Tuesday, July 31, 2007

Private Equity's Traffic Jam in the Bond Market

Four score and seven months ago, the U.S. stock markets peaked and began to fall. They fell for a long time thereafter, and have only recovered this past spring, measured by the numerical value of stock market indexes. Adjusted for inflation, they still haven't recovered. During the late 1990's, the managements of many companies became fabulously wealthy by going public. With the end of the dot com boom, the allure of becoming a public company faded. While many companies continue to go public today, and enjoy the benefits (and burdens) of being public, a lot of the recent action for management has been taking their companies private.

To go private, management usually teams up with one or more investors (typically a private equity firm), borrows a large pile of cash, and buys out the public shareholders. Management and the private equity firm invest a comparatively small amount of money, but hold the stock of the newly privatized (so to speak) company. With the public shareholders out of the picture, management can have a larger stake in the company than before. They work to make the company more efficient and profitable, sell off unwanted lines of business, and do other things that may be easier once they're outside the glare of the quarterly reporting process and those pesky stock market analysts. Then, after one, two, three or however many years, they take the company public again, presumably at a big profit to themselves and their private equity backers.

Skeptics might point out that public stockholders don't share in the big pinata at the end of the process. And the employees may suffer a round of layoffs or two, and maybe some cutbacks on health and retirement benefits. But the human interest side of the story doesn't change the fact that the numbers for these deals have been very good for management and the private equity firms. As discussed one of our earlier blogs, a private equity firm bought Hertz from Ford in 2005 and brought it public about a year later, getting something like a 200% return. http://blogger.uncleleosden.com/2007/07/bond-market-tremors-hit-private-equity.html.
That sure beats savings bonds.

Because of the relatively small capital investment by the private equity firm and management, going private transactions require financing--a lot of it, as in billions--mostly to take out the public shareholders. A lot of public companies now trade at average to above average multiples of earnings, measured by historical standards. So it costs quite a bit of dinero to buy one. This isn't like 1982, when you could buy a public company, do a sale and leaseback of the parking lot next to corporate headquarters, and pay off the acquisition debt.

The financing for private equity deals generally came from institutional investors that bought bonds issued as part of the going private transaction. Until recently, raising the financing wasn't hard. The industrialized world was awash in cash, and big investment banks would line up to provide financing. The banks would promise to find investors to buy the millions or billions of dollars of bonds needed for the deal. They agreed that, if they failed, they'd pony up the money themselves (through an arrangement called a "bridge loan"). The fact that they might also get advisory fees, underwriting fees and perhaps other compensation for their participation in these deals probably wasn't entirely unrelated to their willingness to commit to provide these potentially enormous bridge loans.

The banks didn't really want to make bridge loans, since with a bridge loan, a large part of the risks of failure of the private equity deal would fall on them, instead of on bond holders. However, for a while, finding bond investors was fairly close to shooting fish in a barrel, with a shotgun. Bond investors were a dime a dozen, and so eager to invest they'd agree to deals where they'd have less than normal protection (so-called "covenant-lite" bonds). They even invested in deals where the borrowing company could avoid paying interest by issuing additional debt to the bond holder. In other words, the borrower would provide another promise to pay instead of cash on the barrel head. Even though they might not have much protection, bond investors still lined up to play in the private equity sand lot.

The private equity deals exemplify a process on Wall Street of structuring transactions so that risk is transferred to passive investors while rewards are concentrated on the deal makers. The public stockholders would be eased out of the picture, so that the jelly beans wouldn't have to be shared with them. New financing for the company would consist mostly of debt. Classic B-school analysis would tell you that when debt is readily available and cheap, you make more doubloons for yourself by using debt instead of equity to capitalize your company. The people in the private equity firms are very good at this kind of arithmetic. Reduce the amount of equity capital, concentrate equity ownership in the hands of management and their new best friends at the private equity firm, and finance the rest of the venture with debt. The cost of most of the capital (i.e., the debt part) is low, so the profits that accrue to the holders of the equity are leveraged. And if the transaction should fail, your equity investment would be relatively small and much or most of the loss would likely fall on the bond holders.

In essence, the going private deals largely separated risk from reward. The arithmetic of going private deals had an irresistible logic for management and the private equity firms, because they could get concentrated, low risk and leveraged rewards, while the bond holders were served rice and beans. Vast herds of bond investors abounded, and investment banks easily drove them into corrals and branded them with any deal the private equity firms wanted to do.

Consequently, going private deals were done early and often, over breakfast, lunch, dinner, and in-between meal snacks. Even though stock market price-earnings multiples were relatively high, as long as the debt was cheap, you might as well take the concentrated, low risk, leveraged profits while you could. A pipeline, almost assembly line, of deals was created, with transactions queuing up for their turn at securing financing in the debt markets. Stock market prices rose, as if every public company in the nation thought that it would be the target of the next deal.

Then, a funny thing happened on the way to the forum. Interest rates began to rise worldwide, especially for corporate debt. There are a lot of reasons for this, but it happened. And the rise in interest rates changed the profit-loss equation in private equity deals. Deals that could be successful with cheap credit might fail with more expensive credit. To make things worse, the private equity firms began to pay higher and higher prices for public companies, which meant taking on higher levels of debt to finance the deals. That only compounded the effect of rising interest rates. And, with large number of deals in the pipeline, bond investors began to pick and choose, looking for ones where the deck wasn't stacked quite so badly against them.

Next, a very ugly and evil troll named Subprime emerged from a swamp and stormed down Wall Street, stomping everyone in his path and consuming everything he stomped. The more he ate, the larger he grew. Subprime got bigger and bigger. Maids on Maiden Lane screamed for help. But the doyens of the markets trembled and dropped their bids, fleeing as fast as their limousines could navigate the treacherous pavement of the FDR Drive while desperately searching for any bridge across the East River that wasn't clogged with traffic. Subprime continued on his rampage, becoming even more gargantuan, and reached across oceans to consume a European bank or two and an Australian hedge fund. Many bond investors were also invested in the mortgage markets and learned that having a troll chew on your toes because you bought some risky investments might make you want to stay home and sip tea in the garden for a while.

Bond investors all of a sudden started to balk, and demand greater protection for their money. Greater protection for their money would mean less potential profit for the private equity guys and management. The private equity guys are no pushovers, and caving in to the demands of bond holders could reduce the potential amounts of their hard-won (well, maybe not so hard-won) profits. So the bond market stalemated. Bond investors and private equity firms couldn't agree on terms for bonds, so no bonds were sold. One recent example is a private equity acquisition of Chrysler by an outfit called Cerberus, which was left with no bond financing. Other examples are the acquisition of a British pharmacy chain called Alliance Boots and an acquisition of Allison Transmission (a GM subsidiary that makes car transmissions).

That meant the banks that made financing commitments to the private equity firms had to pony up bridge loans. Large amounts of them. The Chrysler deal involved something like $12 billion of debt, the Alliance Boots deal involved around $10 billion of debt and the Allison Transmission deal involved around $3 billion of debt. Press reports (Wall Street Journal, 7/26/07, P. A1) indicate that there are around $200 billion of deal debt that banks have committed to provide. If they can't find purchasers for the bonds, they'll have to fork over bridge loans themselves. As a result of this traffic jam in the bond market, the banks, who are the heart of the financial system, could find themselves sitting on a rather large pile of unexpected risk.

The private equity phenomenon is another manifestation of the financial markets' recent propensity to create unusually large amounts of risk. The going private transaction, as explained above, largely separates risk from reward. The private equity crew and management get the rewards, while the bond holders (or the banks, if they had to extend bridge loans) take most of the risk. The private equity guys could make truckloads of money by doing a large number of highly leveraged deals of the "heads I win, tails you lose" variety. And they did. Those deals now overhang the corporate debt market.

We've discussed in an earlier blog how the allocation of risk and reward in the mortgage markets, with the rewards concentrated the market pros if they write and underwrite high risk mortgages, led to the creation of a lot of bad mortgage loans that never should have been made. http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html. The impact of those bad loans now has the market sagging. The going private phenomenon has a similar separation of risk from reward, where the private equity firms are rewarded for doing highly leveraged and potentially risky deals without the risk to themselves of more than comparatively modest losses. In such a situation, it can only be expected that they would follow the scent of money and do a lot of those deals. The problems is that the risk of loss was transferred either to passive investors, or to the banking system. For the moment, the consequences now weigh on the banking system.

There must not be many people on Wall Street named Murphy, since Wall Street, despite a long history of panics, corrections and crashes, doesn't seem to understand that if something can go wrong, eventually it will. The fact that risk has shifted from away from oneself doesn't mean that the risk has been eliminated. Once financial risk is created, there is no way to eliminate it. It can be transferred to someone else, and then again to others. But it will always lurk somewhere. If a lot of financial risk is created, that means a lot of risk is lurking somewhere. A lot of risk can inflict a lot of pain, even if it is diffused. We are seeing this happen now with the massive losses in the mortgage markets.

No disasters have yet occurred in going private transactions. The banks that made bridge loans apparently have been able to handle the burden. But there is a serious traffic jam in the road to the bond market, and the banks' bridge loan exposure seems likely to rise. Will the private equity guys help the banks out by agreeing to take bonds with terms more favorable to the bond holders and therefore potentially less profitable for private equity? Well, remember the adage that if you want a friend on Wall Street, get a dog.

Maybe all this will just blow over. The U.S. and world economies are doing okay, and American consumers continue to do yeoman's duty at the mall. But now risk abounds, and more trolls may be stirring.

Personal Finance in the News: man receives 2,000 credit cards he didn't ask for. http://www.wtop.com/?nid=456&sid=1200699. No wonder there's a consumer credit problem.

Sunday, July 29, 2007

The Pricing Fog in the CDO Market

Once upon a time, there were two hedge funds sponsored by Bear Stearns that invested in the mortgage markets. In March 2007, they reportedly had a combined value to investors of around $1.6 billion. In June 2007, delinquencies among mortgage borrowers had impaired the investments of these two hedge funds. The deterioration got to the point where, Merrill Lynch, which had loaned money to one of the funds to finance investments in mortgage-backed securities, reportedly seized about $850 million worth of these investments and sold them off to secure repayment of its loan. Then, with other lenders to the funds hovering closely, Bear Stearns stepped in with a $3.2 billion loan to one fund (apparently, only $1.6 billion was actually loaned). The loan was made to stabilize the situation so that the funds could pay off other lenders in a more orderly manner.

Fastforward to late July 2007. The two hedge funds are now reported to have lost all (in the case of one fund) and over 90% (in the case of another fund) of their investor value. In other words, the investors were left with zero cents on the dollar for the one fund, and less than a dime on the dollar for the other fund. An equivalent drop in the Dow Jones Industrial Average would have been from its approximate average in March 2007 of 12,300 to somewhere around 1,200 or less within four months. If that had happened, sales of the Communist Manifesto and pitchforks for the proletariat would have skyrocketed.

How could the values of these funds go into a tailspin like this? The fact that the funds were heavily leveraged was one important reason. When the value of the funds' investments began dropping, the creditors of the funds started to demand more collateral. If the funds couldn't provide the additional collateral, the lenders wanted their loans to be repaid. If they weren't repaid, the lenders could seize the collateral and sell it to pay down the debt. The speed at which things deteriorated indicates that the funds and the lenders may have overestimated the value of the collateral, particularly the value it could command when put on sale for immediate cash payment.

CDOs don't trade on any active market. They are bought and sold on an ad hoc basis, not in a public market where price quotations are displayed to the world. Instead of using market transactions as a guide to establishing values of CDOs, hedge funds and other market participants use mathematical models. The models tend to be based on expected future performance, and not the cash price the CDO might receive if it were put up for immediate auction.

The use of mathematical models to price derivatives isn't new. The dealers and specialists in markets for standardized stock options have, for some 30 years, used mathematical models to establish their price quotations. One important difference between the stock options markets and the over-the-counter derivatives markets, though, is that the options markets are public. They provide continuously displayed bid and ask quotations to the world, and all trades are reported publicly on the consolidated tape. The open market imposes discipline. If one dealer's mathematical model produces incorrect prices, he gets clobbered early and often by other market participants who trade with him to his disadvantage. He either fixes his model or finds a new line of work.

In the unregulated world of CDOs, there is no continuously trading open market to impose discipline. Mathematical pricing models are based on assumptions, and the numbers they generate will vary depending on the assumptions made. We discussed in our July 27, 2007 blog (http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html) how the CDO market created incentives to write vast quantities of low quality mortgage loans--loans that are now defaulting in many cases and pushing the market down. Was this proclivity toward outsized risk incorporated into pricing models?

Hedge funds and other players probably can exercise some discretion over their valuations. Would they have moved promptly to reflect downturns in values? Well, how are they compensated? 2% of what and 20% of what?

Were there any controls over the valuation issue? Many CDOs were rated by the rating agencies--outfits like Standard & Poors, Moody's and Fitch. Since the Bear Stearns hedge fund debacle, the rating agencies have been downgrading billions of dollars of bonds. Why did they wait until the yogurt hit the fan? The full story may not be out yet, but it seems that the rating agencies, too, were using mathematical models.

The critical problem with mathematical modeling is that, at some point, cash has to enter the picture. When a hedge fund uses leverage, the lender can't rely on a mathematical model to ensure that its loan is repaid. It needs cash. For a collateralized loan, if worse comes to worst, the lender has to be able to convert the collateral into cash. When values deteriorated this past spring from increasing mortgage defaults, the hedge funds' lenders protected themselves by demanding more collateral or selling off the collateral they had. Either option would have involved getting cash (or hard assets readily convertible to cash). This is the point where the rubber hits the road, and mathematical modeling and $5 buys you a cup of coffee.

The CDO market was mispriced. That much is clear. The world of hedge funds and derivatives has been left essentially unregulated--by both Republican and Democratic administrations and Congresses. Absence of regulation facilitates innovation and growth. The plethora of derivatives contracts now available is a bewildering alphabet soup array of financial instruments. The dollar value of transactions in the derivatives markets today probably exceeds the dollar value of stock market transactions. Derivatives are said to diffuse risk and allocate it to market participants that are willing to take it on. All this sounds good.

But the world of CDOs has fostered the creation of risk--a lot of it--as we discussed in our July 27,2007 blog (http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html). And a lot of risk diffused and allocated nevertheless remains a lot of risk. When it materializes, a lot of people will say "ouch." Did the investors in the two Bear Stearns hedge funds that collapsed think there was a reasonable chance they'd lose everything or almost everything?

This isn't just a problem for Wall Street firms, hedge fund operators and the wealthy people and large institutions that invest in hedge funds. The stock and bond market losses of recent weeks affect everyone that has a stake in the financial markets. Every IRA and 401(k) account invested in the stock markets has probably taken a loss due to the mortgage market mess. Every pension fund and university endowment has probably suffered losses. Every small business with a SIMPLE IRA or SEP-IRA plan invested in the stock market has been hit, meaning that the employees of the small business have suffered. A lot of people who have no idea what a CDO is, or if they do, have no interest in them, now have been affected--negatively.

No one knows how this situation will turn out. Prognostications have been made that more mortgage market losses are in the offing. One thing that's clear is that the pricing mechanism in the CDO market needs improvement. We now have a situation where hedge fund managers may be taking compensation based on the valuations of their mathematical models, but investors are taking losses based on cash prices. It's one thing to play "heads I win, tails you lose" with a quarter. But the amounts involved in the CDO mess are much larger than $0.25. These pricing disparities should be reconciled. Since you can't persuade lenders to take repayment in the form of a mathematical model, hedge funds that use leverage (which would be about 100% or so of them) should move toward a cash pricing model. Cash prices may be difficult to establish on a continuing basis, unless CDO and similar products are standardized and quoted on electronic markets. But perhaps these would be good ideas, now that the instruments are proving to be so risky.

Many players in the derivatives markets will recoil at these thoughts, since they would viscerally sense a reduction of profit margins. Nonstandard products traded in an opaque market are likely to be more profitable for dealers than standardized products traded on a transparent market. But the widespread damage that the mortgage market mess is causing will leave the industry with fewer and fewer choices. The perspicacious on Wall Street will get ahead of the curve.

Strange News: a haunted penthouse: http://www.wtop.com/?nid=456&sid=1203832.

Friday, July 27, 2007

How the CDO Market Increased Subprime Mortgage Risks

CDOs have been much in the news lately, because of the subprime mortgage mess. Mortgage loan losses, especially among subprime mortgages, have shaken the real estate markets and contributed to the 311 point drop in the Dow Jones Industrial Average on July 26, 2007. While the market turbulence and losses have gotten plenty of headlines, what has been less discussed is how the market for CDOs increased risks and likely exacerbated current problems.

CDOs, as you may know, are entities (usually trusts) that hold pools of mortgages and other loans. The stream of payments (interest and principal) from this pool is subdivided into different segments called "tranches" (which is French for slices). Each tranche has different rights to the stream of payments from the pool. The highest tranche has the best claim, and is the most expensive to buy while offering the lowest rate of return. That's because it also has the lowest risk of nonpayment. As one descends through the tranches, claims to the stream of payments from the pool become ever more subordinate, prices drop and potential rates of return increase. But risks of loss also increase, so you can do very well or very badly in the lowest tranches.

How do the banks that package CDOs sell these things? It's easy enough to understand why someone might buy the highest tranches. They are often comparable to highly rated corporate debt (although the rating agencies seem to have been caught slightly flat-footed by the drop off in the mortgage markets). But where do buyers for the riskier tranches come from?

Some investors seek out risky investments. Hedge fund operators look for risky investments because they have to beat the S&P 500 in order to attract investor money. Pension funds, university endowments and other institutional investors, often seen as bastions of investment prudence, also seek out risk. Here's why.

The 1929 market crash and subsequent Great Depression cured an entire generation of any interest in risky investments. Even the go-go days of the 1960s didn't involve anything approaching the derivatives boom that led to the creation of CDOs. Starting in the 1970s, an idea evolved that taking some degree of risk was good. A well-rounded investment portfolio, it was argued, should include a speculative fillip, something that could boost returns above the boring level of the S&P 500. Sure, greater risk could lead to losses. But if the amount of the portfolio invested in dicey bets was confined, to say 5% or 10%, then the investor would have a good chance of being better off.

The idea that increasing risk was good was marketed by hedge fund operators and other market players who sold risky investment opportunities. Gradually mainstream institutional (and wealthy individual) investors began to accept the idea. Money flowed into the "alternative investment" sector. The hedge fund industry boomed.

As more money flowed into hedge funds and other alternative investments, they needed to find risky investments. After all, a hedge fund operator who claimed to be an investment genius couldn't put his investors' money into S&P 500 index funds. He had to find something that made him look like he deserved the annual 2% of assets and 20% of gains he charged his clients.

The result was that demand for risky investments grew. CDOs, among other things, attained popularity. Subprime mortgages, with their apparent higher risk levels, looked like a good play. They had higher interest rates because they were riskier. But the rising real estate market of the early 2000s usually gave the borrower an escape hatch--if the borrower couldn't repay the loan (especially after an increase in monthly payments), he or she could refinance or sell the house, and the rising real estate market would make that easy. In this way, subprime mortgages appeared to have low risks, even though they were priced as high risks. In the minds of a money manager, that meant they were cheap in comparison to the risks they supposedly had. And if they were cheap, it would make sense to buy a lot of them and generate larger profits. The CDO was a convenient way to sell these high-risk loans to the investment community.

One thing about institutional investors is that they have a lot of money. Even if they divert only 5% or 10% of their portfolios into alternative investments, the result would be a flood of cash. And that's what happened. Money flooded into the alternative investments market. The banks packaging CDOs began looking for more subprime loans. Commissions paid to mortgage brokers for subprime loans increased, and gave them the incentive to steer more customers into subprime mortgages. No doc loans and low doc loans, popularly known among mortgage bankers as "liar loans," became more commonplace. These loans often wouldn't have been made in the past. Now, though, since they weren't being held by the loan originator, but were being sold--first to the banks packaging the CDOs, and eventually to the investors who thought they should be taking more risk--no one had an incentive to exercise caution. The borrowers thought--perhaps erroneously, perhaps because of fraud--that they were getting a good deal. The mortgage brokers collected big commissions while selling the doggy loans to someone else, so they thought they had offloaded the risk. The banks packaging the CDOs made more money with each new deal, while passing the risk onto investors. The hedge funds and institutional investors thought risk was good, so they wanted to buy more risk. Many hedge funds borrowed heavily to buy even more subprime mortgages (or their CDO derivatives), thinking that the more leverage they used, the greater the return on capital they would achieve. The use of leverage magnified demand for subprime loans.

The result was that a ton of imprudent, reckless, ridiculous, and downright stupid mortgage loans were made. The numbers are perhaps impossible to determine at this point, but the rising default rates show that the losses are and will continue to be very large. Because risk came to be seen as a good thing, the market responded to demand and provided more risky investments. A lot more. It literally paid the mortgage industry to create a lot of bad loans. Now there are a lot of losses that have to be suffered.

The sheer quantity of losses is having systemic impact. The bond market is fleeing toward high quality debt and the stock market is becoming more turbulent. Will the world collapse? No. No need to freshen up your secret stocks of batteries, distilled water and freeze-dried food. But the pain will probably increase before it decreases.

The idea that some risk is good for your investment portfolio is a valid idea in a textbook sense. Historical financial data can be used to demonstrate, in a mathematical way, that you would have been better off with a bit of risk during the last 25 years than without it. But the last 25 years have been exceptionally good ones for the financial markets. The 25 years from 1929 to 1954 were little more than break-even, after adjusting for inflation. Past performance is no indication of future performance.

But what happened in the subprime mortgage and CDO markets wasn't just the manifestation of a boilerplate disclosure in the prospectus for every SEC-registered securities offering. We're where we are today because the idea that risk is good became fashionable--too fashionable. And prudence fell out of fashion. Skirts can be made shorter, but there's a limit to how short. And there's a limit to how much risk is good. Investor appetite for risky investments--fueled by incautious marketing by Wall Street--created the monster that we now must deal with. Since the CDO market and hedge fund industry are essentially unregulated, it's unclear how things will play out and who will ultimately hold the bag. One senses that the legal profession will feast; but many others will have a taste of Oliver Twist's gruel.

Skirts eventually became longer, and financial prudence is making a belated re-appearance. Prudence would be advisable for individuals as well as institutions.

Crime News: bad boys sentenced to do the funky chicken. http://www.wtop.com/?nid=456&sid=1201466.

Wednesday, July 25, 2007

The Derivatives Problem Wall Street Might Have Fixed

One of the largest, and least visible, of the financial markets is the derivatives market. Financial derivatives are contracts that "derive" (or measure) their value by reference to something else. A simple example is the stock option. The option gives its holder the right to purchase the stock on which it is based for a specified price within certain time parameters. The option's value is based primarily on the value of the underlying stock. If the stock increases in value, the option will generally increase in value. And if the stock decreases in value, the option will generally decrease in value.

A more sophisticated kind of financial derivative is the credit derivative. This is a contract that gives the holder protection against loss from defaults in the debt of a company or a country. For example, let's say an investor (usually a large institution) holds bonds of Company A. The investor decides to get some protection in case Company A can't repay its bonds. The investor can engage in a "credit-default swap," which is a transaction where another financial market participant (the "counterparty") agrees to take the risk of a default on Company A's bonds. In other words, the investor buys a kind of insurance against a default by Company A. In this sense, the credit derivatives contract resembles the credit life insurance that many mortgage borrowers are required to buy (if their downpayments are less than 20%)--if the borrower passes away, the credit life policy pays the mortgage loan.

Credit derivative transactions, until recently, were done largely by phone. There is no stock exchange floor, with people running around frantically and dropping slips of paper. There was no electronic quotation system, where bid and ask prices are displayed, and trades are reported. Setting aside the fact that many of the phones have new and strange ways of ringing, the credit derivatives market was much like the over-the-counter stock market of the 1920's and 1930's.

The credit derivatives market was virtually nonexistent ten years ago. Today, it is big--very big. It's reported to involve trillions of dollars of risk coverage, like maybe $35 trillion. Even at $5 a pop, that buys a lot of cups of coffee.

The credit derivatives market has had a wee problem stemming from its rapid growth. Recordkeeping wasn't given exactly the highest priority. Why does recordkeeping matter? After all, enough trees are being killed as it is. But the reason why recordkeeping matters is that records let you figure out who owns what. Today, almost all financial assets consist of entries on paper records or in computerized recordkeeping systems. The green stuff in your wallet is becoming less and less important. If the records aren't good, you don't know what you own. Think about how p.o.'d you'd be if you steadily and patiently saved and invested 10% or 15% of your income each year for 40 years, and then, upon reaching retirement age, found that your financial records were all messed up and you couldn't tell what you had. As boring and painful as it may be, recordkeeping is essential to a sound financial system.

What impact could recordkeeping problems have in the credit derivatives market? Recall the essential purpose of credit derivatives. If a company defaults, the bondholder or other debt holder who bought the default protection would turn to the counterparty on the contract (the insurer, if you will) and smile while extending an open hand. If, however, the counterparty says, "you can't prove I owe you anything because there's no record of the credit derivative transaction," then the bondholder enters a deep vat of yogurt. Lawsuits may be filed, but the only sure winners are lawyers.

In the fall of 2005, Federal Reserve officials got nervous about the recordkeeping in the credit derivatives market. Apparently there were something like 97,000 transactions that were unresolved more than 30 days after they supposedly occurred. As reported in the Wall Street Journal (9/15/05, p. C1), the Federal Reserve Bank of New York convened a meeting and invited 14 major financial institutions to attend. If you're an American financial institution, you never turn down an invitation from the Fed. The Fed had a little credit derivatives coffee klatsch. At the gathering, everyone agreed that they would do better about recordkeeping. Here's how they did, as reported in the press.

Wall Street Journal, Dec. 13, 2005 (P. C6): the 14 major financial firms aim to resolve at 30% of the backlog of open trades by January 31, 2006.

Wall Street Journal, Feb. 17, 2006 (P. C5): the New York Fed said that a 54% reduction in the open trades had been attained.

Wall Street Journal, Sept. 28, 2006 (P. C5): the New York Fed said that 70% of all open trades had been resolved and 85% of the open trades that hadn't been settled for over 30 days had been resolved.

It sounds pretty good. But it isn't entirely clear that all the open credit derivatives trades have been settled. If the counterparties for a small number of large credit derivatives trades cut and run when they should step up to the plate, large amounts of default insurance evaporate and things can become rather unpleasant. Further, there was also a problem of recordkeeping in the equity derivatives market (reported in the Wall Street Journal, Nov. 22, 2006, P. C4). Equity derivatives, as you might guess, are contracts where the risk of a stock, or a basket or index of stocks, falling is covered for a price. If the underlying stock or stocks fall, the counterparty has to compensate the holder of the equity derivative. The New York Fed had began pushing the financial firms to begin straightening out recordkeeping in the equity derivatives market, but it's not clear if those problems were resolved.

The bond markets are getting shakier, with the economy slowing, inflation threatening, consumers running out of home equity to spend, and the mortgage markets having fits. Some companies might not make it. There have been major companies that declared bankruptcy in recent years, which meant defaulting on their bonds. Collins & Aikman Corp. and Delphi Corp., two car parts manufacturers, are examples. One interesting vignette reported in the Wall Street Journal (Dec. 13, 2005, P. C6) is that when Delphi declared bankruptcy, it defaulted on $2 billion of bonds, but the resulting claims on credit derivatives contracts covered $28 billion. That suggests that a lot of people were using credit derivatives to speculate on whether or not Delphi would go in the tank. The ability to use these derivatives to speculate leverages the risks to market players and even the financial system from a big event like a major bankruptcy.

The stock market has been manic-depressive, being irrationally exuberant one day and jumping with a frayed bungee cord the next day. There's a lot of stress in the financial system and the stock market may be more likely to go down than up in the near future. If the market drops significantly or there are more bond defaults, some investors may end up trying to collect on their credit and equity derivatives contracts. If the recordkeeping isn't good, though, they may be in for some bad tummy aches. Recordkeeping cuts into Wall Street's profits. But a loss of investor confidence cuts much deeper. Time will tell whether we'll have a problem.

Strange News: If you're having a bad day, walk by the compliment machine. http://www.wtop.com/?nid=456&sid=1199177.

Monday, July 23, 2007

Those Pesky CDOs and How They're Ruining the Party

You may have read about CDOs in the financial news recently. They're the investment where investors (mostly institutions like hedge funds, pension funds and the like) purchase interests in the stream of payments coming from a pool of mortgages and other loans. Rising delinquency rates among mortgages, especially subprime mortgages, have led to losses for CDO investors. A pair of big losers were two hedge funds sponsored by the investment banking firm, Bear Stearns, which last week announced that the funds had lost all (in the case of one fund) and over 90% (in the case of the other fund) of their investors' money. Less than six months ago, these funds reportedly had more than $1.5 billion in investor money. But now, it appears that anyone that invested in these funds is holding nada, or darn close to nada.

The investors in these two funds have plenty of company. Press reports indicate that lots of investors and maybe some financial firms have lost money in the CDO markets. Lots of it. Chairman Ben Bernanke of the Federal Reserve reportedly said on July 19, 2007 that some estimates of the losses from the subprime lending mess could run up to $50 billion to $100 billion.

Even these days, $50 billion plus is more than lunch money. Many of the losses appear to come from mortgage loans that were poorly conceived. Adjustable payment loans with low initial "teaser" rates offered to borrowers with shaky credit histories, along with little or no documentation of the borrower's ability to repay the loan, created a scenario where the lender (or, more precisely, the investors in the funds that bought interests in CDOs) were speculating on a continuation of rising real estate prices to ensure repayment of their investments. This risk was heightened by funds that used leverage to increase the quantity of high risk mortgages they held--the greater the leverage, the lower the delinquency rate on the mortgages that would be required to blow up the fund. Of course, as long as the real estate market kept rising, things would have remained copacetic. And we all know that once a market starts rising, it never stops. At least, not for a while. A lot of very smart people were involved in creating the subprime mortgage, CDO situation, but the strange thing is that they didn't seem to see this train wreck coming. Or, if they did, they surely didn't do enough to stop it.

Whenever a tamale heats up, it gets passed around because no one wants to be burned. Put another way, chickens are of the habit to come home eventually to roost. It's safe to assume that the investors that have recently been told that they lost 90 or 100 cents on the dollar won't just sit quietly and sip some tea. Lawyers of the plaintiffs persuasion are now surely boning up on the fine points of CDO investments, while lawyers of the defendants persuasion are now surely boning up on the fine points of CDO investments. Well, at least someone will benefit from this mess.

As for Mom and Pop, standing somewhat bewildered behind the counter of their store at the corner of Main and Elm Streets, things will change. Easy credit, especially in the mortgage markets, will dry up, because Wall Street investors will refuse to buy easy loans. With interest rates rising, fixed 15 and 30 year mortgages make more sense anyway. People with weaker credit histories may be unable to get mortgage loans. But if the only loan they could get was a snare that would ruin their finances and wreck their lives, perhaps it's better if they spend a few years building up some savings for a down payment and improving their credit ratings. See our blog on how the right mortgage loan helps you build wealth. http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html.

It was the availability of cheap credit that allowed risky mortgage loans to be made, and then packaged into CDOs that were the subject of investment strategies offering little more than a speculation on real estate values. The torrent of cheap credit that flooded the world in the last few years is drying up. European and Asian governments have been raising interest rates. While the Fed has held rates level for the last year, it by all indications is more likely to raise them than lower them. Easy money seemed to come in the last few years from owning real estate or, more recently, investing in blue chip stocks. A lot of people spent their home equity while real estate prices were rising. This almost casual use of home equity-based credit epitomized the adage, "easy come, easy go." But real estate values are flat or dropping in many markets and there's not likely to be much more easy money in the foreseeable future. At the risk of sounding like Ward Cleaver talking to the Beaver, caution and prudence in finances are now advisable. The thrifty squirrel has the best chance of surviving the winter. Store up some extra acorns, and sleep better.

For more detail about CDOs, read our blog at http://blogger.uncleleosden.com/2007/06/subprime-mortgage-mess-on-wall-street.html.

Animal News: More evidence that a pooch is your best friend. http://www.wtop.com/?nid=456&sid=1196569.

Friday, July 20, 2007

Commodities for Individual Investors

The global economy has grown vigorously in recent years, and the prices of commodities have risen sharply. We all know about oil and gasoline prices. Gold, uranium, silver, corn, cattle, and soybeans have also seen significant price rises. Rising prices attract investors the way shiny objects attract magpies. Nowadays, some people see commodities as the next hot thing. Are they a good idea?

1. Commodities Futures Contracts. The traditional way of investing in commodities is to buy a futures contract. Some view these contracts as a way to make fast money because you can buy one for only a 10% downpayment, or maybe even less. If the contract rises 10% in value, you have a 100% return on your investment. But the reverse is also true: if the contract drops 10% in value, you just lost everything you invested. Further, it's important to understand the nature of futures contracts. You either commit to buy a fixed amount of the commodity at a predetermined price, or to sell a fixed amount of the commodity at a predetermined price. The contract will specify a date on which you have to fulfill this obligation to either buy or sell, called the settlement date. You are locked into the contract--you must buy or sell at the specified price on the settlement date. There is no exit. This is the kicker in commodities futures contracts. If you are in a losing position on the settlement date, you have to take the loss (which could mean forking over more cash in addition to your downpayment if the contract has dropped by more than the value of your downpayment). When a stock drops, you can hold onto it in the hope that it will rise again. When a commodities futures contract is a loser on settlement date, you are stuck with the loss.

Big players in the financial markets can have a hard time figuring out which direction commodities prices will move. Remember the hedge fund called Amaranth, which collapsed because it guessed wrong on the direction of natural gas prices? Individual investors have an even harder time figuring out where commodities prices will go. Some individuals have lost $1 million or more playing with commodities futures contracts. You should avoid them.

2. Stocks with commodities exposure. A safer way to invest in commodities is to buy stocks of companies that have significant interests in commodities. The oil companies are obvious examples. Their stocks have generally done well with the rise in oil prices. Of course, part of the return from investing in oil companies comes from the skill (or lack of skill) of its management and other factors. But if you're looking for a commodities play, oil companies and other natural resources companies are a much safer way to make that bet than a futures contract.

3. Mutual Funds and ETFs. There are mutual funds and ETFs that specialize in providing investors with a chance to profit from commodities by investing in a portfolio of companies with interests in commodities. Since these funds are diversified to some degree, they may be less risky than the stocks of individual companies. They are certainly safer than futures contracts. Of course, you must consider their fees and expenses, as you always would with any mutual fund or ETF.

4. Mattress Stuffers. If you flirt with survivalist tendencies, you can buy gold coins. The 1 ounce 24 carat coins issued by some nations provide a convenient way to own gold--there's the American Eagle, the Canadian Maple Leaf, the South African Krugerrand, and the Australian Nugget. All can be purchased for a little more than the spot (i.e., cash) price of gold in the wholesale market. Owning gold coins presents problems of storage and insurance. And you should buy from a reputable dealer because most people can't tell gold from a bunch of other substances. But if you think the end of civilization is near--or you just want the fun of having some gold to stare at--you can buy gold coins and stick them in your mattress, or in the closet along with your freeze-dried food, bottled water, portable generator, camping gear, compass, flint and steel, tomahawk, coonskin cap, and Pennsylvania long rifle.

Is it a good idea to invest in commodities? If you put a small portion of your portfolio (5% or maybe even 10%) into commodities, you might acheive a degree of diversification that could pay off. Remember, however, that commodities prices are notoriously difficult to predict, and the financial markets have seen long stretches of time when commodities were not winners. Numerous investors have done just fine without investing in commodities.

Crime News: hot dog vendor arrested for parking meter scam. http://www.nbc4.com/news/13716705/detail.html?dl=headlineclick

Tuesday, July 17, 2007

Building Wealth by Going Green

You don't usually associate environmentalism with saving money. Solar panels and windmills aren't cheap, and after you install them, you have to cover legal fees to do battle with the zoning board and the subdivision's architectural committee. The premium you pay for a car with a hybrid engine is often greater than the savings in your gas budget. On a smaller scale, organic fruits and vegetables cost more than the ones grown with chemicals. And fair trade coffee isn't exactly easy to find in the big box discount stores.

There are ways, though, to go green while saving some money. Basically, lighten your footprint on the environment. Here are some suggestions:

1. Drink tap water. The New York Times reported on July 15, 2007 that the annual cost of drinking 8 glasses a day of tap water in New York City is 49 cents. You can have a year's supply of drinking water for less than the cost of a candy bar (and it's better for you). An equivalent amount of bottled water would cost around $1,400. That's the cost of a new desktop PC and a printer, with some money to spare. The plastic used to make the bottle comes from petroleum, the fuel used to transport the bottle to the store comes from petroleum, and the electricity used to keep the bottle cold comes from coal, petroleum or water power. (And if you think water power is benign, remember that the dams that generate electricity and the massive electrical grid system that transports it hundreds of miles mess up a lot of wildlife habitat.) Then, when you're done, many of those convenient bottles you throw away will wait patiently for centuries to be discovered by archeologists, who will be puzzled why the people of the twenty-first century worshiped the bottle. After all, only religious fervor could explain such vast accumulations of unnecessary containers.

2. Cook from scratch. When you cook from scratch, you'll have a freshly made and better tasting meal, which contains fewer chemicals. Do you put alpha tocopherol, disodium inosinate, or sodium nitrite in your home-cooked meals? If you do, don't worry, because they're safe--we hope. It's okay if you have no cooking experience. Just make sure you eat what you prepare and you'll move up the learning curve fast. Prepared foods impact the environment a number of ways: they are cooked twice (once at the factory and once more in your home), so they consume more energy; they are heavily packaged, which means more trees killed for cardboard and more petrochemical products like plastic wrappings; many of them need electricity to keep them frozen at all times (until consumed); and they create more waste (the containers and wrappings have to go somewhere). They also are likely to cost more per serving.

3. Make good use of plastic bags. Plastic bags are now everywhere. Hardly a store uses paper any more. And few make it easy to recycle their plastic bags. Re-use the plastic bags--they can carry your lunch, line waste baskets, hold used kitty litter, and pick up dog poop. Many trash collection services require that you bag trash in large plastic bags. Fill up the bags. They're bigger than you might think. If you fill them only three-quarters of the way up, you'll use 33% more bags per year. That costs money and adds to the pollution of the environment.

4. Re-use containers. Many cardboard, plastic and glass containers can be re-used. When you re-use something, you're running an at-home recycling operation. No need for you to bag stuff for other people to collect. Forget the mindset that everything has to be new and extravagantly wrapped. Clean water, breathable air and safe food have value, too.

5. Drive 65 or 70. One of the primary factors affecting your vehicle's mileage is speed. Greater speed increases the amount of wind resistance you encounter. That's why higher speeds reduce your mileage. We all know the reality of American highways. The few drivers going 55 have shortened life expectancies. But the ones that are driving 80 or 90 mph are both road hazards and environmental hazards. Keep your speed down, and save a little on your fuel costs.

6. Mind the thermostat. Those who lived through the OPEC oil boycotts of the 1970's can probably remember thermostats set at 78 in the summer and 68 in the winter. That was part of the malaise of the times, and no one wants a return to that. But if the house will be empty during the day, turn the thermostat up in the summer and down in the winter. No need to maintain a constant temperature for the furniture.

No one can be perfect. If you're stuck at an airport after your connection was inexplicably canceled, you'll probably have to resort to bottled water and prepared foods (especially if it's late and all the bars are closed). If you're working 50 or 60 hours a week, you won't have time to prepare many meals from scratch. If you live in a small apartment, it's hard to find space to store empty containers until you can use them. And if there's a big tractor trailer swaying all over the road right in front of you, it's understandable if you momentarily bump the speedometer above 80 to get past the danger. You don't have to be perfect. But try to step more lightly on the environment. You'll save some money, your wealth will grow, and you'll have a cleaner world to live in.

Crime News: pilot reportedly steals passenger's iPod. http://www.nbc4.com/news/13694007/detail.html. We've got crowded flights, narrow seats, no leg room, no food service, frequent cancellations, lost luggage, and lousy service. And now this?

Sunday, July 15, 2007

Why the Stock Market Bounces Around

On Thursday, July 12, 2007, the stock reached a record high, with the Dow Jones Industrial Average rising 283.86 points to close at 13,861.73. What the heck happened? News reports attributed the market jump to positive news about retail sales and the announcement of a planned acquisition of a Canadian aluminum company, Alcan Inc. But were those stories really the cause? People still flock to the malls and someone wants to buy an aluminum company? Or was there more to it?

The stock market is the aggregation of the interactions of many thousands of persons and institutions. They buy and sell stocks, options, ETFs and other investments. All of their transactions, put together, create the image of beehive activity that you get from the financial news on cable TV. But the markets today are dominated by large, institutional investors--hedge funds, mutual funds, investment banks, pension funds, insurance companies, and the like. These players are so big that sometimes one of them can alone have a noticeable impact on the market.

For example, let's look at an enforcement case brought by the SEC in 1996 against an investment fund management firm called Tudor Investment Corporation. The SEC's order in this case told the following story. Tudor Investment had a trading strategy that involved selling a large quantity of stocks included in the Dow Jones Industrial Average. It believed that on a particular day, March 16, 1994, the prices of the Dow Jones Industrial Average stocks were going to swing upwards at the end of the trading day (i.e., 4:00 p.m. Eastern Time). Beginning at approximately 3:39 p.m., Tudor Investment traders began to sell, in the hope of profiting from the expected upswing in prices. They managed to sell over 1 million shares of stock in the last 21 minutes of the trading day. In the last 4 minutes of the trading day (i.e., from 3:56 p.m. to 4:00 p.m.), the Dow Jones Industrial Average dropped 16.45 points (or about 0.43%) of the index's value at that time. The SEC asserted that Tudor Management's sales toward the end of the trading day "were a significant factor" in the 16.45 point drop.

The SEC charged that Tudor Investment violated the short sale rule, a regulation that limits the circumstances in which a person or institution can sell stock they don't own. (As odd as it may sound, you are allowed in the stock market to sell stock you don't own--it's a way of betting that the stock will drop in value.) Tudor Investment settled the case without admitting or denying the SEC's charges. (That's another oddity of the stock markets--legal settlements where a party neither admits nor denies breaking the rules.) If you want to read the SEC's order in this case, here's the link: http://www.sec.gov/litigation/admin/3437669.txt.

The important point here is that a single player in the market "was a significant factor" in a noticeable market move. Taking the July 12, 2007 closing value of the Dow Jones Industrial Average, 13,861.73, a 0.43% change would be about 59 points. If you could apply the events of March 16, 1994 to today's market, a single player might be able to move the Dow by 59 points. Today, it would probably take much more than the purchase or sale of 1 million shares. But, these days, big institutional investors command portfolios containing much more than 1 million shares of stock.

The stock market has undercurrents and riptides that are difficult or impossible to see from the outside. If you're an active market player, you might feel their tug. But you'd probably have a hard time figuring out where they are coming from or where they are going. Only in those unusual situations where the SEC or another regulator finds something to frown about will information surface publicly as it did in the Tudor Investment case. The rest of the time, you probably won't know what happened, and will probably never learn. Retail sales and the Alcan acquisition probably did help to push the market up on July 12, 2007. But were there other factors? Did some foreign investors, anticipating interest rate increases in their home countries, decide to shift money into the U.S. market? Did some large institutional investors decide to reallocate their increasing exposures to rising foreign markets and move assets into the U.S. markets? Did some institutional investors losing money in subprime mortgage-backed CDOs decide to cut their losses and shift their money into stocks? These are only a few of the possibilities.

So how can you get a read on the markets? One way to separate the wheat from the chaff is to look at market movements from week to week. Pick one day a week--Friday is a good choice--and look at the closing prices on that day for each week. You'll see that week-to-week movements of the market are much smoother than day-to-day movements. By looking at the market on a weekly basis, you sift out some of the riptides and undercurrents caused by large investors, and can get a better handle on overall market trends.

Another lesson here is that day trading stocks, and other short term trading, is very dangerous for the individual investor. If you try to profit from one day's news about retail sales or aluminum companies, you're playing bumper cars where you have a subcompact and the big investors are driving tractor trailers. They can easily overrun you and never notice. You can't predict where your stocks will go short term because you never know when a big tractor trailer will barrel over your trading strategy. Pick an investment strategy that smooths out the bumps in the road. Invest for the long term, on a diversified basis.

Crime News: If you're confronted by a robber, try offering a glass of wine and a hug. http://www.wtop.com/?nid=456&sid=1188465.

Thursday, July 12, 2007

June 2007 Consumer Product Recalls

Usually, a store or manufacturer wouldn't want you to return anything. Sometimes, though, they do. And when they do, it's a good idea to return it.

The Consumer Products Safety Commission's list of recalled products for June 2007 included, among other things, the following items:

Lasko Ceramic Heaters: fire hazard in power cord. Manufactured by Lasko Inc. For more info., see http://www.cpsc.gov/cpscpub/prerel/prhtml07/07227.html.

Gateway Lithium Ion Battery Packs: fire hazard for notebook PCs. Distributed by Gateway Inc. For more info., see http://www.cpsc.gov/cpscpub/prerel/prhtml07/07219.html.

Briggs & Stratton Snow Throwers: fire hazard. Manufactured by Briggs & Stratton Corp. For more info, see http://www.cpsc.gov/cpscpub/prerel/prhtml07/07558.html.

Asko Cylinda Dishwashers: fire hazard. Manufactured by Asko Cylinda AB. For more info., see http://www.cpsc.gov/cpscpub/prerel/prhtml07/07213.html.

First Birthday Party Hats (Childrens Party Hats): choking hazard. Distributed by Creative Expressions. For more info., see http://www.cpsc.gov/cpscpub/prerel/prhtml07/07208.html.

Nursery-in-a-Box Cribs: fall, entrapment and choking hazards. Manufactured by Simplicity Inc. For more info., see http://www.cpsc.gov/cpscpub/prerel/prhtml07/07205.html.

The full list of recalled products for June 2007 is at www.cpsc.gov/cpscpub/prerel/prereljun07.html.

Crime News: How not to fake being a police officer. http://www.wtop.com/?nid=456&sid=1185352.

Wednesday, July 11, 2007

Why the Fed Won't Bail Out the Stock Market

On Tuesday, July 10, 2007, the Chairman of the Federal Reserve Board, Ben Bernanke, made a speech in which he said very little about the Fed’s current intentions concerning inflation and interest rates. The Dow Jones Industrial Average fell 148 points, the Nasdaq stock market fell 30 points and the S&P 500 Index fell 21 points. What happened? Why would the markets fall when the guy said basically nothing about what the markets were interested in?

You might not think the term “moral hazard” has anything to do with the Federal Reserve Board. It evokes images from the 1950s of nice girls being duped by sly, sweet-talking boys. But moral hazard is one of the principal dynamics in today’s financial markets.

Moral hazard, in the parlance of economists, means that a person doesn’t bear all of the negative consequences of his or her conduct. Moral hazards are often considered undesirable because they lead people to take greater risks than they would rationally take if they had to bear the full cost of their behavior.

For example, taxicab drivers in Manhattan are notorious for not stopping and exchanging license, registration and insurance information after a minor, fender-bender type accident. They’d rather keep driving and collecting fares than get bogged down for a half an hour with paperwork. Because they don’t always bear the full consequences of minor accidents, they may not drive as carefully as other people.

Moral hazard is part of the world of government regulation. When the banking system swooned during the Great Depression, the federal government instituted a system of insuring customer deposits in order to restore confidence in banks. However, the government faced the problem of banks luring customers in with the promise of government insurance, and then making risky, but potentially profitable, loans. If the loans paid off, the banks would win big. If the loans defaulted and the banks couldn’t repay their depositors, the Federal Deposit Insurance Corporation bore the cost of making the depositors whole. In order to prevent banks from taking undue risks, the federal government imposed stringent regulations on the banks’ activities, and hired a staff of examiners to periodically review the banks’ books and records, and see if they were making loans the way cabbies drive in Manhattan.

In the early 1980’s, federal regulators removed many of the limitations on the loans that savings and loan associations (a type of bank) could make. In essence, they allowed the savings and loans to venture into many arenas where they had little or no experience. The result was a debacle. Many savings and loans secured depositors’ money with promises of high interest rates in government insured accounts, and made risky loans that promised big rewards. But they proved incapable of dealing with the risks of those loans. Numerous savings and loans collapsed, and the federal government was left barefoot and pregnant to clean up the mess. The subsequent savings and loan bailout, in the early 1990’s, cost each American taxpayer something in the range of $3,000. Moral hazard can be expensive.

It’s important to understand that government policy and actions create moral hazard. When the government assumes the risks and costs of something, it wittingly or unwittingly encourages people in the private sector to take greater risks (because those people won’t bear all of the consequences of those risks). This applies to the Federal Reserve, as well as other government agencies.

In the 1990’s, the Fed acquired a reputation for being highly skillful at managing the economy. Since the mid-1990’s, the economy has had only mild downswings, but has enjoyed healthy upswings. In spite of a variety of major stresses—the stock market bubble and bust of the late 1990’s and early 2000’s, the real estate bubble and bust of the mid-2000’s, rising energy prices, a flood of subprime and other mortgage defaults, enormous federal deficits, gigantic U.S. trade deficits, and a falling U.S. dollar—the U.S. economy has merrily rolled along, for the most part. Unemployment is quite low under the circumstances. Consumer spending never seems to have a bad day. And inflation largely seems to be moderate—okay, not when it comes to energy prices, but otherwise it hasn’t been out of control.

This picture of ever-sunny days encourages investors to take greater risks. If you believe that the Fed has somehow, through increased knowledge, skill, technology, magic or alchemy, learned how to prevent bad economic consequences, then you’d expect that taking greater risks gives you the potential for larger rewards without much chance of losing money. You’d pay higher price-earnings multiples for stocks, expect lower interest rates on bonds, and buy real estate using the looniest of interest only or option ARM mortgages. Why? Because you'd think that nothing will ever go wrong, and if it does, Uncle Fed will bail you out.

Chairman Bernanke has learned from experience to keep his cards close to his vest. So his intentions are not crystal clear. But it’s fair to say that his principal regulatory goal is to contain inflation. He correctly sees inflation has the greatest long term threat to the health of the economy (see our blog at http://blogger.uncleleosden.com/2007/06/why-federal-reserve-matters.html), and will keep interest rates where they are, or even raise them, in order to tamp down any inflationary brush fires.

The stock market doesn’t want to believe this. It’s gotten used to the idea that the Fed will make all boo-boos go away. These days, there are downdrafts in the financial markets. The subprime and other mortgage markets keep slipping down the slippery slope. The private equity deal market is stumbling from resistance by bond buyers to more “covenant-lite” bonds (which are bonds with terms highly favorable to the private equity firms, and not terribly protective of bondholders). Foreign holders of the U.S. dollar, like the Chinese central bank, are easing towards greater diversification of their foreign currency exposures (which means downward pressure on the dollar). Economic statistics exert a push-me, pull-you effect on the stock market, resulting in breathless short term upswings and stomach-churning short term downswings. The picture on corporate earnings will be revealed in the next couple of weeks, but sunshine isn’t necessarily in the forecast.

Given the ambiguous outlook, the stock market wants the Fed to lower interest rates (or, at least, signal that it will lower them in the near future). Chairman Bernanke didn’t give the market that message today. Reading between the lines, one gets the impression that Chairman Bernanke, and the rest of the Fed, are struggling with the moral hazard created by the Fed’s success of the last decade. People invest aggressively, thinking the Fed will save the day if clouds roll in. But if the Fed bails out the stock market, it will only encourage investors to take more risk and eventually need bigger bailouts.

Ultimately, the Fed doesn’t have the power or ability to save people from investment errors. It can, and will, endeavor to fight inflation. If it can keep inflation contained, it will also try to maintain solid economic growth. But it won’t provide a bailout for the stock markets.

For yourself, focus on long term diversified investing. Don’t speculate in the short term with the expectation that the Fed will support the value of your investments. It won’t.

For more about our practical investment guidelines, please go to Uncle Leo’s Den at www.uncleleosdencom/Step11InvGuidelines.html.

Strange News: the flying lawn chair--a new way to have weekend fun. http://www.cnn.com/2007/US/07/10/flying.lawn.chair.ap/index.html.

Monday, July 9, 2007

How to Get Rid of Your Budget

You hate it. When you've burned up your budgeted allowance for chocolate, and half the month remains, you have to deprive yourself. Or cheat on your budget. But you know you're only cheating yourself because money that should have gone into your retirement account instead has been used to buy fattening food.

And you have hate having to keep track of your spending--inputting data into your PC every day, or making sure the checking account is accurate and balanced, or (if you're really old-fashioned), minding the amount of cash remaining in the envelope for each of the month's expenses.

There's a simple way to avoid the need for a budget. That's to save a significant portion of your earnings every month.

A budget's true purpose is to control your spending so you don't end up buried in debt, and are able to save for long term expenses like retirement and college education for your kids. If you can control your spending enough to save a solid percentage of your income each month, then you can bag the budget.

How much saving is enough? It depends on your goals. At least 10% of your earnings would be advisable for a comfortable retirement. If you want to maintain the same lifestyle in retirement as you have during your working years, save at least 15% of your earnings. More would be necessary if you're planning to help your kids pay for college.

If you save a solid percentage of your income, does that mean that you can spend as much as you want on chocolate? Of course not. You have only a limited amount of money, and rent or mortgage payments, car payments, school debts, groceries, utilities, taxes, etc. all come before chocolate. But if you're sensible enough to save 10%, 15% or more of your earnings, you'll be sensible enough to cover the basics first. And you'll know better than to borrow to support your current lifestyle.

Be a good saver, and liberate yourself from the budget.

For more ideas about personal finance, please go to http://www.widowsquest.com/how-to-solve-your-money-worries-4/.

Strange News: Okay, there's $64,000 in a bag in the bathroom, and what's the explanation?http://www.cnn.com/2007/WORLD/americas/07/07/argentina.minister.ap/index.html.

Thursday, July 5, 2007

Stop Telemarketing Calls

One way to reduce your spending and avoid being scammed is to stop telemarketing calls. Are you maybe, perhaps, just a little fed up with being pestered every evening by unknown callers? If so, put your phone number(s) on the National Do Not Call Registry, which is operated by the Federal Trade Commission.

Go to www.donotcall.gov or call toll-free 1-888-382-1222 (TTY 1-866-290-4236). You can register land lines and cell phones. Not all telemarketers are required to stop calling you. Political organizations, charities and political surveyors can still disturb your tranquillity. Companies with which you have an existing business relationship (such as a company that you bought something from), can call you for 18 months after you make a purchase or 3 months after you make an inquiry or submit an application. Also, any company that you give permission to call can keep calling (warning: there may be fine print in forms and other documents that authorize these calls, so always read the fine print).

After your phone number has been registered with the National Do Not Call Registry for 31 days, telemarketers have to stop calling you (except for the ones that are allowed to keep calling). If you get calls that aren’t permitted, file a complaint at www.donotcall.gov. You’ll need the phone number or name of the organization that called you.

Of course, telemarketers don’t make it easy for you to stop them. Many make computerized calls that don’t leave messages in your voicemail. That way, you have to talk to them in order to identify them as a prohibited caller. If you take the call, ask them to put you on their individual do not call list. They are required to honor this request. Then, if they are a prohibited caller, file a complaint with the government.

From a practical standpoint, having caller ID helps a lot. If the caller appears to be a telemarketer, you can not answer. Most telemarketers will remove you from their calling lists after a while if you don’t answer their calls (because they don’t want to spend the money to call people who won’t talk to them).

There are some people who like receiving telemarketer calls. Sadly, many of them are elderly and lonely, and end up being ripped off one way or another. If you have a parent, grandparent, great aunt, great uncle or other elderly relative or friend, think about helping them get on the National Do Not Call Registry. Each person must personally put his or her phone numbers in the registry. But nothing says you can’t help out. You might be doing them a very big favor.

For information about recent types of scams, please go to http://blogger.uncleleosden.com/2007/05/scam-alert.html.

For more money management ideas, take a look at http://www.widowsquest.com/how-to-solve-money-worries-blog-carnival-4/.

Medical(?) News: smash up a hotel to relieve stress. http://www.wtop.com/?nid=456&sid=1180679

Tuesday, July 3, 2007

What the Wealthy are Doing with Their Money

So what are all those rich people doing with their money? We're not talking about $1,000 handbags, $2,500 bottles of wine, $400,000 cars, or 500-foot yachts . We're talking about what they are doing with the management and investment of their money. Most wealthy people are discreet when it comes to this topic. But every now and then, you can get a glimpse.

1. The Wall Street Journal (June 30-July 1, 2007, P. B3) reports that the wealthy (i.e., $1,000,000 or more in investible assets) have been pulling back from hedge funds and similar investments. In 2005, the wealthy invested about 20% of their assets in these so-called alternative investments. In 2006, they cut back to 10%. There are debates about whether this cutback is short term or longer term, but it's not a minor change and represents a shift away from some of the riskier investments.

2. Even if the wealthy are becoming more cautious about alternative investments, they aren't shy about taking risks generally. They own about half of all individually-owned stocks, and are often willing to borrow in order to finance investments. (Wall Street Journal, March 2, 2007, P. W2). Some also invest in collectibles--art, wine and so forth. Collectibles can be great, or awful, investments; but they are definitely risky.

3. Do the wealthy prudently save and build their net worth? Some do, but others have the spending gene. The Wall Street Journal (Feb. 23, 2007, P. W2) reported on a survey of Wall Street bankers and traders receiving bonuses of $2,000,000 or more in 2006, which revealed that they save, on average, 16.5% of their bonuses. Much of the rest went to buy residences, art, jewelry and watches, home improvements, horses, flying lessons, golf and "mistresses and other lovers." Apparently they believe that because they work hard, they deserve a lot of rewards.

4. The affluent think for themselves. A survey of mutual fund investors with at least $100,000 in investible assets that was reported in the March 15, 2007 edition of the Wall Street Journal (P. C13) revealed that affluent investors show little loyalty toward mutual fund management firms. Evidently, many investors evaluated the managements of their mutual funds quite critically. Vanguard, however, got more loyalty than other mutual fund management companies.

Does this tell you anything? Maybe you now have a few tidbits for the next cocktail party you attend. But as for your own finances, keep saving regularly and invest in a diversified portfolio. Don't think about the rich. Become one of them. Happy Fourth.

For more thoughts about wealth and wealth creation, please go to http://reachformagnificence.com/reach-for-magnificence-wealth-creation-carnival-2/.

Strange News: throughout America's Northland (Mich., Wis., Minn., etc.), ice carvings are a winter tradition. But, a cheese carving? http://www.wtop.com/?nid=456&sid=1178373

Monday, July 2, 2007

Bond Market Tremors Hit Private Equity--and Stocks?

If you read the financial press regularly, you’ve heard of private equity deals. These are transactions where a company’s public shareholders are bought out, and the company “goes private” (meaning its stock ceases to trade publicly). Usually, an outfit specializing in these deals, called a private equity firm (they used to be called leveraged buyout firms), will borrow a pile of money and strike a deal with the management of the company to buy out the public shareholders. Other times, the private equity firm will buy a subsidiary of a public company, again using borrowed money. Once that’s accomplished, management of the acquired company and the private equity firm work to improve the company and then re-issue its stock to the public later at a profit.

One recent example of such a deal was Ford Motor Co. selling its car rental subsidiary, Hertz, in 2005 to a private equity group. The private owners of Hertz then made a public offering of Hertz stock about one year later, and by some accounts realized a profit on their investment exceeding 200%. That’s a lot of lunch money in a pretty short amount of time.

These private equity deals have been fueled by the availability of cheap credit. Interest rates have been low during the 2000s. It’s Econ 101 that when something is cheap, people will consume more of it. Credit is no different—look at how people rushed into the real estate market when lots of “affordable” loans were available. Unfortunately, many of those loans have proven to be a lot less affordable than they first appeared (as we discuss in http://blogger.uncleleosden.com/2007/05/true-price-of-affordable-loans.html). Access to easy credit in the real estate markets puffed up values and created bubbles in many regions that are now popping.

In a similar way, cheap credit fueled private equity deals. Low interest rate bonds, often issued with relatively few terms protecting bond holders (called "covenant lite" bonds), made a lot of the private equity deals possible.

The stock market is up about 18% from a year ago. One reason for this bubbliness is the rash of private equity deals that have taken place recently. Many stocks have been boosted by the expectation that they will be the subject of a private equity buyout. But the horizon is darkening, temperatures are dropping, and the wind is picking up. Interest rates have been rising in the U.S. and elsewhere around the world. Even though the Fed kept its target for the fed fund rate unchanged last week, market rates have risen because of the uncertainties in the mortgage markets (see our earlier blog about the subprime mortgage mess at http://blogger.uncleleosden.com/2007/06/subprime-mortgage-mess-on-wall-street.html). As interest rates rise, the attractiveness of private equity deals lessens. That’s because rising interest rates increase the costs of borrowing that finance these deals, and when costs rise, profits fall.

Last week, a private equity deal stumbled. It involved a grocery store company called U.S. Foodservice, which was a subsidiary of a Dutch company called Royal Ahold. Ahold sold U.S. Foodservice to a couple of private equity firms. They hoped to finance the deal with bonds. As a part of the transaction, a group of investment banks promised to lend the necessary money to finance the purchase first and then sell the bonds afterwards. This is called a “bridge loan.” If the bonds couldn’t be sold, the bridge loan would finance the deal longer term.

This time, the bonds couldn’t be sold. Investors wanted better terms than the bonds offered. Can you blame them? If a private equity outfit can make 200% plus in a year on Hertz, why would a bondholder want a relatively low return investment like a bond with relatively few protective provisions just to let some other private equity people make big bucks on U.S. Foodservice? With interest rates in a rising mode, being a lender to private equity all of a sudden doesn’t look as attractive as before.

A couple of other bond deals last week either had to be altered, or were called off, for much the same reasons. As the costs of private equity deals and other corporate restructurings rise, there will be fewer of them. And that means the impetus to stock prices that these deals provided will diminish. While the stock market has had a good run during the last 12 months, parties don’t last forever on Wall Street and it looks like the booze supply could be running low. The dollar has fallen against other currencies. That means potentially greater inflation in the U.S. It also makes investing in foreign stock markets seem more attractive. Also, the Federal Reserve Board remains concerned about inflation generally, which means it won’t lower interest rates any time soon. The housing market hasn’t found a bottom, and the mortgage markets continue to give Wall Street dyspepsia.

Not all of the picture is negative. The American consumer, as reliable as a Checker Cab, continues to chug and charge through rain, sleet, hail and snow. And unemployment levels remain remarkably low under the circumstances.

Corporate earnings reports will be coming out in the next few weeks. They, as always, will affect the direction of the market. But caution is in order. The availability—or not--of cheap credit shouldn’t be underestimated. Look what it did for the real estate markets--moving them up, and now down. As the bond market shivers, stock investors should think carefully about how much risk they want to carry.

Shopping News: for all you wine lovers, put away your charge cards. A couple of wrinkled bills wil do. http://www.wtop.com/?nid=456&sid=1177862.