Guest Commentary

The Great Game, Gold Arbitrage & Three Little Pigs

By Dan Amerman

March 14, 2007

An astute reader from Atlanta named Ken recently wrote the following in a letter to me:

"It seems that the game plan (for financial heavyweights) is to buy assets, real things that can't be papered away by the gov’t, and pay back with depreciated dollars."

Ken gets it. Ken understands the Great Game as it is being played at the highest levels of our monetary system. The Game has two halves: going long the real, and short the symbol. That is, going long real assets by owning them, and going short the dollar and the financial system by selective and advantageous borrowing. That way if you are a hedge fund manager, CEO or “private equity” investor who has essentially gambled the world monetary system on your speculations, and you collapse the financial markets and the value of the dollar when you guess wrong – you don’t jump out the office window. Instead, you enjoy an extraordinarily lucrative early retirement. Because you still own the real – and by destroying the value of the dollar, this just means that you no longer have to pay back most of what you borrowed to buy the real (in inflation-adjusted terms).

As an example, a financial “heavyweight” borrows $1 billion to buy $1 billion in real assets. If asset inflation continues, the asset climbs to $1.5 billion, he sells the asset, pays off the $1 billion borrowing, and walks away with half a billion. If the credit bubble he used to buy the asset unwinds and destroys 80% of the value of the dollar in the process -- no problem! He still owns a real asset that climbs with inflation, so it is now worth $5 billion in future dollars, while he only owes $1 billion. So he sells the asset, pays off the borrowing, and walks away with $4 billion as a reward for his contribution to the credit bubble. (A better way to look at this is in inflation-adjusted terms, where the asset maintains its value at $1 billion, inflation shreds 80% of the value of the $1 billion borrowing, knocking it down to $200 million, and thereby creates $800 million in equity in real terms). There are a number of simplifications in this example, but that is the essence of the Great Game.

The question then is – how do you personally react to this situation? One response is to loudly and frequently express outrage at the situation. That is a most justifiable response. Another response is to take your piggy bank and try to hide it somewhere where it won't be destroyed by the games other people are playing. That is a most understandable response. Still another response is to say: "I wish this wasn't happening, but it is, so how do I personally profit from it?” That is the most advantageous response.

THE THREE LITTLE PIGS

That "personal profit" part probably sounds pretty good. But, if we personally don't have the millions and billions to directly access the capital markets and play the Great Game – how can we join in the profits? For an answer, we are going to travel back in time, re-examine an old children's story, and explore the little-known key to how millions of households turned inflation into net worth.. The time we will travel back to is the last time inflation raged out of control in the United States, and most particularly, the period between 1972 and 1982, when the dollar lost 57% of its value over 10 years. The children's story is the Three Little Pigs, with the big bad Wolf being played by Inflation. For the Three Little Pigs we will meet three brothers: Dave, Mike, and Jim. Each brother accurately sees the Wolf of Inflation on the way, and each tries to protect himself by building a different kind of financial "house". That is our first variant on the children’s story: we are going to ignore the millions of households who don’t believe the Wolf is coming, and who lose their savings portfolios of straw and wood as a result. Instead, we will concentrate on historical brick-house performance.

The three Brothers each inherited $9,000 in 1972. Each had already used a mortgage to buy a home in 1969, there was a bit of a run-up in inflation and housing prices already by the early 1970s, and the value of each house by June of 1972 was up to an exactly average (rounded national median value) of $18,000, with a $9,000 mortgage outstanding. So each brother started with $9,000 in cash, a $9,000 mortgage and $9,000 in home equity.

DAVE AND HIS HOUSE OF STOCKS

Brother Dave was a well read and educated kind of guy, and being financially sophisticated, he knew that common stocks were not only the key to long term wealth, but were an excellent hedge against inflation. So our first Little Pig sold his house, got his $9,000 in equity, and combined it with his $9,000 inheritance to buy $18,000 in stocks. Being sophisticated, Dave didn’t tried to beat the market, but instead bought a well-diversified basket of common stocks, one that precisely tracked the performance of the Dow Jones Industrial Average. The Dow was at 929 in June, 1972, and after ten years of inflation averaging 8.73% -- it was at 812 in June of 1982. This meant that the value of Dave’s portfolio had fallen from $18,000 down to $16,000, a loss of 13% over the ten years (the more precise value would be $15,733, but we are generally rounding to the nearest thousand).

Dave was disappointed to see that his stocks had not done as well in fighting inflation as the finance professors had indicated they would, even in nominal terms. However, Dave was downright horrified when he remembered to do what the newspapers so often forget, and converted his stock price performance to real dollar (inflation-adjusted) terms. By 1982, after ten years of inflation, the dollar was only worth 43 cents in terms of 1972 dollars. So when Dave took his $16,000 ending value in 1982, and converted it to constant 1972 dollars, he found that his ending stock value was only $7,000. In real terms, Dave had managed to lose $11,000 of his $18,000 starting investment – meaning a real loss of 62% – by relying on common stocks to beat inflation.

(The percentages are based on the actual numbers, not rounded to the nearest thousand. The cost of housing for Dave for ten years and stock dividends are two of the many items left out of this simple educational illustration, see “Assorted Caveats” below for some more discussion.)

MIKE AND HIS HOUSE OF REAL PROPERTY

Brother Mike was a cautious kind of guy who didn’t believe in either the stock market or being in debt, but did believe in the value of real property in times of inflation. So our second Little Pig took his $9,000 inheritance, paid off his mortgage, was now debt-free, and hunkered down in his $18,000 house to await the storm. The Wolf of Inflation blew hard and battered the dollar, the economy, the markets and personal savings for ten long years – and by June of 1982, Mike’s house was now worth $41,000, again the exact national average. So, Mike made an apparent profit of $23,000 or 125%.

Mike felt pretty good about how his house withstood the ravages of inflation. Until he ran the numbers and took into account that a 1982 dollar was only worth 43 cents in 1972 dollar terms. Adjusting for inflation, Mike’s $41,000 house was only worth about 17,500 in 1972 dollars – he had lost $500 (or 2.5%) in real terms over the ten years. For the problem was that by 1982 average mortgage rates were up to 16.70%, being able to afford a mortgage payment was a major problem and because of this, housing price inflation was not quite keeping up with general price inflation during the peak times (something we would all be wise to remember).

Now, this is not to say that Mike did poorly. He almost maintained the real value of his investment during the most powerful bout of inflation in recent American history, and he did have a place to live for ten years without making mortgage or rent payments, money that he could have used for investing. But owning the house, debt-free, did not directly make him money in inflation-adjusted terms.

JIM AND HIS HOUSE OF GOLD, PROPERTY & DOLLAR-SHORTING

Brother Jim liked real estate for fighting inflation, and he liked gold too. Our third Little Pig wasn’t thrilled with debt, but he did have a bit of a brainstorm. “Jimbo,” he thought to himself, “if I am convinced that the value of the dollar is going to be plunging – why should I pay off my debt now, when the dollar is expensive, when I could wait and pay off my debts when a dollar is cheap?” So, Jim did not pay off his mortgage – he refinanced it up to $14,400, using a 30-year fixed-rate mortgage, which brought it up to an 80% loan-to-value. He then took the $5,400 he pulled out of his house equity, added in the $9,000 he inherited, and used the combined $14,400 to buy 232 ounces of gold, at the then current price of about $62 an ounce. (The price is as of June, 1972, to keep comparability with the housing and inflation numbers. Yes, gold did not become legal for individual Americans to own until January 1, 1975, but we’re treating it as if they could, to properly capture the inflationary period over a full ten years.)

So Brother Jim had a starting position in 1972 of owning an $18,000 house, owning $14,400 in gold, and owing $14,400 in a long-term and fixed rate mortgage. The Wolf of Inflation huffed, and puffed and blew hard for ten years, and three major financial changes worked together to dramatically change Jim’s net worth by June of 1982. The first change was that the value of his house had climbed to a nationally average $41,000, just like Brother Mike, meaning it did not quite keep up with inflation, but lost about $500 in real terms.

The second financial change was that owning gold grew quite popular after ten years of sustained high inflation, and by June of 1982, gold was up to about $315 an ounce. This meant that Jim’s 232 ounces were worth about $73,000, meaning a nominal profit of $59,000, or about 407%. When Jim adjusted for inflation, he was much happier than Mike, for even after discounting 57% for the decline in the dollar, Jim’s initial $14,400 had turned into $32,000 for a profit of 120% in real terms.

The third financial change, was that unlike Mike or Dave, Jim had borrowed the equivalent of his 80% of his net worth in a fixed-rate mortgage, that effectively constituted a long-term, tax-advantaged and relatively low-cost short on the value of the dollar. By 1982, inflation had shredded 75% of the value of that mortgage, including both the depreciation in the value of a dollar, and the value of having a long term loan locked in at a far below market rate. So Jim’s debt had fallen from $14,400 down to $3,000 in real terms.

JIM’S WEALTH & ITS SOURCES

Adding it all up, Jim’s net worth in nominal terms went in ten years from $18,000 to $101,000, when we add the $73,000 in gold to the $41,000 in house value, and then subtract the $13,000 in remaining mortgage outstanding. When we look in nominal dollar terms, it appears that Jim made his money in gold and housing, while the mortgage paid down a bit. However, when we adjust all three factors into real dollar terms, we see that:

Jim made about $17,500 on his gold investment (1972 dollars)

Jim lost about $500 on the value of his house

Jim made about $11,000 through inflation shredding the value of his mortgage (and a bit of mortgage amortization)

When we add these up, we find that Jim’s net worth has climbed from $18,000 up to about $46,000 in real terms, meaning an inflation-adjusted total return of about $28,000 (155%) over the ten years of sustained inflation. Jim simultaneously went long the real and short the symbol, and when the symbol (the dollar) then had a loss of confidence and plunged in value – Jim’s net worth soared as a direct result.

While the first Little Pig lost 62% of his net worth investing in common stocks in inflationary times, and the second Little Pig lost 2.5% in real terms through owning real estate – our third Little Pig turned those problems into a 461% nominal profit, and a 155% real dollar profit. As an individual of quite limited resources, Jim played the Great Game and played it well.

THE GREAT IRONY

Gold did excel during the inflationary 1970s and 1980s, as it may again if another round of major inflation awaits us. This performance is well known. The irony, however, is that gold is not where most households made their money. As documented in the newly published book, The Secret Power Within Your Mortgage (more information below), when we track exact national averages from 1972 to 1982, the average homeowner saw their real equity grow from 25% of their mortgage amount to 500% of their mortgage amount as a direct result of being effectively short the dollar during a sustained period of relatively high inflation – even while real estate prices where slightly declining on an inflation-adjusted basis.

This extraordinary growth is far from theoretical. The inflation-driven destruction of most of the value of the outstanding mortgages was what nearly destroyed the Savings & Loan industry back in the 1980s, and the author spent years as a young investment banker trying to help savings institutions survive the massive damage. Indeed, this event constituted one of the largest transfers of wealth from institutions to individuals in American history. You likely know someone who held onto their house for decades over this era, and became “house rich” as a result, enjoying the benefits of a huge equity with their home even as they made little $50 or $100 monthly mortgage payments long after the national average had moved to over $500, then up to $1,000. Yet, to the extent people think about it at all, they often mistakenly believe this increase in personal wealth was a result of the run up in home values (which merely more or less kept pace with inflation), rather than inflation effectively forgiving most of their largest debt and making most of their payments.

CHECKING THE BACK DOOR

Sometimes if the front door is locked, you need to check out the back door. If direct asset purchases are problematic, and your net worth is equal to your assets less your liabilities – liability management becomes your back door. A back door which is standing wide open -- and constitutes a highly effective way of shorting the value of the dollar in a long-term and tax-advantaged manner. It is this back door that created enormous amounts of homeowner wealth the last time inflation went out of control in this country. It is creating the back door that is key to the Great Game as it is being played right now, for when it finally unwinds – the back door of inflation shredding the value of the debts is what will allow many of the people who created the problem to walk away wealthier than ever. In some cases this will be accidental (as it was for most homeowners in the 1970s), but for the more astute investors this is quite deliberate – as it needs to be for you, if you are to enjoy the same protections and profit potential.

When you put a “back door” on your long-term wealth preservation and creation strategy, then you have a 1-2 combination. The assets you lead with are then a matter of choice, and the effectiveness and costs of this strategy will vary widely with that choice. Gold, the choice for Jim illustrated above has powerful advantages for near term and major inflation – but is also quite expensive in terms of cost of carry, as you won’t have interest, dividends or rental income to offset the mortgage payments. There are pros and cons to gold as there are with a diverse range of alternative investments. Indeed, there is a good case for a diversified basket of contrarian investments for the assets.

ASSORTED CAVEATS

This educational essay occupies a kind of middle ground, being long enough to explore a few aspects of an innovative and moderately sophisticated financial strategy – but not long enough to even begin to explore all the associated complexities, which are not technicalities but will be vitally important to determining the final results. As one example, consider leaving the dividends out of Brother Dave’s stock strategy. Yes, it is true that the real source of inflation fighting power for common stocks over the long term is dividends, and their assumed reinvestment and exponential compounding over time. Which is precisely why there is no historical evidence that common stocks at current historically puny dividend levels are an effective investment for fighting inflation. From there, we could go on for multiple chapters or even books, in properly exploring that issue. (Chapter 6 from the author’s 1993 book, “Mortgage Securities”, is a good start.)

The investment advice disclaimer below is very important, and should be read carefully. A small selection of the many other important issues necessarily left out of this essay are the cost of housing for each of the three brothers, the value of the free cash flow for Mike, tax implications of each strategy, and the impact of moving on homeowner returns.

Some of the numerous issues that we haven’t had time to touch on here, are explored at length in the book linked below. Some of the most important of these issues revolve around finding the balance between profiting from turmoil and surviving turmoil – excessive debt or the wrong kinds of debt will increase your risk, not decrease it.

The full title of the new book referenced in this article is “THE SECRET POWER WITHIN YOUR MORTGAGE: Use Historically Proven Methods to Protect Your Net Worth Against a Fall in the Dollar & Prosper During Inflationary Times – Updated With Modern Hedge Fund Techniques & Optimized With Your Insider Knowledge”. The book spends 3 chapters reviewing in detail what actually happened with mortgages, inflation, and homeowner wealth during the 1970s, and then takes 12 chapters to discuss and illustrate the practical application today of those principles for homeowners and investors. The book can be found at the website MortgageSecretPower.com , and a free 26 page sample chapter is available for download there. Daniel R. Amerman is a Chartered Financial Analyst with MBA and BSBA degrees in finance, and almost 25 years of professional experience in working with mortgages and investments. His primary website is The-Great-Retirement-Experiment.com , a series of pamphlets, articles, recordings and books that are dedicated to taking a holistic and people-based look at the long-term future of Boomer finances.

Contact Information:

Dan Amerman

Website: http://mortgagesecretpower.com/

E-mail: mail@the-great-retirement-experiment.com

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