Let's just say that my summer reading has not exactly been an exercise in diversification. I've sampled a large number of books, but I've found myself gravitating to three on financial topics (OK, 2 ½. I'll explain.), and one, Good Omens, that ponders what it would be like if the agents of heaven and hell on earth tried to forestall the apocalypse. No, really. The book's hysterical.
The others, while not hysterical, offer insights into investing and the markets. Each has the capacity to stun. Call them the Ghosts of Markets Past, Present, and Future. One details the ascension of New York City as capital of the financial world, one shows what happens when Washington gets its oafish mitts on the markets, and one details the ever-heightening risk that the housing market is the next big bubble to pop.
The ghost of markets past
Today its place is set in stone. Wall Street, New York City is the center of the financial world. Each and every day, starting at 9:30, the world looks to New York and its markets, to see what is happening. Financial reporters, even in this era of electronic communications, simply have to be in or around Manhattan to feel close to the action. In finance, New York is the action. But why?
Historian Thomas Kessner's new book Capital City argues that the rise of New York as a financial powerhouse began with the opening of the Erie Canal. New York was little more than a port town at the time, and was the major transfer point between canal boats and ocean vessels. It didn't take long for a Manhattan-based shipper to recognize that there was much more money in financing boats than in running them, and thus unwittingly launch the city's investment-banking industry. New York solidified its position as a banking center with its central role in financing the Union's efforts in the Civil War.
We've seen plenty of histories of Wall Street -- some hagiographic, some that paint it as the root of all evil. This book displays a great deal of measure, and Kessner seems to have gone to great lengths to chronicle what certainly is a central engine of the U.S. economic powerhouse -- flaws and all.
Kessner notes about the 1860s railroad boom that, "Corporate officers had mocked their fiduciary responsibilities, printed reams of depreciated stock, undermined equity values..." I simply swear that he's talking about the option-happy, empire-building folks who brought us investing disasters Worldcom, Qwest (NYSE:Q), Microstrategy (NASDAQ:MSTR), or Enron. And yet, a few years later, the speculative juices flowed once again, all driven by the kings of New York.
Kessner offers a text rich in personal anecdotes that doesn't get bogged down trying to detail everything about Wall Street. In short, this is a spectacular book.
The ghost of markets present
A friend of mine told me that I needed to read Dick Morris' new book Off With Their Heads. Political tell-alls aren't generally my cup of tea -- I get enough of Washington living in the darn place -- and I can't say that Morris ever interested me at all. But there is a chapter in this book that simply has to be read to be believed. It describes how back-office dealing in the Clinton administration led to the accounting industry's exemption from shareholder lawsuits relating to their audits of public companies.
Forget the rest of the book -- go read this chapter. Morris, one of Clinton's prime advisors, had nearly unfettered access. Here, he uncovers the roots of the rapid degradation of professional accounting standards, detailing the relentless lobbying by accounting firms, as well as Silicon Valley, both of which offered badly-needed support to Clinton's re-election campaign. I wonder why tech companies were so interested in limiting auditors' liability for bad accounting?
As Morris tells it, Clinton vetoed the original bill, but then let Sen. Chris Dodd (D-CT) know that he would not fight an override, which is exactly what happened. And so, the scam was on, with accounting firms increasingly unwilling to risk millions in consulting revenues by pushing their clients too hard on audits. Why would they? They were protected from prosecution. And thus, as Morris describes it, were investors handed over, "bound and gagged, to the fraud mavens at Enron, Arthur Andersen, [and] Global Crossing." I love the term "fraud mavens", and I think this book is worth reading for this chapter alone.
The ghost of markets future
Over the last three years, as folks have gotten burned in the stock market, more and more have decided to go where they feel they're on firmer ground -- into real estate. It's paid off, with housing prices up 78% in some markets over the last five years. Face it -- housing feels like a safe investment -- it hasn't had a down year nationally in the last 35. But, as John Talbott describes in The Coming Crash in the Housing Market, it is because of the most recent rise that we may be in for a real fall.
Simply stated, Talbott describes an unholy confluence -- extremely low interest rates, decreasing credit-quality standards, and increasing levels of leverage -- which has conspired to push housing prices to record levels relative to average worker incomes/free cash flow. He identifies rising interest rates as the trigger that could cause the entire market to tumble, as the leverage that helped people get into larger houses works in reverse to destroy what little equity they have.
Despite some questionable use of statistics, I found Talbott's arguments highly persuasive. Yes, we have been through plenty of markets in the past where interest rates have risen, and not once since the depression have housing markets collapsed as a result. But history, while it offers clues about the course of events, is no predictor. In the last two years, Talbott points out, homeowners have taken $350 billion in cash out of their houses in refinancing -- of which the Federal Reserve estimates $120 billion went to paying down consumer debt, and another $70 billion was spent on consumer goods. The average household has used cash from refinancing to finance their lifestyles -- and that money is gone.
Most terrifyingly, even with the massive increase in housing prices, the percentage of houses currently in foreclosure nationwide is at its highest in generations. Why don't these people just sell their houses? This is the culmination of a long trend of increasing leverage and increasing housing expenses as a percentage of income in the average American household -- and these two factors cannot continue to trend higher.
Talbott offers some remedies to protect yourself, including a reduction in exposure to real estate, or moving from a high-priced area to a low-priced one. These seem a bit goofy and impractical for many. Where he hits a bull's-eye is in his exhortation that you not overextend yourself by taking on as much leverage as possible to get into a more expensive house, or if you've already have, to decrease that leverage any way you can safely do so.
Regardless of how you feel about doomsday scenarios (and Talbott gives hints that he's decidedly uncomfortable with the fact that he is presenting one), there should be no doubt that the incentive bias for those most invested in the industry, including Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) is to keep prices high. At some point the risks taken on to do so may overwhelm the market, and unless there is an adequate safety cushion, the results may be catastrophic.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann's opinion of doomsday is that he's opposed to it. He holds none of the stocks mentioned in this column. He does hold the books mentioned in this column. The Motley Fool is investors writing for other investors.
