New Year's Eve, Alcohol, Mortgages and Morality

Several years ago at the height of the housing crisis, I was at a New Year's Eve party. A friend of ours who held a senior position in a local credit union (let's call her J), was complaining about the number of people who were committing strategic defaults (walking away from mortgages that they could afford but chose not to pay because the house had negative equity).

"The law should be changed to prevent them from doing that," said J in between sips of her adult beverage.

"Why?" I asked.

"Because it is immoral," she quickly responded.

Now, those who know me know I like a good discussion. The more controversial the position, the better. So given this setup and the fact that I too had consumed several rounds of pre-midnight libations, a discussion was going to occur.

A - "Let me ask you a question. Let's assume that before this crisis, you had a customer who had made 29 years and 6 months of timely mortgage payments on their home and got cancer right at the end so that they couldn't afford to make the last six mortgage payments. Is there any scenario under which the bank would not have foreclosed on them?"

J - "No."

A - "So explain to me how that would have been moral? You've got a customer who's done everything possible to comply with the loan and through no fault of their own, they've suffered an illness that makes it impossible for them to pay their loan."

J - "We are just doing what the mortgage agreement allows us to do."

A - "Well aren't the people who are strategically defaulting doing the same? A mortgage spells out the agreement of the parties. The bank lends the money, the borrower makes the payments. If the borrower doesn't make the payments, then one of the remedies the bank has is to seize the house and sell it to recover its money."

"For almost all of the last 80 years, that was a remedy that was very favorable to the banks because people's houses usually went up in value. Now if the borrower must be bound by that remedy, why shouldn't the bank also be bound?"

"It seems to me that you want to impose an after the fact, unilateral, morality clause on the borrower. So how exactly is that either fair or moral?"  [This draws a chuckle from the small group of other friends who have gathered around as we were discussing this.]

J - "F*ck You, Alex."

Possibility. Probability and Effects

People often confuse possibility with probability. Though they are related, they are not the same. Probability is the likelihood of some event occurring.  Any event with a probability greater than zero is possible. If the probability of an event is one, then it is guaranteed to occur. Very few things in the world are impossible. They might be extremely unlikely to happen but not impossible.

In business, one must at least consider all possible outcomes. Yet people frequently analyze just the best and worst case scenarios and then conclude that the expected result is the average of these two outcomes. This implies that the probability of the outcomes is 0.5 for both the good and the bad outcome. It also ignores the reality that most of the time, outcomes fall somewhere in between the best and worst case scenarios.

Good planning neither ignores these outcomes nor does it treat all those outcomes as equally likely to occur. Instead, a competent manager should attempt to assign probabilities to the range of possible outcomes to attempt to analyze how these outcomes impact the organization. This requires an analysis of the probability of something occurring and an analysis of what happens if that occurs.

It is vital to ensure you are using probability to answer the appropriate question. Professor Sam Savage of Stanford University once wrote a brilliant illustration of this issue. He provides a hypothetical scenario where a drunk man randomly staggers across a busy two-lane highway (one lane of traffic in each direction) with a median in the middle. The drunk stumbles randomly to the right and to the left, spending about half the time on each side. If you were asked what his average position is, you'd be correct to say right in the middle of the road on the median. However, if you used that answer to conclude that he's alive, you'd likely be wrong.

In other posts, I will explain why I believe that a proper understanding of risk is crucial for success in both one's business and personal life as well as introducing what simple tools exist performing this analysis.

Estate Tax and Double Taxation: Really?

A common argument against the estate tax is that it is unfair because it results in taxes on the wealth you have already paid taxes on – commonly referred to as double taxation. In theory, this can be true, particularly if wealth was acquired through cash wages - but with the estate tax rules currently exempting more than $5.5M of wealth from taxation, very few individuals acquire and save more than $5.5M of their cash earnings over their lifetime.

Instead, most people owing estate taxes do so because of the value of stock and other property they own at the time of their death. Take Jeff Bezos for example. He recently became not just the world’s richest man, but the wealthiest man ever in the history of the world with a net worth estimated to exceed $100 billion.

The vast majority of this wealth is in the form of Amazon stock, the company which he founded and built in an organization that has transformed electronic commerce throughout the world. As the company’s founder, he acquired this stock for little or no money. Instead, he was granted those shares at the time Amazon was formed and then went public.

Under most tax systems, including the US’s, a taxpayer does not pay income tax until a realization event occurs. Without getting too complicated, a realization event is usually the sale of the property (shares in this case) for cash.

Therefore, Mr. Bezos’ has avoided paying taxes on the vast majority of his wealth. If the estate tax did not exist, he would be able to transfer this $100 billion estate to whoever he wanted and have (legally) avoided ever paying taxes on it.

In no way do I begrudge Mr. Bezos' success. He is entitled to every penny of wealth he's created because Amazon has transformed the world. Mr. Bezos should be rewarded for his vision and leadership. But at the same time he shouldn't be able to avoid taxes forever, just because he acquired his wealth by forming companies, rather than a weekly paycheck. 

There are many problems with the estate tax, but it also serves a purpose as ensuring that some tax is paid when massive amounts of wealth are accumulated.

Bitcoins and Hurricanes

Recently, millions of my fellow Floridians did what Floridians do when a major Hurricane is bearing down on them - they all ran to the local grocery store and bought as much water as they could. People lined up at 5 AM to be the first to buy ridiculous amounts of bottled water - so much water that grocery carts were tipping over as they tried to maneuver them to the checkout lines. Stores would run out of water minutes after opening only causing people to turn to social media to either update their friends about the scarcity at one location or seek advice on where else water could be found.

Craigslist was full of entrepreneurial sellers offering 16 oz bottles of water for $2, $3 or even $5 a bottle when a case of 24 usually sold for less than $4/case. Police agencies across the state had to divert officers from disaster preparation to ensure that fights didn't break out over the water. Such behavior wasn't just happening in coastal areas of the state that were expected to suffer widespread damage. Instead, it was happening everywhere, regardless of risk or time until expected impact.

In Gainesville, FL (located in the North Central Florida, roughly 90 miles from either coast) stores were out of supplies a full week before the earliest anticipated landfall.

Did people need that much water (particularly in the center of the state, 90 miles from each coast)?

People were buying water because they saw everyone else doing it and feared missing out. All the local water systems were fully functional, and every one of those people could have filled containers of water from their faucet at a negligible marginal cost. They could have filled bathtubs or gone to any number of stores and purchased clean 5 or 10-gallon plastic buckets with lids for $2 each with no wait.

These acts were irrational; the water had value not because people needed it for something, couldn't readily obtain it or because it was expected to appreciate in value in the future. No, it had value just because people wanted to make sure that they didn’t miss out regardless of the probability of that happening.

This behavior is a lot like what is now going on with Bitcoin and the other cryptocurrencies. Why does anyone need these cryptocurrencies? They are not particularly useful means of exchange. The transactions costs for using them are high. They are not universally accepted. They are not currently functional stores of value given their large prices swings over short amounts of time. They are challenging to safeguard and if stolen, completely untrackable. However, people are readily exchanging real money for these digital bits of data that live in the cloud.

Blockchain technology does offer tremendous potential in the future. But what makes Bitcoin better than Ripple? Ethereum better than Litecoin?

As we know, where supply and demand balance we have a real market price. If we talk about Bitcoin, in particular, the supply side of the equation is very well defined - there will only ever be 21M BTC. 

But other than for speculation, can anyone explain what drives current demand? Just because everyone wants something at this moment doesn’t mean that there is fundamental demand for the item (or an appropriate market price for it). In my opinion, the demand here is based merely on the perceived scarcity. People don't want to be left without if others have bought it.

What stops anyone (or any group) from deciding to start a competing cryptocurrency? Just this week we saw Kodak launch a cryptocurrency for photographers. What if OPEC agreed that from here forward all purchases would have to be in its proprietary "OCoins"? What if Amazon develops its currency? Any or all of these things can happen, flooding the market with new supplies of cryptocurrencies for which there would be a higher demand. 

After the storm risk passed, people were left with large amounts of bottled water, that was worth significantly less than what they paid for it. At least the water had some value. You could drink it over time. I'm not sure that Bitcoin or any of these other cryptocurrencies will have value unless they are the one that prevails. Currently, there are over 1,400 competing cryptocurrencies compared to 180 different paper currencies. A few of these digital coins will survive, but most will not.

Too many people who pour money into cryptocurrencies may wake up like millions of Floridians after Irma and realize that their cryptocurrency is worth far less than what they paid. Some people will have guessed correctly and will make money. Most will not and will lose money. But even those who guessed correctly shouldn't try to justify what they are currently doing as investing. Instead, they are gambling and hoping that they are right.

Math and the Federal Debt

The total US federal debt now exceeds 20 trillion dollars. A trillion is such a large number that most people have trouble even conceptualizing it. Think of it this way, there have only been 63,683,236,800 (~63B) seconds since the beginning of the common era 2018 years ago. One trillion seconds won't have elapsed in the common era until the year 31688.

Keep in mind, that's just one trillion. Our federal debt is 20x larger than that number and growing. In fiscal 2017 (which ended on September 30) we added $666 billion dollars to our federal debt.

In 2017 US GDP was approximately $19T. This means that our federal deficit spending added approximately 3.5% to our GDP.

Since almost all of the government's spending is a component of GDP, the balancing of our budget would result in GDP falling by 3.5%. The biggest exclusion of government spending from GDP is amounts paid to service its existing debt. In the last ten years US GDP growth has averaged 2.77%/year. Therefore, if we had balanced our budget each of these years, our economy would have shrunk instead of grown.

So when politicians talk about "balancing the budget" and "living within our means" we should ask them are they really willing to shrink our economy to do so?

As for paying off the debt - well you can forget about that. If we were to somehow balance our budget we would need to keep it balanced for the next 100 years and commit to paying down the debt at the rate of $200B a year. To put that in perspective, total US foreign aid was $22.7B.