Commentary on the FDIC Bank Failure Report (05 March 2010)

Apologies on not updating for the last two-plus weeks. We have a large project which we're in the throes of wrapping up, so quite a bit of other things fell off the table, FDIC reports being one of them.

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The last two weeks' closures were relatively unremarkable, except for their small-ish size - none were larger than $1 billion. Even the least recoverable bank, Rainier Community Bank, wasn't all that bad: it was 'only' 48.25 cents on the dollar. Below average, yes, but not a bell-ringer, as the tenth worst failure by recoverable value - Century Bank FSB - was 40.72 cents on the dollar. Rainier's board of directors needed to fritter away another 8 cents per asset dollar to make our prestigious Ten Nastiest Bank Closures.

Oh well, maybe next time.

It is presently fashionable to blame the U.S. for the ongoing Depression, and we are only too happy to join in: the U.S. banking system has, for the past decade, exported rot and decay to the rest of the world, in the form of securities and derivatives, passed off by the credit rating agencies as somehow AAA debt. In 2007 the domestic became so unutterably septic that even the U.S. banks couldn't handle it anymore, and so the system broke down. Left to its own devices, the banking system would have imploded, taken down the U.S. economy and Government, knocked the stuffing out of the world economy, and then that would have been that.

That obviously did not happen, and now that same rot and decay is not only still extant in the world economy, but the U.S. is attempted to restart the exportation of more, so as to stave off domestic economic collapse. Both issues have severe implications for the rest of the world: first, if said securities and derivatives are not expurgated from the economy, they will with age become even more poisonous than they are now; and second, if the U.S. managed to force-feed more toxic assets to the rest of the world, there will be just that much more poison in the system.

What that means for the person on the ground, trying to make his or her way through this Depression, is rather grim. The greatest Keynesian-Fisherian nightmare is mass liquidation; which is to say, everything must go. We posit that the Keynesians presently holding the purse-strings in the central banks of the world are only forestalling the inevitable, and thereby making the future situation worse, in exchange for papering over the present. When the papering-over fails, as we suspect it will, then more of the baby will be thrown out with the bathwater; or, more good assets (e.g. precious metals, tools, bicycles, et cetera) might collapse in value with those assets which have none to begin with (e.g. AAA rated debt, designer clothing, suburbia, et cetera). This facet will make investing one's financial resources very difficult; indeed, down not so much might become the new high return.

Since the ongoing Depression was fomented in the U.S., we suspect that the next big leg down will also come from the U.S. When - not if - this next drop occurs, we suspect that the FDIC will be caught flat-footed and flat broke. That situation might already be in place, and the economy is not crashing fast enough to reveal the tenuous position of the FDIC, but whatever the case, going into the future, having large and vital amounts of cash sitting on deposit at banks will become a riskier proposition. Put another way, a bank account will change from being an asset, to a liability, for the average person.

Some banks will be better off than other. Some might even be perfectly solvent and capable of performing adequately, and be able to defend their depositors' money. Tying back into our earlier comment, it is highly possible that these rare, healthy banks will be destroyed along with the bad banks, either by hapless Government intervention, or panicked bank runs, or both.

Imagining a Better Future

Seeing how we are writing here about the Depression - which may last a very long time and turn out to be a dramatic economic collapse - we feel it important to state once again we are confident that the future can actually improve for anyone who is prepared for it.

The most important preparation is to be optimistic in the sense we mean it: making the best out of every situation. At its most trite: when life hands you lemons, make lemonade. Loss can be liberating if you find new fields in which to apply yourself.

Of course it is also important to avoid certain traps that will stifle your ability to survive and prosper in the coming years. The biggest trap is the notion that things will go back the way they were. This even applies to a lot of notions of 'prosperity', 'growth' and so forth. More specifically it applies to notions people have about what is worth investing in: a career, real estate, the stock market. Most of the systems that have worked to make people better off in the past are breaking down, and will not deliver the goods going forward.

So what do you invest in? Try to invest as much as possible in yourself, your skills, your tools, things you have control over which will help you produce income or reduce expenditures. You must take full responsibility for your income, and for living within your means.

The biggest shock the world is facing is that the era of an ever-growing stream of material goods and services is coming to an end, and will become an shrinking stream for quite some time. Happily, your quality of life is not measured by how much stuff you can buy. But you have to focus with ruthless efficiency on managing your income and expenses or you will find yourself a Depression victim.

To have a better future, you must also avoid having a worse future. However, for many with debts, children, or other substantial obligations the future may be unavoidably worse before it gets better. In any case, try to identify your weaknesses with some cold honesty, and shore them up.

The route to prosperity is simple in theory: live within your means (no matter how meagre) and profitably invest the surplus. In practice this can be extremely challenging, but it is achievable.

A New Rule for Profit in a Declining Economy

Whatever you might be hearing, reading, or wishing to believe to the contrary, the world economy is still declining. Looking ahead to 'the recovery' is premature. A practical question arises to those who wish to better themselves financially: How can one make sure one is better off tomorrow than today?

In a growing economy, it pays to take risks. For example, if you can borrow money at a low cost, you can invest the funds in an instrument that makes more and profit off the 'spread'. In a shrinking economy, this strategy typically no longer works. Lenders are not inclined to lend, and few investments yield positive returns.

In a shrinking economy it pays to destroy risk. For example, if you have debts - pay them off. You have a guaranteed return in avoided costs. Likewise, seek to reduce operating leverage in business, even if it means giving up work so that you don't have to take on additional costs (such as buying new equipment, or hiring employees).

This will be a tough lesson to learn. It runs counter to the experience of the last 60 years. Recessions may present buying opportunities, but a Depression - at least at the beginning - is a time to hunker down.

It is very important to measure your income and outgo and ensure the former is larger than the latter. If you economise and create safe, secure savings, your net worth will rise. At some point in the future it will be time to consider more aggressive investment strategies, but that time has not yet come.

An Investing Quandry

The Depression is making investing decisions more difficult for everyone it seems. A friend of substantial means just yesterday said he wants to keep more money "in the mattress." We don't doubt the literalness of his words.

Even we, who have made a career of making decisions, find assessing risks very difficult. In particular, an interesting situation has come up that has us stumped. We have become aware of opportunities to purchase real estate at what seem to be very attractive valuations. But yet we are somewhat paralysed.

We ask ourselves: Is this a value trap? Are the neighbourhoods - though adequate now - doomed to decay? Are cities which are not very prosperous (or with large non-prospering segments of their population) at risk of social disorder?

In happier times, we would have assumed that having done our homework to select the best investment candidates, we could expect fruitful results. We have always done well 'buying the dips'. Under the present circumstances, it seems wiser to err on the side of caution. It grates against our indwelling optimism to resist any bargain, but with 'the world turned upside-down' that conflict is a state we will simply have to adjust to.

Extreme Capitalism

Enterprises go out of business mostly for one of two reasons: they don't make a profit; or they don't make enough of a profit. By enough, we mean not enough to attract investment capital. If an enterprise cannot attract investment capital, it more or less gradually goes out of business.

In this era of information technology, savvy investors, fine tune their portfolios at light speed to achieve the maximum return. They want big, fat returns and they don't care if they are buying or selling, or what sort of real-world undertakings are going on underneath their trading.

A lot of financial engineering (a.k.a. leveraging) that went on during the recent boom years, was an effort to sex-up rather prosaic businesses to make them more attractive investments to the hot money. Most of those efforts failed rather spectacularly and the hot money has moved on. Where to, we wonder? Wherever it is, money will be made, and capital will fall into stronger hands than the lumpeninvestor.

We suggest that if you are an investor, you take care that your investing strategy is as careful, rational, and sophisticated as you can manage. Just flinging your money into "housing" or "the stock market" isn't going to cut it any more. It was a great ride while it lasted, but it's time to move on.

Legacy Capital

There is much ado made about saving one's money wisely. "Invest for the long run;" "get in early on a red-hot market;" and so on and so forth. Despite one's best efforts, investing in a 'good thing' often ends up being a hit-and-miss proposition. Sometimes one buys the right stock, or commodity, or piece of real estate, but sometimes one buys the wrong one.

For the sake of argument, let's say one makes a very good investment. What does it become? Some may say 'my retirement,' or 'a gift for my grandchildren,' or 'a source of income,' or what have you. There are many varied ways people seem to describe their invested money, but the way we would suggest to look at it is as future legacy capital.

Here are some examples of legacy capital: the Panama Canal; the New York State barge canal system; the remnants of the United States railroad system; the Interstate Highway system. These examples were massive investments of time, resources, and capital made long ago, and which continue to pay a 'return' to this day through their continued functional existance. Although not all legacy capital is so dense and recognisable, think about a few other examples: the downtowns of most cities built in the late 19th century; vintage or antique automobiles; the United States geological survey.

All these examples of legacy capital represent good investing from yesteryear; so good, in fact, that today the investment still pays out. Legacy capital, though, can also be irrevocably spent. One only needs to look at the collapse of the Minneapolis interstate bridge to see what happens when legacy capital is not maintained properly. In that case, the legacy capital had been 'spent' down to the point where the entire investment became mere rubble.

In the 2008 Depression, it will be difficult to make future legacy capital. However, it is indeed possible, as much infrastructure extant today is from the 1929 Depression, or even the 1893 Depression. Investment must be made very carefully: one must both preserve the legacy capital of yesterday, and create that of tomorrow. They will be sorely needed.