Lending Club YTM Drift: Explained
04/12/2016
A copy of this write up is available here.
A copy of this write up is available here.
If you’ve seen this graph before, you know what I am talking about: the average returns for all Lending Club (“LC”) investors over time.
Embedded in this drift lower (yellow arrow) are two explanatory variables. The first being charge-offs and write downs from non-performing loans. The second, a rather important but ill-televised factor is the natural decay in returns due to Lending Club fees.
I think investors could become disillusioned with P2P products over time as these combined effects work together to erode returns, but it is worth realizing that at least part of the decay is inherent in the loan structure from Day 1. Remember: the initial Net Adjusted Return (“NAR”) or your own self-calculated IRR is the BEST you are going to do in fixed income investing. This isn’t equity investing. It’s fixed income investing!
Let’s consider how a fixed rate mortgage works. In the early years, most of the payment goes towards interest but as it amortizes proportionally more of the payment is devoted to principal repayment.
The same principle applies to LC loans, so the older the loan the more principal, and less interest, you receive. This means that LC fees become more pronounced over time as there is less interest to offset the fee drag.
While I’ve seen a few articles (available here) and blog posts (available here) which speak to the embedded Yield to Maturity (“YTM”) at different points along the amortization schedule I haven’t seen anyone explicitly define the decay you will see naturally over time.
I will do that here.
The first thing to mention is there are different decay factors for different loan maturities (36 or 60 month), which makes sense. 36 month loans will experience the drag to a greater extent than 60 month loans since the loans have an accelerated amortization schedule. In the graph below, I assume both loans have a 10% coupon issued at par meaning no premium or discount if you purchased on FolioFN and a 1% LC investor fee.
Since LC collects their fee on total payment, one would think that the interest rate impacts the decay factor (and it does), but only by a few basis points since the principal payment in a short tenure loan (3-5yrs) is the main determinant of the overall payment. For the sake of completeness, see this table for an example of a 10% and 20% coupon loan. The delta averages 5bps.
Embedded in this drift lower (yellow arrow) are two explanatory variables. The first being charge-offs and write downs from non-performing loans. The second, a rather important but ill-televised factor is the natural decay in returns due to Lending Club fees.
I think investors could become disillusioned with P2P products over time as these combined effects work together to erode returns, but it is worth realizing that at least part of the decay is inherent in the loan structure from Day 1. Remember: the initial Net Adjusted Return (“NAR”) or your own self-calculated IRR is the BEST you are going to do in fixed income investing. This isn’t equity investing. It’s fixed income investing!
Let’s consider how a fixed rate mortgage works. In the early years, most of the payment goes towards interest but as it amortizes proportionally more of the payment is devoted to principal repayment.
The same principle applies to LC loans, so the older the loan the more principal, and less interest, you receive. This means that LC fees become more pronounced over time as there is less interest to offset the fee drag.
While I’ve seen a few articles (available here) and blog posts (available here) which speak to the embedded Yield to Maturity (“YTM”) at different points along the amortization schedule I haven’t seen anyone explicitly define the decay you will see naturally over time.
I will do that here.
The first thing to mention is there are different decay factors for different loan maturities (36 or 60 month), which makes sense. 36 month loans will experience the drag to a greater extent than 60 month loans since the loans have an accelerated amortization schedule. In the graph below, I assume both loans have a 10% coupon issued at par meaning no premium or discount if you purchased on FolioFN and a 1% LC investor fee.
Since LC collects their fee on total payment, one would think that the interest rate impacts the decay factor (and it does), but only by a few basis points since the principal payment in a short tenure loan (3-5yrs) is the main determinant of the overall payment. For the sake of completeness, see this table for an example of a 10% and 20% coupon loan. The delta averages 5bps.
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The first thing I will point out is the YTM (or IRR) starts out below the coupon. For a 36-month, 10% coupon loan, the YTM is 9.31%; in a 60-month 10% loan, the YTM is 9.57%. This is because of fees. If there weren’t any, the YTM would be equal to the coupon.
The decay in your YTM continues declining at an accelerating rate and by the loans’ half-life (month 18 and month 30) we see the expected YTM relative to the stated coupon is 8.76% and 9.21%, respectively!
So why does this matter? Two reasons: First, your IRR is going to be below the promised coupon and will only decline over time. This eventually results in a negative yield to investors in the last month of payment, which is virtually all principal.
Secondly, if you are trying to differentiate between this natural drift and your actual default experience you will need these decay factors to calculate a more accurate implied default rate. You can then use this to compare against Lending Club’s expected defaults. In principle, quantifying your ‘alpha’.
Here is a four step process to do that:
Keep in mind that if your portfolio is less than 12 months old, you probably have not experienced a full default cycle yet so comparing to Lending Club’s expected defaults will be apples and oranges. (Random Thoughts produced a good four part series discussing this: Part 1, 2, and 3 and 4 are available.
If your portfolio is 12-18 months old and your implied default is lower than Lending Club’s projections you’ve beaten the market!
The decay in your YTM continues declining at an accelerating rate and by the loans’ half-life (month 18 and month 30) we see the expected YTM relative to the stated coupon is 8.76% and 9.21%, respectively!
So why does this matter? Two reasons: First, your IRR is going to be below the promised coupon and will only decline over time. This eventually results in a negative yield to investors in the last month of payment, which is virtually all principal.
Secondly, if you are trying to differentiate between this natural drift and your actual default experience you will need these decay factors to calculate a more accurate implied default rate. You can then use this to compare against Lending Club’s expected defaults. In principle, quantifying your ‘alpha’.
Here is a four step process to do that:
- As I mentioned, if LC fees were zero your coupon would equal your portfolio IRR. Therefore, we can start with the weighted average coupon of your loan book. You can calculate it yourself or Lending Club provides this figure under Account>>Summary>> Click hyperlinked “More Details”.
- Calculate your portfolio’s IRR. I would recommend using the XIRR function and there are a variety of blog posts out there that describe this process. A link to one of them is available here.
- Using Table 1 in the Annex pull the decay factor for your 36M and 60M loan portfolio relative to the average age separately. For instance if the average age of your 36M loan portfolio is 12 months with a 10% coupon use -97bps. If your 60M portfolio is also 12 months old with a 10% coupon, use -52bps. Take the weighted average of these two figures (Suppose 60% of your total portfolio is 36M and 40% 60M paper then 60% x -97bps + 40% x -52bps).
- Subtract the sum of [your portfolio’s current IRR and the inverse of the decay factor] from the weighted average coupon.
Keep in mind that if your portfolio is less than 12 months old, you probably have not experienced a full default cycle yet so comparing to Lending Club’s expected defaults will be apples and oranges. (Random Thoughts produced a good four part series discussing this: Part 1, 2, and 3 and 4 are available.
If your portfolio is 12-18 months old and your implied default is lower than Lending Club’s projections you’ve beaten the market!
Learning to trade the structural illiquidity
09/09/2013
The global selloff we saw in June seems like a distant memory these days with most risk and rate products having reset to a new trading range. But markets are once again becoming lulled into a false sense of security. The plate tectonics are in motion once more; my seismograph is registering some early tremors. Investors beware.
But let’s first take a moment to understand the dynamics that were in play during the summer sell-off. It started with Bernanke’s speech on May 22nd where he suggested tapering was a near term probability. What happened next surprised even the most seasoned investors. At the epicenter was the treasury markets and from there rates and risk were simultaneously sold. Carry trades were unwound and greenbacks repatriated. The Fed was calling back its bountiful liquidity. That old saying still holds - “when the US sneezes, the rest of the world catches a cold”.
The catalyst was the ‘shift’ in monetary policy but most believe the June sell off was big technical sell ticket with 1) traders front running the Fed 2) CTA’s getting caught in a ‘long squeeze’, 3) a modest amount of convexity hedging and 4) batting cleanup a tidal wave of redemptions from ETF and mutual funds. [For more information around the diminished role convexity hedging played in this sell-off please read this from creditwritedowns.com].
And while all these technicals played their hand, I think we've overlooked a pretty significant structural weakness that's been festering since the crisis. Over the last 5 years policy makers and regulators have sought to immunize the financial system from the events of 2008 which has meant smaller balance sheets for the nation’s biggest banks, punitive capital requirements, a separation of church and prop desk and a continued distrust of securitization. All this has meant significantly reduced capacity for markets to absorb sell orders with prime brokers reverting to their 19th century roots matching buy and sell orders like a bourse. Without market players with balance sheet capacity we should expect to see prices trade in jagged stairsteps during periods of market volatility. Prudence it seems has hallowed out what once was an impressive financial market torso.
So on one side the Fed has dulled volatility with excess liquidity and on the other regulators have added an enduring, structural component to it. We just didn’t realize it while the waters were rising. Now that the tide has gone out, we see we are all swimming naked. It’s ironic really.
Structural illiquidity is not a healthy sign in the markets, but it doesn’t mean we need to head for the hills. After all, imbalances are an opportunity in disguise. We simply have to deploy our capital with lighting speed (most of the carnage in June was contained to a two-week period). Today we are seeing dislocation in the muni market which has experienced massive redemptions after a lethal cocktail of longer [relative] duration, a steepening yield curve and the high profile default in Detroit. Act fast folks, these deals won’t last.
The global selloff we saw in June seems like a distant memory these days with most risk and rate products having reset to a new trading range. But markets are once again becoming lulled into a false sense of security. The plate tectonics are in motion once more; my seismograph is registering some early tremors. Investors beware.
But let’s first take a moment to understand the dynamics that were in play during the summer sell-off. It started with Bernanke’s speech on May 22nd where he suggested tapering was a near term probability. What happened next surprised even the most seasoned investors. At the epicenter was the treasury markets and from there rates and risk were simultaneously sold. Carry trades were unwound and greenbacks repatriated. The Fed was calling back its bountiful liquidity. That old saying still holds - “when the US sneezes, the rest of the world catches a cold”.
The catalyst was the ‘shift’ in monetary policy but most believe the June sell off was big technical sell ticket with 1) traders front running the Fed 2) CTA’s getting caught in a ‘long squeeze’, 3) a modest amount of convexity hedging and 4) batting cleanup a tidal wave of redemptions from ETF and mutual funds. [For more information around the diminished role convexity hedging played in this sell-off please read this from creditwritedowns.com].
And while all these technicals played their hand, I think we've overlooked a pretty significant structural weakness that's been festering since the crisis. Over the last 5 years policy makers and regulators have sought to immunize the financial system from the events of 2008 which has meant smaller balance sheets for the nation’s biggest banks, punitive capital requirements, a separation of church and prop desk and a continued distrust of securitization. All this has meant significantly reduced capacity for markets to absorb sell orders with prime brokers reverting to their 19th century roots matching buy and sell orders like a bourse. Without market players with balance sheet capacity we should expect to see prices trade in jagged stairsteps during periods of market volatility. Prudence it seems has hallowed out what once was an impressive financial market torso.
So on one side the Fed has dulled volatility with excess liquidity and on the other regulators have added an enduring, structural component to it. We just didn’t realize it while the waters were rising. Now that the tide has gone out, we see we are all swimming naked. It’s ironic really.
Structural illiquidity is not a healthy sign in the markets, but it doesn’t mean we need to head for the hills. After all, imbalances are an opportunity in disguise. We simply have to deploy our capital with lighting speed (most of the carnage in June was contained to a two-week period). Today we are seeing dislocation in the muni market which has experienced massive redemptions after a lethal cocktail of longer [relative] duration, a steepening yield curve and the high profile default in Detroit. Act fast folks, these deals won’t last.
Gold's Selloff a Bad Omen for Equity Markets
05/22/2013
Dear Reader:
I'd first like to apologize for not updating this site more religiously, it certainly hasn't been for lack of material and content! Life just doesn't seem to budget for much down time. Nevertheless onto more pressing matters: I am at a point where I am starting to feel uncomfortable about owning equities and risk assets in general. I acknowledge there is very little alternatives but I believe the Fed will begin tapering their asset purchases in the next 6-12months. This will not bode well for the markets as the fundamentals don't support the multiples. A copy of my latest article, Gold's Selloff a Bad Omen for Equity Markets, is available on the CFAI website.
Dear Reader:
I'd first like to apologize for not updating this site more religiously, it certainly hasn't been for lack of material and content! Life just doesn't seem to budget for much down time. Nevertheless onto more pressing matters: I am at a point where I am starting to feel uncomfortable about owning equities and risk assets in general. I acknowledge there is very little alternatives but I believe the Fed will begin tapering their asset purchases in the next 6-12months. This will not bode well for the markets as the fundamentals don't support the multiples. A copy of my latest article, Gold's Selloff a Bad Omen for Equity Markets, is available on the CFAI website.
Looking Forward: Risks in the Year Ahead
01/24/2013
Dear Reader:
Looking Forward: Risks in the Year Ahead was written for the CFA Institute and a copy of this article is available on their website.
Dear Reader:
Looking Forward: Risks in the Year Ahead was written for the CFA Institute and a copy of this article is available on their website.
Pushing on a String
09/12/2012
Dear Reader:
Pushing on a String was written for the CFA Institute and a copy of this article is available on their website.
Dear Reader:
Pushing on a String was written for the CFA Institute and a copy of this article is available on their website.
The Dividend Yield Cliff
08/23/2012
The Dividend Yield Cliff was written for the CFA Institute and a copy of this article is available on their website.
Why Old People Still Matter
02/18/2012
A copy of this article in PDF format is available here.
For decades, countries around the world have been able to ride their demographic trends toward higher GDP, yet these same favorable trends have started to crest and many will soon begin to experience them, not as convenient tailwinds, but rather formidable headwinds.
Current trajectories are calling for an aging and protracted global population that will put strain on our infrastructure, resources, and ultimately our capital markets. While not all economies are headed there at the same time, we will all inevitably “run a-ground”. And whilst today there exists a sizable gap between the BRIC economies (notably India and Brazil) and the G-7, eventually this arb goes away.
A copy of this article in PDF format is available here.
For decades, countries around the world have been able to ride their demographic trends toward higher GDP, yet these same favorable trends have started to crest and many will soon begin to experience them, not as convenient tailwinds, but rather formidable headwinds.
Current trajectories are calling for an aging and protracted global population that will put strain on our infrastructure, resources, and ultimately our capital markets. While not all economies are headed there at the same time, we will all inevitably “run a-ground”. And whilst today there exists a sizable gap between the BRIC economies (notably India and Brazil) and the G-7, eventually this arb goes away.
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As asset allocators figuring out these structural trends will bear fruit. In equity markets for instance, growth is a quintessential piece of the valuation framework and an aging population is a huge drag on growth. The most immediate impact is on consumption: not only the absolute level but the industries in which they are spent. (Think quality of life industries like pharmaceuticals and personal care products).
Capital markets will be further impacted as an aging population will throw off the traditional balance between supply and demand. The argument is fairly simple but undeniably logical. If traditional portfolio theory holds we should retirees throttle back their risk exposure and shift demand from risky assets (like equity) to safe haven, income producing assets (like fixed income). This increasing demand for fixed income assets will put pressure on equities while supporting bond rates. In one hand we have a powerful retail trend paired with a strong bid from institutions under the captive capital doctrine so my question to you is: are low(er) interest rates here to stay? For me, the demand side arguments are simply too convincing to ignore.
An aging and protracted population also puts strain on our resources and the choice in how we divide up those resources. Today some 18.4% of our national income comes from government transfer payments with the lion’s share of that funding the retired and infirm. Are there better channels and uses of our funds? Say government funded research or infrastructure spending? Is this the stuff of capitalism..or self-directed nepotism?
When Social Security and Medicare were introduced we were neither old nor insolvent. Today we are coming under increasing pressure to meet our social and financial obligations so the hard choice about which promises we keep will have to be made.
What makes an aging and protracted population even more precarious is the fact that our topical solution is worse than the disease. In its most rudimentary form you battle an aging population by simply expanding the youth-base with favorably immigration and family formation policies. But longer term, this only exacerbates the problem, but allows the current generation to skip out on the hard choices.
What’s interesting to think about is the fact that history has never provided us a view into how capitalism fairs under an aging population. Capitalism has existed mostly in periods where there were favorable demographic trends (aka shorter life expectancies). The closest proxy we have is Japan, known as the widow maker for its graying population, ultra low interest rates and lackluster equity returns. Is this what we can expect from other graying economies?
What happens when the favorable trends we’ve been riding reverse and can no longer be counted on for incremental growth? Having defeated the likes of socialism and communism, capitalism has flourished and helped lift the standards and quality of lives around the world, but is its strength also its fundamental weakness? Moreover, is an aging population the logical conclusion of a successful capitalist model: will it be crushed under the weight of its own success?
What’s interesting to think about is the fact that history has never provided us a view into how capitalism fairs under an aging population. Capitalism has existed mostly in periods where there were favorable demographic trends (aka shorter life expectancies). The closest proxy we have is Japan, known as the widow maker for its graying population, ultra low interest rates and lackluster equity returns. Is this what we can expect from other graying economies?
What happens when the favorable trends we’ve been riding reverse and can no longer be counted on for incremental growth? Having defeated the likes of socialism and communism, capitalism has flourished and helped lift the standards and quality of lives around the world, but is its strength also its fundamental weakness? Moreover, is an aging population the logical conclusion of a successful capitalist model: will it be crushed under the weight of its own success?
On China's Punch Bowl
1/13/2012
A copy of this article in PDF format is available here.
China’s New Year is January 23rd and this year will be the year of the dragon. How fitting. As much of the developed world is struggling to meet even sub-trend growth, China will itself enter a period of “slow growth” (consensus has it somewhere between 7.9% and 8.6%). Not bad by western standards.
Yet there is little doubt that the economy is sputtering: the housing bubble appears to have been pricked, exports are waning and internally the consumer is still too weak to pick up the baton. But the Chinese, unlike their western brethren, haven’t come to the end of their policy rope. Rates, reserve requirements, and Beijing’s coffers are all still comfortably unstretched. And there are large incentives for the Chinese to maintain their growth rates. A hard landing would exacerbate the already bubbling social unrest and destroy a good chunk of the newly minted wealth China has been able to create. Moreover, the CCP will want to insure a tranquil year as the Politburo is rechristened in late Oct/early November.
But this makes China a prisoner to its own growth story. In order to sustain growth the Chinese will have to continue supporting a lopsided growth model: one driven by expanding leverage and increased investment and infrastructure spending. And while in the short run, investment (and even a little overinvestment is 'ok') at some point the consumer and organic demand must become the driving force of an economy. Supply side economics in other words has a finite shelf life.
What's puzzling is the fact that China has always prided itself on having patient resolve. Creating a five year plan and sticking to it. And building a consumption driven economy has always been been something they've voiced support for. So why hasn't this been reflected in the hardnumbers? I will invariably get some slack for pointing to this tired graph on consumption vs. investment, but no one has adequately been able to explain why the long term trend for consumption is down.
China’s New Year is January 23rd and this year will be the year of the dragon. How fitting. As much of the developed world is struggling to meet even sub-trend growth, China will itself enter a period of “slow growth” (consensus has it somewhere between 7.9% and 8.6%). Not bad by western standards.
Yet there is little doubt that the economy is sputtering: the housing bubble appears to have been pricked, exports are waning and internally the consumer is still too weak to pick up the baton. But the Chinese, unlike their western brethren, haven’t come to the end of their policy rope. Rates, reserve requirements, and Beijing’s coffers are all still comfortably unstretched. And there are large incentives for the Chinese to maintain their growth rates. A hard landing would exacerbate the already bubbling social unrest and destroy a good chunk of the newly minted wealth China has been able to create. Moreover, the CCP will want to insure a tranquil year as the Politburo is rechristened in late Oct/early November.
But this makes China a prisoner to its own growth story. In order to sustain growth the Chinese will have to continue supporting a lopsided growth model: one driven by expanding leverage and increased investment and infrastructure spending. And while in the short run, investment (and even a little overinvestment is 'ok') at some point the consumer and organic demand must become the driving force of an economy. Supply side economics in other words has a finite shelf life.
What's puzzling is the fact that China has always prided itself on having patient resolve. Creating a five year plan and sticking to it. And building a consumption driven economy has always been been something they've voiced support for. So why hasn't this been reflected in the hardnumbers? I will invariably get some slack for pointing to this tired graph on consumption vs. investment, but no one has adequately been able to explain why the long term trend for consumption is down.
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To me, this brings into focus a troubling, long term structural problem.
China's hand is being forced into investments for a few very simple reasons.
First, consumption based economies can usually only offer their patrons 3-4% of
real growth, far below China’s comfort level and the Street's expectation.
Second and perhaps most importantly, China is trying to build a society of
consumption off a tradition of saving. Historical savings rates for the Chinese
are very high and the proletariat would almost always prefer to save then to
spend. So in many respects the government is 'spending' for its constituents in
what can only be described as the longest running Keynesian experiment ever.
But in the end the government can only hope that one day the masses will turn
from net savers to net spenders. But as a strategist I work with so aptly put
it: “this isn’t Field of Dreams. He won’t come just because you build
it”.
Industry % of Fixed Asset Investment
Manufacturing 34.2
Real Estate 25.3
Transportation 8.7
Environment 8.1
Utilities 4.8
Other* 18.7
Cumulative YTD thru 11/30/2011. Source: NBS
*Other includes 14 smaller investment sectors to: Mining, Agriculture, Education, Hotels, etc.
Today, 13% of China’s overall GDP is property construction and if you add in upstream industries like concrete and steel the figure is closer to 20%. But even these figures ignore the ripple effects that will permeate through the economy. Many provincial governments rely on land sales and real estate taxes to generate revenue and banks have significant, albeit subordinate exposure to real estate. With the Chinese facing a weakened outlook and yet to-be-determined landing type, the PBC will have little choice but to continue feeding an insatiable beast built off increasing leverage, infrastructure spending, and speculative real estate.
China will hit a soft patch over the next two quarters, but I believe they have (and will take advantage of) sufficient policy rope to meet their full year 2012 growth targets. Yet over the long term that same rope will become a noose around their neck: China cannot continue to front run demand indefinitely. For that which cannot last, won't.
Industry % of Fixed Asset Investment
Manufacturing 34.2
Real Estate 25.3
Transportation 8.7
Environment 8.1
Utilities 4.8
Other* 18.7
Cumulative YTD thru 11/30/2011. Source: NBS
*Other includes 14 smaller investment sectors to: Mining, Agriculture, Education, Hotels, etc.
Today, 13% of China’s overall GDP is property construction and if you add in upstream industries like concrete and steel the figure is closer to 20%. But even these figures ignore the ripple effects that will permeate through the economy. Many provincial governments rely on land sales and real estate taxes to generate revenue and banks have significant, albeit subordinate exposure to real estate. With the Chinese facing a weakened outlook and yet to-be-determined landing type, the PBC will have little choice but to continue feeding an insatiable beast built off increasing leverage, infrastructure spending, and speculative real estate.
China will hit a soft patch over the next two quarters, but I believe they have (and will take advantage of) sufficient policy rope to meet their full year 2012 growth targets. Yet over the long term that same rope will become a noose around their neck: China cannot continue to front run demand indefinitely. For that which cannot last, won't.
China: 20 Years on..
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Then: 1990
 Source: BusinessInsider.com |
Now: 2010
 Source: BusinessInsider.com |
The Proof is in the lighting..
12/20/2011
A copy of this article is available in PDF format here.
I came across these photos of the Korean peninsula and African continent. Striking. Truly striking. I think there’s a case to be made that economic development can be measured one light bulb at a time.
Nothing new I can add here. I think the author says it best:
Development means many things. Health, education, roads. But at the end of the day, the most visible symbol of development is where there is light, and where there is not. When someone wants to show how communism retards development, they point to the famous image of the two Koreas: North Korea is dark, South Korea is bright. - Afrikent
A copy of this article is available in PDF format here.
I came across these photos of the Korean peninsula and African continent. Striking. Truly striking. I think there’s a case to be made that economic development can be measured one light bulb at a time.
Nothing new I can add here. I think the author says it best:
Development means many things. Health, education, roads. But at the end of the day, the most visible symbol of development is where there is light, and where there is not. When someone wants to show how communism retards development, they point to the famous image of the two Koreas: North Korea is dark, South Korea is bright. - Afrikent
Hear, Hear FOMC
11/22/2011
A copy of this article is available in PDF format here.
A copy of the FOMC meeting minutes are also available here.
The FOMC meeting minutes from early November were released today. First I’d like to applaud the Fed for not overstepping their monetary authority however tempting lower unemployment figures might be.
The Committee apparently weighed several additional monetary policies including setting explicit targets on unemployment, inflation, or nominal GDP. Now, I realize desperate times call for desperate measures, but setting targets unduly handicaps central banks and puts them in a precarious situation when things go awry. Central banks are then forced to choose between abandoning policy (and losing credibility) or carrying on even when it becomes counterproductive. The prime example of this is the ECB’s mandate on inflation. As long as inflation is above their comfort level, they hike rates. The last rate hike was as late as July 7th just as the sovereign debt crisis was beginning to bud. The ironic thing was inflation was only really a problem in Germany; the rest of the southern EUR countries were actually facing deflation.
You never want to underestimate the power of credibility and trust. Once you lose it it’s gone for a good, long while. The market believes the Fed’s commitment and more importantly their ability to effectively conduct monetary policy. For now, the collective balance sheet of Wall Street is happy front running CB policy, giving them monetary leverage, but what if we grow weary and stop believing Bernanke or Draghi?
A One, Two Punch
10/25/2011
First I’d like to apologize for missing my last entry; September was a busy month, but thankfully I found some time today.
A copy of this article is available in PDF format here.
So what can I say: I just cannot say enough about banks. In July I spoke about what additional regulation and capital requirements would mean for banks. Today, in the face of a seemingly imminent European meltdown, many are being asked to do precisely that.
But the equity markets are closed for new issuance so raising additional capital means taking down leverage and decreasing the amount of loans on their books. This of course exacerbates the problems in the real economy as struggling borrowers cannot refinance and new borrowers find there is less credit to go around. This is the situation in Europe.
For the US, banks are facing a whole new breed of problems. Operation Twist is a done deal. The Fed is increasing the average duration of its SOMA portfolio which has flattened the yield curve and impacted the outlook for banks in a very material way.
Coincidentally, and I’d say rather ironically, the Frank Dodd Act and Volker Rules have forced many banks back into traditional lending where interest margins are key. You see banks make money by borrowing short and lending long. The spread between their cost of funds and the yield on their loan book is their profit, their interest margin. When you play with the shape of the yield curve, you play with the banks' money.
I should probably also clarify what I mean by “cost of funds”. I use it rather loosely. It’s not just their borrowing costs (deposits, CD’s, LIBOR rates); it’s that plus their cost of doing business. When they make a loan, think about how many people they have to employ: a loan officer, an underwriter, a lawyer, and a whole team of Committees and analysts that make a loan book work.
But Operation Twist has effectively lowered what they are able to charge customers on the back end so they are now economically less incentivized to lend in the first place. The end result is the same in the US as it is in Europe albeit from a different catalyst.
The kicker to this story is the fact that banks now have to make a decision about where to put their money. What will produce the best return on their capital? Some now believe that is in the Treasury market. However paltry nominal yields might seem today, the cost of ‘doing business’ in the Treasury market is minimal: a couple of basis points at best. So when you compare the interest margins on originating a loan vs. buying a Treasury note, it might not be obvious which is going to return more in the long run. Throw into the pot, the added benefit of having to carry no capital against Treasury holdings and the asset class (at least to banks) starts to look very attractive even at these yields.
Yet the purpose of Operation Twist was to push investors out of Treasuries and not keep them in. I think academically Operation Twist was the right thing to do, but practically, exactly opposite. Combined with the refocus of many banks on 'traditional' bank operations and we have a perfect storm of legislative and monetary policy that puts a floor on Treasury prices and a cap on available credit. Its ironic to me as it seems the left hand does not know what the right is doing, but somehow the Fed and regulators were able to come up with a lethal Ali-style one, two punch!
First I’d like to apologize for missing my last entry; September was a busy month, but thankfully I found some time today.
A copy of this article is available in PDF format here.
So what can I say: I just cannot say enough about banks. In July I spoke about what additional regulation and capital requirements would mean for banks. Today, in the face of a seemingly imminent European meltdown, many are being asked to do precisely that.
But the equity markets are closed for new issuance so raising additional capital means taking down leverage and decreasing the amount of loans on their books. This of course exacerbates the problems in the real economy as struggling borrowers cannot refinance and new borrowers find there is less credit to go around. This is the situation in Europe.
For the US, banks are facing a whole new breed of problems. Operation Twist is a done deal. The Fed is increasing the average duration of its SOMA portfolio which has flattened the yield curve and impacted the outlook for banks in a very material way.
Coincidentally, and I’d say rather ironically, the Frank Dodd Act and Volker Rules have forced many banks back into traditional lending where interest margins are key. You see banks make money by borrowing short and lending long. The spread between their cost of funds and the yield on their loan book is their profit, their interest margin. When you play with the shape of the yield curve, you play with the banks' money.
I should probably also clarify what I mean by “cost of funds”. I use it rather loosely. It’s not just their borrowing costs (deposits, CD’s, LIBOR rates); it’s that plus their cost of doing business. When they make a loan, think about how many people they have to employ: a loan officer, an underwriter, a lawyer, and a whole team of Committees and analysts that make a loan book work.
But Operation Twist has effectively lowered what they are able to charge customers on the back end so they are now economically less incentivized to lend in the first place. The end result is the same in the US as it is in Europe albeit from a different catalyst.
The kicker to this story is the fact that banks now have to make a decision about where to put their money. What will produce the best return on their capital? Some now believe that is in the Treasury market. However paltry nominal yields might seem today, the cost of ‘doing business’ in the Treasury market is minimal: a couple of basis points at best. So when you compare the interest margins on originating a loan vs. buying a Treasury note, it might not be obvious which is going to return more in the long run. Throw into the pot, the added benefit of having to carry no capital against Treasury holdings and the asset class (at least to banks) starts to look very attractive even at these yields.
Yet the purpose of Operation Twist was to push investors out of Treasuries and not keep them in. I think academically Operation Twist was the right thing to do, but practically, exactly opposite. Combined with the refocus of many banks on 'traditional' bank operations and we have a perfect storm of legislative and monetary policy that puts a floor on Treasury prices and a cap on available credit. Its ironic to me as it seems the left hand does not know what the right is doing, but somehow the Fed and regulators were able to come up with a lethal Ali-style one, two punch!
Dot-com 2.0
8/14/2011
A copy of this article is available in PDF format here.
Looking at the data, we’ve only really just started to see a resurgence of IPO’s in the US. Yet the quality of the companies coming to market has me worried: the offerings seem opportunistic and laden with overly bullish assumptions.
The Street’s appetite for the likes of LinkedIn, Pandora, and the unofficial IPO of Facebook smacks of another dot com bubble as I am struck by just how many high profile social media companies have come to market with just the faintest hint of an earnings stream. Moreover, and as always true to form, Wall Street has embedded extremely bullish growth assumptions and called for multiples that are nothing short of absurd.
It’s true the dot com bubble is just shy of a decade old so I can appreciate the fact that the “lessons learned” might have faded just a bit. But what of MySpace? It wasn’t two months ago that MySpace was sold for a paltry $35M from an initial value of $580M in 2005. Have we learned nothing from our fallen brethren?
While researching this article I found some interesting facts about the MySpace deal I thought were less publicized so thought useful to put out here:
The NewsCorp/MySpace saga highlights the extreme fragility of internet valuations. Site usage and memberships are fickle and internet fades number in the hundreds. Yet social media derives a significant amount of its revenue from precisely this aspect of its business. They follow what I call the “Google model”. Provide the service a gratis and bank on memberships to bring in advertising revenue. But this makes companies heavily dependent on keeping usage up and memberships growing. Now, being the #1 search engine or networking site makes selling advertising slots easy but fall from the throne and you will almost certainly walk the path of MySpace.
The ‘print industry’ is all but extinct having tried to make this same model work. It’s not like this is anything new to us: we are all too familiar with its weaknesses so why are these ‘new’ companies any different? I think it’s important to note that I am not unilaterally opposed to the Google model: it is not inherently evil or a bad investment but at these multiples its ‘priced to perfection’. One hiccup and your value decrease precipitously.
Investing in the likes of Pandora or Groupon is like swinging for the fences: its venture capital not public capital. Valuations are based off future earnings that are projected from current member counts, not stable earnings and assets. I am not sure when this bubble will burst, but rest assured it will. Unfortunately, all we can do is wait and see, as a wise man once said: the markets can remain irrational far longer than you can remain solvent.
Looking at the data, we’ve only really just started to see a resurgence of IPO’s in the US. Yet the quality of the companies coming to market has me worried: the offerings seem opportunistic and laden with overly bullish assumptions.
The Street’s appetite for the likes of LinkedIn, Pandora, and the unofficial IPO of Facebook smacks of another dot com bubble as I am struck by just how many high profile social media companies have come to market with just the faintest hint of an earnings stream. Moreover, and as always true to form, Wall Street has embedded extremely bullish growth assumptions and called for multiples that are nothing short of absurd.
It’s true the dot com bubble is just shy of a decade old so I can appreciate the fact that the “lessons learned” might have faded just a bit. But what of MySpace? It wasn’t two months ago that MySpace was sold for a paltry $35M from an initial value of $580M in 2005. Have we learned nothing from our fallen brethren?
While researching this article I found some interesting facts about the MySpace deal I thought were less publicized so thought useful to put out here:
- First, MySpace now has 34.8M users which is about half of its membership base from the peak.
- In contrast Facebook now has 157.2M users.
- NewsCorp will maintain a minority stake in MySpace and Specific Media is offering NewsCorp a cash AND stock deal, implicitly suggesting that not even Specific Media thinks $35M is a good investment.
The NewsCorp/MySpace saga highlights the extreme fragility of internet valuations. Site usage and memberships are fickle and internet fades number in the hundreds. Yet social media derives a significant amount of its revenue from precisely this aspect of its business. They follow what I call the “Google model”. Provide the service a gratis and bank on memberships to bring in advertising revenue. But this makes companies heavily dependent on keeping usage up and memberships growing. Now, being the #1 search engine or networking site makes selling advertising slots easy but fall from the throne and you will almost certainly walk the path of MySpace.
The ‘print industry’ is all but extinct having tried to make this same model work. It’s not like this is anything new to us: we are all too familiar with its weaknesses so why are these ‘new’ companies any different? I think it’s important to note that I am not unilaterally opposed to the Google model: it is not inherently evil or a bad investment but at these multiples its ‘priced to perfection’. One hiccup and your value decrease precipitously.
Investing in the likes of Pandora or Groupon is like swinging for the fences: its venture capital not public capital. Valuations are based off future earnings that are projected from current member counts, not stable earnings and assets. I am not sure when this bubble will burst, but rest assured it will. Unfortunately, all we can do is wait and see, as a wise man once said: the markets can remain irrational far longer than you can remain solvent.
Zombie Banks
07/14/2011
A copy of this article is available in PDF format here.
The financial sector has lagged the broader market throughout most of the recession and well into the recovery. Logically, this makes sense given the fact that they’ve been at the center of nearly every major market calamity over the past four years. It seems as if banks have a proverbial hole in their balance sheet that they just can’t seem to fill. Quarter after quarter, we’ve seen write downs and bad press, and their stock prices have reflected this dismal outlook.
A copy of this article is available in PDF format here.
The financial sector has lagged the broader market throughout most of the recession and well into the recovery. Logically, this makes sense given the fact that they’ve been at the center of nearly every major market calamity over the past four years. It seems as if banks have a proverbial hole in their balance sheet that they just can’t seem to fill. Quarter after quarter, we’ve seen write downs and bad press, and their stock prices have reflected this dismal outlook.
Put the above chart in front of a contrarian and they might see ‘opportunity’: aren’t we due for a ‘correction’? After all, write off enough of a balance sheet and eventually you have a new one. But as much as I’ve tried to find the silver lining, I simply can’t.
Short term, banks are dealing with the European debacle where contagion concerns and short CDS contracts seem to weigh heavily on their outlook. As if this wasn’t enough, there are legacy loan books and continuing litigation claims that make valuing a bank’s assets and ultimate liabilities very difficult. When markets don’t know how to value an asset portfolio, they haircut it and move on. Better safe than sorry they’d say.
But what worries me the most are the longer term effects of increased public scrutiny and regulation. Already they’ve been forced to spin off their private investments, hedge funds, and their proprietary trading desks in the name of systemic risk. Layer onto this higher capital requirements, a subpar lending environment, and a mountain of new regulatory hurdles to overcome and I cannot help but wonder what ROE is going to look like going forward.
As regulation bears down on the banking sector I expect it to turn into a quasi-public institution, similar to a utility. A stable income base (bank deposits), heavy regulation, high entry barriers, and even lower leverage. For an industry predicated on levering up economic activity, the financial sector will be a shell of its former self (if regulators get their way).
That is not to say that bankers are incredible skillful at redeploying capital and finding innovative ways of making money and efficiently allocating capital. Already I have seen articles circulated that highlight the latest financial crazy: “commodity storage facilities”, principally metals storage. Instead of directly trading commodities, firms like Goldman Sachs, Morgan Stanley, and JPM have been buying up storage facilities to maintain some form of commodity beta.
The alpha drivers of yesterday are not the alpha drivers of tomorrow. Regulation will make certain of that. But when a regulator shuts one door, the bank always seems to find a window.
Short term, banks are dealing with the European debacle where contagion concerns and short CDS contracts seem to weigh heavily on their outlook. As if this wasn’t enough, there are legacy loan books and continuing litigation claims that make valuing a bank’s assets and ultimate liabilities very difficult. When markets don’t know how to value an asset portfolio, they haircut it and move on. Better safe than sorry they’d say.
But what worries me the most are the longer term effects of increased public scrutiny and regulation. Already they’ve been forced to spin off their private investments, hedge funds, and their proprietary trading desks in the name of systemic risk. Layer onto this higher capital requirements, a subpar lending environment, and a mountain of new regulatory hurdles to overcome and I cannot help but wonder what ROE is going to look like going forward.
As regulation bears down on the banking sector I expect it to turn into a quasi-public institution, similar to a utility. A stable income base (bank deposits), heavy regulation, high entry barriers, and even lower leverage. For an industry predicated on levering up economic activity, the financial sector will be a shell of its former self (if regulators get their way).
That is not to say that bankers are incredible skillful at redeploying capital and finding innovative ways of making money and efficiently allocating capital. Already I have seen articles circulated that highlight the latest financial crazy: “commodity storage facilities”, principally metals storage. Instead of directly trading commodities, firms like Goldman Sachs, Morgan Stanley, and JPM have been buying up storage facilities to maintain some form of commodity beta.
The alpha drivers of yesterday are not the alpha drivers of tomorrow. Regulation will make certain of that. But when a regulator shuts one door, the bank always seems to find a window.
The Silent Bid for Oil: Real Yields
06/13/2011
A copy of this article is available in PDF format here.
On July 7th 2008, oil peaked at $145.29. By December of that year (just 172 days later) oil hit a low just under $30 a barrel. Fast forward to 2011 and oil is back up and trading for over $100 a barrel. When you think about it, oil has had quite a remarkable journey.
Whilst its ascent is inspiring it is also quite unsettlin g. Deutsche bank estimates that for every 1cent ($0.01) increase in retail gasoline prices consumers spend approx. $1-1.5B less on non-energy consumption in the US. This inextricably links oil prices to the recovery and several prominent economists believe oil above $130 will materially destroy demand.
Naturally, the resurgence will also capture the attention of legislators in Washington, who are unable to come to terms with the fact that price is dictated by basic supply and demand dynamics. Before long we will have more hearings, more accusations and more calls for a windfall tax. Ironically or perhaps conveniently we gloss over the fact that contemporary monetary theory has created one of the biggest dislocations in the supply/demand equation, a problem that I will elaborate on momentarily.
Meeting trend growth (and keeping unemployment low), has become increasingly difficult. To stimulate the economy central bankers around the world have systematically lowered the level of interest rates over the last twenty years. (Low interest rates can weave that special kind of magic that takes 1% growth and makes it 3%).
As a politician or Reserve banker, it’s an easy sell, but for investors the policy decisions set by the central bank have a meaningful impact on the investment world. We’ve put our pension funds, insurance companies, and oil producing countries in a precarious situation: where do they park their capital when market yields are low and sometimes negative in real terms? PIMCO’s Bill Gross has, under great publicity, completely exited the US Treasury market for preciously this reason. A copy of his thesis is available here.
Yet unlike pension funds or insurance companies oil rich countries have the luxury of leaving their spare capacity in the ground. We must give them a compelling reason to monetize their oil reserves, and we simply haven’t. This has kept true capacity on the side lines which in turn forces oil prices upward. In essence oil producers are demanding a higher price to subsidize the low yields they will earn on their bond equivalent oil reserves.
Looking at the below chart you will notice real yields (Right hand side) have been trending downward while the price of oil (Left hand side) has steadily increased.
A copy of this article is available in PDF format here.
On July 7th 2008, oil peaked at $145.29. By December of that year (just 172 days later) oil hit a low just under $30 a barrel. Fast forward to 2011 and oil is back up and trading for over $100 a barrel. When you think about it, oil has had quite a remarkable journey.
Whilst its ascent is inspiring it is also quite unsettlin g. Deutsche bank estimates that for every 1cent ($0.01) increase in retail gasoline prices consumers spend approx. $1-1.5B less on non-energy consumption in the US. This inextricably links oil prices to the recovery and several prominent economists believe oil above $130 will materially destroy demand.
Naturally, the resurgence will also capture the attention of legislators in Washington, who are unable to come to terms with the fact that price is dictated by basic supply and demand dynamics. Before long we will have more hearings, more accusations and more calls for a windfall tax. Ironically or perhaps conveniently we gloss over the fact that contemporary monetary theory has created one of the biggest dislocations in the supply/demand equation, a problem that I will elaborate on momentarily.
Meeting trend growth (and keeping unemployment low), has become increasingly difficult. To stimulate the economy central bankers around the world have systematically lowered the level of interest rates over the last twenty years. (Low interest rates can weave that special kind of magic that takes 1% growth and makes it 3%).
As a politician or Reserve banker, it’s an easy sell, but for investors the policy decisions set by the central bank have a meaningful impact on the investment world. We’ve put our pension funds, insurance companies, and oil producing countries in a precarious situation: where do they park their capital when market yields are low and sometimes negative in real terms? PIMCO’s Bill Gross has, under great publicity, completely exited the US Treasury market for preciously this reason. A copy of his thesis is available here.
Yet unlike pension funds or insurance companies oil rich countries have the luxury of leaving their spare capacity in the ground. We must give them a compelling reason to monetize their oil reserves, and we simply haven’t. This has kept true capacity on the side lines which in turn forces oil prices upward. In essence oil producers are demanding a higher price to subsidize the low yields they will earn on their bond equivalent oil reserves.
Looking at the below chart you will notice real yields (Right hand side) have been trending downward while the price of oil (Left hand side) has steadily increased.
Many argue that low yields are a positive for growth, a high-octane shot in the arm sort of speak. Yet we walk a thin line between stimulating short term growth and over the long term destroying it. Especially today, the Fed is so focused on getting the economy back on track that they’ve ignored the indirect effects low yields have on oil. It seems as if we cannot have our cake and eat it too.
QE Effects
05/09/2011
A copy of this article is available in PDF format here.
Within the next month we will see the Fed’s second round of quantitative easing come to end. The question is what will happen then? How will markets react? The unwind of quantitative easing is historic as its rarely a tool wielded by central bankers in the first place. We’ve seen QE only once before…in Japan, but there are plenty of reasons why Japan shouldn’t be our model on QE. We are in ‘uncharted’ territory sort of speak.
Not only is QE to be unwound but rates need and must be raised. The tremendous rally in oil, agriculture and all things commodity-based is a function of demand, supply, and Bernanke & Co. It’s rumored that the FOMC will remove the words: “...for an extended period of time” from their communications. That means the time to make hay is quickly coming to a close.
But where will markets settle when the Fed starts to tighten its policy?
The important thing to remember is the Fed moves at a glacial pace and they do so not out of political deadlocks or inertia, they do so very intentionally. They want to give markets time to adjust so the tightening will likely come over several quarters as their balance sheet rolls off naturally.
Nevertheless, the potential for a large market move is more than probable, it’s likely. Fortunately, we do have a brief data set to draw some conclusions from. If you think back to the period right after QE-1 ended and before the Fed had announced its second round of, we had a window into a world without monetary easing.
It was this period between March 31, 2010 and the Jackson Hole speech on August 27, 2010 where Bernanke hinted at additional ‘support’.
Above you will see several of the most important Fed announcements against a time series of the S&P 500, USD/EUR, and the 10Y Treasury rate.
You will notice something of an anomaly in the 10Y rate. Quantitative easing after all involves the printing of money, so you would expect that to depress interest rates, but it didn’t. In fact rates rose during the ‘money making’ period and fell shortly after it ended.
For this reason many questioned the effectiveness of QE. The best explanation I’ve heard on this anomaly postured that QE removed the specter of deflation and further economic downturn. If QE removed the chance of deflation, they theorized that rates below 2% was simply too low. Continuing on this thesis, the printing of money is inherently inflationary so why wouldn’t investors demand higher interest rates to compensate for the loss of real purchasing power?
For equity, the relationship between QE and stock prices is much more intuitive and well behaved. The markets rallied on news of QE1 & QE2. Hay was made as the cheap dollar became the currency of choice for carry trading putting additional pressure on an already weak dollar.
This had another indirect benefit for equity markets as globalization has transformed the income statements of many corporations. Today, nearly 50% of revenue for the S&P500 come from overseas sales which means that earnings become supercharged as they were translated back into a weaker USD. This naturally argued for higher equity prices even as you held the earnings multiplier constant.
But again the important area to focus on is the period between the end of QE-1 and the beginning of QE-2. During this period the Fed allowed their balance sheet to roll off effectively tightening the money supply. The S&P 500 lost close to 9% of its value and the dollar gained 5.8% against the EUR over this five month period.
In my mind, I have no doubt that a healthy amount of Fed dollars is sitting in equity markets, being used to own the likes of Johnson & Johnson, Microsoft, and double levered S&P ETF’s. But what happens when the Fed starts to call back those printed dollars? I’d say it manifests itself through weaker equity prices whether it’s driven by the unwind of carry trades or the reversal of favorable translation effects for non-USD earnings.
The only certainty we know is that quantitative easing moved markets, so a reasonable assumption would be that the end of QE will likely move them again. We have already seen treasury rates rallying and a softening in equity and EUR prices ahead of the end of QE. In light of the current situation in Europe, troubling housing data, and uncertainty surrounding QE 2.0, this would definitely be one of my ‘risk-off’ trades.
The Mother of All Debt Cliffs
4/16/2011
A copy of this article is available in PDF format here.
I remember hearing somewhere that if the government was run like a major corporation the CFO would be fired. I think now more than ever, most of you would agree with this statement. The national house is in disarray: unresolved deficits, an inflation-friendly monetary base, fast approaching debt ceilings, and hemorrhaging war costs come to mind first.
But as long as capital markets are open and willing to lend, the government hums along. Like a great many companies, the government must balance interest costs (which are real and reportable) with abstract and ‘out-in-the-tail’ risks like liquidity and rollover risk.
The battle is waged along the yield curve where the Treasury seeks to find bidders for its debt and like any good salesman widens its product offerings to capture many suitors.
The steepness of the yield curve dictates how expensive it is for the government to mitigate rollover risk by making it (relatively) more or less expensive to place long term debt. Today the steepness of the yield curve makes short term debt very compelling, but the government s behavior is more than just opportunistic. The US, since 1979, has been a chronic abuser of short term financing with average issuance in the 0-2Y space of 75%!
The best way to showcase what I mean is by looking at a debt maturity profile. It plots the amount of debt that is outstanding and coming due within the next few years. When debt comes in large blocks, people refer to it as a 'debt cliff'. Either you refinance the whole block at the same time or game over, you become insolvent.
Debt cliffs are most commonly seen in high yield issuers who have trouble securing long term financing and rely heavily on bank loans. But unlike high yield issuers, the US is creating a debt cliff by front loading the nation’s obligations on the short end, where yields are just 4bps.
I remember hearing somewhere that if the government was run like a major corporation the CFO would be fired. I think now more than ever, most of you would agree with this statement. The national house is in disarray: unresolved deficits, an inflation-friendly monetary base, fast approaching debt ceilings, and hemorrhaging war costs come to mind first.
But as long as capital markets are open and willing to lend, the government hums along. Like a great many companies, the government must balance interest costs (which are real and reportable) with abstract and ‘out-in-the-tail’ risks like liquidity and rollover risk.
The battle is waged along the yield curve where the Treasury seeks to find bidders for its debt and like any good salesman widens its product offerings to capture many suitors.
The steepness of the yield curve dictates how expensive it is for the government to mitigate rollover risk by making it (relatively) more or less expensive to place long term debt. Today the steepness of the yield curve makes short term debt very compelling, but the government s behavior is more than just opportunistic. The US, since 1979, has been a chronic abuser of short term financing with average issuance in the 0-2Y space of 75%!
The best way to showcase what I mean is by looking at a debt maturity profile. It plots the amount of debt that is outstanding and coming due within the next few years. When debt comes in large blocks, people refer to it as a 'debt cliff'. Either you refinance the whole block at the same time or game over, you become insolvent.
Debt cliffs are most commonly seen in high yield issuers who have trouble securing long term financing and rely heavily on bank loans. But unlike high yield issuers, the US is creating a debt cliff by front loading the nation’s obligations on the short end, where yields are just 4bps.
 Source: Bloomberg, TreasuryDirect.gov
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The above graph plots the US debt maturity profile against a composite of 6 blue chip companies in the US. You notice the cliff I was referring to? Over 37% of US debt (or $4.1T) is maturing this year while the blue chip average is 14%. The US is chronically exposing itself to rollover risk. Looking at it another way, the average maturity of US debt is just shy of 5Yrs (4.91Y) while the blue chip average is 6.25Yrs. This means the US is going to have to roll more debt over a shorter time period.
I know what you are may be thinking: treasury markets are some of the most liquid in the world, and more importantly, at present, dirt cheap. So why shouldn’t the DMO (Debt Management Office) issue short duration? 3M Treasury bills yield just 4bps while a ten year treasury yields close to 3.5%. That’s a yield spread of 3.46%, which is very rich. If you were a banker and I offer up a yield spread of 3.46%, you’d be picking up my dry cleaning and driving my kids to soccer practice.
I realize it’s a hard argument to make. Over the last 4 years, following the actual debt issuance of the UST over the more fiscally responsible blue chip average has netted the UST over half a trillion in interest savings. (See Appendix A in the PDF for a breakdown).
But these savings come at an implicit cost: it makes the US a defacto variable rate borrower, and one that is constantly rolling its debt into new money yields. The immediate risk isn’t the same for the US government as it is for a corporate issuer. The market will lend to the US, but one day markets are going to wake up and realize they are unpaid for their services.
Moreover, how do we wean a government off artificially low short term rates that are the equivalent of a teaser rate to a subprime borrower? Debt loads are close to 100% of revenue and deficits forecasted out as far as the eye can see.
I know what you are may be thinking: treasury markets are some of the most liquid in the world, and more importantly, at present, dirt cheap. So why shouldn’t the DMO (Debt Management Office) issue short duration? 3M Treasury bills yield just 4bps while a ten year treasury yields close to 3.5%. That’s a yield spread of 3.46%, which is very rich. If you were a banker and I offer up a yield spread of 3.46%, you’d be picking up my dry cleaning and driving my kids to soccer practice.
I realize it’s a hard argument to make. Over the last 4 years, following the actual debt issuance of the UST over the more fiscally responsible blue chip average has netted the UST over half a trillion in interest savings. (See Appendix A in the PDF for a breakdown).
But these savings come at an implicit cost: it makes the US a defacto variable rate borrower, and one that is constantly rolling its debt into new money yields. The immediate risk isn’t the same for the US government as it is for a corporate issuer. The market will lend to the US, but one day markets are going to wake up and realize they are unpaid for their services.
Moreover, how do we wean a government off artificially low short term rates that are the equivalent of a teaser rate to a subprime borrower? Debt loads are close to 100% of revenue and deficits forecasted out as far as the eye can see.
Countering Euphoria
12/28/2010
A copy of this article is available in PDF format here.
I am often pleasantly surprised by how eternally optimistic the human spirit can be. No matter how precarious a position we might find ourselves in, we tend to look for the good and discount the bad. Over the last few months economist after investment manager after Wall Street analyst have pointed to a tide of marginally better economic data as signs of a recovery. Whilst the numbers are ‘positive’ there are still plenty of negatives in the economy. Perhaps most important: pound for pound the scale still tips in favor of the bears.
Much of the upward revision in GDP has been predicated on the tax stimulus that was recently passed. I don’t doubt that a year from now we will be 3% wealthier but the growth is being subsidized with borrowed dollars which is preciously how we got into this situation in the first place. This time we are substituting the great mortgage machine for the Treasury press.
On either side of the political isle we have Democrats unwilling to cut spending and Republicans unwilling to raise taxes. What is our balance sheet going to look like at the end of 2011? Bond investors are already started voting with their feet. A recent treasury auction for 2Y notes went well but the 5Y auction didn't meet expectation. That tells me investors are comfortable with the credit worthiness of the US government for the next two years, but broaden that horizon to five years and their confidence wavers.
At its simplest we are transferring spending (and debt) from the consumer to the government. We are hoping to nurse the great American balance sheet back to health, but if the consumer doesn't get back on their feet soon we are going to have a second, much larger patient to take care of.
The other two 800lb, apparently translucent, gorillas in the room are housing and employment. Neither of which seem to be doing too well. Yes, jobless claims are at the lowest levels since 2008 but this is a sign that the jobs market is just being to thaw.
On to housing: many economists see housing headed for a double dip all by itself. The Case Schiller index for October showed the third straight month of decline; in fact only 4 cities (out of 20) posted home prices that were higher today than they were a year ago. This is particularly troubling since nearly a third of America's net worth is tied up in home prices. Nearly $6T as of Q3'10. The other $12T is tied to equity/401K accounts. To further my argument: a Moody's economist estimated that for every dollar decline in home equity, owners will spend ~5 cents less over the coming 18 months. With home prices set to take another dip, I don’t see how the American consumer will be ready to take the reins from the government and sooner or later the training wheels must come off.
With these sobering thoughts I leave you: Happy New Year!
I am often pleasantly surprised by how eternally optimistic the human spirit can be. No matter how precarious a position we might find ourselves in, we tend to look for the good and discount the bad. Over the last few months economist after investment manager after Wall Street analyst have pointed to a tide of marginally better economic data as signs of a recovery. Whilst the numbers are ‘positive’ there are still plenty of negatives in the economy. Perhaps most important: pound for pound the scale still tips in favor of the bears.
Much of the upward revision in GDP has been predicated on the tax stimulus that was recently passed. I don’t doubt that a year from now we will be 3% wealthier but the growth is being subsidized with borrowed dollars which is preciously how we got into this situation in the first place. This time we are substituting the great mortgage machine for the Treasury press.
On either side of the political isle we have Democrats unwilling to cut spending and Republicans unwilling to raise taxes. What is our balance sheet going to look like at the end of 2011? Bond investors are already started voting with their feet. A recent treasury auction for 2Y notes went well but the 5Y auction didn't meet expectation. That tells me investors are comfortable with the credit worthiness of the US government for the next two years, but broaden that horizon to five years and their confidence wavers.
At its simplest we are transferring spending (and debt) from the consumer to the government. We are hoping to nurse the great American balance sheet back to health, but if the consumer doesn't get back on their feet soon we are going to have a second, much larger patient to take care of.
The other two 800lb, apparently translucent, gorillas in the room are housing and employment. Neither of which seem to be doing too well. Yes, jobless claims are at the lowest levels since 2008 but this is a sign that the jobs market is just being to thaw.
On to housing: many economists see housing headed for a double dip all by itself. The Case Schiller index for October showed the third straight month of decline; in fact only 4 cities (out of 20) posted home prices that were higher today than they were a year ago. This is particularly troubling since nearly a third of America's net worth is tied up in home prices. Nearly $6T as of Q3'10. The other $12T is tied to equity/401K accounts. To further my argument: a Moody's economist estimated that for every dollar decline in home equity, owners will spend ~5 cents less over the coming 18 months. With home prices set to take another dip, I don’t see how the American consumer will be ready to take the reins from the government and sooner or later the training wheels must come off.
With these sobering thoughts I leave you: Happy New Year!
Liquidity Traps
11/10/2010
A copy of this article is available in PDF format here.
The topic today: QE2. As many of you know, last week the Fed announced plans to buy US Treasuries in the order of $600B over a 6-8 month window. And whilst it was expected, there has been a healthy dose of debate over the program's effectiveness and long run implications. Personally I am very worried about QE2. I am mostly troubled by the Fed's inability to stimulate demand. I hear the term "liquidity traps" mentioned more and more these days. It's essentially what happened to Japan in the early 90's and it’s a central banker's worst nightmare. It means that the central bank has lost control of it monetary policy: no matter how low interest rates go or how much liquidity is pumped into the system, it fails to stimulate demand for loans and commerce. This is true because the Fed can not directly affect employment or growth levels simply by lowering rates or making cash available to the economy. There has to be an underlying need or demand from the market. Without the demand to capitalize on these favorable investment conditions, the Fed becomes powerless in their abilities to change the projectory and momentum of the economy. The Fed starts 'pushing on a string'.
Since the end of 2008, the Fed has dropped rates to near zero percent. As the recession deepened and capital markets seized up, the Fed turned to outright quantitative easing and pumped additional currency into the system. All told over $1.7T. This first injection of capital was meant to stabilize the banking system and compensate for the fact that the velocity of money had fallen off a cliff. A number of central banks employed similar strategies and I think there is general consensus that these actions pulled us back from the brink.
A copy of this article is available in PDF format here.
The topic today: QE2. As many of you know, last week the Fed announced plans to buy US Treasuries in the order of $600B over a 6-8 month window. And whilst it was expected, there has been a healthy dose of debate over the program's effectiveness and long run implications. Personally I am very worried about QE2. I am mostly troubled by the Fed's inability to stimulate demand. I hear the term "liquidity traps" mentioned more and more these days. It's essentially what happened to Japan in the early 90's and it’s a central banker's worst nightmare. It means that the central bank has lost control of it monetary policy: no matter how low interest rates go or how much liquidity is pumped into the system, it fails to stimulate demand for loans and commerce. This is true because the Fed can not directly affect employment or growth levels simply by lowering rates or making cash available to the economy. There has to be an underlying need or demand from the market. Without the demand to capitalize on these favorable investment conditions, the Fed becomes powerless in their abilities to change the projectory and momentum of the economy. The Fed starts 'pushing on a string'.
Since the end of 2008, the Fed has dropped rates to near zero percent. As the recession deepened and capital markets seized up, the Fed turned to outright quantitative easing and pumped additional currency into the system. All told over $1.7T. This first injection of capital was meant to stabilize the banking system and compensate for the fact that the velocity of money had fallen off a cliff. A number of central banks employed similar strategies and I think there is general consensus that these actions pulled us back from the brink.
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The Fed's ultimate goal in QE2, however, has nothing to do with financial markets. They are looking to create jobs and stimulate demand. The problem here is that monetary policy is simply not as effective at stimulating the economy as fiscal policy and can only affect the level of activity through second order effects. This is why the equity markets are raging. Cheap short-term financing is acting as the 'tide that lifts all boats'.
This is not to say, however, that the Fed's thesis is completely devoid of a set of sound economic principles. In supporting (and increasing) asset prices the Fed can stimulate the economy through something called the "wealth effect". Simply put if asset prices (such as stocks and bonds) increase in your investment portfolio by +15%, then you have effectively become 15% wealthier and hopefully will spend 15% more. In addition to raising asset prices, the Fed is also looking to raise inflation expectations. The Fed hopes that if you feel your dollar will be worth less tomorrow then you would prefer to spend today.
This 2nd round of QE has the potential to be very damaging in the long run, yet Bernanke & Co. are of the opinion that it's better to stamp out inflation in the future then deal with deflation in the present. Let me walk you through their rational. As the Fed's prints more dollars, the currency weakens and people start to substitute the US dollars store of value with hard assets such as real estate, gold, silver and energy commodities such as oil. Now you have hard assets appreciating in value. Many of these hard assets, especially oil, is used in the production of goods. (This problem is further exacerbated in developing markets because they are less efficient with their resources so they end up using more oil per unit of finished good. This means the effect is amplified and compounded). Eventually the higher prices in the raw inputs will make their way into the prices of our finished goods that we import back home. We've essentially exported inflation and imported it right back.
Another detrimental effect to consider: if commodity prices were to rise, so would fuel costs. As people spend more on food/energy they have less disposable income (aka discretionary spending), and since consumer spending accounts for nearly 70% of GDP, messing with the wallets of the consumer is serious business. But alas these things take some time to trickle through the economy. For now the Fed is happy lifting asset prices and inflating their way out of this problem.
This is not to say, however, that the Fed's thesis is completely devoid of a set of sound economic principles. In supporting (and increasing) asset prices the Fed can stimulate the economy through something called the "wealth effect". Simply put if asset prices (such as stocks and bonds) increase in your investment portfolio by +15%, then you have effectively become 15% wealthier and hopefully will spend 15% more. In addition to raising asset prices, the Fed is also looking to raise inflation expectations. The Fed hopes that if you feel your dollar will be worth less tomorrow then you would prefer to spend today.
This 2nd round of QE has the potential to be very damaging in the long run, yet Bernanke & Co. are of the opinion that it's better to stamp out inflation in the future then deal with deflation in the present. Let me walk you through their rational. As the Fed's prints more dollars, the currency weakens and people start to substitute the US dollars store of value with hard assets such as real estate, gold, silver and energy commodities such as oil. Now you have hard assets appreciating in value. Many of these hard assets, especially oil, is used in the production of goods. (This problem is further exacerbated in developing markets because they are less efficient with their resources so they end up using more oil per unit of finished good. This means the effect is amplified and compounded). Eventually the higher prices in the raw inputs will make their way into the prices of our finished goods that we import back home. We've essentially exported inflation and imported it right back.
Another detrimental effect to consider: if commodity prices were to rise, so would fuel costs. As people spend more on food/energy they have less disposable income (aka discretionary spending), and since consumer spending accounts for nearly 70% of GDP, messing with the wallets of the consumer is serious business. But alas these things take some time to trickle through the economy. For now the Fed is happy lifting asset prices and inflating their way out of this problem.
Trading Rules
8/22/2010
A copy of this article is available in PDF format here.
Hello again everyone. Since I got back to the States, I've been developing a number of trading strategies. This first strategy looks at technical screens and follows a 'contrarian' view. This means that I buy when others are selling and sell when others are buying.
Now most traders employ what is known as trend following or momentum trading. When certain SMA's cross one another or a stock breaks through resistance or support they pile on the band wagon. Whichever way the wind blows they follow, and its served them well. One of the cardinal rules (and its not lost on me) is not to 'fight the tape'. Trying to buck a trend is like walking through an oncoming crowd. You get knocked over, stepped on, and left for ruin.
A copy of this article is available in PDF format here.
Hello again everyone. Since I got back to the States, I've been developing a number of trading strategies. This first strategy looks at technical screens and follows a 'contrarian' view. This means that I buy when others are selling and sell when others are buying.
Now most traders employ what is known as trend following or momentum trading. When certain SMA's cross one another or a stock breaks through resistance or support they pile on the band wagon. Whichever way the wind blows they follow, and its served them well. One of the cardinal rules (and its not lost on me) is not to 'fight the tape'. Trying to buck a trend is like walking through an oncoming crowd. You get knocked over, stepped on, and left for ruin.
But being a contrarian has its rewards. Some of the most successful investors are contrarian. Warren Buffet is one of the most famous. He buys when when there is blood in the streets; likewise I buy when the markets have satisfied their blood-lust and I pile on shorts when markets have become overzealous with a new flavor de jour. Wall street tends to overshoot the mark (on the upside and the downside). Take a look at a LR chart of the SPX Price-to-earnings or Price-to-book. What people are willing to pay for equity in a company is a function of the Earnings Yield or the value of the underlying net assets in a company. This multiple fluctuate over time. Before the run up that started in March 2009, P/E was approx 9X earnings.
What I look to capture is the dead cat bounce off a low or a retracement as investors take profits or get hit by a case of buyer's remorse.
I won't divulge the actual techniques I am using to screen for buy/sell candidates but I will share with you the backtesting results. I performed my screen on the broad based S&P 500 index. I've used daily trading returns going back to 2000. For comparative purposes I have put up returns for the S&P 500 itself and US large cap mutual funds & fund of funds. (More on these money managers later).
I have optimized the entry and exit points and since I am betting against the markets I have set a rather tight stop loss at +/- 2.5%. If my exit triggers aren't met I implemented a hard sell for these trades after 3-5 BD's for book keeping purposes. In the real world I will cut my losers and let my winner's run.
What I look to capture is the dead cat bounce off a low or a retracement as investors take profits or get hit by a case of buyer's remorse.
I won't divulge the actual techniques I am using to screen for buy/sell candidates but I will share with you the backtesting results. I performed my screen on the broad based S&P 500 index. I've used daily trading returns going back to 2000. For comparative purposes I have put up returns for the S&P 500 itself and US large cap mutual funds & fund of funds. (More on these money managers later).
I have optimized the entry and exit points and since I am betting against the markets I have set a rather tight stop loss at +/- 2.5%. If my exit triggers aren't met I implemented a hard sell for these trades after 3-5 BD's for book keeping purposes. In the real world I will cut my losers and let my winner's run.
So now on to the simulated results on the SPX. Investing in my long book would have earned you 45% returns over the last 10 years; on the short side -21% over the same period. (Just as a reminder, its good to see a negative in front of a short return!).
You will notice a few things, first I tend to make money when the markets are losing. This fits with the contrarian nature of my screens. Second, there is substantially less risk (7% SD vs. market SD of 20%) with only 2 down years: the biggest loss in 2002. In '02 my long book was down -12% and the short up +5%. At least you know I am not Madoff!
Comparatively, passively investing in the S&P 500 over the same period would have netted you -14% over the investment period. I've also displayed the median mutual fund and FoF returns, a common benchmark. They faired even more poorly.
This brings me to a side tangent: a lot of studies have shown that active investment is not worth it. Mutual funds have been a favored example in these studies; you will notice their returns are often in lock step with the S&P 500. When the markets are down, so are they. Exacerbating the problem, the 'active' component increases trading costs and their management fees often make such investments inferior to ETFs.
But the cards are usually stacked against these poor money managers. They are long-only meaning even if they were to turn bearish the only way they can express this view is by liquidating their portfolio and sitting in cash. They can underweight a particular stock with a 0% allocation but that's it. Yet PM's would never abstain from the market completely, else they can not justify their fees! I've touched on this subject before as it relates to retirement accounts; please refer to the article in PDF format.
So why are my returns so splendid? - I don't trade for the sake of trading; I only trade when the odds are in my favor. And I buy at bargain basement prices or sell at exaggerate ones! Buy low, sell high? Pretty sensible no? According to my model, the markets have gotten out of whack 350 times over the last 10 years. But make no mistake, traders are right in following momentum. You could get steam rolled otherwise and for this I have those tight stop losses. Live to fight another day!
I intend on trading this model using the S&P 500 components. I will post my returns here on a monthly basis along with some commentary. I hope to make this a battle tested model and of course a little pocket change.
Regards,
Comparatively, passively investing in the S&P 500 over the same period would have netted you -14% over the investment period. I've also displayed the median mutual fund and FoF returns, a common benchmark. They faired even more poorly.
This brings me to a side tangent: a lot of studies have shown that active investment is not worth it. Mutual funds have been a favored example in these studies; you will notice their returns are often in lock step with the S&P 500. When the markets are down, so are they. Exacerbating the problem, the 'active' component increases trading costs and their management fees often make such investments inferior to ETFs.
But the cards are usually stacked against these poor money managers. They are long-only meaning even if they were to turn bearish the only way they can express this view is by liquidating their portfolio and sitting in cash. They can underweight a particular stock with a 0% allocation but that's it. Yet PM's would never abstain from the market completely, else they can not justify their fees! I've touched on this subject before as it relates to retirement accounts; please refer to the article in PDF format.
So why are my returns so splendid? - I don't trade for the sake of trading; I only trade when the odds are in my favor. And I buy at bargain basement prices or sell at exaggerate ones! Buy low, sell high? Pretty sensible no? According to my model, the markets have gotten out of whack 350 times over the last 10 years. But make no mistake, traders are right in following momentum. You could get steam rolled otherwise and for this I have those tight stop losses. Live to fight another day!
I intend on trading this model using the S&P 500 components. I will post my returns here on a monthly basis along with some commentary. I hope to make this a battle tested model and of course a little pocket change.
Regards,
The BP Oil Spill
07/07/2010
A copy of this article is available in PDF here.
It's been a number of months since I've posted and I apologize for this; it certainly hasn't been for lack of material!
As I look out at the state of the world, I see a number of dark clouds, but for me one of the most troubling is the BP Oil spill. We seem wholly incapable of shutting down this well and I can't help but ask: why are we drilling at 4,992 feet when its clear we have neither the expertise or the technology to work and repair busted wellheads at these depths.
Following the failed containment cap and top kill procedures, one of the first questions that popped into my head was just how much oil is down there? If traditional methods like top kill and relief wells don't work, when will this problem resolve itself? Its our fail-safe, and without sounding too much like a conspiracy theorist, I've heard a figure has been floated around, but its obviously quite staggering and no one seems interesting in reporting on it.
A copy of this article is available in PDF here.
It's been a number of months since I've posted and I apologize for this; it certainly hasn't been for lack of material!
As I look out at the state of the world, I see a number of dark clouds, but for me one of the most troubling is the BP Oil spill. We seem wholly incapable of shutting down this well and I can't help but ask: why are we drilling at 4,992 feet when its clear we have neither the expertise or the technology to work and repair busted wellheads at these depths.
Following the failed containment cap and top kill procedures, one of the first questions that popped into my head was just how much oil is down there? If traditional methods like top kill and relief wells don't work, when will this problem resolve itself? Its our fail-safe, and without sounding too much like a conspiracy theorist, I've heard a figure has been floated around, but its obviously quite staggering and no one seems interesting in reporting on it.
But before I dive into how much oil I think is down there, I'd like to first share with you some interesting background info I learned along the way:
So back to my original question: when will this well run dry? Thinking logically, oil exploration is a very expensive proposition and BP is in the business of making money so the reserves that are developed first will likely be abundant in quality and quantity. The first number you can come up with a break even quantity. How many barrels of oil would BP need to extract before they were made whole on their investment?
Based on average lease rates taken from Transocean 2009 10K, it costs BP almost half a million dollars a day to drill a well. Adding in the cost of employees and miscellaneous expenses, the BE on drilling a well is 2.1M barrels. See Appendix 5. To date (7/6/2010), the NYT reports that between 1-3M barrels have been released into the Gulf. (Conversion factor = 42 gallons / barrel). The riser has been leaking for nearly 2 months and we are just now breaking into the black for BP, yikes!
- The oil fields below the Gulf of Mexico account for 23% of all US oil production.
- The Deepwater Horizon rig is owned by Transocean, a swiss based company, that purchased the rig from Hyundai Heavy Industries in 2001.
- Transocean's corporate slogan is: "We're never out of our depth"
- Transocean owns and in turn leases over 140 different rigs to oil companies such as BP (count as of 12/09).
- Details and specifications on Deepwater Horizon are available here. See Appendix 1.
- BP had filed their application to drill the wells located in Mississippi Canyon, Block 252 in 2009 and received approval just 2 months later. See Appendix 2, 3, 4
- Transocean's Marianas was initially commissioned for this drill site (10/21/09) but stopped drilling due to structural damages from Hurricane Ida (11/28/09). In February of this year, Deepwater Horizon picked up the torch and the balance of the story everyone seems to know. (See Footnote 1).
So back to my original question: when will this well run dry? Thinking logically, oil exploration is a very expensive proposition and BP is in the business of making money so the reserves that are developed first will likely be abundant in quality and quantity. The first number you can come up with a break even quantity. How many barrels of oil would BP need to extract before they were made whole on their investment?
Based on average lease rates taken from Transocean 2009 10K, it costs BP almost half a million dollars a day to drill a well. Adding in the cost of employees and miscellaneous expenses, the BE on drilling a well is 2.1M barrels. See Appendix 5. To date (7/6/2010), the NYT reports that between 1-3M barrels have been released into the Gulf. (Conversion factor = 42 gallons / barrel). The riser has been leaking for nearly 2 months and we are just now breaking into the black for BP, yikes!
BP operates several other production wells in the area. We can use data from these locations to help ascertain how much oil BP expected to extract from these new oil fields.
Horn Mountain is a production field not far from Deepwater Horizon. The well and pipelines cost over $600M to develop and was expected to yield 150M barrels of oil and nat gas. If we assume that BP would be looking to invest in exploration projects that yield similar operating profit we can extrapolate how much oil BP thought was below Deepwater Horizon.
Under the Horn Mountain project, each well cost BP $75M to construct and would yield approximately 18M barrels of oil. Using 2005 oil prices that would yield an operating profit of $834M. As a ratio to costs, BP made back 11x what they spent on the well. A healthy margin no doubt. Applying this same relationship to Deepwater Horizon (and its sister well), the company would be looking to make over $1.3B in operating profit and using 2009 oil prices, each well would be expected to yield about 11.8M bbls. The supporting workbook and calculations are available here. See Appendix 6.
So in sum, my guestimate is anywhere between breakeven bbls per day of 2.1M and north of the constant margin estimate of 12M bbls. Unfortunately the figure has to be closer to 12 then 2 which puts it at more than 6X the amount of oil that's already been released into the Gulf of Mexico. Truly, is an unacceptable number.
Footnotes:
1. SubseaIQ.com
Putting the AIG/Greenberg Question to Bed..
03/03/2010
A copy of this article in PDF format is available here.
In light of the recent release on the Lehman Bankruptcy I thought it might be a fitting time to take a look at the decline of another great American financial institution, AIG. Moreover, given the US government's slug of ownership interest in AIG, the company's storied decline will likely fade peacefully into our history books.
For those interested you can find the bank examiner's report on Lehman here.
A copy of this article in PDF format is available here.
In light of the recent release on the Lehman Bankruptcy I thought it might be a fitting time to take a look at the decline of another great American financial institution, AIG. Moreover, given the US government's slug of ownership interest in AIG, the company's storied decline will likely fade peacefully into our history books.
For those interested you can find the bank examiner's report on Lehman here.
Now back to AIG. What has really bothered me about AIG’s demise is Hank Greenberg, acting CEO of AIG for over 37 years (until March 28, 2005). He has yet to admit any wrong doing in the AIG debacle and insists the trades under AIG Financial Products that eventually brought down the company happened after his departure and outside of his knowledge. His pleas of innocence have been quite vocal, unwavering and in his mind, even genuine.
I direct you to a letter from Hank written to the Board of AIG on 9.16.08:
"[...] Since you [Robert Willumstand] became Chairman of AIG, you and the Board have presided over the virtual destruction of shareholder value built up over 35 years. It is not my intention to try to point fingers or be critical. My only point is that under the circumstances, I am truly bewildered at the unwillingness of you and the Board to accept my help.
- Maurice "Hank" Greenberg. C.V Starr & Company Letter.
So Hank started out strong but faded fast. This quote in particular happens to be one of the most scathing remarks from Hank on the subject and came just two days before AIG was bailed out by the Federal government.
But let's back up the story a little bit and talk about the rise and fall of Hank Greenberg and the fabled AIG. Hank became acting CEO in 1968 and continued on until March 28, 2005 when he was ejected [resigned] by the Board under heavy pressure from then Attorney General, Eliot Spitzer over accounting irregularities. [The company later admitted wrongdoing and settled the case].
"[...] Since you [Robert Willumstand] became Chairman of AIG, you and the Board have presided over the virtual destruction of shareholder value built up over 35 years. It is not my intention to try to point fingers or be critical. My only point is that under the circumstances, I am truly bewildered at the unwillingness of you and the Board to accept my help.
- Maurice "Hank" Greenberg. C.V Starr & Company Letter.
So Hank started out strong but faded fast. This quote in particular happens to be one of the most scathing remarks from Hank on the subject and came just two days before AIG was bailed out by the Federal government.
But let's back up the story a little bit and talk about the rise and fall of Hank Greenberg and the fabled AIG. Hank became acting CEO in 1968 and continued on until March 28, 2005 when he was ejected [resigned] by the Board under heavy pressure from then Attorney General, Eliot Spitzer over accounting irregularities. [The company later admitted wrongdoing and settled the case].
With Mr. Greenberg's abrupt departure and the associated accounting scandal, Standard and Poor's downgraded AIG from AAA to AA-. The rating agency action triggered certain downgrade provisions and led to collateral calls in the neighborhood of $1 Billion USD. Most of the calls came from a group under the AIG umbrella named AIG Financial Products ("AIGFP"). It was one of the first times, AIGFP popped up on any one's radar screen.
The AIG empire was a complex one but at its core the company had three main product lines:
- Insurance,
- Financial Services,
- Asset Management
From there on, AIGFP grew at a healthy clip. For instance, from 1998-2004 the compound annual growth in revenue was 8.6%, compensation expense was $497M and assets just over $95B by YE'04. In deed by any traditional measure, the business was healthy and growing. Now what every business man knows (or should know) is return is commiserate to risk. Always and forever.
For everything that went wrong in AIG, Mr. Greenberg presided over the largest insurance company in the world. Insurance is all about risk, and Hank knew it well, so when AIGFP kept increasing its revenue and asset base, he would have made it his business to understand the risk they were writing. By YE'04, just 3 months before Hank would be removed from his role as CEO, AIGFP had guaranteed performance on $290.7B in notional credit exposure. By YE'05, AIGFP guaranteed credit with a notional exposure of $387.2B.
What AIG (and in deed the markets) didn't realize was that not all AAA's were created equal. If you read an AIG financial statement or 10K, they caveat all their credit exposure saying they are super senior and are in a secondary loss position behind equity. But the later vintage deals had little subordination and were pumped with so much subprime credit that the equity piece quickly evaporated.
So when all is said and done, when the dust settles, did Mr. Greenberg have a role in the downfall of AIG? I think he did. I will admit that part of his ultimate culpability went away with his abrupt resignation, but that was just dumb luck. He left his post kicking and screaming, and it was clear looking at AIG's balance sheet that Hank was actively growing the Financial products business.
If it wasn't for an overzealous, now disgraced Attorney General, Mr. Greenberg would have presided over the firm for 40 years and watched it crumple just the same. If I were in Hank's shoes today, I'd settle down and let the AIG saga fade peacefully into our history books.
For everything that went wrong in AIG, Mr. Greenberg presided over the largest insurance company in the world. Insurance is all about risk, and Hank knew it well, so when AIGFP kept increasing its revenue and asset base, he would have made it his business to understand the risk they were writing. By YE'04, just 3 months before Hank would be removed from his role as CEO, AIGFP had guaranteed performance on $290.7B in notional credit exposure. By YE'05, AIGFP guaranteed credit with a notional exposure of $387.2B.
What AIG (and in deed the markets) didn't realize was that not all AAA's were created equal. If you read an AIG financial statement or 10K, they caveat all their credit exposure saying they are super senior and are in a secondary loss position behind equity. But the later vintage deals had little subordination and were pumped with so much subprime credit that the equity piece quickly evaporated.
So when all is said and done, when the dust settles, did Mr. Greenberg have a role in the downfall of AIG? I think he did. I will admit that part of his ultimate culpability went away with his abrupt resignation, but that was just dumb luck. He left his post kicking and screaming, and it was clear looking at AIG's balance sheet that Hank was actively growing the Financial products business.
If it wasn't for an overzealous, now disgraced Attorney General, Mr. Greenberg would have presided over the firm for 40 years and watched it crumple just the same. If I were in Hank's shoes today, I'd settle down and let the AIG saga fade peacefully into our history books.
Quote of the day: Paul McCulley
01/09/2010
"Our gut feeling is that the moment the Fed changes any one of its words, its going to be a very unpleasant experience, because the marketplace has very little patience and a very big imagination. The most important book at the Fed right now is a thesaurus, and it's probably sitting on top of Paul Samuelson's Foundations of Economic Analysis.
Source: Europe.Pimco.com
"Our gut feeling is that the moment the Fed changes any one of its words, its going to be a very unpleasant experience, because the marketplace has very little patience and a very big imagination. The most important book at the Fed right now is a thesaurus, and it's probably sitting on top of Paul Samuelson's Foundations of Economic Analysis.
Source: Europe.Pimco.com
401K - The Great American Crutch
01/02/2010
A copy of this article is available in PDF format here.
I'd like to invite you all to take a look at the investment universe as prescribed by my 401K administrators. Its not the worst I've been forced to pay in to especially when considering the fact that I can get Gross for 64bps and Goldman for one per cent. But why are 401K's so limiting, long only, and heavily weighted toward equity?
A copy of this article is available in PDF format here.
I'd like to invite you all to take a look at the investment universe as prescribed by my 401K administrators. Its not the worst I've been forced to pay in to especially when considering the fact that I can get Gross for 64bps and Goldman for one per cent. But why are 401K's so limiting, long only, and heavily weighted toward equity?
The only other comment I will make on particular 401k options: recently the street has been abuzz. Gross has been dumping Treasuries and holding record amounts of cash. Now I agree with this fundamentally; rates have nowhere to go but up. But why am I paying up an additional +26bps for Gross to be my CP manager when I can get Investco to do it for 38? That being said, I have a tremendous amount of respect for Bill. For free investment commentary go to Pimco Europe's website at: www.europe.pimco.com
The lack of investment options in today's 401K accounts can be frustrating, but I can understand [at least in part] why. The government doesn't want its constituents (or slick wall street types) rolling the dice with Middle America's nest egg. There is some benevolence here but also a bit of self interest embedded in this policy.
You are playing with pretax dollars (Roth IRA's aside). The government wants to make sure it can collect on those dusty old I.O.U's. Moreover, what happens if you beat the house and lose? Public welfare kicks in and the gov't is left holding the bag. The gov't would rather play the numbers than the odds. 30% of a little something is better than 30% of a whole lot of nothing.
Since the modern day retirement savings system was created in 1974 by the Employee Retirement Income Security Act or "E.R.I.S.A.", the growth of retirement accounts has been dizzying. In 2008, an estimated $14T dollars were earmarked in US retirement accounts. According to the Investment Company Institute, at the end of 2008, 70% of US households had their own IRA or a employer sponsored defined contribution plans (401K) and 9% of a household's total financial assets were held in retirement funds (up from 6% in 1990).
The lack of investment options in today's 401K accounts can be frustrating, but I can understand [at least in part] why. The government doesn't want its constituents (or slick wall street types) rolling the dice with Middle America's nest egg. There is some benevolence here but also a bit of self interest embedded in this policy.
You are playing with pretax dollars (Roth IRA's aside). The government wants to make sure it can collect on those dusty old I.O.U's. Moreover, what happens if you beat the house and lose? Public welfare kicks in and the gov't is left holding the bag. The gov't would rather play the numbers than the odds. 30% of a little something is better than 30% of a whole lot of nothing.
Since the modern day retirement savings system was created in 1974 by the Employee Retirement Income Security Act or "E.R.I.S.A.", the growth of retirement accounts has been dizzying. In 2008, an estimated $14T dollars were earmarked in US retirement accounts. According to the Investment Company Institute, at the end of 2008, 70% of US households had their own IRA or a employer sponsored defined contribution plans (401K) and 9% of a household's total financial assets were held in retirement funds (up from 6% in 1990).
Employer sponsored accounts have become particularly popular: as of 2006, the average worker set aside 7.5% of their annual income for retirement. This rate has remained pretty constant so I won't feel too bad doing some quick and dirty math with consensus and BLS numbers as of 2008.
Assuming a generic 60/40 split between equity and bonds we have $186B dollars flowing into stocks and $124B into bonds. To ground these numbers a bit, the market cap on the S&P 500 at the end of Sept 2009 was $9.3T. Absorbing the $186B in inflows would lead to growth of about +2% annually.
Below I have plotted total assets in core retirement accounts against the S&P 500. I do not mean to imply that the growth in retirement funds have led to the general upward movement on the S&P 500. There are really two things that are driving this: first, as performance increases or decreases the $'s invested In fact, the direction of the relationship is probably reversed and more people allocate dollars to retirement funds when the S&P is trending higher. But that brings up another troubling dilemma: during bull markets, more retail investors pile in and perpetuate the bull run, skewing the valuation metrics even further. In this way you get a levered effect that leads markets to overshoot healthy market corrections on the up and down side.
- Median per capita income in 2008 was $26,964
- times 7.5% retirement savings
- times 153M workers in the labor force (implied from the 12/07 unemployment rate at 5% with 7.5M unemployed).
- = $310B dollars flowing into capital markets.
Assuming a generic 60/40 split between equity and bonds we have $186B dollars flowing into stocks and $124B into bonds. To ground these numbers a bit, the market cap on the S&P 500 at the end of Sept 2009 was $9.3T. Absorbing the $186B in inflows would lead to growth of about +2% annually.
Below I have plotted total assets in core retirement accounts against the S&P 500. I do not mean to imply that the growth in retirement funds have led to the general upward movement on the S&P 500. There are really two things that are driving this: first, as performance increases or decreases the $'s invested In fact, the direction of the relationship is probably reversed and more people allocate dollars to retirement funds when the S&P is trending higher. But that brings up another troubling dilemma: during bull markets, more retail investors pile in and perpetuate the bull run, skewing the valuation metrics even further. In this way you get a levered effect that leads markets to overshoot healthy market corrections on the up and down side.
Your money manager's mandate doesn't allow him/her to significantly underweight any of his benchmark components let alone short them. This leads to a "doubling down" effect on the underperforming asset and a de facto underweight to the performing asset.
Here is an example: suppose you have a money manager with a debt and equity mandate in that same 60/40 split. Let's further assume he will rebalance your portfolio annually. You start out Year 1 giving him $100 which he subsequently invests...
$60 into the S&P and $40 into the Lehman (Barclays) Agg. Now suppose the S&P dips down -5% and Lehman is up a modest 3% from clipping coupons. You now have 58% in equity and 42% in debt. The manager can re-balance by selling bonds and buying equity or he can use your Year 2 contributions to buy more equity than debt. He takes the latter option. Year 2 rolls around and the money manager invests $62 in equity and $38 in bonds.
Now imagine doing this with $310B dollars for 153 million Americans. This supports the weaker asset's price and because you allocate 7.5% weekly, money managers are forced into capital markets almost daily just to stay within benchmark.
Now imagine if money managers were allowed to go long OR short a stock? Trade in and out like hedge funds do? I'd surmise all that volatility would be enough to snap your trading finger like a twig.
With all this in mind I have to say: how convenient.
I am still on the fence though: is this a product of strategic planning or a byproduct of unintended consequence? I do not know. I do know that the way the current regulations are structure is extremely conducive to capital markets: adding (by my math) $310B in funds that wouldn't have been available to capital users before.
And thus, I present to you the great American crutch.
Here is an example: suppose you have a money manager with a debt and equity mandate in that same 60/40 split. Let's further assume he will rebalance your portfolio annually. You start out Year 1 giving him $100 which he subsequently invests...
$60 into the S&P and $40 into the Lehman (Barclays) Agg. Now suppose the S&P dips down -5% and Lehman is up a modest 3% from clipping coupons. You now have 58% in equity and 42% in debt. The manager can re-balance by selling bonds and buying equity or he can use your Year 2 contributions to buy more equity than debt. He takes the latter option. Year 2 rolls around and the money manager invests $62 in equity and $38 in bonds.
Now imagine doing this with $310B dollars for 153 million Americans. This supports the weaker asset's price and because you allocate 7.5% weekly, money managers are forced into capital markets almost daily just to stay within benchmark.
Now imagine if money managers were allowed to go long OR short a stock? Trade in and out like hedge funds do? I'd surmise all that volatility would be enough to snap your trading finger like a twig.
With all this in mind I have to say: how convenient.
I am still on the fence though: is this a product of strategic planning or a byproduct of unintended consequence? I do not know. I do know that the way the current regulations are structure is extremely conducive to capital markets: adding (by my math) $310B in funds that wouldn't have been available to capital users before.
And thus, I present to you the great American crutch.
A Modest Proposal: The Arguments against Real Estate
12/07/2009
A copy of this article is available in PDF format here.
As I am sure you are aware, the "recession" as per Bernanke & Company is over. We won't get official word from the NBER for many more months but initial jobless claims gapped lower some time in the second quarter of 2009.
Looking at the Case-Shiller Index, from peak to trough (April 2006 to May 2009, if the trend continues) there was a -32% decline in home prices across America. In combination with the $8000 tax credit and historically low interest rates, real estate is looking very attractive. But before you go sinking 20% down payments on a first, second or investment property perhaps a little due diligence is in order.
Most of you reading this are not likely in the real estate business, but you are no idiot. You are looking at this real estate market and thinking one thing: opportunity. Real estate is a hard asset. Like gold and diamonds, it’s highly tangible. My father always believed in brick and mortar investing. "People always need a place to live”, he would say. He’d smile as he told me “every day people wake up and go to work for me [rental income]”. And it’s true, your tenants pay for the mortgage, maintenance, utilities, and if you run a profitable building your car, your home, and a vacation or two.
But let me make this analogy, prices across America have declined by -33%. That’s the equivalent of walking by a Banana Republic or Saks and seeing a 30% off sticker in the window. It’s enough to give pause but is it really a steal?
Depends on what your objectives are. If you need a home and were going to buy one anyway it’s certainly your time. If you think you are going to be the next real estate guru, let me give you something to pause about.
Real estate is stuffed [like a turkey] with overhead. Owning a home means heating bills, repairs and maintenance, taxes, and most likely monthly mortgage payments. We call that an alligator investment. You have to keep feeding it upfront and harvest all the benefit on the back end. (This ignores income generation and looks exclusively at home price appreciation).
So here you sit, having bought a home for ‘70 cents on the dollar’ or for everyone else’s benefit 30% off. You think you had a good deal, but that’s assuming prices accrete back to 100. I will tell you anecdotally the commercial real estate property market was getting ridiculous in ‘05/06. People were paying 15-20x income in Manhattan. Put another way, you would pay upfront for the next 20 years of income (assuming zero income growth).
Now in the investing world, thinking about assets as multiples of cash flow and income is common. When you buy a company, look to pay a multiple of that business' earnings or cash flow. Thanks to Professor Aswath Damodaran from NYU Stern School of Business for compiling a ream of financial information and then sharing it!. Take that Capital IQ! Industry Multiples spreadsheet here or you may go directly to Professor Damodaran's site and retrieve the latest updated spreadsheet.
A copy of this article is available in PDF format here.
As I am sure you are aware, the "recession" as per Bernanke & Company is over. We won't get official word from the NBER for many more months but initial jobless claims gapped lower some time in the second quarter of 2009.
Looking at the Case-Shiller Index, from peak to trough (April 2006 to May 2009, if the trend continues) there was a -32% decline in home prices across America. In combination with the $8000 tax credit and historically low interest rates, real estate is looking very attractive. But before you go sinking 20% down payments on a first, second or investment property perhaps a little due diligence is in order.
Most of you reading this are not likely in the real estate business, but you are no idiot. You are looking at this real estate market and thinking one thing: opportunity. Real estate is a hard asset. Like gold and diamonds, it’s highly tangible. My father always believed in brick and mortar investing. "People always need a place to live”, he would say. He’d smile as he told me “every day people wake up and go to work for me [rental income]”. And it’s true, your tenants pay for the mortgage, maintenance, utilities, and if you run a profitable building your car, your home, and a vacation or two.
But let me make this analogy, prices across America have declined by -33%. That’s the equivalent of walking by a Banana Republic or Saks and seeing a 30% off sticker in the window. It’s enough to give pause but is it really a steal?
Depends on what your objectives are. If you need a home and were going to buy one anyway it’s certainly your time. If you think you are going to be the next real estate guru, let me give you something to pause about.
Real estate is stuffed [like a turkey] with overhead. Owning a home means heating bills, repairs and maintenance, taxes, and most likely monthly mortgage payments. We call that an alligator investment. You have to keep feeding it upfront and harvest all the benefit on the back end. (This ignores income generation and looks exclusively at home price appreciation).
So here you sit, having bought a home for ‘70 cents on the dollar’ or for everyone else’s benefit 30% off. You think you had a good deal, but that’s assuming prices accrete back to 100. I will tell you anecdotally the commercial real estate property market was getting ridiculous in ‘05/06. People were paying 15-20x income in Manhattan. Put another way, you would pay upfront for the next 20 years of income (assuming zero income growth).
Now in the investing world, thinking about assets as multiples of cash flow and income is common. When you buy a company, look to pay a multiple of that business' earnings or cash flow. Thanks to Professor Aswath Damodaran from NYU Stern School of Business for compiling a ream of financial information and then sharing it!. Take that Capital IQ! Industry Multiples spreadsheet here or you may go directly to Professor Damodaran's site and retrieve the latest updated spreadsheet.
The Cross Industry Averages
Last Updated in January 2009
# of Firms: 6870
Value/EBITDA: 5.1
Value/EBIT: 6.1
Value/EBIT(1-t): 8.7
*EBIT or EBITDA (Earnings Before Interest and Tax..Depreciation and Amortization)
Last Updated in January 2009
# of Firms: 6870
Value/EBITDA: 5.1
Value/EBIT: 6.1
Value/EBIT(1-t): 8.7
*EBIT or EBITDA (Earnings Before Interest and Tax..Depreciation and Amortization)
Which multiple gets used in a 'valuation model' is generally determined by industry convention: in real estate its usually off of potential income. Either way dollar for dollar people were paying a lot more for income producing real estate over a coffee house, auto body shop or financial services firm. Now it can be argued that real estate income is less risky as it has ‘stable cash flows’. If you think about it: you are under no obligation to buy that cup of coffee from your local coffee house. But renting a home entails signing a lease so the homeowner or landlord has booked a revenue stream for the next 12 months that is semi-secured. So in this regard I won't disagree although there are different striations of risk within real estate (ie commercial vs. residential, et cetera).
But tangents aside, you bought it for 70, what is the true value? At 100? If you can make the leap with me and say real estate was overvalued in 05/06 then the distance from 70 to 100 will be measured in years or decades. You'll have to recalibrate your home value to 80-85 for the medium term.
Next, no doubt you went to your neighborhood bank and secured a mortgage. Now as dumb as banks looked in this last recession having lost billions, let me tell you banks aren't stupid. They pretty much exclusively underwrite what is known as “recourse loans” for individual home buyers. This means they can go after your personal assets over and above the house to recoup any losses on the loan.
So let's say you fall behind on your mortgage payments, lose your job or endured some other kind of hardship. The bank is still going to be looking for its money. Phew! That was close! I thought you were flat broke. No, you own a home. You have assets! But even in the best of times liquidity is lacking in real estate. Count on several months worth of marketing and closing time before you can extinguish your obligations. By then at a minimum the bank has reported your plight to the credit bureaus and damaged your credit.
Now assuming a mortgage you are also looking at underwriting fees, attorney fees, title insurance, mortgage tax, and general administrative costs in the order of 1-3% of closing. By my calculation, it takes over 1.5 years to recoup closing fees. (See Breakeven Closing Fee.xls for a refinancing scenario). On the back end, you are going to end up paying a broker a minimum of 3% unless you plan on marketing it yourself. Tack on attorney’s fees and you are giving back 3-5% of your return in transaction costs alone. And let’s not forget Uncle Sam wants a piece of whatever windfall you make (somewhere in the order of 15%).
The arguments above really hinge on home price appreciation, you must be thinking what about some rental income. That's great, but unfortunately unemployment above 10% and unemployment + underemployed at 17.5% makes finding renters at previous market rates difficult. We shaved some -10% off our top line income in one of our buildings on the Upper East Side. If you haven't already, run your valuation models with a haircut on top line revenue and run it again with an even steeper haircut just to be safe!
So when I look about this market and the frenzy for real estate (again) I can't help but draw parallels to the holiday shopping season:
But tangents aside, you bought it for 70, what is the true value? At 100? If you can make the leap with me and say real estate was overvalued in 05/06 then the distance from 70 to 100 will be measured in years or decades. You'll have to recalibrate your home value to 80-85 for the medium term.
Next, no doubt you went to your neighborhood bank and secured a mortgage. Now as dumb as banks looked in this last recession having lost billions, let me tell you banks aren't stupid. They pretty much exclusively underwrite what is known as “recourse loans” for individual home buyers. This means they can go after your personal assets over and above the house to recoup any losses on the loan.
So let's say you fall behind on your mortgage payments, lose your job or endured some other kind of hardship. The bank is still going to be looking for its money. Phew! That was close! I thought you were flat broke. No, you own a home. You have assets! But even in the best of times liquidity is lacking in real estate. Count on several months worth of marketing and closing time before you can extinguish your obligations. By then at a minimum the bank has reported your plight to the credit bureaus and damaged your credit.
Now assuming a mortgage you are also looking at underwriting fees, attorney fees, title insurance, mortgage tax, and general administrative costs in the order of 1-3% of closing. By my calculation, it takes over 1.5 years to recoup closing fees. (See Breakeven Closing Fee.xls for a refinancing scenario). On the back end, you are going to end up paying a broker a minimum of 3% unless you plan on marketing it yourself. Tack on attorney’s fees and you are giving back 3-5% of your return in transaction costs alone. And let’s not forget Uncle Sam wants a piece of whatever windfall you make (somewhere in the order of 15%).
The arguments above really hinge on home price appreciation, you must be thinking what about some rental income. That's great, but unfortunately unemployment above 10% and unemployment + underemployed at 17.5% makes finding renters at previous market rates difficult. We shaved some -10% off our top line income in one of our buildings on the Upper East Side. If you haven't already, run your valuation models with a haircut on top line revenue and run it again with an even steeper haircut just to be safe!
So when I look about this market and the frenzy for real estate (again) I can't help but draw parallels to the holiday shopping season:
- 33% off is the equivalent of a pre-holiday sale. I'd much rather shop on Dec 26th.
- Offering a steeper % reduction on an higher “Suggested Manufacturer's Price” doesn't mean you are getting a steal.
- Giving a loved one a new puppy: An awesome gift that comes with years of responsibility attached to it.
- What's in the window isn't what you take home in the box. (A bait and switch). Transaction costs eat away at your bottom line. Do an IRR after all is said and done and see what you walk away with. I think you might be surprised.
But let's say you are still not convinced. You are still thinking of this as the opportunity of a lifetime. Why not own a derivative of real estate then? (Blasphemous, I know). How about an ETF under the tickers UUM or DMM?
The Case-Shiller Index is meant to track home prices across the US. What the good folks at MacroShares did was create an ETF similar to Case-Shiller; moreover they levered it 3x. So a long position when the index inches up +1% returns +3%.
Things to consider re these indices:
1. Volume and Liquidity?
2. Limited investment horizon: I believe this index liquidates some time in 2014, so it will crystallize your gain or loss for you.
3. These are zero sum (mirror) ETFs, which means when one fund wins the other loses. I would monitor the collateral of the losing fund. Wouldn't want t to break the buck sort of speak!
Fund prospectuses available here:
So with all the strings that come tied to owning real estate why not own something that will bring you 3x the capital appreciation but without all the headache? Like an old colleague once said: why pay for the whole cow when you can get the milk for free?
Disclaimer: I should caveat this whole dissertation by saying that I am a firm believer in the value of real estate. I am only playing devil's advocate here; traders won't fight the tape but when the bottom falls out it really falls out. Make sure you have done your homework and are buying real estate for the right reasons.
The Case-Shiller Index is meant to track home prices across the US. What the good folks at MacroShares did was create an ETF similar to Case-Shiller; moreover they levered it 3x. So a long position when the index inches up +1% returns +3%.
Things to consider re these indices:
1. Volume and Liquidity?
2. Limited investment horizon: I believe this index liquidates some time in 2014, so it will crystallize your gain or loss for you.
3. These are zero sum (mirror) ETFs, which means when one fund wins the other loses. I would monitor the collateral of the losing fund. Wouldn't want t to break the buck sort of speak!
Fund prospectuses available here:
So with all the strings that come tied to owning real estate why not own something that will bring you 3x the capital appreciation but without all the headache? Like an old colleague once said: why pay for the whole cow when you can get the milk for free?
Disclaimer: I should caveat this whole dissertation by saying that I am a firm believer in the value of real estate. I am only playing devil's advocate here; traders won't fight the tape but when the bottom falls out it really falls out. Make sure you have done your homework and are buying real estate for the right reasons.
On the Margin: Caveat Emptor
11/22/2009
This week I will be responding to a ‘Conversation Starter’ published on Harvard Business website by Dr. Rafi Mohammed of Culture of Profit, LLC in Cambridge, Massachusetts. Dr. Mohammed’s piece is reproduced below for your convenience but links to the article and Dr. Mohammed ‘s company website are also available for your reference. The premise of Dr. Mohammed’s argument suggested that operating margin was not necessarily the "Holy Grail" all businesses should seek to maximize. Instead he suggests you can make up for lower margins with higher volume.
This is true: discount wholesalers make up for low margins by increasing turnover. Sometimes sellers do this by choice and other times it’s inherent in the business of that industry. Grocery stores for one traditionally have low operating margins. Increasing prices mean you hold your inventory for longer periods of time as demand is inverse to price. But because their goods are perishable they cannot let their inventory sit in crates for too long. The end result of all this is to decrease the price (and thus their operating margins) to avoid having their cabbage pickle. I’ve heard industry standard for grocery stores is somewhere in the order of 3-6%.
This week I will be responding to a ‘Conversation Starter’ published on Harvard Business website by Dr. Rafi Mohammed of Culture of Profit, LLC in Cambridge, Massachusetts. Dr. Mohammed’s piece is reproduced below for your convenience but links to the article and Dr. Mohammed ‘s company website are also available for your reference. The premise of Dr. Mohammed’s argument suggested that operating margin was not necessarily the "Holy Grail" all businesses should seek to maximize. Instead he suggests you can make up for lower margins with higher volume.
This is true: discount wholesalers make up for low margins by increasing turnover. Sometimes sellers do this by choice and other times it’s inherent in the business of that industry. Grocery stores for one traditionally have low operating margins. Increasing prices mean you hold your inventory for longer periods of time as demand is inverse to price. But because their goods are perishable they cannot let their inventory sit in crates for too long. The end result of all this is to decrease the price (and thus their operating margins) to avoid having their cabbage pickle. I’ve heard industry standard for grocery stores is somewhere in the order of 3-6%.
Migration of Operating Margins for the largest UK Grocers (2000-2005)
"Economic Note On UK Grocery Retailing": Food and Drink Economics Branch DEF"
Food and Drink Economics Branch DEFRA - May 2006
Food and Drink Economics Branch DEFRA - May 2006
Interesting comment on the above: You see how Somerfield gave up some of its market share to come out of negative operating territory? This is common in retail: the hope is that the slope of that line is vertical and somehow you've established an allegiance with your shoppers that will allow you to increase your margins but maintain your customer base.
Now to Dr. Mohammed’s example. He suggests a Rose shop has $300 in fixed expenses (sunk costs) and variable costs (meaning per unit costs) of $0.80 per rose.
So in his base case: the rose shop sells a rose for $2.00 and at this price sell 500 roses. So doing some simple arithmetic: $2.00 x 500 roses = $1000 in revenue and 500 roses x 0.80 + 300 = $700 in costs for a profit of $300 or 30%.
His new suggestion is to decrease the rose price to $1.50 and increase sales to 1000. Running through the same math from above you get $400 in absolute dollar profit but your margin as a percent decreases to 27%. His argument is: Would you rather have a higher paper percent margin or $100 extra in your pocket? The argument sounds very plausible to me. I’d take the $100 extra and not look back.
But his assumptions are misleading to the reader. His suggestion has prices decreasing by -25% but volumes increasing 100%! That price decline is pretty steep but I doubt you’d be able to double your turnover for a -25% mark down in price.
If you make a simple assumption and say volumes increase by your price decrease (and assume an elasticity equal to -1) you have prices decreasing by -25% to $1.50 per rose and volumes increasing 25% [500*1.25] to 625 roses sold. Running the same arithmetic from above and you get $138 in dollar profit or 15% as a percentage. Under my example, decreasing your price decreases your profit in both absolute and relative terms.
Now I do not hold a “B” school degree, but I do know the importance of operating profit. It’s one of the first things they teach you. Whether its gross or net, margins are KING! You don’t fiddle with them lightly. Even my assumption is pretty generous: in reality most products never have a unit elasticity [aka elasticity = 1 or -1]. So for a % change in price you never get an equal increase/decrease in volume. That takes Dr. Mohammed’s example from cocktail chatter to damn near business slander. You should always be playing within your products' elasticity band but if I had to choose, I’d go for margin over volume any day. And you should too!
Now I realize Dr. Mohammed was using this example to illustrate a point. To start a conversation or even advocate for a volume pricing model like Sam's club or your local grocer. You certainly wouldn't be in bad company. But if you are a baker, florist, or broker caveat emptor. Decreasing your margins in hopes of capturing market share is dangerous. Think about who your marginal buyers are and how quickly they will respond to your price decreases. You might find yourself running in the red with no guarantee of ending in the black.
Original Article Link: Why High Profit Margins Don't Prove Smart Pricing
Author Link: Rafi Mohammed, Pricingforprofit.com
Author Link: Rafi Mohammed, Pricingforprofit.com
Apple Gets Old Man-itis
11/14/2009
As some of you may have heard, Apple is to open a new store on the Upper West Side in New York City. The new store is part of an aggressive plan to open an estimated 40-50 new stores in 2010. They currently operate 280 stores in 10 countries. Looking at their stock performance: since the broader rally began on March 9th and through October 2009, AAPL has outperformed its peers and the S&P 500 by wide margins. Great, fabulous. Could investors ask for anything more?
Count of Permit Type Borough Filing Status Job Type Total Bronx INITIAL NB 243 Brooklyn INITIAL NB 388 Manhattan INITIAL NB 32 Queens INITIAL NB 519 Staten Island INITIAL NB 131 Grand Total 1313
The problem Wal-Mart began experiencing though was something marketers call ‘sales cannibalism’. Their new stores were stripping their existing stores of sales and revenue. As Wal-Mart opened new stores, the shopper that previously went ten miles to the nearest store now only had to travel five miles, and the two Wal-Mart stores split the sales receipts.
The reason I bring up Wal-Mart is to illustrate a problem I think could become even more acute for Apple. In the short run Apple should be able to avoid it but their niche product-lines raises the risk and potential for cannibalism. High end consumer electronics are not an impulse buy. No one just decides to walk in and buy a $3,000 computer or a $200 phone. The marginal consumer for Apple, it turns out, isn’t marginal at all.
So what does Apple gain by aggressively expanding its retail space? It could be argued that here in New York three stores to service 9 Million is a little understaffed, but I find that aggressive store expansion serves management more than investors. It generates paper growth in lieu of organic growth and often happens as executives see their organic growth indicators showing signs of anemia. New stores don't bring anything new to the table, and generally happen toward the latter half of a company's life cycle. Like a decade long pump and dump, the executives at Apple will add to their store count and increase revenue, but long term I'd be worried about Apple ‘Genuis’ coffers running dry. Could Apple be in the middle aged equivalent of their life cycle?
At $200 a share, Apple is trading at 32 times P/E. To put it another way, investors will pay for 32 years of Apple earnings upfront in one lump sum. Looking on a relative value basis, Apple is rich compared to MSFT which trades for 20 times earnings but cheap compared to GOOG at 37x.
Technology stocks always trade at high multiples relative to other companies (General Electric trades at 14.5 for instance) because investors bake in a substantial premia for innovation and growth. The question then becomes does Apple have any ‘juice’ left? Should they trade like a young Google or a stable Microsoft?
I undoubtedly agree that Apple is here to stay, but less so as an innovator. Let's look at the roll out of their recent product line:
The reason I bring up Wal-Mart is to illustrate a problem I think could become even more acute for Apple. In the short run Apple should be able to avoid it but their niche product-lines raises the risk and potential for cannibalism. High end consumer electronics are not an impulse buy. No one just decides to walk in and buy a $3,000 computer or a $200 phone. The marginal consumer for Apple, it turns out, isn’t marginal at all.
So what does Apple gain by aggressively expanding its retail space? It could be argued that here in New York three stores to service 9 Million is a little understaffed, but I find that aggressive store expansion serves management more than investors. It generates paper growth in lieu of organic growth and often happens as executives see their organic growth indicators showing signs of anemia. New stores don't bring anything new to the table, and generally happen toward the latter half of a company's life cycle. Like a decade long pump and dump, the executives at Apple will add to their store count and increase revenue, but long term I'd be worried about Apple ‘Genuis’ coffers running dry. Could Apple be in the middle aged equivalent of their life cycle?
At $200 a share, Apple is trading at 32 times P/E. To put it another way, investors will pay for 32 years of Apple earnings upfront in one lump sum. Looking on a relative value basis, Apple is rich compared to MSFT which trades for 20 times earnings but cheap compared to GOOG at 37x.
Technology stocks always trade at high multiples relative to other companies (General Electric trades at 14.5 for instance) because investors bake in a substantial premia for innovation and growth. The question then becomes does Apple have any ‘juice’ left? Should they trade like a young Google or a stable Microsoft?
I undoubtedly agree that Apple is here to stay, but less so as an innovator. Let's look at the roll out of their recent product line:
- the 3G “S” really just put more horsepower under the hood of its wildly successful predecessor,
- they’ve developed new operating systems but again nothing too noteworthy,
- and they started building laptops from a single block of aluminum. A manufacturing feat in and of itself but more a testament to how much cash Apple is willing to burn through to get there.