with too little sense and too many other bills to pay) again dominated this weekend's Barron's reporting. In "Just How Sub Is Subprime," Jacqueline Doherty details just how many folks on Wall Street had a hand in the Subprime mess, as mortgage brokers shovel this financial manure into the Wall Street product engine where it is sold, repackaged, and re-sold (just) before the first month's payment is ever missed.

Brokers purchased subprime loans by the millions, which local mortgage "bankers" dutiful sold to U.S. consumers desperate for a plasma screen TV and a new house to put it in. The brokers then dump these IOU's into a separate trust so that when they go bad, they won't imperil the brokers own bonus pool. The trusts are then carved up into separate "tranches," some of which are more likely to get paid back, hopefully with interest, than others. The most likely tranches to actually pay off as advertised get a high ("AAA") rating, while more speculative pools receive lower ratings. These tranches can be sold directly to big mutual funds or pension fund investors, but the stuff that is particularly toxic was best suited to be placed in yet a separate bankruptcy remote entity, so-named not because of the remote chance of bankruptcy, but again to protect the hard earned equity of the broker promoting this scheme. The recipient of the multiple tranches of toxic subprime IOU paper is called a Collateralized Debt Obligation (or CDO), which is often funded on money borrowed from honest folks who usually don't charge a lot of interest. This creates a "spread" for the CDO manager, usually some other Wall Street maven, who buys a bunch of high yielding toxic crap using honest money that doesn't pay very much and for a time, as long as the boom lasts, everyone is happy.

Wall Street is happy because it charges a pretty penny, paid up front in cash, for packaging this financial nightmare. The CDO managers are happy because they are leveraged up the wazoo and control billions of dollars of assets, if only for a time, on which they can suck out as much as 1% annually to pay for their new flat overlooking Central Park. The borrowers are happy because they got to see Grey's Anatomy on a TV the size of their grandma's washing machine, and the lenders are happy as long as the economy is robust and the borrower's can afford to pay this month's mortgage.

When the borrower's can no longer afford to pay because, for example, the artificially low 2002 interest rates adjust upward, as might have been anticipated by anyone with a brain sized larger than an ant's, the entire financial "package" begins to unravel. The "overcollateralization" which is supposed to protect the lenders is compromised because loans to deadbeats really aren't worth 100 cents on the dollar. If this economy tips into recession, the problems worsen. Suddenly, some of those tranches are no longer money good, though it's tough to know which right away, and the bankers and hedgies who lent money to the CDO's in order to buy the toxic financial crap want their money back, which seriously inconveniences the investors who had to cut short their ski trip to Aspen in order to begin reading the fine print in the offering statements of the subprime loan agreements.

Naturally, Wall Street (the packager of this toxic crap), who knows what sort of manure is spread throughout the traunches, is one of the few players in a position to offer liquidity to the now distressed subprime lending industry, and Wall Street always stands ready to offer liquidity - at a price. It's a little early to know just how big a haircut the major on-their-way-to-bankruptcy subprime lenders will have to accept. But the same loans that Wall Street once packaged and repacked for $1.00 (less their fees, of course) are likely to receive bids somewhere in the range of 60 - 75 cents on the dollar, if the sellers are lucky. Unfortunately, the subprime industry is very leveraged, meaning that there really isn't 25 - 40 cents of equity for every loan out there, meaning that even non "subprime" lenders are exposed, because anyone who made a loan to New Century or one of several other now bankrupt lenders is also exposed. Not badly exposed, but bank earnings at even the high quality institutions are going to feel a pinch.

Doherty points out that the subprime lending industry is not a "cottage industry." It's big business, and the major Wall Street firms and hedge funds have had a direct hand in packaging this garbage, and now in bidding on the dredge that it created. How can Goldman Sachs afford to pay out annual bonuses of roughly $722,000 per employee? How does Blackstone Group justify a $40 billion price tag to shareholders (when the lions share of its winnings are sure to find their way into the hands of employees)? Because Wall Street gets investors coming and going.

Yet investors continue to delude themselves into thinking that the investment bankers at Goldman and Merrill and Smith Barney, et. al., are their side! These bankers are only loyal to the annual bonus pool, and don't really care which side of the fleecing will generate their fees.

They packaged and repackaged internet companies and IPO'd ideas on a napkin for billions of dollars in market capitalization that vanished overnight. Then, five years later, they packaged the real estate bubble for pension fund investors, who are the primary supporters of the hedge fund excesses, and now we'll watch them switch sides to become bidders, at cents on the dollar, of the financial garbage they manufactured just a few years earlier.

It's a replay of the junk bond debacle and the Resolution Trust Company "solution." And it's probably the second oldest profession, albeit less upstanding by far. No doubt, White House Chief of Staff, Joshua Bolten, New Jersey Governor Jon Corzine, U. S. Treasury Secretary Henry Paulsen, Clinton Treasury Secretary Robert Rubin, and former New York Fed Chairman John Whitehead will want to ensure that such shenanigans never happen again - except that they all came up through the Goldman Sachs grist mill, and aren't likely to bite the hand that once fed them.

At least we know who to thank for the pain we are about to feel.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Local Stocks Nudged Lower in March

The Scout Partners Index of Western Colorado Stocks fell in January, returning -0.30% versus a much sharper -2.2% decline for the widely followed S&P 500 stock index. The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Markets), StarTek, CRH (United Companies), and the Union Pacific Railroad. The performance of Denver-based telecommunications giant, Qwest, helped stabilize the February index performance.

Rising 9% in the month, Qwest (Q) ended the month at $8.88. “Qwest was awarded some fairly minor business contracts during the month and announced a small reduction in staff mid-month, about the time that the stock took off,” said Doug May, President of Scout Partners, LLC. “Qwest also received favorable mention by “Mad Money” showman and former hedge fund manager James Cramer after Wall Street investment firm, CIBC, upgraded the stock on February 12th,” May said. Later in the month, the Federal Communications Commission moved to eased price controls on Qwest’s long-distance services. More recently, on the last day of the month Qwest announced that its CFO, Oren Shaffer, will retire effective April 1.

Choice Hotels (CHH) was the index laggard, returning -11.4% during the month of February. Choice Hotels operates as a hotel franchisor with lodging properties under the Comfort Inn, Comfort Suites, Quality, Clarion, Sleep Inn, Econolodge, Rodeway Inn, MainStay Suites, Suburban Extended Stay Hotel, Cambria Suites, and Flag Hotels brand names. May noted that “the company announced in January that the CEO was leaving, but in February they announced a special charge to earnings of 3 cents per share to buy a really nice gold watch for the departing CEO,” and a number of Wall Street research firms cut their ratings on the company subsequent to the disappointing earnings guidance.

 

Scout Partners equal weighted Index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in industrial stocks, which comprise over 20% of the portfolio. Local stocks are up 0.57% for the year while the overall market has returned -0.47% over the same time period.

 

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This Week in Barron's

Alan Abelson (the only reason anyone actually subscribes to Barron's) notes that the Chinese have just entered a new year, the Year of the Pig, probably in tribute to America's Wall Street investment professionals. In describing the competitive advantage that Chinese manufacturers have over locals in a post-NAFTA world, he points out that "the average toiler in a Chinese factory is (paid) about 3%...of the hourly wage of the average Joe doing the same job in the good old USA. Including benefits, U.S. workers probably earn about $20 per hour (including benefits), while Chinese workers are happier to have their job, but receive only about 50 cents an hour. I tried to compare both of these with Euro-worker rates of recompense, but everyone was on vacation and I finally had to abandon the effort.

Barron's cover story (The Last Laugh) is particularly interesting to LeapIntoRetirement readers since it focuses on the financial importance of spenders in the over-50 crowd, which now comprises over 40% of all U.S. households, controls 50% of all U.S. discretionary spending, supervises 65% of America's household net worth, and accounts for 75% of all prescription and drug spending (mostly, it would seem, in an effort to maintain sexual performance and to treat diseases accumulated through years of practicing in the same arena). Barron's talks about several major companies and their attempts to woo the baby boomer demographic.

Barron's writes about a trend called, "aging in place," where empty nesters turn their kids' rooms into dens, install larger door handles and light switches, and wander through their wider halls on non-slip floors practicing mental games and taking "brain age" games. In fact, Barron's reports that aging may even be good for your game, referencing studies by the AgeLab and the American Assn. for the Advancement of Science studies and resources.

Barron's also revisits the debt problem unfolding in the "sub-prime" lending market, which we've talked about before and which got worse, last week, with the bankruptcy filings of ResMae Mortgage and the stock of Kansas City-based Novastar plunging 42% on an earnings impairment announcement. Sub-prime loans are loans made to folks who really can't afford to pay them back in the first place, often at artificially attractive terms that eventually ratchet up to less attractive rates, hopefully after the original lender has had a chance to pawn the loan off to an institutional lender or mutual fund manager who happens to have their head in the sand and is desperately seeking a yield advantage over his more experienced peers. The strategy is a little like a ponzi scheme in that it works for awhile, but then it doesn't work at all and by the time that everyone wants out, there isn't much left. For America the last few years, as real estate speculators reached too far to buy homes they couldn't possibly afford, it's been a way to keep the bubble going and prolong the party. It looks like the punch bowl is gone.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Is A Tontine In Your Future?

Investment News describes a Tontine as an investment pool that pays dividends only to a pool's surviving members. Tontines were used 350 years ago, but are banned in many countries today because of an unfortunate side effect; tontine members had an incentive to kill one another off in order to increase the dividend payments to remaining members.

And you thought that there was a lot of back-stabbing in your investment club!

Ralph Goldsticker, CFA, in a recent Financial Analysts Journal article (January/February 2007) has suggested that a mutual fund sponsored tontine-like vehicle might provide a cost effective alternative to the traditional annuity. Both are designed to provide retirement income and protect individuals from outliving their resources. By spreading the risk among thousands of individuals, a mutual fund company could lessen the benefit to one individual of killing his or her fellow shareholders.

The new-fangled Tontine Fund would invest in fixed income securities, use an actuary to annually adopt a payout structure appropriate for that group of shareholders, diversify investment risk and provide higher potential payouts - partly because tontines would likely be lower-cost vehicles and also because "payments would be based on average life expectancy rather than the maximum life expectancy.

Although financial product providers often add bells and whistles, usually in an effort to confuse consumers, true innovation in the financial arena doesn't happen often enough. Schwab's invention of the "mutual fund supermarket" was a consumer friendly innovation, for example, as was the more recent creation of ETFs (exchange traded funds).

Hopefully one of the large fund complexes had a chance to read Goldsticker's article. Vanguard, Fidelity, are you listening?

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Default Risk Hurts Financial Stocks

People have been talking about the debt problem for years, and the mortgage debt problems that stem from rising adjustable mortgage rates for months, but last week (finally!) financial sector investors were forced to acknowledge something might be amiss. California-based sub-prime mortgage lender, New Century Financial, securitized millions of dollars of these sub-par loans but couldn't get rid of the paper fast enough. The fine print on those securitizations forced New Century to take back loans that went into default within six months of issuance, and as a result the company reported it will have to report a loss in 4Q 2006. As a result, the stock tumbled 36%. Barron's reminded its readers that it first highlighted the risks New Century was taking in an October 11, 2004 article. The stock has lost 67% of its value since then.

HSBC, the UK's biggest bank, acquired Household Finance in a distress sale a couple of years back, and then used Household to make all number of risky mortgage loans to borrowers who didn't used to qualify for mortgages based on the borrowers' poor track record of paying people back, paltry income, and the over-sized price tags on the homes involved.

Last week, HSBC was forced to admit that over $10 billion of shareholder money lent to sub-prime borrowers in the U.S. mortgage business wasn't likely to get paid back after all, even after reposessing and re-selling the homes in question. The Sydney Morning Herald reported on "How HSBC Bet the Household and Lost." Not all is lost, though. HSBC bought Household in 2003 for $27.7 billion, so last year's misadventures only cost HSBC about 37% of the purchase price.

HSBC executives believe they've got their arms around the problems at Household, while still admitting that the problems were about 20% worse than they'd calculated a couple of months back. CEO Michael Geoghegan vowed that, "the buck stops with me" and then fired the CFO of HSBC Finance Corp. Let's hope HSBC doesn't hold the mortgage on the recently departed CFO's house.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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High Yield ("Junk") Bonds

Junk bonds, and the mutual funds that own them, are an often misunderstood asset class. These high yield bonds offer higher yields (returns) to investors because of the higher risk of default that accompanies them. In general, though, they still stand senior to common stock, so in theory they are less risky than stocks, and are almost certain to have less risk than stock in the issuing company.


Are these appropriate investments for conservative retirees? They are at least as appropriate as stocks. Any investor who is willing to take market risk and be in the stock market, ought to be familiar with opportunities to invest in junk bonds. On the other hand, like most asset classes, the timing of purchases and sales is the most important determinant of investment returns, so investors need to be wary.


Particular now, as 2007 begins, junk bond investors ought to go in with both eyes open. High yield investors get current income, from bond coupons, and the potential for capital gains or losses resulting from price moves of the underlying bonds. If a bond is at risk of defaulting, the price of the security falls. If this credit risk declines, the price of the bond may rise. Changes in the underlying price of the bond can provide investors with equity-like gains on the upside, and losses that more than wipe out coupon income in the event of a default.


As 2007 begins, the extra income associated with buying a junk bond (the so-called "yield premium") is very narrow. Junk bond investors aren't requiring much extra yield for accepting the higher default risk. In the January 2007 issue of Institutional Investor, Carnegie Corp. Chief Investment Officer, Ellen Shuman, notes that we're "seeing a lot of triple-C debt issuance. People have forgotten that 50% of triple-C debt defaults over a 10-year period."


If defaults rise, the price of all junk bonds might fall to better reflect the risks, and the extra income that junk bond investors receive could quickly be offset by capital losses. We're already seeing sub-prime lenders increasing loan loss provisions. It shouldn't come as a shock to high yield investors if junk bond prices get hit as well.


Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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