Friday, June 26, 2009

John Mauldin #128

This week Bruce is joined once again by John Mauldin from Millennium Wave Investments. John is a New York Times Best Seller and is writer of the highly acclaimed “Thought from the Frontline” e-newsletter.

There was a time when we thought that making loans to anyone that can buy a property was the wisest thing. Bruce asks John if we have discovered this to be untrue. John says that the answer is clearly yes, but making loans to people who can pay them back is still not a bad investment. What we began to do was use a model to predict who could pay off a loan and who could not. These models made us think that we did not need to be as careful about how we lent money. These models assume what is known as a bell curve, but in the real world there is no such thing as a bell curve. In the real world, there is a thing that we call “fat tail.” This means that when you get down to approaching zero, the curve starts going back up at the end. Mathematicians say that this should only happen every 10,000 years, but this seems to happen once every 4 years. You cannot model this sort of phenomenon and it is arrogant to think that you can. Yet we trained two generations of economists and MBAs in such things. Then we unleashed them on investment advisory firms and brokers, and these economists created these models saying, “If we start here, and save this much money, then your stock market investment will grow over time.” People believed them because they were smart people, but they were smart people using bad theories. Some of these theories won Nobel prizes.

One of the books that John recommends reading is “The Black Swan”, which claims that it is arrogant to think that anyone could figure out these models so easily. In the book he says that “A black swan event is retrospectively obvious.” Looking back, we could have seen that loaning money to people who did not have to prove much would have a bad ending. When John first started looking at collateralized debt obligations (CDOs) during the middle of 2006, he discovered that people were taking the worst part of a mortgage backed security (the bottom five percent) and grouping them together, which created a brand new security. They would then create models for rating companies who would then take that bottom five percent and call 70 percent of it AAA. When John discovered this he thought, “All you need to have is a five to ten percent drop in prices to make everything go down to zero.” You would think that if people from different areas of the United States could figure this out then the people actively investing and lending would be able to figure this out even quicker. Not only did they not figure out the problem they were creating, but they actually bought some of the garbage they were creating and they put it into their banks. This is why companies like Merrill Lynch, JP Morgan, and Citi with really bad paper. `

Bruce asks John what the current mood is towards the U.S. and capitalism in general. John thinks that it is more skeptical, and rightly so. A lot of the third world thought of America as this shining city on a hill, but they also thought we were rather arrogant because we told them how they should run their banks. We were not doing the things that we told other people to do. The epicenters for bonds sales were located in California, Nevada, and Florida but we sold all our bonds to Europe and Asia. This is going to come out within the next 6 months to a year. They are going to have write down far more money than they currently are. European banks are in far worse shape than American banks.

Bruce asks if this is because they have lent to emerging countries, or because they have invested in mortgage backed securities. John thinks that both of these options have created problems and other things as well. Western European banks took a huge chunk of Eastern European debt. Austrian banks lent more than the entire Austrian GDP, so the Austrian government could not rescue the Austrian banks if they wanted to. A lot of European banks also lent money to Asia. The UK is in better shape because they have their own currency. Businesses are not making as much money. Ireland is deflating by about four percent every year. There are some serious problems going around the world.

Bruce asks if there is any other time comparable to this downturn. John says we’ve never gone through anything like this worldwide. John says that world trade is down 10 percent and equipment orders in Japan are down 80 percent. Japan is doing their best to destroy their currency, but they are having trouble doing it, because if their currency rises then their products will be more expensive.

In California, there are currently about 240,000 properties in some stage of foreclosure. Today, there is a new moratorium. Bruce asks John how he feels about moratoriums. John thinks that moratoriums are just delaying the inevitable. It is not unusual for lenders to have a loan balance worth $200,000 dollars more than what a house is worth. Fitch recently said that 50 percent of people who bought their home after 2005 are under water on their mortgage payments. They are also estimating that home values will go down another 12.5 percent. This is a very difficult environment. Bruce says this says something about American character.

The problem is that if prices continue to decline and unemployment continues to go up, then you are going to have a much bigger problem. John estimates that unemployment will rise another one percent. It is going to be difficult to entice businesses in Southern California to hire people. If you compare taxes between California and Texas, it makes sense that people would want to move out of California. It is hard to attract people to your state when you are raising taxes. The states that have the highest taxes are losing the most population. John says that Florida was hit harder than California but Florida will come back faster than California because they have a low tax environment and people want to go there to retire.

In one of John’s news articles, he discussed Gary Schilling’s thoughts on solving housing problems. Gary’s idea revolved around creating demand. Gary said that about 800,000 people come into America every year. For the next two years, if these immigrants can buy a home and maintain their lives, then they could get a green card. Within a year, all the vacant homes on the market would be taken. They would also have to live in the home they are buying in order to receive the green card. There are countries such as Canada and Australia who do this. They are searching for immigrants with education and money to come into their country. One of the biggest competitions in the world is to attract young, educated workers. There are only two ways that you can make an economy grow: you can either increase the number of workers or you can increase their productivity. We’ve got a boomer generation who is trying to retire, so we need to be bringing in more educated middle class entrepreneurs. John thinks that we need to have a more welcoming immigration policy.

Bruce says that investors, who are having difficulty getting financing, are having trouble right now. There are a lot of properties in bad condition that investors could fix and make valuable but they cannot get the money to do the job. We have destroyed 40 to 50 percent of the financers for housing construction and development. We destroyed the shadow banking system which helped special investments. They are gone and they are never coming back, so now we need to make new structured security vehicles that investors will feel confident in. This is something that is going to take some time to develop, but John thinks that in 10 years we will be much happier.

For more information on John, you can visit

John Mauldin is a prolific author, recognized financial expert, and editor of the popular Thoughts from the Frontline e-letter which goes to over 1,500,000 readers weekly. His critically acclaimed new book, Just One Thing and previous Best Seller Bull’s Eye Investing, Targeting Real Returns in a Smoke and Mirrors Market cuts though the fog of information and gives concrete advice for structuring absolute return portfolios. John is primarily involved in private money management, financial services, and investments and research. His next series of books involves the largest millionaire study done in over 15 years with personal interviews with hundreds of affluent individuals. Investors can visit his website at or get his free weekly e-letter by sending a request to

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