Adverse Selection

The Arrogance of Wall St.

2009-07-17T09:48:00.000-07:00

Goldman Sachs is a smart firm...very smart. But their recent position on the re-purchase of warrants from the Treasury has me a little perplexed. Allow me to explain. Goldman took over $10 billion in TARP money from the Treasury to insure against insolvency. In exchange for the $10 billion or so of cash from the Treasury Goldman issued warrants to the Treasury (read: taxpayers). Warrants give one the right, but not the obligation, to purchase shares of a company's stock at a certain price. It's very similar to an "option" with the key difference being the length of time one has to exercise the warrant (the life of a warrant is typically 5-10 years while an option is generally shorter than that, sometimes only months). Here's an example using the Goldman case (I'm too lazy to look up the exact numbers but I think an approximation will suffice).

The treasury receives twelve(12) million warrants that allow them to buy Goldman stock at $122/share. Last I knew, Goldman was trading at $150 (or thereabouts). If the Treasury exercises its right to buy the shares, it would buy them at $122/share and sell them for $150/share, making a tidy profit of $372,000,000. By my rough calculations, that's about a 5% internal rate of return. Not bad for 12 months. But, it's not quite that easy. The contract Goldman signed with the Treasury allowed them to buy these warrants back from the Treasury. But price is negotiable. So what should Goldman pay? Whatever the Treasury wants. I'm guessing the Treasury won't give up their warrants for the $372,000,000 because of the tremendous long-term potential they see in Goldman. Remember, as Goldman's stock increases, so does the Treasury's profit. Since Goldman is one of the first to pay pack their loan, I would bet the treasury is eager to show the taxpayer what a good deal the TARP is for them and is asking for a little premium on their warrants. In other words, more than $372,000,000 and more than Goldman is willing to pay. If I'm the Treasury (and it's a good thing I'm not), then I would NOT let go of those warrants for any less than $750,000,000, yielding an attractive 10% IRR. That's a nice double digit number. It's O.K. for Goldman to 'stick it to the man' as long as the "man" is not the Treasury/tax payer/life saver.

If somebody saves your life, you take what they give you. I'm firmly rooting for the Treasury on this one!

Thoughts on Obama's Plan for Restructuring Financial Services

2009-06-25T09:11:00.001-07:00

Last week, Tim Geitner laid out a plan to restructure regulation within the financial services industry. The net result was an additional three government regulatory agencies with clearly defined mandates, which, among other responsibilities include monitoring banks, hedge funds, and consumer protection. One can easily find Mr. Geitner's testimony online (which I will find and post) but, in essence, it boiled down to 1) require banks to hold more reserves and keeping a close eye on banks that are "too big to fail" 2) require certain private investment vehicles to register with the SEC and 3) create a new division whose sole responsibility is to protect consumers. Here are a couple of thoughts. But before I share those, I should disclose (lest there be some agregious misconception that I know what I'm talking about) that I have no idea how to fix the problem. If I did, I would be there...fixing it (and making a lot more money). While I'm generally opposed to creating more governement agencies, I'm sure Mr. Geitner and the entire administration were thoughtful in their proposal, and it is certianly better than anything I would have come up with.

1) I don't think more "regulation" is THE solution, nor was lack of regulation the problem. On the face of it, it would seem Mr. Geitner does think regulation was the problem. I get it, that's what he does, he exchanged a multi-million dollar private contract for a multi-million dollar public contract and his party line is, by necessity, "Re-establish confidence in the banking sector via broader regulation." But this is a faux-solution that is only optical in nature. Nope, more regulators won't work because employees working at Hedge Funds, Investment Banks, and other Financial Institutions are smarter than regulators. These firms made billions of dollars maneuvering through the OTC, FDIC, SEC, Treasury, FED, and the office of Thrift Supervision (just to name a few).

2) I think there is a misalignment of interest between banks that are too big to fail, the shareholders, and the public. If a bank is too big to fail, then the purpose of that bank should NOT be to maximize shareholder wealth. Since maximizing shareholder wealth requires banks (because it is economically rational) to circumvent regulation and shoot for the moon. In other words, pushing the price of the stock higher and higher sometimes means you take more "risks" (that, in theory, you are compensated for). In the end, you have a limited liability since many of your liabilities (deposits) are insured by the state. However, if you are deemed systemically relevant (a very slippery definition) then you should have the public interest as a primary objective with shareholder value subordinate to that of the public. So this position, I think, creates a lot of philisophical problems for capitalism.

Regulation may not be THE solution, but PART of the solution. What I believe we are grappling with are the incentives of capitalism. One tenent of capitalism is constant innovation and efficiency which result from risk taking at some level. Unfortunately, the higher the climb, the steeper the fall.

Investing in the New Economic Paradigm

2009-06-15T10:01:00.000-07:00

Image by ocean.flynn via Flickr

I'll continue with the sparse summer posting. It seems these days my time is spent passed out on the couch from overconsumption of otter-pops.

There's little doubt the last two years have changed the rules for investing and managing risk. Constructing your investments based on historical information worked as long as financial markets dealt the same types of risks (though the timing around the manifestations of those risks were completely random). In short, we all learned that when dealing with models, garbage in equals garbage out. Yes, models are helpful and they help crystallize your thinking, but it should not be a substitute for a good deal of independent critical thinking. So with all the uncertainty surrounding where the market is headed over the next 1,3,5, or 10 years I thought I would share a couple of thoughts. Perhaps they will be of some benefit (but probably not).

1) The current recovery may be little more than a "Dead Cat Bounce". Perception is reality. Based solely on the number of editorials, articles, and reports I've seen over the last few weeks, I conclude the majority of US citizens assume the worst is behind us. Which is extremely curious. Based on fundamental information only, there is no justification of a recovery. In fact, less than 15% of all the stimulus has been deployed. Although this is curious, its not surprising. In a previous post I noted Mordecai Kurtz's (Stanford) research on behavioral economics. Kurtz concludes fully four-fifths (80%)of the movement of a stock price is based on behavioral factors, not technical. Markets move up when the majority of investors hold optimistic expectations of the economy and down when the collective view is pessimistic. To me, this conclusion means the American psyche could be in for a huge disappointment. Banks and Insurance companies still have a tremendous amount of exposure to commercial mortgage backed securities, which, by the way, have yet to correct for pricing. If this happens, unemployment could easily reach 15% which, I imagine, will have a devastating affect on investors who assumed the worst was behind us.

2) If traditional asset allocation, modern portfolio theory doesn't work, what does? Perhaps a prudent way to evaluate investments is with three scenarios in mind; growth, depression, inflation. This allows one to be less rigid in their approach and forces investors to consider the macro environment before making a decision, instead of blindly following an allocation model. How much you allocate to each is based on your personal macroeconomic perspective. True diversification is a moving target. Writing in broad generalities, in the growth bucket you would target public stock, high-yield bonds, Real Estate, and avoid T-bills and some commodities. In the Depression bucket you would focus on holding T-bills, Gold, Foreign Reserve Currencies, and short duration government bonds but avoid exposure in US stocks or high-yield bonds. Inflation warrants investment in Commodities, Infrastructure (like toll roads, power, hospitals, etc.)and international markets. You might allocate a third of your resources to each bucket (growth, depression, and inflation) and tilt the allocation one way or the other based on your outlook. One note, exercise prudence when purchasing or selling securities to avoid buying at the height of the market. You could either dollar-cost average (purchase $200 of XYZ security every month/week/etc.) or use some light market timing. An example of "light" market timing would be waiting to buy gold. Gold is trading at historically high levels. Rather than wait for it to return to "normal prices", which may not happen for a few years, you would wait for it to come down, say 10%, and then make your purchase. In other words, you're simply being more opportunistic when you make your purchases. Unless you have a good understanding of a sector, its probably best to dollar-cost average.

Anyway, I'm not providing specific advice, nor am I providing any advice for a fee (now you can't sue me). Rather, I'm simply introducing a couple of ideas that readers might find helpful and would like to study in more detail (on their own).

The New York Common Fund Scandal

2009-05-10T20:04:00.000-07:00

Thanks for bearing with me throughout the hiatus. Truthfully, aside from the Chrysler bankruptcy, there wasn't a whole lot going on. However, if you've been reading the financial times or the wall street journal you'll have come across several stories regarding Cuomo's latest smackdown involving one of New York's largest pension plans. Why should you care about this? Because some of the underlying details actually get to the problem with decision making in the institutional world that is equally applicable at the individual level.

Here's what happened. The New York Common Fund is a public pension fund, one of the largest in the world. The fund is being investigated for allocating funds to money managers who made political/personal contributions. That's basically it. Most public pension funds have a Board of Directors acting as a check and balance on what the internal investment team is doing to avoid conflicts such as these. However, at the New York Common fund, they have a sole decision maker, the Comptroller. This Comptroller allegedly allocated money to several external money managers who investigators say also contributed heavily to the local political party. These "contributions", ahem...bribes were made by investment managers directly (think hedge funds and private equity funds) and also by placement agents. Placement agents are basically hired by hedge/private equity funds to help them raise money. They are paid a commission on any money they bring in. Cuomo says these placement agents paid fees to the comptroller, or his party, in exchange for several millions of dollars worth of commitments. Also, the NY Common fund hired consultants that almost had discretionary authority and approved several of these allocations. It's messy. Of course now it's turned into a massive witch hunt that will ripple across the institutional universe. I'm not to naive to think this doesn't go on elsewhere.

There are obvious lessons here, but a couple I think we can apply personally. The first mistake is having a sole decision maker. It's a stupid idea for institutional investors and it's a stupid idea for individuals. You should never make a major money decision without a second opinion. You need someone else to help you think through the idea and help you discover if perhaps you are seeing something that simply isn't there. Second, many pension funds rely on consultants for opinions. This might seem like a good idea. But not taking any action unless a consultant approves such action is essentially giving de facto discretionary authority. This can be equally damaging. So if you don't want to make decisions on your own, and you don't want to rely too heavily on a consultant (or perceived "expert"), what do you do? Something in the middle. Make sure you listen to others but use some good judgment. Ask yourself, why would this individual be considered an expert in a certain field? What are his motives? Are they aware of other opportunities? Are they on the hook for the decision? Do they have money at stake (in other words, if I lose, do they lose?)?

Being honest of ones intellectual and behavioral limitations could save thousands of dollars. It's not enough to be right or wrong, but to be right or wrong for the right reasons (or something like that). Good luck.

Double Standard for Auto Industry

2009-03-31T17:43:00.000-07:00

I'm going to field this question as I walk out the door because I don't think it's too difficult. Many are wondering why the Obama administration is taking such a hard line with the auto manufacturers while being so tolerant to the banks. Here are five reasons, in no particular order.

1. Banks pose greater systemic risks than the auto manufacturers. Although the effects of auto manufacturers going bankrupt would be immense, it would be worse to let the banks fail.
2. Banks are operationally solvent. Meaning, they have enough money to pay their bills and have only taken money from the Government to comply with regulation. Auto manufacturers can't even pay their bills, which is mostly due to their high labor costs.
3. Auto makers have been losing market share for the last ten years or so. Up until last year, banks have made money every year.
4. The White House is teaming with former Wall Street executives, which may account for why they understand the wall street funk.
5. The automobile industry has a lot more long-term uncertainty surrounding their business model (i.e. cars that run on alternative fuels, etc.). On the other hand, the low interest rate environment has actually helped banks this year as the spread between what they pay the depositors and what they lend is relatively wide. The majority of banks will be profitable this year (by profitable, I mean in a healthy way).

Insights from PE Conference Part II

2009-03-30T09:47:00.000-07:00

More of the same doom and gloom scenarios with some interesting comments from the former head of the EBRD (European Bank for Reconstruction and Development).

-There are major issues with banks in Europe since it is not uncommon for a bank's subsidiary, which functions entirely separately from its parent, to need additional capital to prevent a failure. Here's the problem, the parent bank is located in a different country. So XYZ bank is headquartered in Poland and has an Italian subsidiary that needs additional capital. Taxpayers in Poland have to put up the money to save an ostensibly Italian bank. That's caused some contention.

-Eastern and Central European consumers are more reselient than U.S. consumers because they are not as demanding. Most Europeans in the developing regions are more resourceful and use to living on meager incomes. So it's unlikely the consumer will be as distressed in those areas as they are in other developing regions.

-Lots of talk regarding the deleveraging of the U.S. consumer. That's a fancy way of saying americans are going to save more. According to a brand new study by McKinsey, every percentage point gained in the personal savings rate translates into $100 Billion of decreased spending, which can be a major drag on the economy. This of course, assumes income growth remains stagnate (which it has since 2000). If incomes increase, then spending can increase and savings can grow.

Insights

2009-03-26T14:21:00.000-07:00

For the next two days I'll be at the Thunderbird Global Private Equity Conference. The first couple of presentations have been interesting. Here are some tidbits.

Regarding TARP Money. An executive from a large bank that took money from the TARP had to rescind job offers to several candidates because he was informed that banks who recieve money from TARP can't hire non-U.S. citizens. Ouch. Can you say talent flight?

On the Treasury's new plan. Seems like consensus is that the new proposed partnerships (I know, I promised a post on this and will complete it soon) between the governement, banks, and private money, is a logistical nightmare. I can't say I'm surprised. You have three separate parties trying to establish a "fair" price. And everyone has a different agenda.

More shoes to drop. Not to go into detail, but bond spreads are predicting defaults to go from approximately 5% to 15%. That's not great news for employment, and, by extension, GDP.

China's political backlash. Earlier this week China said it was worried about the solvency of the U.S. That should scare most people. China is the largest holder of U.S. treasuries. If China decides to dump them for a safer investment, we would have massive hyperinlation (I know, that's redundant). I don't think that will happen for two reasons. First, there really aren't any other currencies I can think of that are safer and second, they'd be shooting themselves in the foot. China's GDP is like 50% exported and the U.S. is the largest net buyer. Guess what happens if we can't afford their goods due to our hyperinflation?

More to come.

Summing up the AIG bonus debate

2009-03-22T21:27:00.000-07:00

Hard to watch/listen to any news without hearing about AIG's $165 million dollar bonus payout. I guess I was a little surprised how quickly the story spiraled out of control. My blood started to boil when I heard a prominent democrat (I won't mention HER name but will only say that it rhymes with "smelosi") illustrate what could generously be referred to as a complete lack of insight, knowledge or even a general awareness of the circumstances and points of debate regarding the bonuses AIG paid out to their employees. I'm not making a political statement. This is not a political blog. Many members of congress, on both sides of the aisle, misunderstand the situation but I only heard her comments due to her public profile.

What Happened
AIG received $170 billion from TARP and posted a 4th quarter loss of ~$60 billion. A week ago AIG announced it was paying out $165 million in bonuses to various employees. Total payouts by AIG could reach over $1.2 billion. The difference accounts for additional performance and retention bonuses. Can't wait for that to happen. And you think $165 million is bad?

So here's a smattering from around the web. I tried to find arguements on both sides, but gave up after discovering there really isn't a logical contra-arguement against the paying of the bonuses, mostly just populist rage. Here what strikes me as funny, everybody hates these guys are getting paid, but no one knows for what or for when and everybody hates the 90% tax. Tell me again why we're having this arguement? Is it even productive?

As you can expect, comments range all over, from very sophisticated "These bonuses are terrible but must be paid as a matter of contract" to "Hey, Pa, come n' see what those @#$%* from AIG that knocked up Jenny done did!" Alas, the apparent risks of a computer in every home.

First....

Rick Newman U.S. News explains why we are so outraged.
Myriad experiments in behavioral economics have found that people are willing to pay to punish members of a group whom they believe to be shirkers or free-riders. In other words, people are willing to make themselves worse off (they have to pay their own money) in order to insure that others don’t get undeserved rewards. But when it comes to the A.I.G. bonuses, the costs of clawing them back are trivial at best, while the public satisfaction at seeing what feels like justice being served will be great. Getting all worked up about this money may not, strictly speaking, be rational, but I think that paradoxically, if some of this money is clawed back, it’ll increase the chances that we’ll be able to keep dealing with the ongoing crisis in a rational way in the future.

On to the rational minds...
Andrew Ross Sorkin (Editor, NY Times).
The fundamental value here is the sanctity of contracts. Imagine what it would look like if the business community started to worry that the government would start abrogating contracts left and right. A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it. Let them leave, you say. Where would they go, given the troubles in the financial industry? But the fact is, the real moneymakers in finance always have a place to go. You can bet that someone would scoop up the talent from A.I.G. and, quite possibly, put it to work — against taxpayers’ interests.

SmartMoney
For the stock market, this is a rally-killer. Or worse. No one seems to want to determine whether the people getting this money deserve it or not. Maybe some of them don't—maybe some of them are even the bad people who got AIG into trouble in the first place. But maybe some of them do deserve it. Maybe there's one guy or gal who has just done some brilliant trade that has made taxpayers billions, at least offsetting some of the billions in losses. Should that trader not get a bonus? No one seems to care that the 90% tax will apply to all banks that have accepted federal money, not just to AIG. That includes banks like Wells Fargo, who told Treasury secretary Henry Paulson that they didn't even want the money when the Troubled Asset Relief Program (TARP) was enacted last October. Reluctantly, Wells took the money at Paulson's urging, as did other healthy banks such as JPMorgan. Now virtually every employee of every one of them faces a 90% tax on their bonuses. No one seems to care that the Internal Revenue Code is designed to collect federal revenue, not to punish particular classes of people. These employees will simply leave. Or they will turn their brains off. Either way, the taxpayers whose money is at stake in these companies will be hurt—because these companies will crash and burn.A successful economy depends more than anything else on the rule of law. There has to be a stable set of rules governing the interactions between economic players, and between players and the government.

From the Wall Street Journal
If the A.I.G. bonuses looked were the quintessential example of Wall Street self-dealing, the House’s bill looks like a quintessential example of blunt and ill-considered political policymaking. On top of that, one logical consequence of this bill would be that companies will simply pay people much higher base salaries, which takes us in the wrong direction.

Henry Blogett at Clustershock
Today’s frantic passage of the Populist Rage Tax was a new low in the US government’s response to this crisis. It shows just how likely we are to doom ourselves to a decade or more of misery — by choking our markets, closing our borders, turning our banks into tools of social policy, and wrecking what’s left of our economy. If the “TARP bonus” bill the House passed today becomes law, any of the hundreds of thousands of people who work for Citigroup, Bank of America, AIG, and nine other major US corporations will have to fork over 90 cents of every dollar they make that puts their household income over $250,000. That’s household income, not individual income. If you’re married and filing singly, you’ll have to surrender anything over $125,000. Indefinitely.

Eric Etheridge, NYTimes
As the financial crisis has evolved its moral has been simplified, grotesquely. In the beginning this crisis was messy. Wall Street financiers behaved horribly but so did ordinary Americans. Millions of people borrowed money they shouldn’t have borrowed and, not, typically, because they were duped or defrauded but because they were covetous and greedy: they wanted to own stuff they hadn’t earned the right to buy. But now that taxpayer money is on the line the story has changed: innocent taxpayers are now being exploited by horrible Wall Street financiers. The guy who defaulted on mortgages on his six spec houses in the Nevada desert has turned himself into the citizen enraged by the bonuses paid to the AIG employees trying to sort out the mess caused by his defaults.

David Harsanyi at DenverPost

Here's an idea: If you stop nationalizing banks, there will be no need to engage in phony-baloney indignation over bonus payments anymore. Don't we want AIG to succeed and get off the government dole? What sort of employee would work for an entity that doesn't honor its contractual obligations? How many valuable employees will walk away from such a company?

Chris Bowers at OpenLeft describes why the tax needs to be broad

1. Passing Constitutional Muster: Lawrence Tribe has written that, in order for a bonus tax to be constitutional, it must be "sufficiently general to avoid classification as a measure targeting solely a closed class of identified and named individuals." The more narrow the bonus tax legislation, the less likely it will be ruled constitutional. As such, making the bonus tax as broad as possible is necessary to the survival of the legislation.

2. Weeding out thieves from the bailout program: The bonus tax must apply to all participants in the bailout program, so as to guarantee that only those firms and people interested in helping the economy participate. Anyone who considers their personal compensation to be more important than helping the economy needs to be kept as far away from the bailout program as possible.

3. Addressing a broad culture of greed and excessive executive compensation: I agree with President Obama that the bonus scandal is a "a symptom of a larger problem," based on a broader "culture of greed.". As such, if the bonus tax that is aimed only at AIG, then it simply is not good enough legislation. The bonus tax has to make a broad dent in broader problem of excessive financial services industry employee compensation, which is directly connected to our ever widening income inequality. This is one of the best opportunities I can ever remember to pass such a law.

Banking Paralysis

2009-03-14T14:19:00.000-07:00

Some of you could probably tell I've been intentionally avoiding posting on the economy specifically for a few weeks as I was waiting for the stimulus mess to sort itself out. I hoped to post something about President Obama's stimulus package in more detail, but, after following several publications over the last couple of months on the matter, determined there are enough sites out there to explain what the stimulus means to the "average Joe." But I would like to address a couple of items that have come up in conversations/emails. They are 1) What is taking the Banks so long to get their act together and 2) What does a Bank "Recap" mean?. So there's still lots of discussion around financial services. This discussion however, is different than the commentary six months ago. I'm not going to answer these questions in order, or even in one post, but instead lay out, basically, how banks work. Doing this, I think, will help give perspective to the ongoing financial paralysis. I apologize if this sound condescending, but I have no idea who is reading this blog so I will write to the least common denominator.

How Do Banks Make Money
You open a checking and/or savings account with the Bank and they pay you little to no interest. Then, they take your money and lend it out at say 6%. If the Bank pays you 2% on your savings account, they are making 4% on your money. More specifically, they pay you 2% on your savings account and lend your money to home buyers (in the form of a mortgage) for 6%.

What does it mean to "Securitize" a mortgage?
I wrote about this in an earlier post but will briefly summarize here. Let's say your mortgage is with Bank A for $200,000. You pay the bank say $1,500/mo for 30 years in exchange for the $200,000 up front (you're total payment is $540,000 over 30 years). But perhaps Bank B wants to buy your mortgage from Bank A. So Bank A sells the mortgage, for about $200,000. In this role, Bank A acts as an intermediary and only makes money off of closing fees. Your mortgage is now with Bank B, and they have claim to all future payments. Over the last several years Bank B would typically be an investment bank. Not only would they buy Bank A's mortgages, but they would buy mortgages from thousands of banks. Bank B bundles 1,000 (for example) mortgages together and divvies them out in slices of 10 (each slice has payments from 100 mortgages). This slice can now be called a security, or, a CDO (Collateralized Debt Obligation). The price that another bank would pay for this security is based on the perceived riskiness of the underlying payments, or, the credit worthiness of the borrower. At the time, none of the Banks anticipated the steep decline in housing prices.

Bank Capital
When borrowers began to default because they couldn't refinance their homes the Bank holding the CDO had to write the value of that CDO down accordingly based on mark-to-market (or fair value) accounting. The CDO is an asset to the bank that owns it. Future payment streams from mortgages are assets to banks. However, if the value of the Bank's investment was $10 million a year ago, it's now worth $2 million and they must take a $8 million dollar loss. That's what has been going on over the last year. Let's look at how that affects the Bank by providing an example.

Say you wanted to start a Bank and you were able to come up with $20 million dollars in cash from investors in exchange for equity (i.e. stock) in the bank. Then, you went and borrowed money in the form of Bonds for another $80 million. Now you have $100 million to "invest". Remember, with a bond, you pay the bondholder a set percentage each month, say 4%, of the face value of the bond and at the end of ten years you have to make a lump sum payment to the bondholder for the face amount of the bond (you would have thousands of Bondholders with individual bonds for $1,000 each paying 4%/yr). From the Bank's perspective, Bonds are liabilities. They represent a future obligation the Bank has to someone else. Then, with your $100 million, you go out and buy some CDO's that are paying you 6%. That's a great business model. Your CDO's are paying 2% more than you have to pay your bondholders. But if CDO's fall in value by 80% due to defaulting borrowers in the underlying mortgages, your $100 million of CDO's is now worth $20 million. Keep in mind, you still have to pay your bond holders. Now, your assets are less than your liabilities. Meaning, you don't have enough money coming in from your CDO's to pay your bondholders. The Bank is insolvent. I'm over-simplifying here, but you get the picture. This gets us to about Q3 of last year.

One Thing Exacerbates the Problem
There's a timing issue. You may have noticed at the onset that Banks borrow short and lend long (to use standard industry vernacular). A deposit is a short term liability to the bank, whereas a mortgage is a long term asset. At any point in time a Bank may only have 15-20% of all their deposits on hand in cash. Should depositors want to withdraw all their money at the same time the Bank would not be able to liquidate enough assets to pay their liabilities. This is one sort of "Bank Run." We know from the IndyMac fiasco last year, that all deposits are guaranteed by the FDIC up to $100,000. The problem lies in the fact that most Bank's short-term liabilities are not deposit accounts, and are not insured. To meet these obligations, Banks will typically borrow from other banks. But today, Banks are unwilling to lend to eachother because 1) they are worried the bank won't be solvent based on their exposure to CDO's and 2) they want to hang on to their own cash in case they have the same problem. So banks are just staring at eachother. Finally, a derivative product is to blame for the most recent stagnation--the dreaded Credit Default Swap.

Credit Default Swaps Explained
Back to bonds for a minute. If you want to buy a $100 Bond from JPMorgan you would pay JPM $100 (usually) and they would pay you a set interest rate, say 6% for 10 years, at which point they will pay you $100. You make $6/yr for 10 years and get your $100 dollars back, for a total of $160. Not bad, better than a 2% savings account. But there are two big risks. What if JPMorgan can't pay you back? What if interest rates go up and you're stuck at 6%? You could buy a Credit Default Swap for a few hundredths of a percentage point from an insurer to hedge the default risk (but you can't do much about interest rate risk). The insurer would step in and pay you off in the event the company you bought the bond from defaulted. Simply, they are insurance policies. But, since they're derivatives, the swap itself could be sold for a specific value. Let's make it a little more palpable.

Merrill Lynch owns a bond OR a CDO from Lehman Brothers. They do the sensible thing to protect themselves and buy a CDS to insure against a Lehman default. Since Lehman is a huge company, they go to AIG for the insurance and pay AIG .5%/mo in exchange for the coverage. See the problem? CDO's default, Lehman is insolvent, AIG can't make everyone whole (CDS' aren't regulated so "sellers" of the insurance don't have to have reserves). ML is stuck holding the bag. Whereas ML thought they would be made whole via AIG they are now stuck with major losses on their own assets and are themselves, insolvent Now holders of ML bonds or CDO's must mark down their assets and they are insolvent, triggering another payout by insurers of ML to those that had CDS on ML. And by the way, ML sold their own CDS to other Banks, which they will no longer be able to honor. This massive chain reaction is still playing out across the financial sector. A bank may look healthy but they may be depending on an insurance payment from an insolvent bank.

Hopefully I've been able to elucidate the current financial faceoff in a little more detail. AIG was bailed out because they were the largest sellers of CDS in the world. The government is still trying to figure out ways to either get these toxic CDO's and other mortgage backed securities off the Banks balance sheet, or provide additional capital to "Recap" the bank. Both of which I will treat in the next post.

We interrupt your program to...

2009-03-02T18:47:00.001-08:00

Image via Wikipedia

...bring you a message of hope! GEEZE! I have to say it's getting a little annoying how CNN is reporting on the stock market.

"DOW reaches a new twelve year low today. Wait...nope, now is its lowest in twelve years, wait, NOW...now...now...no, NOW."

I get it, it's low. Fortunately, this market has done wonderful things for my popularity at social functions. Although I am getting a little cynical. Conversation:

Partygoer: "What do you do for work?"
Me: "I'm a greedy bonus-mongering private equity investment guy."
PG: Blank stare
PG: "Um, how would YOU fix this mess."
Me: "The way I figure it, the wealthiest people in the world right now are the Somali pirates. I think they should apply for Bank Holding Status and expand operations with money they receive from TARP. Since the government isn't asking any questions, I figure they could get to $20 billion or so with TARP money, plus whatever they get through routine plundering. At traditional 30:1 ratios, they could lend up to $600 billion (USD) to help stimulate the economy. The pirates that get sea-sick can go work on Wall St."
PG: Silence. "Did you see how low the DOW was today?"

On a different matter, I love talking to venture capitalists. They are the only ones that aren't afraid to say they are going to "change the world." I grin like a giddy school boy when they say it and I can never figure out why. Maybe it's because, subconsciously, I know some have actually already done it. Venture capitalists are behind some of the biggest game changing technologies like, Apple, Google, Yahoo, eBay, Amazon, Skype, Twitter, Cisco, MySpace, and Facebook. That's not even including the VC's who are working on advanced biotechnology and Life Science projects that will synthetically replicate human organs without the chance of rejection. I suppose I like talking to them because they're not depressed like the rest of us--they still dream. Here's one of the premier VC's in the world, Steve Jurvetson, of Draper, Fisher, Jurvetson, talking about his love of rockets. Incidentally, my son loves this clip.

http://www.ted.com/index.php/talks/steve_jurvetson_on_model_rocketry.html

A Bong, an IOU, a Favor

2009-02-18T08:21:00.000-08:00

While I was stopped unnecessarily on the freeway this morning for President Obama's speech that was less than 15 minutes from my home, I recalled one of my favorite scenes from Dumb and Dumber. It's where the evil kidnapper finally tracks down Lloyd (Jim Carrey), grabs the briefcase and opens it while pointing a gun at Lloyd's head. Instead of finding a suitcase full of ransom money, he finds a bunch of I.O.U's, meticulously accounting for every dollar Harry and Lloyd spent upon learning there was actual money in the briefcase. Lloyd, apparently recognizing the kidnapper's distress, gently picks one of the pieces of paper off the ground and says, in a gentle voice, "Those are I.O.U's, that's a good as money. Look, this one for $250,000 (for a Lambourghini), you might want to hang on to that one..." So classic.

My amusement quickly diminished as I replayed the scene in my head. In the replay, I played the role of Lloyd, my son played the one opening the briefcase (only he wasn't an evil kidnapper), and instead of $250,000 the price tag was $1.5 trillion, and instead of a lambourghini, it was social security. Yep, you can obviously tell that I'm worried about our future generations and the obligations they'll have to face, or not. Todays economic climate is in many ways primal and its given me reason to pause and consider a few random thoughts.

Impact of Today on Future Generations: Economists and politicians have said very little regarding the impact of todays decisions on our children. To what extent are we mortgaging the future? At what point does someone (meaning someone in Washington) stand up and excersise some monetary and fiscal discipline now so that we pay for our decisions, and not our kids? We need to take action and solve the entitlement problem in the U.S., meaning health care and social security. In investing, you are taught to always look at a companys unfunded liabilities (i.e. pensions that are underwater or other obligations they can't meet) and run the other way if they have any. Then that begs the question, why would anyone want to invest in the U.S. with our underfunded pensions, broken social security and medicare programs? Could the U.S. default on its national debt? It's possible, but not probable. I think it would be more politically expedient to pick hyperinflation over default, but I'm not an economist. Time will tell what "kind" of Obama emerges. Will he step up and demand that deficits created from todays debacle be payed back with future suprluses, similar to the EU? Or will he continue to allow politicians make decisions based on the short-term and stick our children with the bill? I'm not saying that's irrational, as the current incentive program enduces such behavior, but we shouldn't expect legislators to act altruistically, better to make it law, which I don't think is probable. But that all leads me to my original soap-box that the problem with politics started when we made it a career.

And another thing. Much has been written about Michael Phelps' bong debacle. Phelps was pictured smoking some herb at the University of South Carolina a week ago. I believe he should definately be more careful as he is a role model but, the amount of outrage over this matter is completely unnecessary. I mean really, even if it is deplorable, is that what we need to be focused on? A swimmer smoking a drug, which to my knowledge, has killed zero people? This seems to be a recent development in America--we're captivated by "breaking" yet useless news which only serves to distract us from other problems we should be dealing with. What's ironic about America's "outrage" is its generally directed toward people engaged in an action that the majority of american's have also participated in, but have not been caught. I love how the news anchors shake their heads in disgust when reporting stories about marijuana use, teen sex, or drunken icons, as if THEY have acted any better (see youtube "newscaster bloopers" if you don't believe me). Anyway, I'm not saying that such actions like those of Michael Phelps or others are acceptable, but I am asking that 1) is that really the most pressing news? Doesn't it just cheapen American intellect? I know that's what sells, but is that the point? To report only what sells? How about what's important? and 2) why should we be accusatory for something the majority of american's have engaged in? C'mon, FOCUS AMERICA! We're too distracted by shiny things--like clearance tags. We love to point the finger and blame other people for their "mistakes". Rhetorical question. Are you saying we are to blame for this mess and not Wall St. executives? I'm choosing not to answer that. But let's scream and throw chairs when discussing their bonuses. Is anyone else concerned that we are outraged at the bonuses of professionals who work in banking (a necessary industry) and not the compensation of professional athletes? Wait, wait, before you respond with "Professioal atheletes haven't caused any harm", I would like you to think about that question (since the two fundamental assumptions can be debated 1) did bankers actually cause today's issues? or did debt hungry Americans and 2) professional atheletes haven't caused any social or economic problems. To which I would say "really?")

A Note About "Interesting Websites"

2009-02-16T08:07:00.000-08:00

Some of you may have noticed that I have a list of interesting websites to the right. Every so often I add a site to the list but I have never introduced them as I've posted them. So, since I have some spare time on President's day, I thought I would write a sentence or two on each of them. There is one commonality--all are backed by well known venture capitalists.

Zemanta. Contextually relevant pictures, links, and suggestions for email and blogs. Ba
Image by chucks via Flickr
sically, you download Zemanta to your browser and while you are typing an email or blog post, Zemanta suggests pictures, links, or tags you may want to add. You can even easily pull a quote from another blog and include it on your blog. Even as I type this, my Zemanta tool bar to the right suggests several pictures for "President's Day" as well as links to useful trivia and blog posts. See the image to the right.
BillShrink. Checks credit cards and cell phone offers to ensure you are getting the best deal possible. You enter your balance/monthly fee, your interest rate (for CCd's), zip code, usage, etc. and BillShrink will come back to you with the best result. In the case of cell phones, it list alternatives by signal strength.
ScrapBlog. You can create stunning multimedia scrapbooks online for free! Rather than simply send your friends sterile pictures, you can personalize your vacation, first day of school, with one of Scrapblog's templates or create one of your own. It is free to register, create and share your multimedia scrapbook online, but if you want to print it out, that will cost you. Not a bad business model.
SearchMe. This is a new way to search the web. SearchMe lets you see what your looking for. Choose your category and you'll see pictures of web pages that contain your answer. This way, you can scan the web page for the necessary information before clicking through. It uses "stacks", which, if you've cycled through the top-movies section on iTunes, it has a similar feel--web pages cycle through your view as you move the toolbar from left to right, or right to left.
Yelp. No rocket science here. Yelp is an easy way to find what's good, or not so good, in your area. You type what your looking for in the search bar and then your zip code and a list will populate with user reviews.
Wetpaint. A Wetpaint website is built on the power of collaborative thinking. Here, you can create websites that mix all the best features of wikis, blogs, forums and social networks into a rich, user-generated community based around the whatever-it-is that rocks your socks. A social website that’s so easy to use, anyone can participate.
Widgenie. If you're one to include polls or other types of tables in your blogs or just want a sharp looking graphic then Widgenie is for you. You can register for free, customize data and create a graphic to post to your blog, facebook, or igoogle account.
Prosper. Looking for extra money? Prosper creates an online meeting place for those seeking money and those that have money but want a higher yield on their investment. It's a social lending site. You can apply for a loan or make a loan. Only there aren't any banks involved directly here. If you're looking for a loan, then you enter your information and those willing to make loans, will bid on your loan. Prosper asks for a lot of information on the borrower and will pull a credit score to show to potential lenders. Lenders can slice the data any way they want and bid for high or low-risk loans. What if you don't want to expose all your money to one person? You can spread your money around. If you have $1,000 to lend, you can parcel that out between different borrowers.

There you have it. Some creative sites all aimed at making the universe more efficient. Also, since these are all venture backed companies they are all in the early stages of creation and I know CEO's are open and anxiously awaiting feedback from interested users. So take a look and don't be afraid to drop them a note via their "feedback" links if you don't like something. They will welcome your input with open arms.

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Why Not Give Bailout Money to Taxpayers?

2009-02-03T20:16:00.000-08:00

In keeping with the theme of shedding a little light on financial topics you may be forced to discuss or have an opinion on at parties, funerals and baptisms, I would like to highlight a common question. It generally sounds something like this...

"Why not give the bailout money to the taxpayers? We'll spend it. If they want to help us, just give us the money? How come the government is still giving it to irresponsible Wall St. companies? Bailing out Wall St. creates a moral hazard."

Those who hold this view are assuming that 1) all bailouts create a moral hazard, 2) giving money to taxpayers in lump sums is preferred and 3) taxpayers will spend the "stimulus" money. I'd like to present a few alternatives to each of the three basic assumptions. And since the party you are speaking with will probably hold the "pro" side, it will be your job to introduce an alternate view (unless you don't care for confrontation, in which case you can smile and nod, or make a trip to the bathroom).

1) Moral Hazards. This is the idea that if people are insulated from their bad decisions, they are more likely to act irresponsibly. Therefore, if Wall St. knows it's going to get bailed out in a pinch it will continue to act recklessly, or so the argument goes. If I have fire insurance then, according to the argument, I would be less vigilant about having fires in my home. But let me assure you, I would be equally concerned about a fire in my home with or without insurance. Likewise, we would expect banks that have received bailout money to continue in rash behavior. But we haven't seen that. In fact, they've pulled back too much and no lending is going on. Perhaps one solution to the moral hazard issue lies in the perceived outcome. For example, most people are ambivalent towards which banks hold their deposits because of FDIC insurance. That's because FDIC insurance offers a quantifiable solution, a known outcome. But a bailout or a house fire creates uncertainty and potentially complex and messy situations. I think the less certain the outcome, the less impact the moral hazard argument holds. As I stated in an earlier post, I don't think shareholders in Bear Stearns, who lost 100% of the value of their shares, or unemployed CEO's, are still running around like druken frat boys looking for more mischief.

2) Giving money to taxpayers in lump sums. I've heard ridiculous numbers running around the internet about how much we'd all get if the government were to cut us a check. I think CNN ran an article today or yesterday showing the number to only be $9,500 (far below some claims of $100k). There is a psychological difference between a windfall (such as a stimulus check) and increased monthly wealth. Americans tend to save windfalls and spend when long-term prospects for personal wealth increase. Which is why...

3) I don't think consumers will spend like we say we will. I'm not going to spend anything extra this month if I think my income will be zero next month. I believe the issue here is perceived job security. Stimulus from 2002 wasn't very helpful, nor was the stimulus from last year (so far). In environments of financial turmoil and uncertainty Americans save bonus money. However, this is why I think President Obama's taxpayer stimulus might actually work. His idea is to give taxpayers a credit by decreasing the withholding amount. Pretty clever. For most, it will amount to an extra $50/mo. in our paychecks for one year. Some economists think that this will help Americans spend money because we see a long term, fixed increase in our take home pay.

To conclude, I'm saying the moral hazard argument should not be overstated, that if the governemenet wants us to spend, then they should attack the heart of the uncertainty--the job market, and that Pres. Obama's proposed stimulus is fairly astute.

No, wait, DON'T GO!

2009-01-25T13:39:00.000-08:00

This is still the blog for the infamous Toad Musings. Only, I think I've grown out of my wife's pet nickname for me. I also thought Adverse Selection was more appropriate. In economics, adverse selection is what you call it when you do business with someone/thing that you should not have only because the other party had information you didn't (what many call informational asymmetry). Confused about the parallels? Excellent. Feel free to tell me if you don't like the new layout.

This will be a big week for the markets. There are a lot of earnings reports coming out this week and if the DOW can stay above its psychological floor of 8,000 that will be a good sign that maybe we've reached the bottom. Notables announcing earnings this week include McDonalds and Wells Fargo. Both may act as the proverbial canary-in-the-cole-mine. McDonalds historically has done very well in recessionary environments and Wells Fargo will provide a proxy for financial services in general. My prediction is that it will not be pretty. I think most firms announcing are going to take a big bath in order to lower expectations going in to the next quarter. Losses will be greater than what most analysts predict and I think its highly probable the DOW will slip below 8,000.

Oh yeah, I haven't said happy New Year yet.

A Laughable Year

2009-01-13T19:46:00.000-08:00

So I've been patiently waiting for an interesting financial news story to write about, although I have no idea how any could top what we saw in '08. 2008 was the year we saw the average Joe become a genius. Any schmuck could complain about any industry/politician/policy and be right. It was all a mess. From a rogue trader taking Societe Generale (a HUGE French bank) for $7 Billion, to bank runs, bailouts, and oil frenzies. Whew! What a year. It had all the hallmarks of a good action movie--non-stop explosions, car chases, and blatant disregard for extras. And like a good action flick, just when you think the action is over there is a dramatic outburst of unexpected last-minute action. Like last December where we were supposed to all hold hands and sing like the Who's in Whoville (much to the chagrin of the Grinch) on Christmas Eve--BAM! The grand finale featured Bernie Madoff wowing the audience by taking $50 Billion from savvy investors. In the words of Syndrome (from the Incredibles), "I'm still geekin' out about that!" I got back to my office after the holidays, sat back in my chair, took a deep breath and thought, "What next?" That's when my eyes wandered through the days headlines and saw.....

A Porn industry BAILOUT? Excuse me? Yep, turns out the CEO of Hustler and the CEO of Girls Gone Wild paid a visit (no pun intended) to capital hill for a piece of the stimulus action (no pun intended), approximately $5 Billion. Where did THEIR money go?! America wastes money on boos, cigarettes, gambling, and porn. What's Hustler's excuse? They don't get any love from Jenga (and if the CEO of Hustler is reading, "Jenga" is just my stage name). Hilarious.

Changing gears, my vote for "Best Decision nobody knows/cares about": How about the GAO (government accountability office) refusing to opine on the Governments financial statements for the 11th consecutive year. They claim the government misdirected $55 billion, meaning, it went missing, in 2007. That's up from $41 billion the year before. How about Obama focuses on mowing his own lawn first this year. I'd start with the Defense department, where the GAO sites "accounting chaos." Good call GAO for not putting your name on THAT.

I got a good chuckle out of these cheeky headlines from 2008 from about.com

1. Iraq War Ends; Bush Indicted For Treason (NY Times Spoof Edition)
2. Obama's Use of Complete Sentences Stirs Controversy (Borowitz Report)
3. Black Man Given Nation's Worst Job (The Onion)
4. Failure to Blow Election Stuns Democrats (Borowitz Report)
5. America to World: "We're Not Retarded!" (23/6)
6. Bush in Race Against Time to Wreck Country (Borowitz Report)
7. McCain To Suspend Campaign In Order to Rescue Campaign (Opinions You Should Have)
8. Bill Clinton Sadly Folds First Lady Dress Back Into Box (The Onion)
9. Nation Finally Sh*tty Enough To Make Social Progress (The Onion)
10. Bush To Put FEMA in Charge of Wall Street Rescue (Opinions You Should Have)

Honorable Mention:

11. McCain Replaces Palin with Startled Deer
12. Ponzi Estate Sues Madoff Federal Prosecutors For Slander

2008 set the bar pretty high.

What are some unintended consequences of the auto bailout?

2008-12-10T10:35:00.000-08:00

Okay, I'll let the deep philosophical discussions (or lack thereof) on the new altruistic American business model rest for a second to discuss the bailout for the automotive industry (which will no doubt change in the coming days/weeks).

I thought the comment below, from the Cato Institute, provides a nice context for discussion.

"Surprise! President Bush is willing to spend taxpayers money and inject the federal government into the economy – yet again. The financial bailout might have been justified on the grounds that finance is the lifeblood of the entire economy, and a frozen credit system brings every industry to a halt. But a bailout for a specific manufacturing industry has all the hallmarks of lemon socialism. It puts the federal government in the business of picking winners and losers, reduces the incentive of other industries to avoid excessive risk, creates a lobbying frenzy, and brings the inefficiency of the government sector to the normally more efficient private sector, which under free enterprise must stay in the black or go out of business. But I want to focus on a particularly scary part of this bailout bill.

The bill provides that if the government gives companies money, the government will make some of their decisions: limit executive compensation, ban dividends, review large contracts, get rid of their executive jets (certainly a reduction in corporate efficiency, where the time of their top executives is the most valuable resource), make “green” cars rather than the cars consumers want, and so on. But it adds a new twist: The bill currently bars the car companies from pursuing lawsuits against California and other states trying to implement tougher tailpipe emissions standards. Jonathan Cohn of the New Republic suggests taking that concept further and requiring General Motors to fire a vice chairman who has expressed skepticism about the catastrophic effects of global warming.

This ought to scare any genuine liberal. Congress is going to use our money to censor political dissent? Usually libertarians warn that if you take government money, you’ll eventually find yourself subject to government restrictions on your freedoms. In this case, there’s no phase-in, no “eventually.” Congress wants to tell private companies, private individuals, that once they take government money, they will shut up and toe the government’s line.

If economics isn’t a good enough reason to oppose this bailout, preserving independent thought ought to be."

I think the author's point regarding political expression is valid, while at the same time recognizing this also creates a material disincentive to take government money, which I think should be the point. Make no mistakes, the deal will be very good for government, but can you also say the deal will then be good for taxpayers? Hmm. I get a little uncomfortable when I see media sources interviewing GM or Chrysler workers/suppliers who talk about how much they hope the government goes through with the bailout so they can keep their jobs. Does anyone see fallacious logic here? Whether or not the government grants the support, the big three will still have to drastically reduce excess and change business models, which means layoffs, plant closings, and breached contracts. Although staying in business is better, I think it might create a false sense of security for workers and suppliers.

Then there's this little gem of a comment I read in the NY Times:

"Basically what we have here is the corporate equivalent of AA meetings. “My name is General Motors and I’m a financaholic.” (Applause please!) His long suffering mother, aka the United States government, attends Alanon meetings where she justifies giving junior a large enough allowance so he needn’t work enabling him to stay drunk 24/7."

Where will the government draw the line? How many industries will/can we bail out? Is this the last one? Or are we just being taken for a ride (pun intended)?

Creative Capitalism

2008-12-02T11:37:00.000-08:00

With an Recession officially under our belts, massive global uncertainty, and volatile capital markets, perhaps now is as good a time as any to revisit the traditional capitalistic model of making money. Earlier this year, Bill Gates delivered a speech at the World Economic Forum in Davos, Switzerland, entitled "Creative Capitalism." You can view his speech, which is about 20 minutes with an additional 10 minute Q & A, by clicking on the link below.

http://www.youtube.com/watch?v=Ql-Mtlx31e8

In his speech, Gates calls for a new form of capitalism whereby businesses focus some of it's efforts and resources towards eradicating the world's largest inequalities (i.e. Malaria, AIDS, Education, etc.). His speech received a warm response from the forum but was largely ignored by the global community (except for Warren Buffet and U2's Bono). However, yesterday on the Diane Rehm show, NPR featured a book called "Creative Capitalism" which is a compilation of essays and responses by some of the World's leading economists, legislators, and business executives on whether Gates' new business model, focusing on the global poor, could succeed. I looked through the table of contents and couldn't wait to read it. It takes a very "Hey, this is what he said to what you wrote, do you want to respond?" mentality which makes for some very passionate writing.

Gates' speech is worth listening to, if for no other reason than the fact that the majority of the fortunes of the two wealthiest men on the globe will be deployed to combat or solve some of these maladies. But what do you all think? Who is responsible for solving some of these problems? If it adversely effects shareholders, should businesses be required to direct valuable time and money to alleviate the spread of malaria in Africa? Is there a problem with how "shareholder value" is defined and should it attempt to quantify the value of a company's social impact? And what about Gates himself, he made his billions thanks to the current free market system. Over the last 20 years, he spent his valuable time working on building a global giant, watching every penny to get Microsoft to where it is today.

But what does everyone think? I would like to get your feedback.

A REAL Rich Man's Opinion

2008-11-24T15:56:00.000-08:00

The last time I met with somebody who made Forbes' list of 500 Wealthiest Americans, the individual walked away with my pen. I was somewhat agitated since my pen cost about $6.00 (which I would usually have to disclose to my wife) and he probably has a dozen pens each worth ten-times the value of mine. Granted, this 'perp' was number 200something on the list, you know, not THAT wealthy, only worth a few hundred million--so I should expect him to be fairly thrifty.

Last week I had to meet with another one, this time higher on the list (I didn't bring a pen to the appointment). He handed me his card and I noticed he had one of those nifty nicknames people make up and put on their cards that have nothing to do with their real name. Like Larry "Buck" Smith, or Fernando "Hank" Velazquez. But, in this case, I thought it was deserved since he was probably beat up time and again on the playground because of his first name. Good call.

I won't disclose his name since I didn't inform him that potentially up to TEN people might read about his comments on my blog, so it will have to suffice to say he is the CEO of a publicly traded company. He graduated from Harvard Magna Cum Laude with multiple honors (no "gentleman's" C here), which means he's a legitimate smarty-pants.

Here's what HE thinks (emphasis here on his THOUGHTS not the fact that the individual is a MALE)

Q: Why has your stock price gone from $36/share to $4/share in just a few months?
A: I'm not entirely sure, when we went public I put on the cover of our shareholder report that our daily stock price would not be an accurate reflection on the underlying, long-term economic value of the firm. So we don't manage around our stock price. Also, I don't think the majority of the public understands what we do. Believe me, I watch the stock price but there is little more I can do other than provide some level of comfort to investors.

Q: How do you think the government is handling the current crisis?
A: On the whole, doing a good job. They've obviously made some mistakes. For example they tried too hard to help individual companies without figuring out how to help the broader economy at first. It's like a pack of wolves attacking Caribou and once a Caribou is injured and goes down, the government tries to revive it, while they're doing that, another one goes down and they have to run over and help that one. But what they didn't do, is stop and figure out how to get the wolves from attacking the heard. I think now they're on the right track. But they blew it when they let Lehman go under. In my opinion, Lehman posed a greater risk than AIG. In fact, the organization that stood to lose the most amount of money from Lehman's bankruptcy was the government. Now, AIG's biggest counter-party (in other words, the biggest loser if AIG goes under) is Goldman Sachs. And by the way, Hank Paulson is an ex-Goldman banker and the Treasury is swarming with ex-Goldman employees who still probably own a good chunk of Goldman stock. But, that book hasn't been written. I'm only speculating here.

Q: So you think what they're doing with the TARP, in all it's variety, is the right thing?
A: For the most part. Buying the troubled loans never made any sense to me. Here's why. If you buy something from the Bank for one dollar (as an example), all that bank gets is one dollar. If however, you provide them with one dollar of equity (which is now the goal of the TARP) they can turn around and get 15 dollars of additional capital since banks are leveraged 15:1. This is how credit and lending resumes. Without that outside capital, banks will not be able to lend.

Q: So are you saying we should see liquidity and lending start to come back in the next few months?
A: No. That's what the treasury screwed up. We should have followed Europe. In Europe, when central banks had to step in they provided not only equity but added that the new capital had to be tied to increased levels of lending. We didn't ask for that in the U.S. The treasury should tie the equity infusion to resumption of lending, but either we won't, or have not to this point but may in the future.

Q: What opportunities do you see over the next year?
A: Bonds! Debt! That's where the money will be made. I have no idea why anyone would want to take equity, or stock, in any company when the bonds will get you 20%. From a geographic perspective, we really like China because they have a very robust national balance sheet and there is a lot of organic growth. GDP estimates over the next year put China at 7 or 8%, which is huge given what's going on in the world today.

Q: Where do you see our economy in three years?
A: Dealing with inflation. I think the government will continue to pour billions of dollars in new stimulus packages and will continue to do so until they overshoot. Since there is a lag, it will be impossible for the government to see the benefits of their stimulus packages and that will create inflation which will be exacerbated by high commodity prices, especially oil.

Q: The latest question on everyone's mind is what to do with Detroit. Why are automakers being asked to come back with a plan when the Treasury is giving money away to institutions without any plan?
A: Automakers are further down in the food chain. They benefit from increased credit access. Although it wouldn't be pretty, we could do without automakers, we can't do without banks.

So there you have it. The pride of Harvard. Any thoughts?

My Economic Agenda for President-Elect Obama

2008-11-11T08:04:00.000-08:00

The other day someone asked me, half jokingly, what I would do to fix the economy. I blurted something incoherent because I'm not very good on my feet and went back to work. Then I started thinking a little bit more and decided I would share my conclusions with the ten people that read my blog. I've given it a good day's worth of pondering, so, clearly, my opinions are very broad. Here are three thoughts, in no particular order.

1. Create a principles-based rather than rules-based economy. This is no surprise to accountants. Most of them have had long philosophical discussions late into the night regarding the benefits and drawbacks of principles-based accounting (remember I spent a summer with a bunch of them). I'll share an example from the accounting world that will help illustrate my point. International accounting standards have a principles-based rule for the accounting of leases while the U.S. standards (according to GAAP) favor a rules-based standard. According to international accounting, leases must be booked as capital leases (nevermind the terminology here, that's not the point) "if it transfers substantially all the risks and rewards incident to ownership." However, U.S. accounting standards lay out four different criteria for differentiating the different types of leases. If the lease meets one of the four criteria, it must be classified as a capital lease. The international standard is based on a principle, while the U.S. standard is based on several rules. There are obvious advantages and disadvantages to both. We generally like rules because they're easier to communicate and understand. They also create standardization. Conversely, while rules are better for communicating, we generally see that principles are better for compliance and forces one to use judgment. Broad principles avoid the pitfall of creating specific requirements that allow contracts to manipulate their intent. It's emphasizing form over substance. I'm not arguing we shouldn't have any rules, just that it currently seems a bit excessive and most savvy individuals and firms are quite good at finding ways around the rules.

2. Lower Corporate Tax Rates. Currently the U.S. has the second highest corporate tax-rate (behind Japan) for developed nations. The tax rate, combined with the increasingly onerous regulatory environment (i.e. Sarbanes-Oxley) decreases the relative attraction of establishing businesses in the U.S. It also de-incentivizes companies currently headquartered in the U.S. to maintain operations, or a public listing. So this repels business investment, and creates both un- and under-employment. But there is yet another disadvantage of high corporate tax rates. Interest from debt is tax-deductible. The higher the tax rate, the greater the savings from the interest write-off (which eventually increases your firm's value, and, thus, share price). Therefore, elevated tax rates create an economic incentive to obtain leverage. This will come as no surprise to anyone in finance familiar with the "optimal capital structure." At it's core is a theorem which basically states in a world with no taxes, the amount of debt you have is irrelevant (from the standpoint of the value of your business and shareholder wealth, although it does increase risk) but as rates increase, so does the corresponding incentive to obtain debt since the tax savings from the interest write-off will be greater than the cost of the debt. The theorem states that there is an optimal amount of debt a company should have where it maximizes the risk adjusted return to shareholders. So decreasing tax rates will correspondingly decrease the economic incentive to lever a business. As a nation I think it's fair to say we are over-levered.

3. Boost Government Spending in Infrastructure, Health Care, and Education. It may be good to introduce how GDP is calculated. GDP = C + I + (G-T) + X where GDP equals the sum of consumer spending C, Private Sector Investment (corporate spending) I, fiscal stimulus (netting government spending G minus what they bring in taxes T) and net exports X.

How can GDP increase when consumer spending is down C, businesses are investing less I, and exports are decreasing because of the global recession X? That leaves fiscal stimulus. And, according to our equation above, if GDP is to remain constant, the fiscal stimulus (G-T) must be great enough to offset the losses in the other three categories. So we focus on G and T. Certainly decreasing taxes, both consumer and business, or creating tax credits will increase aggregate consumption in both (C and I). But many overlook the importance of government spending. Whatever the government spends will obviously increase the overall deficit. But the deficit will be a smaller problem if the money is spent on infrastructure rather than fettered away into adult film consumption (which, by the way, is very resilient in a recession). Instead of sending out more stimulus checks to Joe the Plumber (I'm referring here to the average American, not the actual guy that's been identified) the government should think longer term and invest to decrease the cost of education, increase access to Health Care, and update our ailing 30-year old infrastructure (highways, roads, and utilities). If my children are going to be responsible for the deficit the government creates, then I want them to benefit.

As I said at the onset, I haven't given this a great deal of thought, but enough to perhaps elucidate where I think our economy should look over the next ten to fifteen years. I'm sure I've left some vital piece of information out, but blogs are obviously imperfect (afterall, you get what you pay for). I think some of these changes will create a more intelligent, agile, and sustainable economy. And one last suggestion, I don't think Obama should run for re-election. He needs to be able to make decisions without the subconscious desire to please potential supporters in 2012 .

Looters after the Hurricane

2008-10-28T20:58:00.000-07:00

I thought I was the first to use the term "Financial Terrorism" in the context of today's financial crisis, until I saw Jim Cramer on CNBC's Mad Money going crazy about it a few weeks ago. Seems like the idea that 9/11 type terrorists are going after our pocket books is gaining some ground on Wall Street. Although many banks feel like they've been victimized by motivational short-selling, I don't think we can call this one the result of "nefarious" international investors...yet.

The most popular purported "tool" of these economic pirates is called short-selling. Short-selling is the art of selling something you don't own. Until relatively recently, you could only be rewarded in the market if you correctly forecasted the company whose stock price would increase, but there wasn't a way you could benefit from your ablity to forecast a decrease in the stock price if you didn't own any shares.

Here's an example

XYZ stock price is currently $100/share - I think the stock price of XYZ will go down tomorrow - I don't own any shares of XYZ - I borrow 100 shares of XYZ from a bank for 24hrs and pay $5/share (total cost = $500) - Same day I sell my borrowed shares for $100/share (total proceeds = $10,000) - Next day stock price of XYZ falls to $85/share - I owe bank 100 shares - Purchase 100 shares for $85/share (total coast = $8,500) - I make $1,000 (10,000-500 cost of borrowing - $8,500) and 24 hrs earlier I didn't own any shares and only had a guess.

Short-selling is a popular practice of Hedge Funds. What's a Hedge Fund? The name is somewhat misleading and mostly historical. A Hedge Fund is nothing more than an investment vehicle open to a limited range of investors (either institutions or very wealthy individuals) and, because of the sophistication of their investors, is permitted to engage in a much wider range of investment strategies. It may be helpful for a moment to compare them to mutual funds. A mutual fund is nothing but a "shell", just like a Hedge fund. In other words, saying you own mutual funds doesn't tell us in any detail about your investment strategy. You can have mutual funds that invest in international stocks, in Tech stocks, in large or small companies, or in bonds. So we care more about whats IN the mutual funds. And they are heavily regulated and must stick to the disclosed strategy because they are open to the public. More bluntly, Mutual Funds serve the 80% of the population that make up 20% of the money. And because "Joe the Plumber" can own them, they must be simple (according to the SEC).

Conversely, Hedge Funds cater to the 20% of the population that control 80% of the global wealth. They escape regulations, in most jurisdictions, governing short-selling, the use of debt, and derivatives (options, etc.) contracts. To qualify for these exemptions, you must have fewer than 100 investors AND your investors must be "accredited," meaning an individual must have more than $5,000,000 in investable assets. ALSO, they do not have to disclose their activities to third parties. Approximately 75% of Hedge Funds are registered off-shore, usually in the Cayman Islands. Lastly, Hedge Funds control roughly $2.6 TRILLION dollars, and are attracting approximately $200 BILLION a quarter. Those are scary numbers. If you participate in a Hedge Fund, you are essentially giving your money to a manger with almost full discretion. For all of the reasons listed above, the government is taking a closer look at tighter control.

The SEC Hammer

Last month, the SEC banned short-selling of 799 financial institutions and issued this statement:

"We are concerned about the possible unnecessary or artificial price movements based on unfounded rumors regarding the stability of financial institutions and other issuers, exacerbated by naked short selling. Our concerns, however, are no longer limited to just financial institutions."

Just before 9/11 several Hedge Funds, primarily using the Toronto and Frankfurt stock exchanges shorted the stocks of several airlines and financial companies housed in the Trade towers. Obviously, after the attack stock prices tumbled. Their profits were thought to be huge, and virtually untraceable. This time, the majority of short-selling is being done from London and Dubai. There are literally hundreds of Hedge Funds with murky ownership structures, investors, and strategies. If even a handful of them act in concert and begin active short-selling to "artificially" push the price down it would have a massive impact on the economy and they would be making millions of dollars. Where is that profit going? Who knows. But one thing I do know; because of all the words I've used in this post, I'm sure the CIA has at least read it.

...And the Kitchen Sink. Part II

2008-10-09T21:16:00.000-07:00

Why am I reminded of the movie "The Money Pit" as I watch our economy fall apart piece by piece? Probably because what looked good from the outside was really rotten to the core. It's clear now that what is moving the market is sheer contagion. The DOW is down around 20+% over the last month, with no signs of slowing down. The other day I was speaking with an older economist who felt the need to help me understand that I will never see this type of environment again in my lifetime. I wasn't sure what to make of that.

So I have just a few random thoughts to share, nothing too heavy.

1. I expect to turn out like my Grandpa. Those of us who had Grandparents that grew up in the depression are very familiar with the tireless rantings where our Grandpa/Grandma would espouse the virtues of savings accounts, CD's, no debt, and hiding money under the mattress. Now, I don't think that's such a bad way to go. Although, some savings accounts aren't even THAT safe these days. I truly believe this crisis will have a profound effect on the younger generation in respect to how they view long-term savings and their appetite for risk.

2. The most troubling statistic of the week. Earlier this week MSN reported that 1 in 6 Homeowners owe more than their house is worth. That's almost 20 million homes. If 25% walk away (likely to be much higher) then that means banks will own 5 million homes. That means more fire sales which will decrease the value of existing homes even further. And don't forget about the already existing inventory sitting on the market. Indeed, it is difficult to believe housing will recover anytime soon. Think at least five years out. My solution? Burn the home. This accomplishes two things. First, it decreases the supply of homes for sale, thus bringing the demand/supply curve into closer equilibrium. Second, it prevents a fire (no pun intended) sale from bringing down housing prices even further, preserving the current value for existing homeowners. Or you could donate it to Habitat for Humanity (I think they could use a solid pre-built home).

3. Regarding the recent rate cut by the Fed and European Central Banks. This was a fascinating development. On Monday the Fed decreased the federal funds rate another half-a-percent. At the same time, Central Banks in Europe also decreased their interbank lending rates. Why did they do it together? I think there are two reasons. First, I believe they want to demonstrate a very united front. European Banks started to slide and at least a dozen had to be bailed out. The message is SUPPOSED to be "Hey, we are serious about taking action and will do so on a global scale." However, I think it had the opposite effect. Most Americans, and, from the reaction of the market, most people worldwide, took the Central Bank's action as meaning "Yep, it's much worse than we thought and we don't know what else to do," which in turn served to confirm everyone's fears. Perhaps in this case, inaction is the best solution. But there is a more technical reason why the Central Banks cut rates in concert. They are worried about capital flight out of their countries. If interest rates in the U.S. drop, then, if I'm China, I pull my money out of the U.S. and invest it in another country that is paying higher interest. But if all major central banks cut rates together, and maintain the same relative relationship, then the economic incentive to pull your money is severely diminished.

4. The importance of Commercial Paper. The Fed also announced this week that they would begin to buy Commercial paper. Why is that significant? Commercial paper is short-term debt (usually with a maturity anywhere from 1 to 270 days) that a corporation will issue to fund operating cash flow. Think of it as a very short term loan. For example, if I'm Microsoft I issue commercial paper for $1 million dollars at 4% interest with a 30 day maturity. A money market fund will buy it from Microsoft because, after all, Microsoft is highly rated and the Money Market Fund can earn 4% interest over 30 days rather than 3% in the bank. At the same time, Microsoft can use the money to pay salaries or fund other assets. Now the problem is no one is buying this Commercial Paper from Microsoft because they don't trust them. Only highly rated companies are allowed to issue commercial paper. The fact that Money Market funds in particular don't trust them, even over a very short period of time, speaks volumes regarding the uncertainty in the market. The Fed stepped in because they recognize businesses depend on this financing to operate on a daily basis.

Hot Investment Tip of the Week. Residential homes in Houston, Texas. Some rather astute real estate investors have indicated that Houston has a bright future as a place to invest in a home. These professionals cite the low cost of living, and favorable population demographics based, in part, on the growth of the Energy sector which is getting ready to boom with the energy demands of the global middle class.

On the bright side, Alan Greenspan did say he thought the economy would turn around in the first quarter of next year. I think that sounds about right. I'm not sure though, I think I'll go ask my Grandpa.

$700 Billion Don't Buy What it Used to. Part I.

2008-09-28T21:29:00.000-07:00

This will probably be my most ambitious post. In what could be termed the greatest triumph of mediocrity, I'm going to try and explain the mechanisms by which we find ourselves in this current economic state of affairs with Uncle Sam pumping $700 Billion into the economy and explain how the plan (TARP, Troubled Asset Relief Program) will work. My analysis will be, at best, imperfect in predicting its long term impact (and anyone else who professes to know anything should probably confess the same) on the U.S. and global economies, and, at the very worst, a disturbing reminder of the agony of a mediocre mind. This is part I.

First, A Quick Review of the Mortgage Mess

I'll refer everyone to my prior two posts, found below, on the "credit crunch" and birth of the mortgage back security. As a quick reminder, subprime mortgages were packaged into portfolios of Prime and Alt-A (between prime and subprime) mortgages and inappropriately rated 'AAA'. These portfolios were sold to other financial institutions (both public and private). Since there was no historical mechanism by which to price these assets (I'm referring here to the "securitized", or packaged product, obviously not mortgages themselves) it should come as no surprise that they were mis-priced. Now, hold that thought. Here, one needs to understand a basic accounting principle called mark-to-market.

What is all this Mark-to-Market and Fair Market Value jazz?

GAAP (Generally Accepted Accounting Principles) requires that assets (including portfolios of mortgages) should be reviewed (usually quarterly, or earlier if necessary) and priced at Fair Market Value. FMV requires you to 'mark' the asset as if you had to sell it in the market today, so you 'mark' your asset according to the 'market' price (mark-to-market). This is all in the name of greater transparency for the shareholder so that any quarterly statement accurately reflects the economic viability of that institution at that point in time. So we have hundreds of financial institutions that are having to mark-to-market their portfolios of troubled mortgages. Okay, let me address the "market" and why I don't think it's efficient (meaning, it can not be relied on to deliver accurate pricing).

Efficient Market Theory

Efficient Market Theory was the product of Harry Markowitz in 1952 and is widely held today as the paradigm explaining market prices. I've already written about EMT as well in a previous post on investing, but I will revisit it here.

Basically, EMT claims that markets are able to correctly price any asset at any point in time. In other words, markets are completely 'rational.' When news regarding a certain company or event is 'known' the market automatically correctly, and 'efficiently', prices the news. However, this assumption has been tested. In fact, a theorem coming out of Stanford asserts that technical fundamentals, based on EMT, only account for about 20% of stock price volatility. Investors as a whole are simply incorrect in their assumptions of future events. This is the classic difference between "Experience" and "Exposure." Where experience looks to the past, exposure considers the likelihood, and risk, of an event that history may not reveal. I think most investors are currently wrong about 1) their ability to forecast future events and 2) their ability to correctly price the news. And those are two fundamental assumptions one needs if EMT is to hold true.

Is There Any Pride in Being the Last Lemming off the Cliff? The Wisdom of Crowds.

What we're seeing is a fundamental shift in belief-structures. Mordecai Kurz's theorem on belief structures indicates that the other 80% of stock price volatility is the result of shifting belief structures. Again, this is a theorem, not an opinion. Belief Structures represent the proportion of all investors at a given point in time that hold below average/above average expectations of returns. Logically, a constant, or diminishing rate of good or bad news, can create a growing proportion of optimists or pessimists. EMT holds true, most of the time, in a heterogeneous population. However, when heterogeneity (or diversity) is lost, markets perform poorly as herding sets in and immitation becomes a substitute for reason. I think this accurately describes today's environment. Belief Structures work independant of fundamentals. Many economists think that, based on fundamentals, we should only see a 30% drop in these mortgage backed securities and we've seen 80% decreases. As I mentioned in my previous post, the presence of severe uncertainty exacerbates the problem. For nobody knows how high-is-high or how low-is-low. Last year, Alan Greenspan stood up at a conference, and, holding a mortgage back security, waved it around and said, 'Can anybody tell me what this thing is worth?" Note, this was after the news about subprime mortgages hit the fan. This alone should severely question anyone's allegience to EMT and rational markets.

Back to Fair Market Value

So I ask, "Why are companies forced to price their securities according to market prices when the market is probably not accurate?" It's this inaccuracy that is creating the balance of the economic crisis. Follow the logic below:

Institution 'A' must write value of security down (based on markets pessimistic belief structure and mass uncertainty) - Institution becomes insolvent (more liabilities than assets as a result of the new asset "price") - Institution must sell asset quickly or risk bankrupcy - Institution sells assets at fire sale price (thus setting the new "market price") - Institution B must write down value of security based on 'A's' price - Cycle Repeated

What results is a self perpetuating downward spiral that can only be stopped by external influences (unless you allow for widespread systematic failure).

The Fed's Bailout

Is it a good idea or not? Time will tell. But I have to strongly disagree with the position of many politicians and friends who assume that Wall Street gets all the upside while the tax-payer is stuck with the bill. This opinion incorrectly assumes Wall Street and Main Street operate on separate planes, which couldn't be further from the truth. Anyone who has ever received a business loan, or a mortgage, or purchased stocks, mutual funds, or ETF's illustrates that Wall Street and Main Street are unseperable. At the same time, there are bad actors on both sides. We should not only be pointing fingers at Wall Street. Clearly, there were nefarious actors who made a ton of money and disreputable credit agencies that acted out of greed. But, at the same time, there were thousands of consumers who lied on mortgage applications (granted, some were tricked) and that bought more house than they knew they could afford. I think blame should go both ways and that politicians should quit pandering to us like we're Harry Potter's fat spoiled cousin Dudley Dursley (although that may not be too far from the truth).

Anyway, if you would like to read the entire 110pg bill that's being debated this week, you can do so by clicking here:

I would simply like to make a few points about the proposed plan.

1) The Fed will be buying direct mortgages and mortgage portfolios from institutions requesting aid.

2) It's a "principles" based bill as opposed to "rules" based. In other words, Hank Paulson's mandate is to act in a manner that is in the best interest of the country and the tax-payer, maximizing profits and reducing costs. Granted, there are plenty of rules, but Paulson's authority is fairly broad in the bill.

3) Executive aren't making out like bandits. First, all the executives are getting canned, and, according to the bill, if any institution wishes to participate in the $700 billion, the executive must reimburse the company any bonus received which is deemed to have been previously paid for inappropriate self-enrichment. Also, they are doing away with any 'golden' parachutes. And no investor that watched their stock go from $70/share to .20 cents/share is going to think they are getting bailed out. And what about tax-payers? I think we already made our money. Most of us wouldn't be in our houses if not for Wall Street's innovation. Not to mention Real GDP grew to almost 4% (historical average of 3.5%) which translates in to trillions of dollars that came to most of us in the form of rental homes, new tools, xbox 360's, cars, and flat screen T.V.'s.

4) The Fed is buying these mortgages using Net Present Value. Essentially that is above market price (putting the cab-bosh on the downward spiral) but below what the company paid for them. They will buy most of the mortgages in a reverse auction, where banks basically compete for the Fed (lowest price wins). The fed will then service the loans and cut deals with individual borrowers by extending terms, reducing principle amounts, or deferring payments.

5) Some of the money will come back. The Government isn't going to simply spend the money. As I stated above, many, if not the majority, of the mortgages will get worked out and the Fed will make money (For example, your loan is for 100k, the Fed buys it from XYZ corp for 10k, turn around and cut a deal with you, the borrower, for 70k). Win-Win-Win. And the Fed is able to take equity (but non voting) stakes in a company that is a participant in the program, thus giving the tax-payer potential upside.

6) The language is interesting on the total amount borrowed. The program allows for more than $700 billion. It simply says the Fed cannot have more than $700 billion outstanding at any one time. In other words, it will function like a line of credit in that they could have $300 billion, sell it, buy $400 billion, sell it, buy $250 billion, sell it, buy $400 billion, etc. etc.

Although I support the plan, the touted ramifications should Congress not act sounds eerily like George Bush's threats of Armageddon should we not invade Iraq. Anyway, that's it for now. I'm going to follow up in a couple of days after I get some sleep and do more research.

Useful Sites

2008-09-19T09:45:00.000-07:00

You'll notice to the right that I posted some of the financial websites I check on a regular basis. I clearly did not list all of them, but most of the ones I thought were helpful. In addition to the ones posted, I would also like to recommend reading commentaries and whitepapers posted on the sites of the various Federal Reserve Banks across the country. I didn't list their links because there are 12 of them, but you can get to them from here:

http://www.federalreserve.gov/OTHERFRB.HTM

You'll also notice underneath the "Useful Websites" list that I have a short list of "Interesting" websites. These sites are owned by prominent venture firms (the same ones that started Google, Yahoo, Amazon, eBay, Apple, 3Com, etc.). There's no shared theme, other than they are all owned by venture capitalists and could be the next big thing.

You can also click on the map to the right for local news on any country in the world.

Indeed, the other shoe has dropped

2008-09-17T09:02:00.000-07:00

The current environment demands and explanation. So let me first reiterate the impact of uncertainty and then share one perspective on the recent news of Merrill, Lehman, and AIG.

"Uncertainty" is different than "Risk." In risk, the underlying probabilities of a certain event are known, as well as the effects (i.e. you are able to quantify the payoff) those events will have. Thus, roulette is a game of risk (all probabilities and payoffs are known). War is an uncertainty, in that the effects of the same can't be accurately quantified. As I stated in a previous post, when you are unable to quantify the problem, the more likely you are to follow the herd. And the herd will demonstrate a tremendous amount of overshoot (up, if the news is good, down, if the news is bad). And the less one is able to identify the "high" and the "low," the less likely the trend will end anytime soon. The presence of magnificent leverage, or debt, exposes both institutions AND individuals to extraordinary financial risk amidst uncertainty. So I think we're in for a long ride. Unfortunately, the overshoot and uncertainty is so great, and the leverage all too common, that it has produced multiple victims (seen in high profile bankruptcies on the corporate side, and massive foreclosures on the consumer side).

Now, on to the hemorrhaging on Wall St. Merrill was sold to Bank of America (not a big deal, although alarming), Lehman declared bankruptcy and will sell off various divisions, and AIG was bailed out by the government. I don't think I will address the actual remedies of Merrill Lynch, Lehman Brothers, and AIG. Those have been treated in great detail by others more qualified than me. Perhaps the question you may be asking is, "Why was one sold, one bailed out, and one not? And what does that say about our financial system?"

Merrill Lynch was wise and found a potential buyer before things got really ugly. They realized they were going to run out of money. But unlike many of their competitors that kept the news quiet until the last moments, Merrill's CEO was forthright and honest about the current state (probably because he was only hired in November and is still in the honeymoon stage with the Board). In the words of beloved JPMorgan CEO Jamie Dimon, "It's one thing to buy a house (referring to BoA's acquisition of Merrill), it's an entirely different matter to buy a house on fire." Merrill bailed while the flames were beginning to torch the grass but have not yet reached the home.

Before discussing AIG and Lehman, let me interject here that I've been pleased with the coordination between Bernake's Fed and Paulson's Treasury (the Fed is responsible for monetary policy while the Treasury is responsible for fiscal policy, or, how the government spends money). They've both approached this disaster with very innovative ideas, which I think are in the best long term interest of the U.S. economy. The biggest problem most people have, rather, what I hear people complain about most frequently is the doctrine that government should not undertake bailouts because it creates a type of "moral hazard." Although the government is stepping in to help AIG, average taxpayers face a higher standard of living over the long run from utilizing a taxpayer-funded "bailout" to re-establish growth than they do by permitting a collapse of the global financial system. Furthermore, management and shareholders often pay a heavy price under such circumstances (which is not the case in other countries where governments have stepped in and protected shareholders).

So why save AIG and not Lehman (who filed for chapter 11)? Although Lehman is huge, AIG is the hub of a spoke and wheel network whose wheel is the global economy. Their integrity must be protected. One economist we work with said, "what we are seeing is a certain level of experimentation and sampling. The financial system has never really been stress-tested and is evolving." No one really knows how it will end up. That makes it difficult to say "bailouts" are either good or bad. Apparently, the risks of testing the system by letting a huge global giant like AIG go bankrupt are too high to assume until we have experimented with smaller companies, like Lehman. I believe we are seeing a testing-while-protecting strategy from the Treasury and the Fed, and, I think on the balance, they are doing a good job.

Again I'll end with an ominous prediction. Whose next? Wall Street seems to think Morgan Stanley and Goldman Sachs are next (based on credit default spreads, which gauge risk). I would not be surprised to see a partnership between the two. I would be surprised, if twelve months from now, those two organizations still stand independant.

Did $100Billion of Stimulus Checks Help?

2008-08-20T11:43:00.000-07:00

Somebody at worked asked me if I thought the stimulus checks sent out in May and June of this year have helped prop up the economy. The short answer is that it's too early to tell. But, doing some preliminary math will add at least some transparency. The federal reserve shows that the household savings rate spiked in May and June to 4.9% and 2.5% respectively (compared to .61% over the last three years). In order for those numbers to hold true, then Americans recieving rebate checks would have had to save 80% of May rebates and 60% of June rebates. This isn't exactly what the Fed was hoping for. The goal was to either boost spending or extinguish debt, and, so far, none of that seems to be happening. Although the rebates do seem to be supporting consumer durables (necessities) the general impact on spending does not seem to be proportionate to the size of the rebates. But, most experts agree that we need to see data from the third and fourth quarters to be more definite. And then you have to ask yourself, "was this even the best way to spend $100 Billion dollars?"

The Current Economic Conundrum

2008-08-16T20:57:00.000-07:00

My wife informed me that I must be more brief in my posts. So while I make no promises, I will try my best.

The market has been all over the place the last couple of months and pundits are on both sides of the fence as to when and how this slump will end. What I want to do is briefly share four things that explain the current environment and offer an ominous prediction. I'm not saying these are the only four drivers, but they make a lot of sense to me. These are simply four "conclusions" I've reached through informal conversations with economists, and really old bankers.

1. Too much debt, or, in finance speak, "Leverage." Finding the right amount of debt a society should use is difficult. People need access to mortgages and banks need access to collateral. However, it turns out that too much debt is bad for society. That may be obvious in today's environment, but some economists actually saw this downturn coming years ago. The reason too much debt is bad is because it increases the riskiness of societal wealth without creating a proportionate economic gain. In other words, too much debt, or leverage, creates a cycle of boom and busts that cause people to lose their home and job more often than would be the case. Since 1990, the volatility of personal income (measured by standard deviation) has remained the same. While at the same time, household debt/income ratios went from 80% to 130% over the last ten years. So, as a society, we've increased debt without increasing the stability of personal income. And societal wealth growth (measured by GDP) averages 3.4% and is unaffected (directly anyway) by the use of leverage. (FYI, sources are the Federal Reserve, BEA, and SED).

2. Uncertainty. Due to some very complex financial engineering, there is a high degree of uncertainty on Wall St. these days. Nobody has any idea how bad the current mortgage defaults will effect the economy. Note, everyone is in agreement with regards to the fact that the news is "bad," but nobody can quantify it. And being able to quantify the impact of certain events is a main premise of risk management. In an environment of high uncertainty, markets tend to overshoot (overly optimistic or pessimistic depending on the news). Everybody is on a train and no one knows when to get off. The only thing you know is that nobody else knows when to get off. This is precisely why banks have been writing off loans for the last three quarters, rather than coming out at one time with the appropriate number. They are clueless

3. Oil (and other commodities). What is so interesting about oil is that demand has increased over the last five years even with rising prices. Why is this? Because of the growing middle class worldwide that want to drive cars. Although demand for oil in the U.S. may decline, it will not in India and China. The other problem elevated prices create is delayed exploration in new fields. Why increase the supply if that will drive down my price? This is the thinking of most producers. Obviously high food and energy prices effect consumers to a greater extent when they don't have any money and are unemployed.

4. American Short-termism. There is no incentive for publicly traded companies to manage for the long-term. Wall Steet CEO's are rewarded and evaluated against quarterly earnings. This creates an incentive to do what may be profitable today, at the expense of long-term economic viability. Citi Group's CEO said, last June, "As long as the music is playing, you have to dance." Well, now it's not and he got fired. However, he would also have been fired for not taking advantage of easy money (i.e. debt). So this model has to change.

Conclusion. With the global middle class tripling over the next 15 years I predict the U.S. will not be the global economic leader it has been for the last 20 years. It's not only the demographics that are not in our favor, but the huge amount of debt we carry. At some point, you have to pay the piper and I think the time has come for the U.S. No other country (accept the U.K.) is more leveraged that we are. If our major lenders (China and other developing countries) wanted to redeem their loans (because the U.S. economy is no longer the safest) that will mark the end of our high consumption economy as we know it. It's ironic isn't it? That these developing economies have aided our growth over the last 10 years.

Gas at 3.99 a gallon? What fortune!

2008-07-14T20:30:00.000-07:00

A few months ago I wrote in my post that the current economic condition would worsen over the next year. At the time, although the Dow Jones had dropped 1,000 points to around 13,000, it was holding against rising oil prices and a weakening dollar. Many experts proclaimed that we had reached the proverbial bottom and were on our way out. Today the Dow is holding just barely above 11,000 and is coming off the worst June in 20 years. There is also talk that Freddie Mac and Fannie Mae are insolvent (which I'll write about next). I'm not one to gloat, but I will say I told you so.

Maybe you noticed last week that oil leveled off a little bit. Did you wonder why? I'll explain in a moment. The other day I was forced to listen to a comment by a presidential candidate (who shall not be named since this is a bi-partisan blog, but, I'll just say he's the older of the two) regarding how nefarious "speculators" are to blame for the high oil prices. What?! It's painful for me to listen to someone who pretends to understand the drivers behind billions of dollars moving among billions of homo-sapiens the world over. Of course, it's my job to explain this (rather, why he is wrong) to the four readers of this blog. How can a system be right when people are making money and wrong when people are losing money? This smacks of public pandering! And how does this relate to oil prices taking a brief respite from their break-neck ascent last week? Read on.

What are "speculators?" It sounds like a dirty word that connotes greed and irresponsibility, but that could not be further from the truth. I'll explain in more detail shortly. This presidential candidate was blaming the derivatives markets, which is sometimes synonymous with "speculation." I'm not going to explain what a derivative is except that it is only an asset class, like a mutual fund, but could be defined further. Options, Swaps, and Futures are all "derivatives." In this case, the blame seems to be directed at the futures market.

I love the futures market! Here's how it works. Futures allow organizations/people to lock in future exchanges (backed by a contract) at future prices. If I'm an oil refinery, I can buy a futures contract committing to buy a certain amount of oil from a seller who agrees (in contract) to sell the oil at a specified price at a specified future date. By the way, this is exactly why Southwest airlines is whoppin' up on their competitors. They bought futures contracts years ago that allowed them to buy oil at $60/barrel today! They can lower fare prices without losing profit and they are killing their competition. Futures markets allow organizations to control some of the volatility behind prices. For example, say Southwest airlines wants to add a new route but it would only be profitable if oil stayed below $90/ barrel. At the same time, say an oil company wants to drill in a new oil field but this endeavor would only be profitable if oil stayed above $80/barrel. A futures contract can be negotiated at $85/barrel between the two parties. It's a win-win. The value of the contract itself is adjusted periodically depending on the price of oil relative to the negotiated price. But the contract now allows both the oil company and airline to move forward regardless of market outcomes. So, why the blame?

Here is where large institutional investors like Pension funds are involved. There are two types of speculators; traditional and index. Traditional speculators engage in active buying and selling. Index speculators usually have an investment policy that stipulates how much exposure the pension plan can have to derivatives instruments. If the policy designates an allocation of 2% of assets, then the plan purchases futures contracts to gain their 2% exposure. What this one presidential candidate claims is that these index speculators never sell their contracts and thus "remove" liquidity from the system, which increases demand and, subsequently, prices. But this conclusion is simply unacceptable.

If a large pension fund decides to allocate 2% to oil futures at, say, $120/barrel, then any rise above $120/barrel would increase the value of the overall contract, right? Therefore, instead of having a 2% exposure, a fund might find themselves with an exposure of 2.5% (of the overall portfolio) reflecting the increased value of the futures contract, especially if the rest of the economy is in the crapper (which it is) and other holdings are decreasing in value. At this point the pension fund must "rebalance" the portfolio, or bring the allocation back in compliance with the 2% mandate. This forces the fund to sell .5% of their futures contract. This could easily equal millions of dollars which would push the price of futures back down. So institutional investors actually help the market. What is the corollary to the recent fall in oil prices last week?

Many institutional investors have fiscal year-ends of June 30th. Many of them also have direct exposure to oil and oil futures. Every quarter or year-end these funds must "rebalance" their portfolios to bring them back into compliance, which means selling off oil futures as well as direct exposure in equities. Increasing the supply back into the market decreases the overall price of oil. Over the last two weeks, plans across the nation have been rebalancing portfolios thus bringing down he price of oil futures and energy stocks in the short-term. Futures contracts allow companies to continue focusing on core business strategies instead of worrying about commodity prices. And institutional investors bring much needed liquidity to the derivatives market and help to keep prices in check.

Banning institutional investors, like this candidate proposed, doesn't help anyone and only displays obvious ignorance.

Section V- Why you will probably make bad decisions; a brief note on behavioral finance

2008-06-25T20:48:00.000-07:00

What would you estimate the average weight, in tons, of an adult male sperm whale to be? Go ahead, try and answer.

How about giving a high and low estimate, in miles, of the distance between here and the moon?

If your answers to both of those questions were narrow ranges, like 5 to 10 tons for question one or 100,000 to 150,000 miles for question two you probably are susceptible to overconfidence bias. Psychological biases will play the single most important role in the success of your personal investment program. Fortunately, most biases are the result of simple ignorance and can be solved through education (there are also intense emotional biases that I won't cover here). In case you're wondering, the answer is 20 tons and 240,000 miles. Those of you that answered with wide ranges probably are less likely to develop overconfidence bias.

Individuals demonstrating overconfidence bias will usually have concentrated portfolios as they believe they possess superior analytical abilities and selection skills. They will also tend to ignore the potential downsides as they believe it is unlikely an investment they select will lose value. Luckily, the overconfidence bias is cognitive, meaning it is treatable with a little education.

Advice: Be upfront and honest about your capabilities and get an outside opinion. If you have been managing your own money for awhile, be honest about your performance. This is why Financial Advisors are so helpful, they act as a filter for your dumb ideas and biases.

Here's another question:

What is the probability that George (a shy, introverted man) belongs to Group A (stamp collectors) rather than Group B (BMW Drivers)?

You might conclude that George's shyness is more typical of stamp collectors than BMW drivers when statistics show there are more BMW drivers than Stamp collectors.

This is called Representative Bias. People have a tendency to group situations into familiar buckets, even when statistics disagree. Here's how it might play out in your mind as you are investing. Say you're looking for a great long-term investment and your friend informs you of a hot pharmaceutical stock that will have an IPO and explains the kind of drug the company manufactures. This sounds good to you so you go ahead and invest. The problem? You incorrectly assume that owning a company that might potentially have an IPO is a good long-term investment. Statistically speaking, it is more likely you will lose money over the next few years. You have to actually ask yourself if you've made an incorrect assessment of the situation. Again, your best friend is information. Always study the behavior of a potential investment and approach the decision logically. Understand where the opportunity falls.

One more, try this question:

Say you're outside washing your new car when your neighbor comes by. He notices your new car and immediately says, "Wow, did you know they are giving away free DVD players in model XYZ?" You were not aware of this when you made your purchase. What do you do?

If you run inside and begin to do research but then stop, for fear of what you might learn, you may suffer from cognitive dissonance (buyers remorse). This bias causes all sorts of problems for investors. CD happens anytime someone has to make a selection. While the offering we select has obvious downsides, the one we didn't select has redeeming qualities. Investors dealing with CD often won't sell a poor performing holding only because they do not want to confirm they made a bad decision. Or they might continue to contribute money to a poor performing holding to simply confirm their earlier decision that it was a great investment. It also leads to herd behavior and following the press.

Cognitive dissonance is such a tricky bias to deal with. The best thing to do here is to set ground rules ahead of time, have a plan and maintain objectivity. In the case of selling a losing investment, your policy might be that it's O.K. to hold on to a losing investment for 18 months (or whatever timeframe) and then re-evaluate. Adhering to a policy helps to mitigate the potential dissonance one might feel as the result of a previous decision.

Now, I just shared three basic, albeit pervasive, investment biases. The questions above come from a great book by Michael Pompian entitled "Behavioral Finance and Wealth Management." The point here is that as an investor, you are aware that you most likely are making a biased decision. If you find yourself making decisions without consulting disinterested third parties or gathering independent information, you may want to take a step back and attempt to identify your logic. At the same time, try and understand when an exception to the prevailing data may be warranted and if you are then justified. But for heaven's sake, don't listen to somebody's hot tip at the family reunion!

Next week I'll be back to blogging about current economic events. Stay tuned.

Investing IV

2008-05-29T21:25:00.001-07:00

I ran into a person recently who was relentless with their "index investing" mantra. And let me repeat, index investing makes a lot of sense for those who do not consider themselves very sophisticated or those who do not want to bother with management. Your essential claim is "the general market's expectations are more accurate than my own would be." And that makes sense for some people.

Now I want to turn to portfolio strategy for a moment, then I'll turn to vehicles and useful tools. The strategy I laid out in the last post (mixing actively managed funds and passively managed funds) is called the Core/Satellite strategy. In this strategy you gain broad exposure by investing in index mutual funds for the majority, or core, of your portfolio. The core is usually made up of a Large-Cap U.S. index fund, a Mid-Cap U.S. index fund, an International Index fund, a Real Estate index fund, and a Bond Index fund. This should comprise about 70-85% of your portfolio. The rest is meant to be deployed a little more strategically in opportunistic or alternative investments. So what are some of those?

Emerging Economies: Tons of variety here. If you want Indian nano-tech, you can find a fund in that space. This could be a country or industry specific investment. Other up-and-coming countries to evaluate would be Vietnam, Ukraine, Scandinavia, Poland, Brazil, Mexico, and South Africa. You are looking for political stability, strong GDP growth (above 4%), currency stability (if the currency is pegged to the dollar, that is generally not a good sign. The country should have a market determined exchange rate), and a favorable business environment that enforces rules.

Infrastructure: Infrastructure is another interesting space. Infrastructure includes roads, bridges, utilities, airports, etc. The asset class will not give you as much up-side potential as investing in equity mutual funds because they are more conservative. But, they could dependably offer a return in the high single or low double-digits. Also, most infrastructure is tied to inflation (i.e. tolls, utilities, etc) so you can protect against potential rampant inflation. Inflation may not be your concern in the U.S. but it might be in Latin America. Infrastructure could give you meaningful exposure without the risk of losing big in the event of a massive peso devaluation.

Commodities: These include precious metals, timber, crops, and oil. Obviously these have been attractive areas over the last few years. And they are the only asset class that is negatively correlated with the S & P 500, meaning they do well with the stock market performs poorly (the opposite is also true). Commodity prices are tied to inflation, when inflation increases, so do commodity prices. There is also a strong demand component. Global demand is what really fuels commodity prices. As you might guess, developing countries like Brazil, India, Russia, and China are consuming more and pushing the global demand for commodities through the roof.

Clean Tech: Here's an area that has received substantial attention over the last couple years. You can reasonably assume that major dollars will continue to flow to cleantech. This is a very broad area that covers solar power, wind power, alternative fuels, green infrastructure, etc. However, the asset class is very dependent on political mandates.

You can make investments into any of these arenas through mutual funds. You could also use ETF's. ETF stands for Electronically Traded Fund. Their composition is similar to a mutual fund (pool of money spread across various holdings), but they trade like a stock. To this point, I haven't mentioned trading. Whenever you trade a Mutual Fund you have to wait until the close of business to get your price. So, if I decide at 9:00am to sell my mutual fund, I can enter (assuming you use an online account) the trade but will not know what the underlying price of my fund will be until the close of business. Many people don't like that. With an ETF, you can trade immediately and know exactly what the price is. They are also cheaper than Mutual Funds, with lower expense ratios. The downside? Everytime you buy or sell, you pay a commission (which is minimal). If you are one to actively trade, they probably don't make sense. But if you are the type to buy and hold, then they are a great option.

Some websites are very helpful in building a portfolio. I've mentioned Morningstar, but there are others that are equally as helpful. Here's a list.

Yahoo Finance (www.yahoo.com) Portfolio tracking and market news
Motley Fool (www.fool.com) Advice
Bogle Heads (www.diehards.org) People will critique your portfolio (beware, not are all qualified)
AAII (www.aaii.org) American Association of Individual Investors. Great site, excellent resource. You can become a member for a very small fee (I think around 20 dollars) and they will introduce you to various portfolio strategies with performance. They also put out a nice publication and list top finance websites.

There are thousands of others, but the ones above are a little off the beaten path. In my next post, I'll tie up personal portfolio construction.

Investing III, Picking apart a Mutual Fund

2008-05-23T21:36:00.000-07:00

Finally I'll get to some of the finer points of personal portfolio optimization. One quick word about Stock picking first. I used the example of purchasing one share of stock in my previous post; well, you can't really do that. Stocks usually sell in lots of 100. If Citigroup is trading at $60/share, you need to fork out at least $6k. Again, that's why MF's make more sense (for most people).

What the Heck do all these numbers mean?!

Let's pick apart a mutual fund. Here's one from Morningstar's website; Fidelity Large Cap Stock. The name tells me that this is a mutual that invests in Large Cap (see previous post) companies. The "ticker" (used for referencing, is FLCSX). You can look it up yourself at www.morningstar.com by typing in the "ticker" in the upper left hand corner. Now, let me explain some of the salient terms you should definately know!

Front Load: None. What is a "load"? It's a commission. There are front, back, and no-load mutual funds. A so-called front loaded mutual fund is one that has a commission right off the top, usually 4-6%. So approximately 95% of your money starts working for you. A back-load is where you don't pay anything up front, but you do when you sell it (usually the same commission). No load means no commission, and no help. Meaning, most mutual funds that brokers offer will carry a commission, or, you are paying them for their advice. No load mutual funds mean you don't have an individual to talk to. Fidelity, T. Rowe Price, and others are all no load mutual funds. There is no dedicated advisor that you speak with.

Expense Ratio: .81%. This is your annual cost for the fund. This money pays the guy managing the money and his staff. Again, large cap mutual funds are generally cheaper. Expense Ratios range from .05% to 2.5% a year.

Minimum Investment: $2,500.

Standard Deviation: 10.9. This is a statistical term that measures volatility. Nevermind how you calculate it, it's the interpretation that matters. One "standard deviation" means that if you looked at the historical performance over a certain time period (in this case five years per the website), the returns of the fund would have fallen within plus or minus 10.9% of the five year average (which is 11.35%) 70% of the time. There's a good possibility (70%) that the value of your fund will be somewhere inbetween 22.25% and .45%. Obviously, for two funds with the same standard deviation, you want the one with the higher average, and given the same average, you want the one with the lower standard deviation.

Alpha: 1.71. Alpha measures out-performance, the higher the better. In other words, given the amount of risk the manager is taking, they are adding 1.71% of value through their skill.

Beta: 1.17. Beta measures the amount of risk they are taking. A Beta of 1, means they are taking the same risk as their index. The higher the Beta, the more returns will swing. So, if the market goes up 1%, this will go up 1.17%. If it goes down 1%, it will go down 1.17%. Again, these are all historical numbers that may not explain the future.

R-squared. 92. Another statistical term that essentially tells you whether or not you can use Alpha and Beta in analysis. If the R-squared is below 80, you should throw out Alpha and Beta as a means for explaining how your mutual fund will behave.

Number of Stock Positions. 185. You would own an interest in 185 publicly traded companies. Not bad for $2,500.

All this will help you understand a mutual fund, but how can you tell if your mutual fund is beating it's "benchmark?" A "benchmark" is an index.

Why You Need to Look at Indexes

Indexes are really important. What is an index? It's essentially a basket of stocks tracked by wall street that are supposed to represent a particular constituency. Here is a list of indexes that are most widely followed.

Dow Jones Industrial- Measures the stock performance of 30 U.S. Blue Chip companies.
S&P 500- Measures the stock performance of the 500 largest U.S. Corporations
Russell 1000- Measures the 1000 largest companies on the U.S. stock exchange (92% of all traded securities).
Wilshire 5000- Broadest index measures all U.S. equity securities.

The above are all U.S. indexes only. Chances are, your portfolio will track the indexes pretty closely. Which one should you follow? That depends. Obviously the Dow Jones, on its own, is not sufficient since it only follows 30 companies. If you're holding a portfolio of Mutual Funds, spread across various asset classes, you are holding thousands of securities. The answer is that your large cap mutual funds will follow the Dow Jones and S & P 500 fairly closely. Your medium and small caps will more closely track the Russell and Wilshire indexes. What about international?

MSCI EAFE- This stands for Morgan Stanley Capital International. The "EAFE," stands for Europe, Australia, and Far East. Your international mutual funds will track this one more closely, assuming you're in developed economies.

The key with looking at indexes is knowing what their constituents are. If you are properly diversified, no single index will explain your portfolio.

My Original Questions Was..

Why should you follow them? If I owned the mutual fund above, then my index would probably be the S & P 500. I want to know if the Fidelity Large Cap Stock mutual fund outperformed the S & P 500. Why? Because I'm paying for it (.81% a year). If the manager can't outperform, then I would rather just invest passively in the index and not pay anyone for it. Wait, you can do that? Oh yes....

Index Mutual Funds

One way to cut down on costs in your portfolio is to "index" your portfolio using "index" mutual funds. The premise for indexing comes from the aforementioned post on "efficient market theory." Which states that the market correctly prices every security, at any point in time, due to the transparency and availability of information. Adding to this is substantial research showing that most mutual fund managers will underperform their index, net of fees. There are mutual funds that are "passively" managed. This means they look at a certain index, i.e. the S & P 500 and do absolutely nothing but hold the exact same 500 companies in their fund. And for this, you pay a measly .05%. Much better.

There are many huge proponents of index investing. These people will quote tons of studies that illustrate what a rip-off advisors and money managers are since they can't beat the index and charge unnecessary fees. But I'm not entirely on board with index investing. In financial services, everything has a place and time. And there is definitely a time for active money managers. Indexing only makes sense for those asset classes that are very efficient, like Large, publicly traded, companies. But other asset classes have major inefficiencies (By inefficiencies I mean that it is possible for you or a money manager to know something that the general public does not). Inefficiencies increase as you move down in size (from medium to small and even micro-caps) and down in economic development (developing or emerging economies). Few analysts cover these areas and you can find some money managers doing very well in these spaces. With this in mind, a more efficient portfolio might look like this:

Large Cap: Index Fund
Mid Cap: Index Fund
Small Cap: Actively managed fund
Micro Cap: Actively managed fund
International, Large Cap: Index
Emerging Markets: Actively managed fund

Next up, "Beyond the Core (interesting opportunities and vehicles and the problem with Mutual Funds)."

What to do with your money, Part II

2008-05-18T21:28:00.000-07:00

Once you've taken care of the short term, how do you go about building a portfolio, and what instruments should you use?

First things first. You should take a survey that allows you to asses the amount of risk you are willing to bear. There are numerous surveys available for free to help you do this. Here's one from T. Rowe Price, http://www.troweprice.com/common/indexHtml3/0,0,htmlid=904,00.html?rfpgid=8283

They mostly ask about your time horizon and your appetite for volatility. In other words, if you come home from work and find out that the Dow was down 5%, are you going to freak out?

Let's walk through the basics to portfolio construction. In the next post, I'll talk about how to understand and interpret the market.

I'm going to assume the long term here. In other words, I'm assuming you have adequate savings, and have paid off high-interest bearing debt.

Let's say after taking a survey, you (via the survey) determine that your asset allocation should look something like this: 50%Large-Cap U.S. equity, 15% Mid-Cap U.S. equity, 10% Small-Cap U.S. equity, 20% International Equity, 5% bonds. Now, let's stop there. What does all of this mean? 'Cap' stands for capitalization. This is calculated by taking the price of the stock and multiplying by the shares outstanding.

Large-Cap Companies: These are the largest companies in the world, i.e. Wal-Mart, Exxon, etc.
Mid-Cap Companies: Smaller than the large-cap and generally lesser known. But they are still huge. Examples include Starbucks and Abercrombie and Fitch.
Small-Cap Companies: Smaller than the mid-caps and fairly obscure. Still, they are very large with several hundred million in annual revenues. One semi well-known company is Ann Taylor (if you're not married, you probably haven't heard of it)
International Companies: Don't let these scare you. Most of these are very well-known in the U.S. Some large international companies include Toyota, Nikon, Rolls-royce, Bayer, Daimler, and Nestle.

Wait a minute, can't international companies be broken down further into large, medium, and small? Yes, but for simplicity, I will not do that here.

How do these categories react? Well, what you should be more concerned with is how they react to one another. In other words, if large-caps get slaughtered, will small caps as well? And if it's a bad year in the U.S., will my international portfolio also get slammed? That's the whole point to diversification, it isn't necessarily adding a ton of different holdings, but adding ones that do not correlate with eachother. How many times has the U.S. been the number one performing economy? Never! That's the argument for having exposure to international companies.

Tools to use

Mutual funds (I'll suggest some hybrids in my next post so don't run out and buy anything yet) make the most sense in trying to build out your portfolio. Why? Going back to my previous post, you can purchase one mutual fund that will hold 100 large-cap companies (or mid-cap, or small-cap, or whatever). If you want nano-tech in India, there is a mutual fund for that. If resources are tight, you could buy one mutual fund for each type of asset class and be done. Now, for this, the average mutual fund will charge anywhere from .5% to 2% a year, with small-caps and international stocks on the higher end (reason being more research goes into those asset classes). I'm being very general here, I will explain more in the next post, but this will do for know. I like morningstar's website the best (www.morningstar.com), you can register for free and get great information and search available funds.

Why I'm not a stock picker

Again, greater detail will be forth coming, but, in general, I'm not a stock picker and I don't think others should be. To be able to properly assess whether or not you are buying a company that is fundamentally worth more than the market is pricing it at (for this is the premise to picking stock of an individual company) you would have to know how to properly conduct a company valuation (which most people can't do) and have a very good grasp on intermediate to advanced accounting issues to locate potential trouble spots. And even if you could do that, the chances of you knowing something that hords of Wall Street analysts don't already know (when they travel in their Jet to meet with the CEO), are slim. Most likely, they've already priced the stock accordingly. This is called the "efficient market theory." Which says, the greater the transparency (the U.S. market is highly transparent, almost to a fault), the higher the efficiency which means the less likely it is that you will uncover something the "market" did not six months ahead of you. Does that mean the opposite is true (i.e. emerging markets)? Yes, now you are beginning to understand. I'll save advanced portfolio construction for the next post.

So what do we know now? We know that, taking a longer time horizon, we should have our money spread across multiple asset styles in order to hold assets that do not correlate with eachother or have a very low correlation. And, the quickest way to obtain excellent diversification is through mutual funds. And that I've deferred the 'meat' of the discussion until next time. Take a look around at some of the websites, it might make the next post more meaningful.

Now we have a basic introduction to portfolio construction.

Basic Investing

2008-05-12T20:37:00.000-07:00

So I'm thinking I should actually write a post on investment strategy, since that's what I set out to do in the first place. But, I'm not sure where to start. If you're an "experienced" (defined as your mastery of knowledge and practice, not time) investor, then you could probably skip this post. I'm a little anxious because there are actually some very attractive opportunities out there that people should be taking advantage of (and it doesn't involve recruiting others and making $8million dollars a month without getting out of bed). I'll start with some vocab, and then, in a few days (I promise), I will follow up with some of those interesting opportunities. Then I'll conclude the 3-part series with some basic behavioral finance.

Basic terms.

Stock- Stock represents ownership in a company. If the company does well, you do well. Likewise, if it performs poorly, the value of your stock decreases.
Bond- A Bond represents a loan that YOU make to the company. In other words, a company may need $10million dollars for a new venture and they want to raise money for that venture. They issue bonds which means they will pay you for lending them money every year, and, at the end of whatever time frame (1,3,5,10 years), you get all your money back. So you get your money back and you get all the interest payments in the meantime. Whereas a stock is OWNERSHIP in a company, a bond represents LONERSHIP. What's the downside? Bonds are backed by the full faith and credit of the issuing institution. The more risky the institution, the more interest they pay you in the meantime (thus government bonds are considered to be the safest and pay the least amount of interest).
Mutual Funds- Sometimes the cost of one share of stock or the purchase of one bond is prohibitive. For example, a share of Google may cost you a few hundred dollars. Or one bond might have a minimum face value of $1,000 dollars. Additionally, you may not like the fact that all your wealth is tied up in a few companies be it as a stock or bond. Mutual Funds are the answer. Nevermind the name, here is what they are. They basically pool everyone's money and buy in bulk. So, you may only have $1,000 dollars to invest. Well, you could own a few shares of Google, or, maybe, one share of Google, and maybe a few shares of something else. You could also buy one bond (maybe). Or, you could buy a Mutual Fund. Here, they combine your $1,000 dollars with everyone else and come up millions of dollars. Then they go out and buy shares, or bonds (usually one or the other, but not both), in several different companies (typically 100 or so) and you participate proportionately. Now, instead of only being diversified over a few companies, your spread across one hundred. Much more diversification. Which is an important term.

Where do you put money? How do you start? Here are my basic rules.

Take the free money
Short term savings. First things first, if you don't have 3 months worth of living expenses in a savings account you should do that first.
Employee Retirment Plans. Some of you may have a 401(k) where you contribute 6% and your employer will match it (remember, you should do this. See rule number one). If you can't contribute the max, then start with whatever you can, because your employer matches.
Roth IRA. This is a personal retirement plan. The IRS allows you to put a certain amount of money away each year that grows (without taxes) until you take it out (can't touch it until you're 60 without penalty). When you get to distributions, you don't have to pay taxes on them. This is a nice compliment to your 401(k), which you do have to pay taxes on when you take distributions.
Brokerage account. This is where you open up that Fidelity, E-Trade, Scottrade, Schwab, T Rowe Price, account. You can buy and sell stocks or bonds whenever you like (but beware of extra costs).

As a note, 401(k)'s, IRA, and brokerage accounts are only shells--you still have to choose what to invest in (stocks, bonds, U.S., International, etc.)

Anyway, I'll get more detailed but I wanted someone with no experience to be able to read this and get a general idea.

Private Equity, friend or foe?

2008-05-01T20:52:00.000-07:00

Hectic week, easy post.

In order to understand the old, heavy-set, gentlemen (except on Fox, where, they've determined through scientific study, that when talking about money, people prefer to see women) that debate financial and market news, one should understand the world of private equity. And it's not too difficult to grasp but is so vital to our economy that I thought I would give everyone some insight into this very private world. You've probably heard buzz words in the news, or on the radio, maybe some terms like, "leveraged buyout," "Blackstone," "IPO," etc. First I'll explain the vocabulary, then move to economic factors that influence success of private equity firms, and conclude with advantages and disadvantages.

Private Equity is an investment in a privately held business. I know, no surprise, but many don't really understand what the alternatives are. Let me take a step back. Anyone can buy a share of stock. For example, if I fancy Microsoft, I can purchase one share of their company at any time and there is plenty of information available to help me analyze Microsoft. That's because Microsoft is "publicly" traded. What does that mean? It means the general public can buy shares and participate in the growth, or demise, of a company. In order to do this, Microsoft must follow very strict reporting and accounting guidelines so that the general public can make an educated decision since most people are not financial experts. O.K., good. How is private equity different again?

Who are they and what do they do?

Private Equity is an investment into privately held companies, so they don't have to comply with the excessive reporting standards of the SEC, and because of that, the general public can't participate. So who can? The SEC has determined that, because of the lack of transparency, only financially sophisticated and wealthy individuals/organizations can participate (in other words, you better know what you're doing). And they have a checklist to establish who may or may not be potential investors. Some privately held companies include AMC Theatres, Countrywide, Chrysler, IKEA, and Earnst and Young, to name a few. Rather than ownership being split up among millions of shareholders, private companies may only have four or five larger shareholders.

Some of the largest private equity firms are Blackstone, KKR, Caryle, Apollo, and Bain and Company. You'll hear about all of them in the news on a weekly basis. Now, here is where it gets a little tricky. These firms don't use their own money to invest in these private companies, rather, they mostly use debt and other people's money. And they will invest in multiple companies, here's how. Take Blackstone for example. Blackstone will say, "We think there are some pretty good deals out there, let's go raise some money to invest in these attractive deals." Blackstone decides they need approximately $10 billion to invest. Then they say, "We'll put in $1 billion and let's see if we can go find the other $9 billion from pension plans, college endowments, and large foundations." Once they come up with $10 billion in commitments they're ready to find deals.

Here's an example of how a transaction might work: Blackstone finds company A and offers $300 million (for example, $150 million could come from Blackstone's investors, and the other $150 million they might borrow from the bank) to purchase 51% of the company. This is called a Leveraged Buyout ("leverage," because that's what it's called when you use debt, and "buyout" because they are taking a majority). Once they take control, Blackstone works to improve the operations of the business with the intent to either sell it to someone else (for more than they paid), or take the company public (IPO, for Initial Public Offering) where they list on an exchange and offer shares to the public and comply with all the reporting guidelines.

What determines if they are successful?

Buying cheap. Isn't that how it works for everyone. Essentially, you want to make sure you bought the company at a very attractive price.

Access to Debt. Since they use debt to purchase these companies, the restriction of debt causes serious problems. That's why the credit crisis is affecting the large Private Equity firms. They can't get lending to purchase these companies.

An exit market. They have to be able to get rid of the company. A down market can really affect their two most promising exits; an IPO (again, offering shares to the public), or the sale to another firm. IPO's are hard because public investors do not want to invest in the new kid on the block when everyone is worried about the economy. A sale to another firm is hard because the prospective buyer may not be able to get lending from the bank to make the purchase in a tight market like our current one.

Are Private Equity firms good or bad?

There are two sides to the story. When private equity firms take over, they usually discontinue unprofitable or non-core business lines. This means job loss, which is never good. Conversely, some posit that private equity firms create better businesses in the long term. The argument here is that private companies don't have to be worried about quarterly earnings (as publicly traded companies do) so they can focus on building strong organizations rather than gaming accounting rules.

Anyway, hopefully this allows you to understand just a little more on the nightly news, or NPR.

Why I'm hoping for $6.00/gallon gasoline

2008-04-22T21:38:00.001-07:00

Gas prices are high. And while we don't typically see drivers rending their shirts and screaming up at heaven, cursing prices at the pump, most of us recognize it costs us almost twice as much to fill up our automobile now than three years earlier. So what's the deal? Is this outrageous price gouging? Are we running out of oil? Do we need government intervention? Again, answers are (in no particular order), no, no, and no. Let me attempt a meager explanation to the crude oil conundrum.

As you probably guessed, there are a few factors at play. But the underlying theme is that we are experiencing very basic economic theories here. What follows is an amalgamation of personal research along with some salient points as explained to me by an energy executive I met with upon contemplation of an investment.

What's behind the price?

Demand has a little something to do with it, I'll explain that in a minute. But approximately 30% of gas prices are determined by taxes and inflation. So, in an environment where both taxes and inflation are increasing, we would expect the price of oil to increase as well. According to the representatives I met, adjusted for inflation and taxes only, the price of a gallon of gas should be approximately $3.13/gallon. But prices are higher than that (based on national averages) and there is clearly more to the picture than inflation and taxes. It's the cost of crude oil, refining capabilities, and demand. Refineries are having a hard time keeping up since the energy infrastructure we are dealing with is thirty years old and was built to accommodate a somewhat lower demand. Producers also deal with increasing environmental compliance. Some crude is also more difficult to reach. Obviously, the easier it is to get from the ground, the cheaper it is. For example, because of the location (in the ground/ocean) of the crude oil in the middle east, it only costs about 15$ to extract a barrel, while in the gulf coast it could cost up to 65$ a barrel. Factors such as the depth and quality of the crude will determine the cost to pump and refine. But a common mistake is to think that the costs of production are solely responsible for the rising prices at the pump. The first step is to realize that inflation and taxes play a critical role. Now, is there price gouging on top of that? Nope.

Bottom-line, we don't have a choice. Or do we?

Price in-elasticity. That's what is at work here. In simple terms, if something is said to be price inelastic, it means that the change in demand will be minimal relative to price changes. If something in price elastic, then demand will change more drastically relative to price. What determines whether something is elastic or inelastic? Substitutes. For example, if you're going to the store to buy Ketchup you will notice there are roughly a dozen brands to choose from. And, for most of us, the Ketchup tastes the same. If Heinze decides to increase the price of their ketchup, most rational shoppers will simply choose another brand, maybe the generic label, because it is cheaper. In this example, Ketchup is price elastic, rather, the demand for their ketchup is very sensitive to price fluctuations due to the prevalence of substitutes. In contrast, let's take, um, gas as an example. If gas prices increase, where can we go for alternative fuel in the short term? Nowhere. There are no substitutes in the short term. If gas prices increase 20 cents between today and tomorrow, I can't go out and buy an alternative fuel. Then why don't gas stations simply jack the price way up? Because they also have to worry about the long run. Although I can't do anything about a gas substitute right now, I can over the course of a year or two. I can figure out how to take the bus, ride my bike, or buy an alternatively powered automobile. But for now, I'm stuck.

What about our shrinking oil supply?

Now that we understand a little about demand, let's briefly talk about supply. Is there a problem? Yes, but probably not the one you are thinking. Most pundits report we are "running out of oil!" or "We only have 30 years of oil supply left!" Well, this is technically, but not actually, true. Going back to the costs of production, it makes sense to drill where you know oil already is. Looking for more oil costs money. And you can rightfully assume that oil has been discovered long before drilling takes place. So even though the supply we are working with now is certainly finite, that does not mean we are talking about all the crude oil on the face of the earth. If I carried the pundits mentality of a shrinking oil supply to my own life it would be like me walking into my kitchen, examining all the food I have available, and then exclaiming "Holy crap! I only have 14 days of food left!" See the problem? I am going to buy more food and oil companies will drill in new reserves once the current lot is substantially depleted.

Now the truth to the supply argument comes from the uncertainty of demand. Oil companies try and forecast the demand years out in order to determine what they need to pump today (it takes roughly eight years to get oil from ground up). What they totally missed fifteen years ago was the demand for oil in China and India today. Whereas five years ago the industry could say "based on our current supply, we have 45 years of oil in reserves," today they are saying "if this current consumption keeps up, we only have 30 years of oil." But remember, we are only using developed oil fields. There's plenty more untapped elsewhere. So the majority of the huge spike has to do with anticipation of future demand (i.e. China and India in ten years).

The final problem comes from the control of the supply. Yes, it would make things a lot easier if we stopped threatening to nuke Iran. And you can be sure a major reason we are still in Iraq is oil. And Hugo Chavez (in Venezuela) hates our guts. By the way, what do I think of Hugo Chaves? Most experts agree he is a very astute populist politician. Here, I differ from the experts, I just think he's exceedingly stupid. In fact, he's an idiot! I don't know how you run a national deficit with the kind of oil money he's bringing in. Wait, yes I do. That leads me to my next point.

Government Intervention

Hugo Chavez, because he runs a socialist regime, has implemented price ceilings on many goods and services in order to make goods more cost effective for his constituents. What's wrong with that? Again, incentives. If I'm a corn producer why would I sell my goods to Venezuela, or any other state/country, if there is a ceiling on the price? I'm simply going to sell to whomever can give me the higher price (which may be another country). There goes your supply and you've increased demand by keeping prices artificially low. Consequently, you see long lines, shortages, and riots. While Hugo is waiving the Venezuelan flag, farmers are giving him the finger.

This is why price ceilings are not the answer to gas prices in the U.S. The free market needs to be able to do its job. What about in emergencies, like hurricanes? Again, the market should be allowed to do its job. In the Gulf states, during hurricane Katrina, many gas stations, for fear of impending lawsuits from price gouging, refused to raise prices even though there was huge demand. The result? Thousands of motorists stranded on the highway in the path of the hurricane. Recognize the ripple effect if the opposite happened. What if the gas station owner increased prices to $50/gallon or even $1,000/ gallon? "That's just price gouging," you say? How can an owner be accused of gouging if he can justify that his price meets the demand? That's rational economics. But, hear me out. Say the price, overnight moves to $200/gallon at news that a hurrican will hit land in two days. Then many would simply not be able to afford to fill up and leave town. Then they are incentivized to take extra precautions at home, or go to a fascility (like a stadium, school, etc.) or find any other alternative solution, which would decrease interstate traffic. But more important would be the long term impact if every consumer expected prices at the pump to climb due to emergencies. In short, consumers would come up with alternative plans, or any plan, and that would be a step in the right direction.

Look on the brighter side

The recent ascent of oil prices is finally making an economic case for alternatives. Before, it wasn't cost effective to produce alternative fuels, without governement subsidies. Now, we have an economic incentive to produce cars and other equipment that run on alternative fuels because they are becoming a more viable substitue for oil. For those "green" fans out there, the worst thing that can happen is for oil to fall back down to $50 a barrel. I say keep going up. I'm already reviewing how I'm going to adjust. Does this mean Ethanol will take off? No. Why? Because we eat corn. Anytime you try and create energy from part of the food chain someone is going to complain, probably, those that don't have food (as an aside, it's hard to make a compelling case for turning corn into fuel when there are massive food shortages in parts of the world. Maybe this shortage is the last straw we need to convince government that corn subsidies are a bad idea). No, corn-ethanol is not the answer.

Instead of imposing price controls, the government should make it easier for companies to refine oil (i.e. by lessening regulatory requirements, excise taxes on crude, and drilling requirements). That is, unless their constituents are asking for alternative solutions. In my estimation, this is the real issue. Cheaper gas prices create an economic argument against alternative fuels.

An incentive for innovation, that's what $5 or $6/gallon gas prices will do.

How a couple with no money and a home can sink Bear Stearns

2008-04-14T21:34:00.000-07:00

Raise your hand if you don't quite understand the whole financial crisis/recession/subprime writedowns/housing bubble/Bear Stearns bail out/insert any other financial term from the Wall Street Journal over the last quarter.

Since this is my first official post I thought I would cover a topic most are at least hearing about. The question some might ask is how subprime loans can bring down Bear Stearns. So I'll share my understanding of recent events (when I say "my understanding" it is because I've become acutely aware that even those in the closest circles on Wall Street don't really have any idea). Who's to blame? Where did it start? How bad is it? Are we in a recession? Well, if you only have thirty seconds, the answers are; us, late '90's, really bad, and "yes." If you have 15 minutes, read on.

Background

Some of us don't remember, but the housing market was a mess in the early '90's. By the late 90's many investors, both domestic and foreign, thought Real Estate was still a bargain. In the U.S. there was plenty of liquidity from the beginning of the internet boom and foreign investors were enjoying higher commodity prices and, yes, even rising oil prices. All this extra money needed a place to be and U.S. Real Estate was relatively cheap. During the dot.com bust the Fed, recognizing that the fragile Real Estate market could not endure another recession drastically cut interest rates.

Problem #1 Incentives

Since Real Estate was fairly cheap and debt was easy to acquire, it became more competitive. It went from using regional banks as lenders to introducing national and international competition. Loans became more "creative." The Fed also enacted several regulations to make it easier for Banks to make loans to low and middle-income families. By 2003 the "subprime" market was in full swing. "Subprime" refers to loans where lenders require little to no documentation, or where the credit score is below 660. This was also the birth of the infamous 3/1 or 5/1 arm, where the borrower pays interest only for either 3 or 5 years, then the rate increases after that. At the same time, the mortgage business essentially "split," meaning, the company that originated the loan was not the end owner of the loan. It is a basic principle of economics that people or businesses do what they are incentivized to do. If the loan originator was not on the hook for the actual performance of the loan, then what incentive did they have to make quality loans? But this is exactly what happened. For example, you approach a mortgage broker for a loan, they complete the underwriting and grant you the loan. If you read the language in the loan docs you will see that they have the right to sell your loan to a third party. So they do and did, they sold them to banks. It is no surprise, when loan officers work on commission, and their company isn't on the hook for the performance of the loan, that many loans were just plain fraudulent. What does this have to do with Bear Stearns? I'm getting there.

Problem #2 Magic

Let's use Citigroup as an example. Citigroup purchases thousands of these subprime mortgages from various originators across the country. These subprime loans pay more because they have higher interest rates (because there is greater risk) . Citigroup realizes that if they keep all these loans on their books, they have to keep money in reserves. Rather, the Federal Government mandates they keep a certain percentage of cash on hand in the event of default, so the bank remains solvent. Well, Citigroup's finest gather in a room to figure out how to efficiently manage this obligation. Their conclusion is that they can package these loans together, say 1,000 at a time, and sell them in bulk. Whenever you sell "debt," like residential mortgages, you must have them rated by a rating agency (Standard and Poors, Moody's, etc.) as to the safety of the packages. Since Citigroup is smart, they recognize if they simply package all the subprime loans together they will receive a lower "rating" (AAA is the highest, then AA, and so one to CCC, which is junk). So Citigroup bundles subprime and conforming (high quality) loans together. This is called "magic," I mean, a CDO (collateralized debt obligation). These CDO's are also able to achieve a AAA rating. What?! If they are subprime how do they get AAA rated?! Remember, this is a new type of "borrower," they don't have a track record since it didn't emerge in earnest until 2003 (and there are also high quality loans bundled in the CDO).

Problem #3 Greed at Home and Abroad

Back to the international markets for a minute. Interest rates determine the extent of foreign investment that flows to a certain country. For example, if I'm the U.K. I can invest my money locally, or in an international institution. I'm going to invest wherever the interest rate is highest. So, if interest rates in the U.S. are 3% but they are 3.5% in Japan, then I might invest in Japan (assuming the same relative risk). And governments usually invest in the safest instruments. In the U.S., those are government treasury bills...and now, CDO's. Yes, CDO's were AAA rated and paying 6% (on average). Somebody (and by "somebody" I mean, Bernake, Greenspan, and thousands of PhD's on Wall Street) should have called "Bull Sh#@%" There is no free lunch! How can two securities, rated AAA have different returns (3% vs. 6%)?

Problem #4 Tremors

Enter Bear Stearns, stage right. Bear Stearns, and several other investment banks, purchase billions of dollars in CDO's because of their attractive risk/reward tradeoff from banks like Citigroup. Since, in our example, Citigroup sold the loans they are off the hook, right? Wrong! In order to attract buyers Citigroup also sold insurance policies against potential defaults within the CDO. They are essentially guaranteeing liquidity. So they are very much still on the hook. Housing prices in the U.S. have never declined. Banks figured the appreciation in the underlying homes would offset any negligible defaults in the CDO's. Especially with housing values increasing at a 50% clip in some markets. Now we have the end owner, Bear Stearns, and the seller/insurance provider Citigroup, on the line for the mortgages. Back to the homeowner.

Housing values increased beyond what would be considered a financially healthy rate. Interest rates were low, debt was cheap, interest-only payments were easy, and originators weren't asking any questions. Demand exceeded supply for a couple of years. As housing values increased, home owners took out second mortgages to capitalize on the value of their home. With the second mortgages borrowers bought cars, purchased other homes, remodeled, and basically pumped a lot of money into the economy. Supply eventually exceeded demand as the Fed started raising interest rates. Housing prices started to "revert" back to the mean. Here's an example:

I buy a home in 2003 for $150k, no money down, with an interest only loan for three years, my payment is $800/mo. The value of my home over the next three years goes from $150k to $250k (Arizona, Nevada, California, Florida, New Mexico, Texas, etc.). During that time, I take out a second loan to purchase a T.V., two cars, a family trip, and to remodel a room, life is good. Since my three years interest only term is up, my payment turns in to principle and interest, $1200/mo. So I try to refinance. But instead of owing $150K, because of my second I owe $230k. And, because easy loans are no longer available, and my housing prices has fallen from 250 to 230K in six months, I can't get a loan for 100% of the value of the home. I can't make the monthly payment so I default.

This played out at the start of 2007 in certain markets and slowly, as these interest only loans came due, made it's way across the country.

Bloody Hell!

Mortgages started to default, Bear Stearns, and others, got the "willies." The rating agencies came back to the investment banks and essentially said, "That bundle of loans we rated AAA is really rated CCC, you have to write the value of the loans down." That's why you see all the banks writing down billions of dollars worth of loans. And they have no idea how bad it really is. The insurance providers are also getting kicked in the teeth because the defaults are much higher than forecasted. Making matters worse, banks like Bear Stearns purchased these CDO's with borrowed money. Now lenders aren't lending and they want their money back. No buyers, no lenders, out of luck.

JPMorgan Bailout

Bear Stearns was going to declare bankruptcy. That would have been devastating to our economy. Experts are pretty unanimous in their opinion that something of that magnitude could have started a Depression. Shareholders moaned when JPMorgan offered $2/share, which, in my opinion, was $2 more that what it was worth. Then JPMorgan offered to increase the share price to $10, just to help the shareholders. The additional $8/share came, in part, from the Federal Government! The Fed hasn't intervened to this extent since the Great Depression! This was huge! Here's the caveat; JPMorgan stands ahead of the Fed in Seniority. Meaning, if Bear Stearns doesn't get its act together and declares bankruptcy, JPMorgan will collect first and then the Fed (i.e. taxpayers). But, that is the lesser of two evils. If Bear Stearns would have declared Bankruptcy there would have been massive global panic. Everyone should send a personal thank you to Jamie Dimon at JPMorgan for his generous offer.

Not Over Yet

This is a long post. Banks did the same thing with credit card debt, auto loans and home equity lines of credit that they did with mortgages. These haven't hit the market yet. Logic is, if someone defaults on their mortgage, they will probably soon default on their auto loans and credit cards. If someone loses a job, which happens in a recession, then they will probably default on their auto loan or credit card. When, not if, this hits our economy it could plunge it into a deep recession. The answer must come from a correction in the housing market. The fed is on the right track with some of the adjustments they've made in addition to the interest rate cuts. However, this is really the fault of every American. We turn anything into an ATM that we can. We don't save and we demand cheap credit. Lowering interest rates is only a band-aid.

...More thoughts later

Why did I choose a Toad?

2008-04-11T22:39:00.001-07:00

First things first. Many of you might be asking, "Why does he call himself a Toad?" Jessica gave me that name when we were first married because of how I sounded when I sang. I know, kind of emasculating. But, I thought that was preferred to being compared to Josh Groban. Now THAT is emasculating!

Welcome to my Blog!

2008-04-11T22:02:00.000-07:00

With my wife's help, I've begun my own blog.

Working for a $7 billion pension fund has plenty of benefits. I get access to the top money managers and portfolio strategies used on Wall Street (which is exiting for me). I have regular communications with money managers at Goldman Sachs, Morgan Stanley, and JPMorgan, to name a few. I've learned a great deal and I think this has been very helpful for our family. But then I was thinking (rather, my wife was making fun of me for not knowing how to blog) that I could share my views and ideas with friends and family in a more efficient way--that I could spread the wealth (disclaimer: by "wealth" I am referring to ideas, not actual money). So, on this blog I plan to explain financial events, strategies, and ideas with the intent to bring everyone up-to-speed on the financial world around us and what Wall Street is really saying. I figure at least this way you won't have to read what we in the business call "Financial Pornography." Feel free to ask questions or ask advice.

These are my three sons.
Pretty cute.