Monday, May 31, 2010

Politicians + Banking Reform = Financial Disaster

Anyone who doesn't harbor some degree of animosity for the bankers who, through a combination of stupidity, short-sightedness and avarice, caused the global financial crisis is a better person than I am.  That said, financial reform should not be tantamount to financial dismemberment.  And there's a little known accounting rule winding its way through financial reform that may be just that.
My writer husband and I often discuss our finances.  He is a brilliant man, one whose brilliance is primarily that of adept observations and the facility with which he uses language to share them.  His writer friends, many of whom are dear to me, share a trait with him:  they hate math.
Consequently, when the business channel drones on about FASB's consideration of mark-to-market accounting for mortgages held by banks, his eyes glaze over like a weary parent listening to his two-year-old blathering unending baby talk.  I imagine many others do as well.
This bill, however, is important.  And I believe that a combination of me speaking English and you being smart will result in your understanding that this is a big deal, and something you should tell your Congressional representatives to stop.
Here goes.
Let's pretend you lend money in the form of buying a bond from the ABC company.  They pay you interest and agree to repay you on a certain date.  Let's say your bond is worth $10,000 (the amount you lend them), your interest rate is 3% and the bond is due (repayable to you in full) on June 1, 2013.  Unless ABC company files for bankruptcy protection before your loan is due, you can expect to be paid $150 twice each year (3% on $10,000), and the full amount you lent them, $10,000, in three years.
Now let's say interest rates go up this Summer.  Now companies like ABC have to pay 4% for borrowed money, 1% more than the amount they're paying you.  If you sell your bond to someone else after rates go up, it will now be worth less than the $10,000 you paid for it, because anyone can now get 4% for their money, and your bond only pays 3%.  If you mark your bond's value to the current market price (mark-to-market), your bond will be worth less after rates go up than it was what you bought it.
But, what if you don't sell it?  What if you hold your bond until June 1, 2013, collect your 3% per year, and get all your money back?
While you hold your bond from now until 2013, what is it worth?
  • Is it worth what you could sell it for after rates go up?
  • Is it worth what you know you'll receive what the bond is due?
With that in mind, let's pretend you're a bank.  You are now lending money to people to buy houses.  You don't sell your mortgages to investors.  You keep the loans, collect the payments and keep the interest your customers pay.  When rates go up, are these mortgages worth less?  When rates go down, are they worth more?
Yes, according to this new rule.  Why should you care?
If banks have no intention of selling their mortgages, then they probably will be very careful how they lend money.  Why?  If they keep the mortgages, they keep the risk that if borrowers don't pay them back, they'll take the loss.  They won't make crazy loans to people and sell them to investors.  That's good.
But, when rates go up (as they are sure to do), these loans will be worth less.  Then, the banks have to put more money aside for them, and will have less to loan to you.
Seems crazy, doesn't it?  Banks will be penalized for NOT selling their loans to investors, and you'll have a harder time getting a loan.
So, here's the English translation of what's going on.  FASB  (pronounced FAS-bee), is the Financial Accounting Standards Board.  They're considering marking-to-market (immediate sale to investors value, not repayment value) all mortgages that banks intend to keep.
FDIC Chair Ms. Bair is against it, as is former Chair Mr. Isaac.  So am I.  So should you, if you intend to borrow money from a bank who makes mortgages and doesn't sell them to investors.
Contact your Congressional Representatives if you agree, and tell them that you are against FASB Topic 220, 825 and 815.

Monday, May 24, 2010

Things Are (Sort of) Looking Up

In the midst of a stomach churning stock market correction, Dr. Nouriel Roubini predicts another 20% down.  Why I think he's wrong (and why I think the moniker "Dr. Doom" fits him well).
April Jobs Report
After losing over 8 million jobs, an upturn of 290,000 may not sound like much.  But, our April jobs report sends a strong signal that business recovery is gaining a firm foothold.  As businesses continue to expand, we are seeing signs of stability in the housing market, as well as signs that the US consumer is beginning to spend again.
Type of Recovery
Generally, after a deep recession, business recovery bounces back at the GDP rate of 5% or more for several quarters, releasing pent-up demand.  Not so this time, it appears.  With a slower job recovery similar to that after the deep recession in the early 1980s, and significant housing inventories from buyers who should never have been owners in the first place, economic indicators point to a sustained, but muted recovery of 3%+ for the remainder of this year into 2011.  More of a "U" shaped recovery than a "V" is likely under current conditions.
In addition, exports to Europe, where the declining value of the Euro to the Dollar make our goods more expensive, will dampen, but not eliminate US export growth.
Economic Indicators
This year started with a respectable 3.2% GDP growth in the first quarter.  Most strength was in manufacturing and consumer spending.  Business equipment spending was a moderate contributor. 
Challenges to growth are in business real estate, which was very overbuilt.  With the slowdown during the recession, it will be a while before businesses will grow into current vacancies. 
Other challenges remain in residential real estate, which, while stabilizing, is far from growing at normal levels, and exports, which we mentioned before, will be subdued in the European region because the dollar's strength will make them more expensive. 
In 2011, as the European situation stabilizes, improvements in exports will likely follow. 
Subdued, for now, as residual effects of the recession, including high unemployment, keep demand low.  In the future, there are concerns that high levels of public debt will compete with private borrowing when the economy regains its footing.  Look to the current European problems to see how increasing rates for borrowing fuels higher costs both in government and the private sector, resulting in higher inflation.
That's down the road, but a grave concern nonetheless.
Business Income
One of the residual benefits of a recession is the cost cutting that businesses must do to retain profitability.  As consumer demand increases, these lean businesses will enjoy profits based more by sales than cost cutting. 
Stock Market
The so-called easy money has been made.  The brave investors who bought well run companies in March, 2009 have enjoyed a 70%+ gain.  Lately, prior to the recent correction, investor sentiment was very high (a bad sign), and price earnings ratios were nearly 14 times future earnings, slightly lower than the 15.8 long term average, but nowhere near the bargain prices in early 2009.  The recent correction provided a slightly better buying opportunity, but with a sub-par growth projection into 2011 and 70% gain from its lows, investors are understandably wary.
We're pointed in the right direction, to be sure.  Some caution is, however, warranted. 
A further 20% correction?  I'd have to be nicknamed Dr. Doom to say that.  And, I follow the data.  Not a nickname.

Friday, May 21, 2010

What If There Were a Sale (and Nobody Bought)

Do you remember looking back at the market low in March, 2009 and thinking, "I wish I had bought then"?  Here's another chance.
When I was in the business of investing other people's money, I often thought it ironic that I picked the only business where nobody wanted to buy when there was a sale.  Investor sentiment is a powerful thing, and, like the little girl with the little curl right in the middle of her forehead, when it's bad, it's horrid.  Fear paralyzes, and when the paralysis wears off, then the fear turns to greed - "I'd better buy soon or I'll miss the rest of the upturn."
It's not often that two corrections occur when memory is fresh.  But here it is.
Let's talk a little about why you may want to summon the courage to invest the money you won't be needing for the next five years.
I.  Safe isn't safe
If you thought you were very smart by keeping your money in cash over the last ten years, if history repeats itself, you will find the last decade an anomaly.  Generally, Certificates of Deposit, insured Money Market Accounts and the like are very good places to keep money that you need in the near future, and the very worst place to keep money you need for the long term.  Why?
  • Inflation, the slow increase in prices over time; and
  • Taxes.
Let's look at an example.  Right now, you can find money market accounts paying about 1% interest.  Inflation over the last twelve months is running just under 1% (.95%).  So, the increase in the cost of goods and services that you buy reduces your return to 1% - .95% = .05%.  Then, you also have to pay taxes on your interest income.
Federal and state tax rates for most people run about 20%.  20% of 1% is .20.  Subtract .20 from the .05% you had left after inflation, and you are left with negative .15%.  After inflation and taxes, your real return is negative.
For money you need in the near term, that's fine.  You can't risk the volatility of the stock or bond market with  short term money.  But, as you know, women live longer than men.  And most women don't like the idea of "old and poor."  So, we have to invest our money where it will earn more than inflation.
For that, you have two choices.  Real estate (investments, not your home) and stock and bonds.
Real estate requires a very large initial investment, so most women choose to invest in the capital markets.
II.  The two primary considerations
When you buy stocks and bonds, there are only two things you need to decide.  First, you need to know what to buy.  Second, you need to decide at what price to buy it.
The discussion of how to evaluate stock purchases is a primary focus in Financial Planning courses I taught at UCLA, and it required years of study.  But here are a few useful shortcuts.
If you are a value investor, you can buy Berkshire Hathaway Class B shares managed by Warren Buffett.  These shares trade at about $72 per share right now, down from $83.57 last March.
If you'd rather invest in the Standard and Poor 500 Index, including 500 US companies, you can buy it for about $1085 per share right now, down from about $1220 last April.
For risk purposes, many women
  1. Subtract their age from 100
  2. Invest that percentage of their long term money in stocks
  3. Invest the rest in investment grade short term bonds.
So, there you are.  Stocks are on sale.  The sale's not as good as it was in March, 2008, but you have another chance.
Mary Buffett notes that women are good shoppers.
For the sake of our long term well-being, I hope she's right.

Friday, May 14, 2010

Vital Lessons Learned from the Market's Recent Freefall

Now "fat finger" and "high frequency" trades are part of the common vernacular.  Not much solace for those who lost money during the stomach churning drop.  What you must know to protect yourself from losing money, while the slow process of figuring out what happened occurs.
When you buy or sell stock, there are several ways that your order can be placed.  The first, and most common, is a "market" order.  When you place an order "at the market," you buy at the lowest price any seller asks, or sell at the lowest price any buyer bids. 
During the recent market free fall, however, prices fell precipitously.  Had you sold Proctor & Gamble "at the market" late in the day on May 6, you may have thought you were selling at about $61 per share, but were executed at $40.  That's because the selling was so intense and buyers were so few.  People in this predicament may have thought they were selling at a profit, but actually locked in serious losses.
So, lesson one is never sell "at the market."  Always enter a "limit" order" by checking the quote on the stock you want to sell, and entering it at the "bid" price.  That way, you'll be assured that your sale will be at that price (or better).
Some investors like to place "sell stop" orders.  These are orders that will automatically sell if the price falls to a given price.  Again, using the example of Proctor & Gamble, any such sell order for under $60 may have been executed at as low as $40, because the price of the stock fell so quickly.  Those who thought they were protecting their profits at $58 may have locked in losses at $40.
There are two lessons to be learned here.  If the investor absolutely wanted to place a "sell stop" order, if it is placed with a "limit" price of $58, the orders would have tried to execute when the price fell to $58, but if that price were not available because the price was falling so quickly, the order would not have been executed.  That investor would have likely been executed when the stock price bounced back later in the day.
Even still, after the execution when the price was on the way up, the investor would have sold at $58, and seen the price rise to $60 almost immediately.
The other alternative is not to place automatic orders at all.
This type of order was undoubtedly a part of the problem on May 6.  Why?  When many such orders are placed, more and more are executed as prices fall, causing more selling.  When there are few buyers, these type of orders just exacerbate the problem.
So, we never place a market order when selling stock.  We always place limit orders at the bid price.
We never place a "sell stop" order, without adding a "limit" price.  Perhaps we just don't place "sell stop" orders at all.
That's how we protect ourselves from unintended losses.  But there were some people who made money during the market drop.  What did they do?
Some were value investors.  These are investors who calculate the price at which they will buy a stock, and simply wait (sometimes for years) for the price they want.
Again, using the example of Proctor and Gamble, if an investor decided they wanted to buy this stock, but at a price no higher that $43 per share, she may have placed a buy order at that price that was "good until canceled."  That investor may well have had that order executed on May 6.
One of the problems the market experienced is lack of uniformity.  Stocks that trade on the New York Stock Exchange have strict rules during market corrections.  Trading is suspended for a period of time.  We take a breath.  We look at information.  We make informed decisions that are not based in panic.
Unfortunately, there are automated exchanges that do not have such rules, and trades will sometimes be routed from the NYSE to these other exchanges during a panic sell.
There is virtually no argument against implementing uniform trading suspensions in all exchanges.  The problem is executing this uniformity.  The programming that is necessary to ensure that all exchanges operating under the same rules is complex, and cannot be written in a day.  It will take time, but it's a good idea and will undoubtedly be a reality before the end of the year.
Until then, remember:
1)  Sell only with limit orders;
2)  If you place sell stop orders, add a limit price;
3)  Consider not using sell stop orders at all; and
4)  If you're patient, place buy orders at the value that the earnings stream is worth.
If you want to know how to calculate the value of future earnings, buy Mary Buffett's book titled "Buffettology."  Or make sure your broker does.

Tuesday, May 4, 2010

Who's Most Guilty of Financial Malfeasance?

You may have heard Warren Buffett has said that he has no problem with the Goldman Sachs deal that has resulted in charges of client misrepresentation by the Security and Exchange Commission (and is being considered for criminal charges by the Justice Department).  As discussed in a previous article, I agree.  If not the banks, than who is most responsible for the financial meltdown?
1.  The Players  
The Quants
First, there were the "Quants," the quantitative analysts, fresh from Ivy League graduate schools, who prepared studies showing the extreme unlikelihood of all regions of the US housing market dropping in value at the same time.  As these were academically gifted young people with virtually no practical experience, I hesitate to lay blame here.
The Quants' Bosses
It started at JP Morgan.  The bosses, seasoned professionals, read the analysis, looked at the commercial banks' and thrifts' mortgage profits, and decided to get into the business.  The big question is, "Did they understand that the increase in demand that would result from broadening the real estate market would result in a crash?"  While the answer to this question is unknowable, there are two issues that may point to the truth.
The first, is the recent "Internet bubble."  Anyone could have seen that the amount of money that was invested in Internet stocks would have pushed their valuation to ridiculous levels.  Surely, an analogous investment in the real estate market would do the same.
The second, is the fact that the risk to increasing the number of real estate owners was mitigated by selling that risk to investors, instead of holding those investments on their books.
The Banks
Once JP Morgan entered the real estate business, it had to offer terms that would be more attractive to borrowers than commercial banks and thrifts.  So, underwriting standards were decreased.  So what if you didn't technically qualify for a mortgage?  A rising real estate market would allow you to sell your property at a profit, and a low "teaser" rate would result in low initial payments.  After five years, you'd be making more money at your job, wouldn't you?  Then you could afford the payments.
For banks and thrifts to compete, they, too, must lower their underwriting standards, or risk losing their loan portfolios to those banks that offered better refinancing opportunities.
So, we're off to the races.
The Borrowers 
The fact that borrowers were not required to prove their income did not force them to lie on applications.  Even if the borrowing terms were difficult to understand, people who earned $50,000 knew they could not afford a $500,000 house.
A lie is a lie.  Lies have consequences, and I am not in the camp that says, "Poor little borrowers didn't know what they were doing."
I don't think people are that stupid.
The Rating Agencies
Rating agencies are paid by the companies that generate the securities that they rate.  That is inherently insane.
If I have a security I want to sell to the general public and it's inherently risky, it is the job of the rating agencies to say "That is risky."
The problem is, if one agency declined to rate the security as "not risky," all the issuer had to do is take it to another and say, "Here's my fee.  See if you can rate this as 'not risky'."  And they did.
Packages of loans, geographically diversified in the US were sold to the general public as AAA - the same rating given to ultra-safe US Treasuries.  "Widows and orphans" could safely buy them.  Why?  Because, even if the underwriting standards were lax, there was good evidence provided by the Quants, verified by the Quants' Bosses (who paid big, fat fees for safe ratings), that a majority of the loans would be good, even if there were regional difficulties at times.
2.  Common Thread
If the Quants hadn't come up with the studies about the general safety of the US mortgage market, someone would have figured it out.  Maybe the Quants' bosses would have done it themselves, as they saw quarter after quarter of real estate lenders' profits.
Some percentage of borrowers have always lied on mortgage applications.  Underwriters catch some, but not all of them, but the number that squeak through the system were never significant.
But, this bubble could never have grown unless the issuers of laxly underwritten mortgages could have sold them to a "greater fool."  If they'd kept these mortgages on their books, the banks who lent the money would have had to acknowledge the losses.
That leaves the rating agencies.
3.  The Rating Agency Issue
There is no excuse for the ratings agencies giving AAA rating to risky securities.  Taking money to do so is effectively the same as taking a bribe.
Ratings agencies are charged with the responsibility of analyzing underlying securities and giving the public an easily understood way to know the level of risk they have.  This is the one place where, "I didn't know" isn't an excuse.  Maybe the Quants didn't know.  Maybe the Quants' Bosses didn't know.  Maybe the banks didn't know.
But the ratings agencies can't claim stupidity.  Rating securities is their reason for existing.  If they can't do that, they don't deserve to exist.
4.  Blame
Maybe the Quants should have known.  Probably the Quants bosses should have known.  Likely the banks should have know.  The borrowers should not have lied.  But, most definitely, the ratings agencies should have known.
So, the next time you hear that a security is rated AAA, what will you think?
It's time to hold the ratings agencies' feet to the fire.  Either rate securities by using generally accepted accounting principals or rename yourselves as, "Bribe Takers."
Perhaps a little something in this regard should be passed in Financial Regulatory Reform.  And, if it isn't, I wonder. 
Will it be because someone has been paid to ignore it?