A-Train Finance

and part two….

Now that we are officially in a recession, the worst one of my short life and what could very easily end up being the worst one since the Great Depression, it is important to take a step back and try and figure out how we got here. We would like to believe that another great depression could never happen again because our financial system has become so much more sophisticated and protected than we were back then, however the causes of the economic strife of the 1930s and what we are going through today is in many ways frighteningly similar.

The plain and simple reason we are in a recession is leverage. Leverage is when you buy more than you can with your money so you borrow somebody else’s money to buy things with. In many cases investment banks and hedge funds will leverage up to 80 to 1 so for every dollar they actually hold they will hold $80 worth of some asset class. In boom times this equates massive gains for traders at these firms, imagine for every 1% that you made on your portfolio you were actually making 80%, of course the guys that ran these firms were making 8 and 9 figure bonuses. Even in flat times and small pull backs these firms remained profitable using techniques like short selling. During the roaring 20s there was a similar sentiment about leverage, firms overleveraged and when the market turned even a small splash caused a huge disruption that turned into a storm of selling.

Today we can trace back several small splashes that turned into the hurricane that we are in today. The first two major splashes occurred all the way in 1999. First, a major piece of the Glass-Steagall act was effectively repealed. This was an act that was put in place in 1933 to prevent large corporations like Citigroup from existing. This legislation was put into place with an eye to prevent what occurred in the Citigroup bailout, it aimed to prevent companies becoming to large to fail. The reason that Clinton signed the bill to allow this is the second major reason we are in the predicament we are in today. Within the same bill there was an order that if companies were to become such large money making machines that they would give back to the country by strengthening the Community Reinvestment Act which allows people with weak financial footing buy houses.

All in all this seemed like a great compromise where everybody got what they wanted without giving up to much. Corporations would be able to grow very large and profitable and in turn they will help out the less fortunate by bumping up home ownership from 65% to 70% in our country. The problem with this is that every time home ownership levels increase by that much it has lead to a housing bubble and a subsequent recession, usually these are the bad recessions too (see early 30s, early 70s). Now this was the ground work that was laid for this recession, but it was the engine of growth in the early part of this decade, home building took off infrastructure took up and consumer purchases took off since there were so many people now owning homes that could finance against those homes, and since more and more people were buying homes the prices kept going up so people could take out more and more money against them. In fact you could have taken out a loan in 2001, paid only interest on it and then in 2005 you could have had it reappraised and chances are it went up 15% and you could take that money out again and pay only interest.

This is where Bush and his policies come into play. A greater level of home ownership is not a bad goal in and of itself, as long as there is some restraint and control on the process. Interest rates were simply kept too low for too long and this allowed for the bubble to fester longer and longer, this allowed the economy to grow despite a very expensive war while the countries manufacturing base effectively crumbled. Our problems were masked by the housing markets effects on our financial institutions and the low income people that could pull equity out of their houses for cheap. Homes were reach ridiculous prices but many felt that they would be worth 20% in 5 years so just keep buying.

Then it happened, there were many causes to what triggered that first wave of foreclosures, but there were two main causes, first and foremost was the way that the mortgages were structured, many had rates that reset after a grace period in which people only paid interest or a small amount of the principle. People went into these loans thinking in five years they would get the promotion and be making six figures, for the most part, that didn’t happen. The other cause was mostly unforeseen, the commodities boom. In an effort to make American exports more attractive the dollar was purposely devalued. This also had the added benefit of lowering our debt level since our debt is held in dollars. The unseen consequence with this was metal, food and fuel prices, already on the rise started to skyrocket. Wages could not keep up with this rise and as more people felt the pinch at the pump they chose to fill up their SUVs to get to work at the expense of paying their mortgage.

This caused the suffering on Main Street, but surely Wall Street would have known better, these guys are a bunch of Harvard MBAs, they could make money faster than the government could print it. Well back in the boom times as banks were forced to hold all of these bad mortgages by the CRA they figured might as well make lemonade out of lemons and make some money with these high risk assets. They in turn leveraged them selves and sold securities back by these risky mortgages diversified in location (i.e. backed by bad mortgages all over the country). The worst offenders of this were Merrill and Lehman followed closely by Citi. Due to the way these were structured and sold if even half as many foreclosures occurred as what has happened then these companies would be on the hook for billions of dollars that were tied up in leveraged assets. To pay for these losses the big hedge funds and Banking entities started to deleverage driving the cost of everything down (this is major evidence that the price of oil was completely fixed by hedge fund oil trading desks) including stocks and commodities. These companies started to go under and since other companies had invested through them and lost a lot of money they also went under causing more unemployment and the further erosion of the economy.

So when does it stop? Hopefully soon, the actions that the government has taken have been costly and will be a burden on this country for most likely the rest of my life time, but they should dampen the effects of this recession and prevent an all out depression. Hopefully this time we will learn our lesson that major short term gains are temporary, there is no 100% safe way to invest and that if we want to prevent painful events like 2008 then we should keep both eyes on the long term and forget about short term gains.

The question is, where exactly are you going to keep 750 gallons of gasoline while you wait to use it? Unless you have about 20 standard 35-gallon trash drums sitting around your house and a lot of spare time - you’re going to need to find another way to store all that gas. Enter stage left: Oil futures.

What are oil futures?
I’m glad you asked. Oil futures are an agreement to purchase or sell oil for delivery in the future at an agreed upon price that may be satisfied by delivery or offset. In other words, they are contracts to buy oil at today’s prices for delivery in the future, say, when prices go up.

This is the strategy that successful airline carrier Southwest has used to control their fuel costs since 1999. It contributed greatly to their success over competitors and has saved them an estimated $3.5 billion dollars in fuel costs.

How can it help you?
As a consumer, you can use the same techniques as large corporations like Southwest to buy a lot of gasoline while the prices are low or, hedge your gas prices. We won’t be buying oil futures directly, because that would most likely require different kind of brokerage account, and be a lot more complex. Making your finances as simple as possible should be the idea here. What we will be using are oil futures ETFs, or Exchange Traded Funds. Much like a mutual fund, ETFs are a collection of stocks based on an index or sector that is typically picked by a fund manager.

How do you do it?
Unfortunately, in order to take advantage of this process, you will need to have all of the money that you spend on gas per year up front. But  even if you only have half of the amount, you can still hedge half a years worth of gas.

-Figure out how much gas you need to buy
Using this spreadsheet, enter the relevant information in order to calculate exactly how much money you’ll need to hedge your fuel costs.  You only need to fill in the GRAY boxes, and the GREEN box will tell you how much you need.

-Open an account
It doesn’t matter who your account is through, but you’ll need some kind of brokerage account. I recommend a discount brokerage like Zecco or Scottrade.  Zecco offers four free trades per month and you can get 3 free trades with a new Scottrade account by using my referral ID: GZMN8881,  I will also be credited 3 free trades if you use it.

-Transfer the cash
Transfer the amount of money calculated with the spreadsheet into your brokerage account. This is the money we will be using to buy the oil ETFs.

-Buy it!
When the price of gas gets to a level where you wouldn’t mind paying that same price all year, buy it! Make your investment and lock in those gas prices. You’ll either want to buy ‘OIL’ or ‘USO’.  Both will work well for our purposes.  Keep in mind that the prices of these futures funds won’t exactly reflect the price of gasoline, as prices can be very different across the U.S.  But, they will absolutely trend with the price of gas enough to compensate for any rises in price.

-Drive!
Now that you have all your fuel hedged for the entire year, you can drive worry free, knowing that you’ll not have to pay any ridiculously high oil prices should they start to rise again.  When it comes to cashing in your account, you’ll need to be careful how you do it.  I would recommend pulling the money out in 3-6 month intervals, so you don’t have to pay much in commissions for the trades. On Scottrade, you’d have to pay $7 per trade, and that can eat away at your profits if you take money out say, every month.  Remember, the point of doing this is to save as much money as possible!

Sean Sez: A new segment on A-Train Finance written by none other than Mr. Sean Sullivan. Enjoy.

America is falling apart. The Dow has lost over 5000 points in the last year alone and venerable institutions that were perhaps taken for granted in better times are dissolving in front of us. Wall Street has taken the brunt of the blame and losses during this crisis and rightly so. Even if they were not properly regulated like they should have been by the government, as finance experts, they should have known better. However the problem with Wall Street is that much like a drug dealer it has gotten its customers (not only Americans but most of the western world) hooked on its product to the point where we don’t know how to live with out them. Government intervention was necessary although I am still not convinced the government is actually doing anything that is affecting the markets with the exception of saving AIG.

Detroit, unlike Wall Street, has been hurting for the last 10 years. The Big Three have slowly been losing market share to foreign rivals, foreign rivals who now make their cars in America unlike American car companies which are increasingly moving to Mexico. If GM goes under you have to buy a Camry instead of a Malibu, that isn’t so bad for the average American, right? Unfortunately it isn’t that simple. GM, Ford, and Chrysler are a huge part of the American GDP and there are simply not enough competitors to come in and take over for them. We as a country have put ourselves into a difficult spot here; on the one hand these companies really are poorly run cash burning machines that produce cars that for the most part are not profitable or not relevant. On the other hand they are responsible for millions of jobs and being able to produce vehicles domestically is a matter of national security and as proven in World War II can be the difference maker in a war.

So what is a fiscally conservative politician to do with such a problem? On the one hand we can let all 3 fail, which on a long term (we are talking twenty years here) scale would probably be the best thing to do, new companies would spring up to try and take the business the old car companies had and would be more efficient, the industry landscape would look a lot like it did in the early 20th century before the companies consolidated. However letting them fail would have an enormous impact on tax revenue, GDP, and a thousand other unforeseen consequences. The government let Lehman fail to save face after saving Bear Sterns and saying it was a one time thing. If they could take it back now, they probably would. The consequences of letting the largest American Manufacturer fail would be catastrophic in the short term. The clueless finance guys who say it won’t have a big effect are fooling themselves. The government must do something to preserve our auto companies.

I propose a plan that would save face for everybody involved, restore confidence in American manufacturing and long term, and make the government money. We must nationalize the auto companies. This nationalization would be much like a bankruptcy with the exception that the stock holders would get money (this needs to happen or people will look at as a bankruptcy which cannot happen or nobody will buy their cars). The government would buy Ford for 6 billion, GM for 5 Billion and Chrysler for much less (sorry Steve Feinberg) as it is privately owned and ultimately in my plan will no longer exist.

The government would now have complete ownership of all three companies. The first thing to do would be to wind down Chrysler, the marketplace would simply be better off with only two players right now and Chrysler is by far the company of least consequence. The profitable Chrysler brands would be divvied up between Ford and GM and the rest scuttled. Step two would be the government assuming all pensions, and healthcare costs for retires. These would now be on government balance sheets and would be paid out the way a standard government employee pension would be paid out, and yes they would have to be reduced as the people receiving those pensions are partly to blame for the current mess the industry is in.

A significant change would have to be made to the car companies to make this worthwhile and as the government could direct both GM and Ford’s board on their actions. The government would be able to force the companies to produce at least half of the cars they make as clean diesel, plug in hybrid, and natural gas. This would greatly reduce our dependence on foreign oil, which would be worth the cost in and of itself so far. The companies would also have be heavily restructured to be leaner and without a burden of future retirees benefits.

With the employee restructuring, newer cleaner products and without the burden of union contracts and retiree benefits the now big two would be extremely profitable companies. The government would now be able to hold an IPO (hopefully by 2013) for the two companies to recoup the costs it incurred from taking on the retiree benefits and company operations.

Would this work? Probably not as smoothly as is written here, the government usually finds a way to do things worse than private companies. However just giving the auto companies a loan today is not the answer; their business model is broken and cannot be fixed with a loan. This plan goes against my political beliefs, but I see it as the only way to save the auto companies, which unfortunately is 100% necessary.

At this point, not even the most stubborn of optimists can argue against the fact that we are in a recession. As thousands of jobs are being cut and the stock market sinks to lows not seen since the 90’s, being prepared for the worst is an absolute necessity. Here are 10 ways you can make sure you stay afloat through the next few years.

1. Start or grow your emergency fund.
- Financial advisors recommend a cash savings emergency fund that could support you and your family through three to six months of no income. If for some reason you or your spouse were to lose your job, this would protect you from having to charge up the credit cards to pay your monthly expenses.

2. Find ways to earn extra money.
- Making side income is a powerful way to supercharge your savings plan. Whether it’s going through your apartment and putting up that DVD collection on eBay, (You know you just download all of your movies these days anyway) or starting a business raking leaves with a friend, any extra income that you pull in outside of your normal salary is money that you typically wouldn’t have had. Using this philosophy, it can go straight to bettering your financial situation.

3. Have a plan of action.
- Spend an hour sitting down with your house mates, significant other, or family to discuss some hypothetical scenarios. What if one of you were to lose your primary source of income? What steps would you take to find new sources of income and would you be able to live off of your current emergency fund and a single income? How long would it be until you were required to start taking out loans or using credit cards to cover expenses?

4. Contribute less to retirement accounts in favor of cash savings.
- Some retirement investment vehicles like a Roth IRA allow you to withdraw the principle put in to the account. In other words, the money that you put in, you can always take out penalty and tax free. Although you won’t be penalized, you most likely won’t have quick access to this money in case of an emergency. Keep in mind though, that once you take money out of a Roth IRA from previous years contributions, you can never put them back without it counting towards the current years limit (currently, $5,000 per year). When it comes to 401(k) accounts, the amount of taxes and penalties that would be taken out of a potential account withdrawal could be extremely damaging to your wealth. Don’t stop investing, but make sure you’ve allotted enough money to cash savings to cover any potential emergencies.

5. Create and maintain a budget.
- Creating and maintaining a budget is the single most effective way to be financially aware. By knowing exactly what you’re spending your money on, it makes it ridiculously easy to keep spending under control. Figure out your set monthly expenses first, (rent/mortgage, utilities, transportation, childcare) and then set a monthly savings and debt payoff goal. Based on the money you have left over, figure out ways to reduce spending on food, entertainment and similar things that we tend to spend more money than necessary on. (Eating out rather than cooking, movie theater rather than renting a DVD, etc.)

6. Reward positive financial behavior.
- The board and nail tactic may work, but I promise you the fishing pole and carrot approach is much more enjoyable. If one month you beat your savings goal by $60 dollars, it means that you made your savings goal. Congratulations. Take $20 dollars of your $60 surplus and get a 20 minute seated massage. Heck, maybe even that bottle of merlot you’ve been eying for the last two months - I believe 2001 was the best year. Any machine running at 100% capacity will eventually break. By rewarding yourself upon success, you are not only saving money but also creating good financial habits that will last a lifetime.

7. Get everyone involved.
- There are obvious reasons why every plane flies with a pilot and a co-pilot. But honestly, I bet the pilot would get pretty bored on a seven hour flight without some decent co-pilot conversation. By involving your family or house mates in the money saving process, it makes it fun and can create a sense of camaraderie. Every time you leave a light on in the kitchen, I eat your cereal for breakfast and vice-versa. Better start turning off that light before someone has to start hiding their Lucky Charms.

8. Kick it old school
- A deck of cards costs about a buck. There have got to be literally tens of thousands if not millions of games you can play with a standard 52 card deck. Invite three friends over for a euchre night. In this modern day and age, I feel like every day we take real human interaction more and more for granted. Go to the park, go for a walk. Walk up to a random stranger downtown and ask them a random question. ‘Who would win in a thumb war, Spiderman or Superman?’ You might get a raised eyebrow in return, but who knows. I bet that could start up a pretty interesting conversation.

9. Make purchases that will earn their keep.
- Purchasing a tool that will enhance your efficiency or job performance is an investment that will return it’s value. Buying a used laptop to allow you to do work on the road allows you to make better use of your time while increasing your efficiency. It will likely pay for it’s up front cost over time.

10. Change your method of transportation.
- Transportation can be a very high expense in one’s budget. Even though gasoline prices have dropped significantly from this summer, all those miles can really add up. Try biking to extra curricular activities. See if you can find people who have similar commutes to you and alternate drivers using a carpool. Driving 65 miles per hour on the highway instead of 75 mph can increase your fuel efficiency by 30%. Also, using cruise control uses less gas than your lead foot on the gas pedal.