Friday, January 29, 2010

Sending the Right Kid to Detention

In the Catholic school I attended, nuns often kept an entire class after school for the behavior of a few.  In the current economic climate, We the People are likely to do the same for any public official who has responsibility for anything "financial."  In order to avoid throwing the baby out with the bathwater, here's a list of who is responsible for what, so we don't fire those who may not have misbehaved.
The Federal Reserve Bank
The "Fed" is responsible for two things:  Price Stability and Full Employment.  Easier said than done.
Price Stability means keeping inflation at bay.  As anyone who lived through the 1970s can tell you, inflation is an insidious and difficult problem once it takes hold.  It is the amount prices increase over the value of the currency.  If prices increase 3% over a year and the value of the currency remains stable, you'll be able to buy 3% less every year.  You'll need to earn 3% more to keep even.  At that rate, in 25 years, you'll need to double your earnings to stay even.
When the economy slows, the Fed lowers short term interest rates to make it easier for banks to lend money and get business moving again.  When the economy starts to rev up, though, the Fed must raise short term interest rates to the rate of lending, or risk inflation.  It's a tricky process because the effect of raising or lowering rates isn't felt throughout the economy for about 6 months. 
When the Fed raises rates, businesses slow down their borrowing, hiring and expansion.  Some will lay off workers to keep costs in check, raising the unemployment level.  To keep full employment and price stability, the Fed is dealing with opposing forces.  Low rates = full employment, but the threat of inflation.  High rates = higher unemployment, but the control of inflation.
Because of the likelihood of political pressure to keep interest rates low (and employment high), and the long term devastating economic effect that would have by causing inflation, the Fed is and must remain an independent body.
The Chairman of the Federal Reserve Bank is Dr. Ben Bernanke.  He has held this position since February 1, 2006, and was on its Board of Governors from 2002 - 2005.  From 2005 - 2006, he was the Chairman of the President's Council of Economic Advisors.
The Treasury Department
The mission of the Treasury Department is to manage the U.S. Government's finances effectively, promote economic growth and stability, and ensure the safety, soundness, and security of the U.S. and international financial systems.  This includes:
 Managing Federal finances;
Collecting taxes and paying US bills;
Currency and coinage;
Managing Government accounts and the public debt;
Supervising national banks and thrift institutions;
Advising on domestic and international financial, monetary, economic, trade and tax policy;
Enforcing Federal finance and tax laws;
Investigating and prosecuting tax evaders, counterfeiters, and forgers.
Supervision of national banks and thrift institutions is the responsibility of the FDIC (see below).
Timothy Geithner has been Treasury Secretary since 2009.
The Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation (FDIC) is an independent agency created by the Congress to maintain stability and public confidence in the nation's financial system by:
•insuring deposits,
•examining and supervising financial institutions for safety and soundness and consumer protection, and
•managing receiverships.
If procedures or policies of insured financial institutions are unsafe or unsound, it is the responsibility of the Chairperson of the FDIC to protect government insured deposits by reporting such action to the Treasury Department and taking action against the institutions that engage in such practices.  Note:  Virtually all investment banks now operate under commercial banking charters.
The Chairperson of the FDIC Board of Directors is Sheila Bair. She's held this position since June 26, 2006.
The Security and Exchange Commission
 The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
If procedures or policies by investment bankers result in a lack of protection to investors or are disruptive to markets, it is the responsibility of its five commissioners to:
It is the responsibility of the Commission to:
interpret federal securities laws;
issue new rules and amend existing rules;
oversee the inspection of securities firms, brokers, investment advisers, and ratings agencies;
oversee private regulatory organizations in the securities, accounting, and auditing fields; and
coordinate U.S. securities regulation with federal, state, and foreign authorities.
It is these commissioners who are ultimately responsible to have determined and reported the highly leveraged (borrowings of  $30 per $1 of assets) positions that contributed to the financial meltdown in 2008.
The Chairman of the SEC is Mary L. Shapiro, who replaced Christopher Cox in 2009.  He held this position from June 2, 2005 through Ms. Shapiro's appointment.
Glass-Steagall Act
The Glass-Steagall Act of 1933 established the FDIC under the Treasury Department, and separated the activities of commercial bankers, who accepted insured deposits from the community and made business loans, from investment bankers, who offer shares of stock ownership to investors and raise capital for businesses. 
This act was repealed under the Clinton Administration.
Fannie Mae and Freddie Mac
These are government sponsored enterprises that were started for the purpose of purchasing home loans from banks.  These loans were underwritten under strict parameters, and proceeds from the sale were used by banks to make more loans, and the loans which were "backed by the full faith and credit of the US government," were sold to the public as income investment. These companies became publicly owned ("for profit") companies in 1989.
In September 2003, Treasury Secretary John Snow proposed placing the Freddie Mac and Fannie Mae under Treasury oversight with strict controls over risk and capital reserves.
Representative Barney Frank, ranking Democrat on the Financial Services Committee, responded, "These two entities—Fannie Mae and Freddie Mac—are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing."
The seizure of Fannie Mae and Freddie Mac cost taxpayers $121 billion.  The AIG bailout cost taxpayers $85 billion.
Representative Frank has served in the House of Representatives since 1980.

Taxpayers are angry, that is a certainty.  Where they are aiming their anger may not, in fact, be where blame actually lies.
To support financial reform, email your Congressional representatives.

Friday, January 22, 2010

Corporate Subsidies, Anyone?

Yesterday, the stock market slid precariously with dire warning about the impediments to profitability we can expect if Obama's limitations on risk-taking by "too big to fail" banks are enacted.  Let's take a look.
I.  The Big Conglom-ocom
Bank in the 1980's, the savings and loan industry, which specialized in mortgage lending and savings accounts, was badly damaged during a period when the rate they could pay for deposit accounts was deregulated, and mortgage rates were not.  Paying extraordinarily high unregulated rates for deposits and charging low regulated mortgage rates was, as 747 failed institutions found, a flawed business plan.  Through corrective regulations that addressed these problems, the difference between commercial banks and so-called thrift institutions was blurred, and banks increased their mortgage lending as thrifts began opening checking accounts.
In the late 1990's, the Clinton administration, under the advice of Robert Rubin (soon to be Citibank CEO) and others, repealed the Glass Steagall Act, which had separated investment bankers (those who invest in capital markets and raise money with investors) from commercial bankers (those who lend to businesses and raise money with insured deposits).  As a result, after the turn of the century, JP Morgan was presented with an intriguing study from its newly-graduated MBA Quantitative Analysts, concluding that, at no time in recent history had the entire US mortgage market ever experienced a downward price correction.
Concluding that, based on this study, that mortgages could be packaged and sold as high grade investments, since payments on a diverse geographic basis be reliable even as there may be regional problems, investment bankers entered the mortgage business.  Relying on the "general rise in housing value" premise, they relaxed their lending standards, forcing commercial bankers to either compete on those relaxed terms or lose their business.
We all know the end of this story.
II.  All Banks Under One Roof
Just as the savings and loan mortgage lenders became virtually indistinguishable from commercial bankers, now investment bankers were becoming more like commercial bankers, and vice versa.  As the recent crisis progressed, nearly every investment bank ducked under a commercial banking charter, received Troubled Asset Relief Program money, and again, as you know, many have repaid that money, returned to profitability and began paying bonuses equivalent to those in 2008.
III.  TARP, TLGP, FDIC (and Other Four Letter Words)
What you may not know is that, as a benefit of acquiring a commercial banking charter, these investment bankers have benefited from another four lettered program - TLGP, or the FDIC Temporary Liquidity Guarantee Program.
Unlike TARP, a preferred stock investment to encourage bank lending through increasing capital, TLGP is more of an ultra-cheap bond program.  Here's how it works.
If, for instance, Goldman Sachs wanted to raise money by issuing bonds (loans) to capital investors, it would have to pay a competitive market rate for those borrowings.  Bond buyers, a notoriously skittish sort who prefer being repaid, demanded 7.5% for the 10-year $2 billion debt it raised in January last year.  Under the TLGP program, however, Goldman raised money for just 2%, with a 1% fee. 
For 4% less than market rate, Goldman borrowed from the FDIC and has acknowledged it can do more "at pretty attractive rates."
IV.  Glass Steagall Anyone?
TARP and TLGP were designed to encourage banks to increase lending.  Goldman's CFO has said, however, that it has "virtually no direct exposure to the consumer."
So, banks' allegations that Obama's requirement that banks who utilize FDIC insurance for their depositors in order to lend to commercial enterprises must not operate proprietary trading desks, hedge funds, etc., will derail the economic recovery is straddling the fence.  Using the government to insure high risk endeavors is clearly inappropriate.
Here is the question Obama poses.  Do you want to operate as a commercial bank or an investment bank?
Getting the benefit of FDIC insurance and cheap borrowings used to NOT lend to consumers is a bad deal for consumers and a good deal for banks. 
He's right on this one. 
I welcome discourse from anyone who disagrees. 

Monday, January 18, 2010

Farewell, Banker Welfare

US women seem to have an innate sense of fairness.  Whether it is because of nature or nurture, even with our more liberated world position, it is women who empathize with the plight of those who have had seemingly insurmountable obstacles in their lives, and we endeavor to help them to help themselves.  Our maternal instincts appear to apply to more than our offspring.
Mothers, however, are more than nurturers.  They also prepare their children to be self-sufficient, self-reliant members of society, and that requires more than giving.  It also requires knowing when to practice "tough love," knowing when not giving is appropriate.
During the early years of the Clinton Administration, most US women supported welfare reform, after seeing that government spending toward our poor sisters seemed to have the effect of a pattern of generational poverty from which it was nearly impossible to extricate themselves.  Paying for the opportunity for self-sufficiency was a more effective solution than an endless number of monthly checks that stubbornly kept women at the poverty level.
We've spoken often about the causes of the latest recession, which could have easily been a depression, had governments not doled out dollars that paled against those paid for welfare during the 1980s and 1990s.  For our investment, we avoided a certain economic meltdown, but for the 16% who are unemployed and looking for jobs, the resentment for that deal could not be higher, particularly when the bonuses paid to bankers, some of whom were the direct cause of the melt-down, have never been higher.
It is instructive to not only examine the root of this anger, but also, like the angry middle-class in the 1980s that paid the cost of welfare, look to a long term solution.
Changing welfare from an incentive NOT to work to an incentive to work reformed the system to one that both provided a safety net for those who were truly in need and an incentive for those who could better themselves to do so.  What such incentive have we given for bankers who lowered lending standards, then sliced up, securitized risk and sold it throughout the world NOT to take inordinate levels of risk again?
None.  Not one piece of financial reform legislation has passed.  Bonuses based on short term profits, largely made by merely buying long term US debt we created to save them with the money we gave them, continue largely unabated.
Our bankers are the urban poor of twenty years past, incented to do the wrong thing by the money we pay them. 
It's time to show some tough love to our bankers, and pressure our lawmakers to pass meaningful financial reform that incents long term capital growth over high risk short term behavior. 
An email to your legislators is an excellent place to start.

Monday, January 4, 2010

Sizing Up the Competition

We're going head to head with stock market pros this year, by comparing the results of buying the S and P 500 Index with that of professional investment strategists.  In order to compare track records, let's look at how they did last year.  All initial recommendations were taken from Barron's Magazine December 22, 2008 (and changes to portfolios were published as of September 7, 2009, and calculated as of September 30, 2009).

What Happened Last Year

S and P 500 Ended the Year at 1115.10
S and P Earnings were $55.91
Fed Funds Rate was .25%
10 Year Treasury was 3.85%
Best Performing Sectors were: 
Technology (59.92%), Materials (45.23%), and Consumer Discretonary (38.76%)
If you'd bought the Index, you'd have been up 23.45% for the year.

What the Pros Predicted

Black Rock (Robert Doll)
S and P 500 - 1050 (5.8% low)
S and P Earnings - $57.5 (3% high)
Fed Funds Rate - 1% (300% high)
10 Year Treasury - 3.25% (16% low)
Best Performing Sectors: Technology (49.47%), Energy (11.29%), and Health Care (17.07%).
Sold Technology in the 4th quarter.
Portfolio return 25.94%

Deutche Bank Private Wealth (Larry Adam)
S and P 500 - 1025 (8% low)
S and P 500 Earnings - $71 (27% high)
Fed Funds Rate - .125% (50% low)
10 Year Treasury - 2.75% (29% low)
Best Performing Sectors:  Technology (59.92%), Consumer Staples (11.2%) and Health Care (17.07%)
Sold Consumer Staples in 4th quarter, and replaced with Energy and Industrials. 
Portfolio return 32.4%

JP Morgan (Thomas Lee)
S and P 500 - 1100 (1% low)
S and P 500 Earnings - $65 (16% high)
Fed Funds Rate - 0% (was .25%)
10 Year Treasury - 1.65% (57% low)
Best Performing Sectors:  Financials (14.8%), Consumer Discretionary (38.76%) and Health Care (17.07%).  Sold Consumer Discretionary and Health Care in 4th quarter and replaced with Energy, Technology, Industrials and Materials.
Portfolio return - 28.04%

US Trust (Christopher Hyzy)
S and P 500 - 1020 (8.5% low)
S and P Earnings - $60 (4% high)
Fed Funds Rate - .5% (50% high)
10 Year Treasury - 3% (22% low)
Best Performing Sectors:  Energy (11.29%), Consumer Staples (11.2%), Utilities (6.8%), Technology (59.92%).  Sold Consumer Staples, Utilities, and replaced with Industrials and Materials.
Portfolio return - 22.64%

Citigroup (Tobias Levkovich)
S and P 500 - 1000 (10% low)
S and P Earnings - $62 (10.8% high)
Fed Funds Rate - 0% (was .25%)
10 Year Treasury - 3% (22% high)
Best Performing Sectors:  Technology (59.92%), Financials (14.8%), Consumer Discretionary (39.76%), Telecom Services (2.63%), Health Care (17.07%) and Industrials (17.27%).  Sold Consumer Discretionary, Telecom Services, Health Care, and bought Materials and Energy.
Portfolio return - 23.26%

Goldman Sachs (David Kostin)
S and P 500 - 1100 (1% low)
S and P Earnings $53 (5% low)
Fed Funds Rate - .125% (50% low)
10 Year Treasury - 3.6% (6% low)
Best Performing Sectors:  Consumer Staples (11.2%) and Health Care (17.07%).  Sold both and replaced with Energy, Materials, Financials and Technology)
Portfolio return - 20.35%

Commission and Taxes

Do-it-yourself investors typically pay about .5% in annual fees, and full service brokers typically charge about 2% for their services.

Short-term capital gain tax rates are the same as ordinary income tax rates, which are 25% for most people (who earn between $33,950 and $82,250 per year).  We'll ignore the tax effect on the relatively low (1.94%) dividend rate on both the index and its sectors in this comparison.
Using these assumptions to adjust the returns:

S and P 500 Index - 23.45% - .5% commission = 22.95% net return
Black Rock - 25.94% - 2% commission - 3.25% capital gain taxes = 20.69% net return
Deutche Bank Private Wealth - 32.4% - 2% commission - .58% capital gain taxes = 29.8% net return
JP Morgan - 28.04% - 2% commission - 1.42% capital gain taxes = 24.62% net return
US Trust - 22.64% - 2% commission - .5% capital gain taxes - 20.14%
Citigroup - 23.26% - 2% commission - 1.61% capital gain taxes = 19.65%
Goldman Sachs - 20.35% - 2% commission - 1.94% capital gain taxes = 16.41%

In 2009, 1/3 of the pros listed beat the S and P 500 net return with their recommendations for investing, and you can see for yourself how each predicted the other investing categories for the year.  

Congratulations if you followed the advice of Deutche Bank Private Wealth or JP Morgan last year.  I suspect, however, that Deutche Bank Private Wealth charges higher than 2% for its advice, but we'll keep the figures consistent for comparison purposes.

If you followed the other 2/3, you'd have been better off just buying the S and P 500 Index.  It will be interesting to see if Deutche Bank and JP Morgan will continue to outperform, and whether the others will improve their performance in 2010.

Saturday, January 2, 2010

Who's Smarter, the Pros or the Little Guy?

Last September, I published the 2010 investment advice given by several market professionals and posed the question,
"What would earn you the most money,
  • Buying the entire S and P 500 Index or 
  • Buying just the sectors of that Index that the market pros suggest?"
Buying the S and P 500 Index would initially cost you a commission, but since you would to pay for no advice, you could pay under $10 commission at a deep discount broker like ScotTrade or ETrade. 

Taking the advice of the market pros would cost you a much higher fee, because
  1. You'd need, not only to know what to buy, but also when to sell. 
  2. You pay a commission when buying and selling, and must pay capital gain taxes on any gain on your gain on sale, unless you buy in a tax-deferred retirement account.
  3. Then, you pay an additional commission when replacing the sold securities with another investment.
So, here's our little 2010 experiment.  We're going to track how much you'd make by just buying the index (consisting of Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Information Technology, Telecom Services and Utilities) versus buying just the sectors in that index recommended by the pros.  Here's where we'll start:

What Sector, Price

S and P 500, 1115.10
Black Rock,
Energy, 429.95
Health Care, 362.22
Deutche Bank Private Wealth Mgmt   
Technology, 370.71
Health Care, 362.22
Industrials, 242.99

Morgan Stanley                          
Health Care, 362.22
Technology, 370.71
Energy, 429.95

Financials, 193.78                                
Technology, 370.71
Material, 199.81
Industrials, 242.99

US Trust                                        
Technology, 370.71
,Energy, 429.95
Industrials, 242.99

Barclays Capital                      
Industrials, 242.99
Technology. 370.71

Materials, 199.81
Financials, 193.78
Technology, 370.71
Energy, 429.95

Goldman Sachs                         
Energy, 429.95
Materials, 199.81
Financials, 193.78
Technology, 370.71

Energy, 429.95
Industrials, 242.99
Financials, 193.78
Technology, 370.71
Materials, 199.81

RBC Capital Mkts                     
Technology, 370.71
Consumer Discretionary, 235.07
Financials, 193.78
Industrials, 242.99

I'll give you an update at the end of every calendar quarter.  What do you think?  Will trading make you more money than just buying the Index?

It will be an interesting experiment, and one that just may result in you taking charge of your investments yourself.