The Economic Crisis and You

Skip VictorNovember 4, 2010

The Economy

“I have learned in my life as a composer chiefly through my mistakes and pursuits of false assumptions, not by my exposure to founts of wisdom and knowledge.”

Igor Stravinsky

The Point

Experience With False Assumptions

My Background

Resume• 1956 Born in Detroit, Michigan• 1974 Cranbrook High School• 1978 Cornell University, A.B. in Economics• 1981 Bankers Trust Company• 1983 UCLA Anderson, MBA in Strategy & Policy• 1984 Drexel Burnham Lambert• 1990 Chanin Capital Partners• 2005 Balmoral Advisors• 2006 Duff & Phelps / Chanin Capital Partners

Observations• Assumptions

• Questions

• Listen

• Synthesize

• Mistakes and Failures and Rejections

• Luck and Serendipity

Economic Crisis

What Happened• Severe Decline in Stock and Bond Markets

• Record Foreclosures

• High and Persistent Unemployment

• (Near) Collapse of the Financial System

• Decline of American Pre-eminence

Implicit Assumptions. . .• Home Ownership

• Low Interest Rates

• Financial Innovation

• Globalization / New Prosperity

• Ratings Agencies

• Optimism

HousingIn 2004 the George W. Bush administration urged Congress to pass the American Dream Downpayment Act.

Federal Housing Commissioner John Weicher said, “the White House doesn’t think those who can afford the monthly payment but have been unable to save for a down payment should be deprived from owning a home.” He added, “We do not anticipate any costs to taxpayers.”

“These two entities Fannie May and Freddie Mac are not facing any kind of financial crisis. . .”

“I want to roll the dice a little bit more in this situation towards subsidized housing. . . “

Rep. Barney FrankHouse Financial Services Comm.

September 2003

Housing

Housing

“Improvements in lending practices driven by information technology have enabled lenders to reach households with previous unrecognized borrowing capacities.“

Alan GreenspanOctober 2004

Financial Innovation

“Derivatives have permitted the unbundling of financial risks.”

Alan GreenspanMay 2005

Financial Innovation

“Derivatives are financial weapons of mass destruction.”

Warren Buffett

Risk

“As long as the music is playing, you’ve got to get up and dance.” “We’re still dancing.”

Charles Prince, July 2007CEO of Citibank

The Day “The Music” Died. . .

Citigroup’s stock market value dropped from $244 billion to $6 billion, 75,000 in employee layoffs, and approximately $45 billion in TARP/government assistance.

Lessons• Policy Confusion about Home Ownership• Home Values Don’t Always Increase• Spending Beyond Your Means Usually Doesn’t Last• Financial Economy vs. Real Economy: Volatility• Global Interdependence• Faulty Assumptions and Reliance on Ratings Agencies• Severe Under-pricing of Risk• Most of the Experts Missed It• Lessons Likely to Be Forgotten

LessonsWhat Economic Crisis Doesn’t Mean

• Never Buy a House• Never Use Leverage• Don’t Buy Derivatives• Restrict Globalization• Prosperity is Over• Will Never Be Another Bubble / Crisis

LessonsWhat Economic Crisis Means For You

• Tough Job Market• Lower Housing Prices• Harder to Obtain Financing• “Less”• Less Optimism, More Pessimism• Less Confidence, More Anxiety

“ . . . Human beings assume that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect change.”

John Maynard Keynes

Human Nature

Perspective• 9-11• Savings & Loan Crisis• Long Term Capital Management• Internet Bubble• “Flash Crash” – May 6, 2010• Recovery in Financial Markets in 2010

Dow Jones Industrial Average: January 1973 to December 6, 1974

500

600

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1,000

1,100

Jan-73 Mar-73 May-73 Jul-73 Sep-73 Nov-73 Jan-74 Mar-74 May-74 Jul-74 Sep-74 Nov-74

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Dow Jones Industrial Average: January 1970 to Present

--

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

Jan-70 Jan-75 Jan-80 Jan-85 Jan-90 Jan-95 Jan-00 Jan-05 Jan-10

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Possible Next Crises• Pensions – Public and Private• Medical Care• Government Debt• Social Security• Environmental• Political• Terrorism

Future Economic Crisis:Underfunded State Pensions

Costs to Taxpayers

Savings and Loan Crisis

Troubled Asset Relief Program(“TARP”)

Fannie May / Freddie Mac

Underfunded State Pensions

$124.6 Billion

$109-127 Billion

$389 Billion

$3 Trillion

Source: Taxpayers for Wilson

PensionsDefined Contribution vs. Defined Benefit– Difference between setting aside a fixed amount

of money each year and promising to pay a fixed amount in the future for an unknown amount of time

– All about risk allocation

PensionsPredictions:– Move to defined contribution and away from

defined benefit

– Some promises will be broken

Greek Response to “Pension Reform”

Government Debt– Federal and state deficits and debt loads

skyrocketing

– History is littered with ruins of empires and kingdoms that have taken on debt they couldn’t repay

“The Federal Reserve can make a difference, but it doesn’t have a magic bullet. It can’t take a weak economy facing a lot of major challenges and rapidly turn it into a strong economy.”

Donald KohnFormer Federal Reserve Vice Chairman

“Consumption when brought forward must be financed, and that financing is a two way bargain between borrower and creditor.

When debt levels become too high lenders balk and even lenders of last-resort sovereigns, central bankers and supernatural agencies – approach limits beyond which private enterprises productivity itself is threatened.”

Bill GrossPIMCO

July 2010

Conclusions• Good News / Bad News• Humility, Curiosity, Flexibility• Mentor(s)• Think Independently• Read The Fine Print• Move up the Problem Hierarchy:– Cause– Identify– Solve

• Assumptions Drive Behavior