The immediate crisis is passing ... what the future must look like ...

Yes, the immediate crisis is now in the process of passing, with all the extraordinary measures taken to assure the financial system remains liquid. There will still be, perhaps, moments of further high-wire acts over the next 12-24 months, but these now appear less likely to take down the entire financial system, given the exceptional world-wide commitment to blitzkrieg measures as necessary.

I think that, given the unbelievable bungling by companies, CEOs , and boards in the banking and insurance sectors, a round of applause is due to central banks, and governments, world-wide in managing the crisis. This isn't the same as saying that they took measures to prevent the crisis from arising but, once it was upon us, took appropriate measures to make sure this didn't become "The Great Depression, II".

Given the enormous failure of systemic corporate foresight and governance on an individualized corporate basis, governments must now take steps to regulate systemic strength and redundancy into both the banking and insurance sectors. The government must also reform obscene and excessive-risk-encouraging executive pay schemes, since boards have clearly failed to perform their duties to protect shareholders in particular and, as a group, their actions have endangered society in particular.

Here's some quick thoughts on what some of this regulation can and should look like (by the way, corporate boards, take some notes in case this doesn't get legislated, as it's still solid corporate practice: good and prudent governance, if you will):

Banking:
Never again allow the total disconnect between the lender and borrower to occur, by mandating that any pools of capital moved "off balance sheet" (i.e. sold to hapless investors), have some significant portion retained by the originating institution. Whether that amount is 15%, 25% or 50% should be thought about carefully, with the two competing objectives of robustness of system, and efficiency of capital, duly and thoughtfully considered.

The FDIC and similar institutions need to consider "100 year events" in pricing their deposit insurance, as secular increases or declines playing out over a couple of decades can hide fundamental flaws in this type of insurance pricing (i.e. the current scenario). The pricing needs to properly reflect the risk of the loan book of a particular institution - in other words, those playing in areas of the pool with no lifeguard, need to have appropriately steep insurance costs to discourage the most egregious type of risk-taking - or alternatively, to protect the general public when the inevitable failures occur. More highly levered institutions also need to pay higher premiums.

Insurance/Banking:
Anything that looks or smells like some sort of insurance scheme is appropriately reserved. This means that pretty much anything that is insurance against some other event, and involves a trade (swap) of potential event happenings, or pricings etc. It doesn't take a financial genius to recognize that things that are "insurance" aren't always called "insurance". Here's some keywords for regulators, boards and investors to think as insurance: "hedge", "swap", "obligation" (in certain contexts), "derivatives", and so on. No longer should these be allowed to be unreserved. They are all some type of insurance, and need appropriate regulation and reserving to recognize those risks.

Pay schemes:
Federally regulated industries need to have banned, outright, stock option grants. Options encourage excessive risk taking, without the offsetting consideration to downside risk. A winner take all mentality, if you will. This must be discouraged, as it produces unacceptable systemic risk.

In fact, had boards collectively produced proper and appropriate compensation schemes, I argue that much of these systemic excesses may never have happened. For further thoughts on executive pay reform, go here. (In fact, I'd now go one step further and say that the CEO should have to own stock equivalent to at least two years base pay during his entire tenure + eighteen months, as CEO).



JW

The Confused Capitalist

Fear: An Investors Biggest Friend & Worst Enemy

Although I've laid out a very conservative and creditable plan for using leverage (see the Leverage Series, just completed) to help an older couple with poor retirement prospects significantly improve their future, many people will see the same plan and completely pass it by.

Why? The reason is usually fear. However, many people won't admit to that; they'll talk about the market at a peak (although they might know very little about the market), or use some other justification to avoid changing their situation. Many great investors have said that managing one's own emotions is the largest hurdle to becoming a successful long-term investor.

In this way, you can avoid selling when "the market" has declined in value (and in fact look to BUY at that time), and not panic and sell your own investments (or "rebalance" from a position of emotional weaknesses) during a market downturn. Managing your own emotions also allows you to avoid chasing a hot market or sector, as many people did (like I did, too!) during the NASDAQ rocket ride in 1999 - only to be shortly followed by the crash thereafter.

Being emotionally balanced and remaining committed to the long-term, despite the markets burps and belches, is the best way to have the success in the long run.

JW

The Confused Capitalist

Financial Leverage: $3.06 Opportunity missed?

So, we have a relatively diversified portfolio for our pre-retirement couple, that should spin off a very nice cash-flow in just a few years.

Now, the thought has been brought up that maybe some people don't like certain sectors or companies (tobacco is a frequent mention in this regard), and they'd prefer not to have them in this leveraged dividend portfolio. Certainly, with some of the yields available today, there's the opportunity to have the portfolio with somewhat of a different profile. For instance, some folks (including me), like the valuations in the banking sector and think it offers above-average potential for long-term gain in comparison to some of the selected companies.

For those people, you might lean away from one sector or company you didn't like, and lean a bit more towards those you did - bearing in mind that you're intending to create long-term value with positive cash-flow as soon as practical (bearing in mind the safety consideration of the portfolio). The thing here is that everybody's ice-cream can be flavored a little bit differently, depending upon their age and individual investment goals and profile.

The other important thing is NOT to sit on your hands forever - right now, mortgages have a fairly attractive interest rate to use for the leverage, and many stocks currently offer pretty decent dividend yields in relation to their stock price. I don't think this situation is going to last forever - I think some of these stocks are going to increase in value (thus lowering the dividend yield), and it's almost certain that the cost of the leverage (mortgages) is going to increase.

It's much harder for those with modest incomes with little ability to service negative cash-flow to make these number work if the average dividend yield drops to 3.5% and mortgage rates increase to 7.5%.

Sometimes opportunity must be seized quickly ... it seems to be one of those times.

JW

The Confused Capitalist

Financial Leverage: $3.05 Diversification

An important safety component in any portfolio is based upon diversification. That means NOT buying companies that are all in just one sector or industry. This protects a portfolio against a dramatic cyclical decline based on one industry or sector weakening over time. Against that, hopefully other companies or sectors held within our portfolio will be experiencing an asendancy in their fortunes.

In short, diversifying sufficiently protects our portfolio, provides possible enhancement of returns, and best of all - allows us to sleep well at night.

Let's consider this portfolio. While it lacks some components of diversification (such as smaller companies, foreign companies, and emerging market companies) the large companies are well-suited to having the probability of providing a steady stream of dividend income to us - a very important consideration. So we are mainly looking to see that we haven't inadvertently selected companies in just one market sector. So let's look at them:

1. ATT - Telecom
2. Altria - Tobacco / Food
3. Bristol Meyers Squib - Pharmacueticals
4. Conagra - Foods
5. Progress Energy - Utilities
6. Reynolds American - Tobacco
7. Sara Lee - Foods
8. Southern - Utilities
9. UST - Tobacco
10. Verizon - Telecom
11. Bank of America - Bank/Financial
12. Citigroup - Bank/Financial

Although we can see some concentration, particularly in tobacco, most of these companies are in areas where there has traditionally been good dividend yields available, especially tobacco, banks, utilities, and telecoms. In general, given our insistence of a high dividend yield and the safety of large companies, this portfolio has fairly good diversification.

The point is here, that it's currently possible to construct a conservative portfolio that's initially close to cash-flow positive, after borrowing all the money to buy that portfolio. I'll talk about some other possibilities later ...

JW

The Confused Capitalist

Financial Leverage: $3.04 - value of stocks & cash flow

So our 50 year old couple are anticipated to have a positive cash-flow after a few years, reaching over $91,000 annually, by age 80. In addition to this rather nice supplement to their living income, the value of the stocks they purchased should also be increasing.

Over the past 10 years or so, the average total annual return on the 12 stocks we picked for them increased by about 10% annually. However, about half of that was being received in annual dividends, meaning that the value (or cost) of the stocks was inflating by about 5% per year.

While this might seem small, remember that we wanted them to have an adequate cash-flow for living expenses, and some nice extras in their retirement years, rather than having to scrimp and worry.

Using the 5% projected annual increase in value then, the expected value of this initial $200,000 stock portfolio is:

1. In 10 years: $325,000
2. In 20 years: $530,000
3. In 30 years: $864,000

and our positive annual cash-flow is projected as:

1. In 10 years: $5,957
2. In 20 years: $28,728
   
3. In 30 years: $91,376 (loan payment has expired)
   

So not only do the dividends pay well, but the increasing base value of the portfolio means that they are offered some protection against inflation for their income component, plus they may have the opportunity to pass this on through their estate to loved ones, or favorite causes.

And again, this was all because they took a fairly modest risk at this time, using some leverage to buy a high yielding stock portfolio. We'll later examine this portfolio to see if it meets some basic criteria for diversification.

JW

The Confused Capitalist

Financial Leverage: $3.03 - situation overview

Financial leverage continued ...

Our couple: 50 years old, limited savings, poor retirement prospects, so did equity take-out of $200,000 from their house, additional loan payments of $1,199 monthly, intend to invest in dividend paying "Widow and Orphans" stocks, which are projected to have a small negative cash-flow for a few years, but are expected to become cash-flow positive in the sixth year and by their 70th birthday, is anticipated to be providing around $28,728 annually in positive cash flow.

We found them 12 large NYSE-listed companies. Not only does it seem likely that the dividend will cover the mortgage payment in a few years and continue to increase thereafter, there's also the prospect that at some point the mortgage will be fully paid off. In addition, we've got to consider that it's quite likely that the value of these stock holdings will be increased in the future.

We'll take a look at what those values are likely to be ...

JW
The Confused Capitalist

Financial Leverage: $3.02 - the actual portfolio

Financial leverage continued ...

So we have our 50 year old couple, limited savings, poor retirement prospects, so did equity take-out of $200,000 from their house, additional loan payments of $1,199 monthly, intend to invest in dividend paying "Widow and Orphans" stocks, which are projected to have a small negative cash-flow for a few years, but are expected to become cash-flow positive in the sixth year and by their 70th birthday, is anticipated to be providing around $28,728 annually in positive cash flow. Here are the 12 NYSE-listed companies that were selected from the newspaper and met a few other criteria and, as you can see, there are some large companies included such as Citigroup and ATT, amongst others .... (scroll way down, I'm having some trouble formatting this puppy!)

Company	Symbol	Yield	Annual Yield Growth
ATT	T	4.70%	6.70%
ALTRIA	MO	4.40%	9.50%
BRISTOL MEYERS SQUIB	BMY	4.90%	0.00%
CONAGRA	CAG	5.20%	4.60%
PROGRESS ENERGY	PGN	5.40%	2.70%
REYNOLDS AMERICAN	RAI	4.80%	6.20%
SARA LEE	SLE	4.40%	7.60%
SOUTHERN	SO	4.40%	2.50%
UST	UST	5.70%	4.60%
VERIZON	VZ	4.70%	1.00%
BANK OF AMERICA	BAC	4.50%	13.60%
CITIGROUP	C	4.20%	34.40%
AVERAGE		4.80%	7.80%

You can also see that they produce an average dividend yield of 4.8%, and that dividend has, on average, been growing by 7.8% annually. Later, we'll consider other aspects of these 12 stocks as a stand-alone portfolio.

JW

The Confused Capitalist

Leverage Edition: $3.01 - Do what you CAN afford

Financial leverage continued ....

50 year old couple, limited savings, poor retirement prospects, so did equity take-out of $200,000 from their house, additional loan payments of $1,199 monthly, intend to invest in dividend paying "Widow and Orphans" stocks, which have a small negative cash-flow for a few years, but is expected to become cash-flow positive in the sixth year and by their 70th birthday, is anticipated to be providing around $28,728 annually in positive cash flow.

Of course, your home might not be worth the same as those folks, or maybe you couldn't afford that amount of initial negative cash flow (averaging about $2,000 annually for the first five years [without considering the tax benefit of the deductibility of the mortgage interest]) - so you might be able to only afford a $50,000 equity take-out. In that instance, everything would simply be divided by four, but otherwise the example would remain the same.

On the other hand, you also might be starting out younger, and that allows much more time for everything to build up by retirement age.

Later we'll look at the specific companies I used in this current example.

JW

Leverage Edition: $2.01 - Escape Financial Jail

Financial Leverage Continued ...

50 year old couple, limited savings, poor retirement prospects, so did equity take-out of $200,000 from their house, additional loan payments of $1,199 monthly, intend to invest in dividend paying Widow and Orphans stocks.

So, carrying on, I was able to quickly go through the local paper, and find a number of large company names I recognized (Widow and Orphans Stocks), and looked for yields in the 4-6% range. Lower than that, it wouldn't provide enough immediate cash-flow to help pay the mortgage, and higher than that can indicate a smaller company, or a large one in trouble. And we want a reasonable amount of safety, so we're staying in that general range.

I was quickly able to find 15 stocks (just from an abbreviated list) that met those criteria, then I went over to Morningstar to look at the recent dividend payment history. I was looking to eliminate stocks which decreased their dividend payment compared to five years ago, and also whose total annual return (dividend payment plus change in the stock price) wasn't greater than 2%.

This left me with twelve big name stocks, who have an average market capitalization in excess of $50 Billion, with only one of those names below $10 Billion market capitalization. They produce an average current dividend yield of 4.8%. Not only that but, on average, those dividends had been increasing by 7.8% annually over the past few years.

So this offers the very distinct possibility that the dividend payments in the future will more than cover the increased mortgage payment of $1,199 monthly.

In fact, if we divide the $200,000 evenly in stock purchases among those 12 companies, we should recieve $9,600 annually in dividend payments for the first year, compared to our annual mortgage payment of $14,388 (12 x $1,199). So the first year, we'll have to cut our expenses and dig into our pockets to fund the difference of $4,788, or $400 monthly. However, there's also the matter of the tax write-off for the interest on the mortgage (about $12,000 is interest in the first year), which should help narrow that $400 monthly shortfall (talk to your accountant about the exact amount).

Since the recent history is that these companies increase their dividends on average by 7.8% annually, we can reasonably expect that we'll get a higher payment in the future. Using the 7.8% increase per year, by the third year we'd be getting $11,148 annually, and by year five, our dividends of $13,968 almost cover the mortgage payment. If these companies continue increasing their dividends just like they have in the recent past, then by year six we be getting a positive annual cash flow of about $672.

Fifteen years from when we took the loan out, at retirement age of 65, the positive cash flow (after the mortgage payment has been fully paid from the dividend) would be about $15,228 annually. This cash flow continues rising so that five years later, it should now be around $28,728 annually in positive cash flow. At the time we hit 80, the loan is then fully paid off, and our annual dividends are $91,368. SWEEEET!!

And all because you decided to fund a small shortfall for a few brief years - and managed both your risk and leverage wisely.

More later ...

JW

Leverage Edition: $1.01 - The Basic Plan

A little title humor there, folks!

Continuing on - 50 year old couple, bleak retirement prospects, but nice home, mostly paid for.

Well, WAS mostly paid for - now we approach the bank. Your current home value is $400,000, against which you've got a $100,000 existing mortgage - the bank agrees to a 30 year refinance of $300,000, at 6%, which would increase your current payments by $1,199 per month, which we can find out by using this Mortgage Calculator. Yiiiiiikes!

But let's see how we can make that extra $200,000 go to work for us, by the power of leverage. We are going to use that money to buy some Widow and Orphan Stocks that pays high dividends.

By going through my local newspaper, with its condensed stock listings of large companies listed on the NYSE, I can pull up a number of large company names that I recognize, where the dividend yield is above 4%.

If I can find enough of these companies, and ones that have generally increased their dividend payment over time, then I can - after a spell - get the mortgage to pay for itself. After a bit more time, I can start to get a positive cash flow, because the dividend payments become more than the loan payment, and after a while, I'll own a whole lot of stock that has increased in value, and is now loan free and spinning off even more in dividends.

More later ...

JW

The Power of Leverage: Find a Class 1 Lever

Financial Leverage can be truly awesome when used correctly in the proper balance between growth and safety. Too much of one is likely to impede current cash flow (growth costs money), while too much of the other (safety) won't produce an adequate financial return for the risk taken.

Let's say that you're a 50 year old couple, who is realizing with some alarm that you haven't put away enough for retirement. You've got a nice home, but that's about it. You're starting to think that things will be very bleak once you hit 65. Your pension will be minimal and your savings aren't currently much. It certainly doesn't look like you'll be able to go south for the winter, and you fear having to sell your home to finance current living expenses as you age. Not pretty.

But with a little bit of the right financial leverage, and just a bit of scrimping for five years, you can let leverage take care of those nasty retirement fears. Using current some current examples, we'll see how it's very possible to have a positive cash flow of almost $1,300 per month at age 65, and if you live to 80 - $7,614 per month (wow, what a bonanza!).

Next time

JW

Financial Leverage

Leverage: Fear and Enjoy!

Leverage: in the investment world, that's the ability to buy something with part equity (ie your cash), plus some portion financed. The portion or ratio financed is the leverage.

I recently read that seven out of ten millionaires achieved that status primarily through real estate. And the reason they were able to do so, was through the wise use of bank-provided (or equivalent) financing. Real estate is often loaned upon on a 3:1 basis of debt to equity. Very few other investments can be financed to this high a ratio.

However, leverage is also to be feared, since it can magnify investment losses. So if you choose to re-finance your home to invest it in the stock market, you have to be careful - careful both that your investment is conservative enough that your principal is protected over the longer term, but also careful that it's likely to grow in value (thus paying for the leverage).

Finally, you also have to have enough earning power - either through your own job OR through the investment itself, that you can afford the increased loan payments.

Leverage - a fabulous wealth creator - or a potential bankruptcy helper!

I'll be discussing leverage - and some different types of leverage - more in the future.

JW