March1991
Vol 14 No 5

There used to be a game we played based on questions which seemed to have obvious answers, but for which the correct answer was completely different. The answer to this month's question would vary depending upon which side of the world a person was standing on. So also would the answers to questions regarding the future for investors and entrepreneurs. Here are some more questions you might try to answer. We've provided some helpful hints.

 

a.   Why do people fight wars? (Defense? To gain territory/markets? As a favor to friends?) 

b.   How do we afford war? (Higher taxes? More debt? Counterfeiting? Tricky accounting?)

c.    Who gets the money? (Defense contractors? Politicians? Draftees? VA Hospitals?)

d.    Who loses money? (Tax payers? Fixed income retirees? Schools? Our kids? Their kids?)

e.    Who^'s helping us fight? (Saudis? Oil dependent Japan? Germany? Oil rich Russia?)

f.    Who will be the big winners? (Tax payers? Americans? Germans? Japanese? Russians?    Saudis?

g.    In war-time, what^'s the best investment? (Gold? Dollars? Bonds? Stocks? Real estate?)

h.    Where's the best place to invest? (Away from the war zone? In America? Europe? Japan?)

i.    Is the war going to be long or short? ( Long? Short? Wider? Bigger?)

j.    What effect will it have on the Economy? (Inflationary? Recessionary? Neutral?)

k.    What effect will it have on availability of credit? ( More? Less? Higher or lower   cost?)

l.  What effect will it have on real estate? (Rising values? Less liquidity? More liquidity?)

m.    Will long term mortgage paper be worth more or less? (More? Less? See above?)

n.    What should investors/entrepreneurs be doing? (No change? Get into cash? Get out of cash?

o.   What effect will war have on income? ( Increase? Decrease? More government controls?)

Got your answers marked? Look what happened the week the war started. The stock market zoomed upward. Gold and the dollar plunged. Interest rates continued down. Real estate sales were unchanged, continuing slow. House prices continued to drift downward. Gas prices continued lower. Russia started military operations to suppress dissidents in the Baltic states. The Mark, Yen, Pound all gained ground against the dollar. Defense suppliers went on 24 hour shifts. All domestic problems were shunted aside. The deficit will exceed $300,000,000,000 in 1991. Tax increases went to the top of the list at local, state and federal levels. After two weeks of war, primarily between their missiles and our missiles, the big news is the ecological disaster being created by the oil slick in the Persian Gulf. Once Saudi distillation plants are fouled, the big problem will be to find water to supply half a million fighting men in the desert. Sneaky, using a cheap, low tech trick against us.

 

This is a totally new kind of war and it^'s creating changes in our investing environment. Where oil prices doubled at the threat of war, they were halved by actual start of combat operations. Odd! Where investor funds historically pour into the dollar from all over the world when international war starts, they poured out of the dollar. This bodes well for our export trade because our products have suddenly become cheaper. Lowered interest rates should have pepped up the housing market, but it hasn^'t because the lenders are shell shocked from worsening real estate loan defaults. With the FDIC predicting early bankruptcy without a massive injection of billions of dollars, the government still bailed out the Bank of New England's big depositors because they were afraid of a stampede of capital out of the area into safer climes. Maybe overseas! Our challenge is to do the right thing in investing.

 

THE WAR CREATES THE PLAYING FIELD, BUT THE PLAYERS CONTROL THE OUTCOME OF THE GAME

Hopefully, the above questions and answers got your mental juices flowing. There are lots of variables with this war. A short/small war can be an economic shot in the arm while a long/big war can be a real drag on the economy, leading to war-time controls. As a war expands, Congress has historically given the President more and more leeway to exercise power normally shared by the legislative branch. A quick look backward at the past 50 years reveals that FDR, HST, LBJ all accrued power at exponential rates, then used it to regulate the activities of government, industry and the military pretty much as they pleased. We^'re still paying for their decisions. When the State of the Union address speaks of a 'NEW WORLD ORDER^', you kind of get the idea that Bush intends to continue the process. While the above war-time Presidents were all Democrats, we^'ve got the Nixon Administration to thank for devaluation of the dollar by 10%, freeing the dollar from the gold standard once and for all, and implementing price controls. He was a Republican.

While controls are applied to the way we do business and the amount of profit we can make, they rarely apply to the amount of losses we can sustain. If we look at a short war scenario, then we can make the presumption that there will have been some accord with Iraq that saves everyone^'s face and the troops will all come home. Things will go back to normal. You remember normal don^'t you? Rising unemployment! Slumping stock market! Tax increases every year! Cut-backs in Defense spending with thousands of layoffs slated for Southern California, Texas, New England and scattered defense industry enclaves across the landscape. Nothing has changed in the economy to interrupt the recessionary scenario. We continue to lose manufacturing jobs. No modern nation can have a growing Gross National Product based upon the service sector alone. And we need a growing GNP to pay our interest.

Let's look at a longer war. We^'ll assume the best – that this won^'t grow into a World War as it did in 1914 when it started as a small skirmish only to fracture the alliance of European nations as they squabbled over the spoils. After all, who could possibly get nervous about an American military presence in control of the richest oil producing region outside Russia in the whole world? Everybody, that^'s who! So, we^'ll assume that the war continues for several years. your years seems about the limit of Americans' willingness to fight wars. We won WWII in less than four. We just quit in Korea and Viet Nam because the public got tired of it. Remember that Eisenhower and Nixon both won elections by promising they'd stop the war. And then they stopped it. Not won it. Stopped it, but not our costs. These continued on in the form of VA benefits, reparations, occupation forces, lost weapons. We funded these first with inflation, then debt and now with taxes which will keep rising.

Looking at our experience in Viet Nam, the French war with Algeria, or Russia^'s abortive invasion of Afghanistan; we can see that any victory will be hard won. Long term stabilization of the region will require occupation forces for decades as happened in Korea. We can expect about the same amount of financial assistance from our erstwhile military and political partners as we^'ve enjoyed supporting the maintenance of our military overseas in NATO, Korea and Saudi Arabia. So, we can expect to be taxed by inflation and by every level of government. When government extracts the fruits of productive labor and consumes tax money supporting non-productive enterprises, it deprives business of both customers and capital/credit. That depresses the economy, slows GNP growth, limits opportunities for new businesses, removes incentives for entrepreneurs to take risks or to create opportunities which will provide new sources of employment. Voila: recession/depression.

I can virtually guarantee that the battle cry of the next Presidential election will be to ^'get the country moving again^' with INFLATION. And nobody will mind at all. After all, it only affects the poor, elderly, those on fixed incomes, those with indexed mortgages. But it benefits VOTERS, BANKS, POLITICIANS, BORROWERS WITH FIXED RATE LOANS – say like BONDS: U.S. TREASURY BONDS! This way, we can sandbag the rich bond holders, the foreign debt holders, foreign dollar holders. We can make our products cheaper. Sell our companies at a lower cost to foreigners, improve stock prices, move all tax payers into higher brackets, create an astounding real estate boom fueled by those rushing to dump dollars, raise interest rates to destroy the bond markets while attracting more investment dollars into T-Bills and out of the credit markets. DY-NO-MITE! And won^'t we all get well with another 1979 boom?

O.K. – this describes the playing field and the sideline markers. Inflation on the one side, recession/deflation on the other. Our goal is profit. Government is still aiming for higher taxes and control of your wealth. Let^'s see how we'll play the game.

FIRST, GET YOUR INVESTMENTS HEDGED AGAINST ALL POSSIBLE SCENARIOS

Last month we took a look at real estate mortgage paper. If we^'re trying to find a vehicle to. sustain us over the next 4 or 5 years, why not FIRST mortgages, TAX Liens, Judgements, or second mortgages where there is very little senior debt ahead of our claim, and considerable equity behind it? Currently these are available with cash flow yields that will surprise you. Florida tax certificates can yield up to 18% SIMPLE interest for as long as 7 years, but for practical purposes, the compound yield drops over that time to just under 12.5%. And while the lien supersedes almost all other liens, there's no cash flow. To use Tax Certificates effectively, you should plan on calling for a tax sale every two years, and rolling over the proceeds into more Tax Certificates. There^'s some expense and trouble to bear when foreclosing tax liens, so I think it's better to invest in tax certificates in the larger denominations. These will normally be paid off by partnerships or corporations before sale can actually be held, so there's a real possibility that they could be exchanged for stock or corporate debt advantageously at a point in the future. Anytime the owner can^'t redeem them, then he's in the distress market. You can either go to sale and wind up with the property at a fraction of it's true value, or find that other investors will bid the property up sufficiently for you to cash out. Either way, you win.

This is a pretty good hedge against recession as long as you don^'t need the cash. After 2 years, you can choose to foreclose, hoping that the owner or another bidder will pay you back. On the other hand, if inflation threatens to wipe out the benefit of 18% yield as it did from 1977 – 1980, you can actively bid to buy the property at your own sale, and substitute a TANGIBLE real estate asset for a depreciating piece of paper. The relatively short term of 7 years will reduce the effects of rising market interest rates that would decimate the 30 year zero coupon bond market. So, you've also got some inflation protection in Tax Certificate investments. First mortgages and foreclose-able liens can work the same way.

People overlook the value of relatively low yield 30 year mortgages which are in their final 5 years of amortization. Suppose that 25 years ago someone bought a $50,000 house. That would have been a luxury home in 1961, and would probably have a value in the neighborhood of $200,000 in many areas of the country. (Yes, Virginia, single family houses have outperformed every other market over the past 30 years when leveraged at 80% or more. Interest on that loan would have been about 6%, with fully amortizing payments of +/- $240 per month. After 25 years, the loan balance would be about $12,400. Let's say that the distressed lender would sell the loan discounted to yield 10% over the remaining 5 years. Say we buy this loan for $11,250. Our KONSTANT (the ratio of payments to loan balance) would be 25.6%. This is the CASH FLOW PAYMENT return that would consist of interest plus the return of our principal each year. In contrast to 18% tax certificates which trade off cash flow to get higher yields, this investment in older mortgages would trade higher yield for more income and faster loan pay back.     Both would be relatively liquid in the event we had the legal right to foreclose, and we might still be the only bidder at sale in depressed times. This type of investing offers a way to profit in a variety of scenarios.

 

ONE PLACE WHERE I DON'T WANT MONEY IS IN BANKS!

The Chairman of the FDIC has announced that he's running out of money. So is the government. 30 years ago, Chicora Federal Savings and Loan of Charleston, SC went broke, taking all my accumulated savings. FSLIC DID NOT PAY OFF. After 7 years in court, I got 3.5C on the dollar back. I've never trusted the government safety net since. I believe that international money markets offer much more safety than domestic, especially with a falling dollar. You don't have to be a big investor to play. There are variety of Money Market Funds that will invest in high quality foreign bonds or commercial paper, bank paper, market index schemes, etc. In our country, banks are legally able to lend money they don^'t own based upon reserves they can borrow. In short, they're just over leveraged speculators like those who^'ve failed in real estate. Both go broke hoping for good luck to bail them out, or easy credit, or inflation. BY using foreign currency hedges, when the dollar falls, my accounts rise. So will yours. But beware, it works the other way too, so don^'t put all your eggs in one basket. Moderate investments in T-Bills, Medium term Bonds, Utility Stocks will keep you liquid and balanced.

THE BEST DEFENSE IS A GOOD OFFENSE . .

The financial 'fetal position^' can be fatal. Simply protecting your assets won't enable you to grow. You have to be financially and emotionally prepared to take advantage of opportunities as they come to you. That means having liquid funds safely positioned as explained on page 3, and being mentally geared to anticipate both future opportunities and the way you'll recognize them and act upon them. And you should do this well in advance.

 

When you can make money when all around you, others are losing theirs, your worst enemy is going to be ENVY. Everybody's happy when they^'re all going down in the lifeboat. They don^'t want to see anyone get away just because they prepared better. Traditionally, envy in America takes the form of RENT CONTROLS, EXCESS/WINDFALL PROFIT TAXES, ALTERNATE MINIMUM TAXES, INCOME TAXES, PROPERTY TAXES, CORPORATE TAXES. In the past decade, the tax contributions of the top 20% of the income earners have risen twice as fast as for the lowest 20%. It will get worse. Just 10 years ago the top income tax bracket was 70%, Don't be surprised if it returns to that level. Similarly, there were restrictions on the amount of gifts between spouses, the amount of the Unified Credit, and higher effective estate taxes. One of the simplest devices for offsetting this problem is to become as many tax payers as possible. This is accomplished via Corporations, Irrevocable Trusts, Family Partnerships, multiple family sole proprietorships, splitting income up among your offspring. Each of the tax generating profit centers will be in a lower bracket than one single large payer.

 

The next step is to get a firm grasp on your present and near term future financial vulnerabilities and strengths, this involves doing an honest appraisal of your cash flow position, liquidity, income protection, quality of your paper and rental income streams; then taking remedial action. Most real estate investors will find themselves relatively illiquid and with marginal income streams. The best thing to do is to use SALES to create CASH even at the cost of some profit, then to create the income protection you^'ll need by carrying hack indexed and short term mortgages on property you sell. These techniques have been explained in prior newsletters over the past year. You'll want to review them.

 

From this point on, you'll be poised to enter the fray. We^'ve found our biggest profits by buying assets from small INSURANCE COMPANIES who were suffering from defaulted JUNK BONDS and NON-PERFORMING REAL ESTATE LOANS. By buying their mortgages for pennies on the dollar, then giving a full release of liability to the deed holder in return for a deed in lieu of foreclosure, we've been able to buy at big discounts. Surprisingly, both lender and debtor have been happy with these transactions. Now, to raise cash, we are willing to discount properties to wholesale prices for quick sales. Then we make up our losses when we re-enter the market at even bigger discounts. This is a lot more profitable than holding out for top retail prices for months or borrowing against equities with high personal risk.

 

There are other ways to transact business when interest rates are high and credit is scarce. Real estate investors are optimists. They borrow money for personal consumption against properties which then become cash sink holes. Full personal liability on the loans threatens all other property in the event of default. Buying such a property with cash at discount with the stipulation that the distressed seller use the cash to pay down the debt restores the property to viability as an income producer. To pay the seller for his equity, you can offer a SINGLE PAYMENT NOTE, no interest or payments until a future date at a point when the economy would have settled down. In the meantime you^'ll enjoy the cash flow to hedge recession, and the ownership of a tangible to hedge inflation with fixed rate loans. In lieu of a single payment note, you can substitute passive land equities, or leveraged equities with less negative cash flow which will marginally improve the seller^'s position. This way you get rid of a lot of debt and acquire better properties through use of your cash.

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