Adventures in the Investing Food Chain

Adventures in the Investing Food Chain

One of my recent post, "Playing the Mutual Fund Lottery," wasn't written entirely by me -- my friend, CPA, and trusted tax advisor, Tom Wheelwright, was the primary author.

While the piece was written in jest, Tom made valid points about why retirement plans filled with mutual funds are risky. As expected, the rader response was both positive and negative. Some people just didn't get the joke, or couldn't learn from its absurd extremism.

Unfunny Lessons

Obviously, the lottery is for losers, casinos are for gamblers -- and mutual funds are for dreamers. While there are some good funds, for the most part the only people getting rich from them are a few key employees of the mutual fund companies.

As you've no doubt read, Wall Street is paying out record bonuses to employees even though most funds perform marginally. In March of this year, the Wall Street Journal reported that Congress finally opened an investigation into the 401(k) and mutual fund industry. It's about time.

In my lottery column, Tom pointed out that tax laws are horrible for mutual fund investors. These people are being taken to the cleaners not only by the fund companies but also by the federal government. So to all of you who love mutual funds and hated the column, you may want to read it again to glean some of its not-so-humorous financial lessons.

The Investing Food Chain Explained

While I'm not a CPA, I am an investor. As such, there are a number of reasons why I don't care for mutual funds. One comes from a lesson my rich dad taught me. He said, "Humans are at the top of the food chain, and capitalists are at the top of the investing food chain."

To illustrate, he created the following diagram:

In the investing food chain, capitalists are at the top and workers are at the bottom. You'll notice that mutual fund investors are just above the bottom.

Professional investors often ask, "What position are you in?" That's another way of asking, "Where are you in the investing food chain?" Bankers, as a general rule, want to be in first position. If anything goes wrong with an asset, they want to get paid first. That's what being in the first position means -- you get paid first. So one of the reasons I don't care for mutual funds is simply because mutual fund investors are close to the last to get paid.

During the Enron debacle, it was workers who took the pounding, not bankers. Not only did Enron employees lose their jobs, many lost their retirement savings. That's because they were at the bottom of the investing food chain.

Still not convinced? Try asking your banker if he or she will lend you millions of dollars to invest in mutual funds or stocks to fund your retirement. I suspect the answer will be a polite, "No, thank you." Bankers want to be in the first position, not the last.

More Food Chain Lessons

There are other lessons to be learned from the investing food chain. One is the power of debt in contrast to equity. Debt holds a higher position than equity, and bankers and bondholders are in debt positions. Preferred stocks, stocks, and mutual funds are in equity positions.

The takeaway here is that most amateur investors try to get out of debt positions and into equity positions, where they invest with their own money or assets. Professional investors would rather be in a debt position -- investing with a banker's money, for instance -- simply because debt is less risky than equity.

Another term professional investors use is "subordinated debt." This is simply debt in a lower position on the chain than that of another claim on the asset. Many homeowners have it in the form of a second mortgage. If they fail to pay this subordinate debt, the banker in second place gets what's left after the banker holding the first mortgage gets paid.

Most homeowners have debt that's known as recourse financing, or full-recourse loans. As a professional real estate investor, I ask for non-recourse financing.

What's the difference? If a homeowner has recourse financing, that means the banker can go after the homeowner's other assets if the mortgage isn't paid. If the bank forecloses on the home and there's not enough money from the sale to cover the loan, the banker can sue for the homeowner's other assets, such as cars, stocks, bonds, and so on.

With a non-recourse loan, the banker can only get the property the loan was made against. The borrower's other assets are off-limits, although most bankers will try to get those as well.

Subprime Debt Feeds Off Workers

The subprime mess is another example of big fish eating little fish in the investing food chain. When interest rates dropped, mortgage brokers began calling people who had no business borrowing money and offering them loans they could never hope to repay. With low interest rates and consumer demand, the price of homes went up and caused a real estate bubble.

Now that the bubble has burst and home values are dropping, many little fish owe more on their homes than the home is worth. I suspect the real estate bubble will continue to deflate as more and more people are forced into foreclosure. People will lose everything because they can't pay their full-recourse loans. Not only will they lose their homes, but many will be forced to liquidate their other assets.

Here's the worst part: Much of the money for subprime mortgages came from the bottom of the food chain. Billions of dollars for these loans were drawn from workers' pension funds, where they were touted as "collateralized debt obligations," or CDOs (a few years ago they were called junk bonds).

Consequently, it's estimated that employee pensions could lose $75 billion dollars on bonds backed by subprime debt. Not only are workers losing on the value of their homes, their retirement plans have been poisoned, too.

Compare and Contrast

So what can you take away from such investing food chain behavior? This contrast might be useful:

My rich dad trained his son and me to be capitalists, and we become entrepreneurs and real estate investors. Instead of working at jobs and investing with equity, we create jobs and invest with debt with our bankers' money. My poor dad encouraged me to be an employee and trust my money to a pension plan.

Simply put, one dad pointed to the top of the investing food chain, the other to the bottom. My question to you, then, is, "Where are you on the food chain?"