Friday, October 31, 2008

Delta-Northwest merger

The Delta-Northwest merger was approved this week. Some of you may remember that the Edward Bastian the president and CFO of the combined airline is an SBU graduate who was the keynote speaker at this spring's graduation. (now if he would only give BonaResponds some discounts!)

From BusinessWeek:
"In their Oct. 29 statement, DOJ antitrust lawyers offered not just their tacit approval, but they elaborated some of the benefits they anticipate from the enlarged Delta. The agency says the transaction “is likely to produce substantial and credible efficiencies that will benefit U.S. consumers and is not likely to substantially lessen competition.” Financially, a team of Delta and Northwest employees has been working feverishly for months to make this work. It’s an MBA student’s dream.

Among this deal’s likely advantages, according to DOJ:
cost savings in airport operations, information technology, supply chain economics
fleet optimization that will benefit consumers
improved service made possible by combining under single ownership the complementary aspects of the airlines’ networks...."

What is less clear is how many of these benefits will be realized and why, short of existing competition, will any of the savings be passed on to consumers (BonaResponds discounts would be great PR! hint hint ;) ). Any company will price items as to what the market will bear, not on the costs of production.

Thursday, October 30, 2008

Accounting Changes Help Deutsche Bank Avoid Loss -

Continuing the accounting issue from last article, so much for German conservatism. Again from the NY Times:

Accounting Changes Help Deutsche Bank Avoid Loss -
"Deutsche made a pretax profit of 93 million euros ($118.5 million) in the third quarter, a result only possible because of changed accounting rules. These allowed it to cut write-downs by more than 800 million euros to 1.2 billion euros during the period.

The new rules, sanctioned by Brussels lawmakers, soften the old system that demanded all assets reflect market prices.

Deutsche Bank is, for example, sitting on more than 22 billion euros of leveraged loans — commitments often made to private equity investors to lend money to buy companies.

Farming out these loans had become difficult as worried investors retreated to safe havens and their value had fallen. The new accounting rules now allow Deutsche to hold some of these loans on their books at a fixed price."

A Question for A.I.G. - Where Did the Cash Go? -

From the NY Times Article A Question for A.I.G. - Where Did the Cash Go? -

"The American International Group is rapidly running through $123 billion in emergency lending provided by the Federal Reserve, raising questions about how a company claiming to be solvent in September could have developed such a big hole by October.....Mr. Vickrey says he believes A.I.G. must have already accumulated tens of billions of dollars worth of losses by mid-September, when it came close to collapse and received an $85 billion emergency line of credit by the Fed. That loan was later supplemented by a $38 billion lending facility.

But losses on that scale do not show up in the company’s financial filings. Instead, A.I.G. replenished its capital by issuing $20 billion in stock and debt in May and reassured investors that it had an ample cushion....Mr. Vickery and other analysts are examining the company’s disclosures for clues that the cushion was threadbare and that company officials knew they had major losses months before...."

Several reasons for including this one. First and foremost it gets to a serious question. Were the initial infusions by the government just a stop gap measure and will even more be needed. (The idea of throwing good money after bad comes to mind). Secondly in class yesterday we talked about information asymmetries and how accounting can only partially lessen the problem and that firms can have billions of dollars of losses that investors may not be aware of even after reading the financial statements. And finally a student in class is doing a paper on this and what the executives must have known (or at least should have known) before hand.

Wednesday, October 29, 2008

Video of Leo Melamed

Previously we had the text of the Melamed speech, but here is the actual video of the speech from Vanderbilt.

Bentley University Class Creates Local Microfinance Fund - MarketWatch

Congrats to Roy Wiggins and his class. What a great idea and learning experience that will help many. Please keep us posted onto the success. I would love to do the same here. Any donors?

Bentley University Class Creates Local Microfinance Fund - MarketWatch:
"An honors finance class at Bentley University has paved the way for an innovative financing initiative: a domestic microcredit organization that will fuel economic and community development by providing loans of $1,500 to $6,000 to local entrepreneurs at or below the poverty level."
Want to know more about micro-credit? Here are some past blog articles on it.

Tuesday, October 28, 2008

Do we have a new Orange County? Exclusive FBI Proble of JPMorgan Fees focuses on Swaps...:
"Nowhere have JPMorgan's derivative deals wreaked more havoc than in Jefferson County, Alabama, home of Birmingham, the state's largest city. A combination of soaring rates on its bonds and interest-rate swaps is threatening the county with the biggest municipal bankruptcy since Orange County, California's default in 1994."
The article also starts out with a story eerily similar to Citron's defense (I never knew it was risky) in the case of a Pennsylvania School district:
" Joseph Ambrosini says the deal looked so easy. JPMorgan Chase & Co. bankers told him there was really no risk. All he had to do was sign a public financing contract, and the bank would give $280,000 to his school district in New Castle, Pennsylvania.

``They basically said, unless the world goes under the sea, we'd be in good shape,'' says Ambrosini, the district's business manager.

In September, Ambrosini says, his 3,400-student district went underwater. On Sept. 25, the week after Lehman Brothers Holdings Inc. collapsed, the New Castle Area School District's interest rate on $9.7 million of financing arranged by JPMorgan hit 10.6 percent, more than doubling since the month began...."

Don't remember Orange County? Erisk has a very good case study available online.

BTW as a teaching note, this would be a great way to introduce swaps. From this article you could explain what they were and how they operate and how they are now (due to increased volatility) leading to trouble for many investors.

Structured finance, the rise and fall Exclusive: "Evil Wall Street Exports Boomed With `Fools' Born to Buy Debt"
"The bundling of consumer loans and home mortgages into packages of securities -- a process known as securitization -- was the biggest U.S. export business of the 21st century. More than $27 trillion of these securities have been sold since 2001, according to the Securities Industry Financial Markets Association, an industry trade group. That's almost twice last year's U.S. gross domestic product of $13.8 trillion.

The growth over the past decade was made possible by overseas banks, which saw the profits U.S. financial institutions were making and coveted the made-in-America technology, much as consumers around the world craved other emblems of American ingenuity from Coca-Cola to Hollywood movies. Wall Street obliged, with disastrous results: two-thirds of a trillion dollars in bank losses, about 40 percent of them outside the U.S."
How did this come about? Christopher Peterson (in particular pages 2191-2213) gives an interesting look at of securitization it in a Cardozo Law Review article available through SSRN. Just a small taste:
"This process, usually referred to as securitization, can lower the cost of funds for lenders, allowing them to offer better prices. But, it can also capitalize fly-by-night companies that specialize in fraud, deceptive practices, abusive collections, and other predatory behavior...."
Given that this was written last year, I will predict that Peterson might well be called as a witness in some upcoming trial against rating agencies:

"By pooling mortgages together and relying on a rating agency to assess the securities funded by the pool, investors can have a relatively reliable prediction of expected returns without investigating each individual originator and each individual loan.
Which worked out pretty well, huh? lol..

BTW the Bloomberg article begins with a short story of how one trader decided to get out before the Bear collapse last May. WOu

-GM/Chrysler seek $10 bln govt aid for merger - sources | Deals | Private Capital | Reuters

UPDATE 2-GM/Chrysler seek $10 bln govt aid for merger - sources | Deals | Private Capital | Reuters: "General Motors Corp (GM.N: Quote, Profile, Research, Stock Buzz) and Cerberus Capital Management have asked the U.S. government for around $10 billion in an unprecedented rescue package to support a merger between GM and Chrysler LLC, two sources with direct knowledge of the talks said on Monday.

The government funding would include roughly $3 billion in exchange for preferred stock in a merged automaker, according to one of the sources, who was not authorized to discuss the matter publicly.

The U.S. Treasury Department is considering a request for direct aid to facilitate the merger and a decision could come this week, sources familiar with the still-developing government response said earlier on Monday."
From the NY Times:
"Banks are getting billions. Insurance companies are getting billions. Why not G.M.?

The answer to that question depends on a few crucial points that few people seem willing to talk about, at least publicly: jobs, wages and the United Auto Workers.

Mr. Wagoner hopes that one way or another that Washington will help finance a merger..."
I was trying to imagine what someone who had just awoken after a ten year nap would think. The government not only bailing out banks, but now at least considering buying stakes in car companies? Where do you stop? My family's small grocery store chain would definitely like a government handout too. Or better yet, how about FinanceProfessor which clearly is in the red every year.

Monday, October 27, 2008

Shouldn't Bonuses be tied to performance?

Really? I find this very hard to believe. Yes they will get bonuses, but if the bonus is tied at all to performance, you have to expect they will be well down from last year.

Moreover, even for political reasons, if I were on the board of any of these firms I would be arguing for lower pay since high bonuses in the midst of a market collapse (which at least in part caused by bankers) will surely bring on even more ire and regulation from Washington.

But still, this from Bloomberg: Exclusive:
"Five straight quarters of losses and a 70 percent slide in its stock this year haven't stopped Merrill Lynch & Co. from allocating about $6.7 billion to pay bonuses.

Goldman Sachs Group Inc. and Morgan Stanley, both still on track for profitable years, have set aside about $13 billion for bonuses after three quarters, down 28 percent from a year ago....

The bonus figures are based on estimates that about 60 percent of the compensation and benefits expenses reported by the companies will be paid in year-end bonuses, as occurred in past years. Average bonuses aren't an indication of how much any employee will receive, since payments range widely from assistants to top traders....

....Goldman Sachs plans to cut about 3,200 people, or 10 percent of its employees, a person familiar with the matter said last week. That's a reversal from Sept. 16, when Chief Financial Officer David Viniar said he expected the number of employees to grow this year. Viniar told analysts in March that compensation costs make up two-thirds of the firm's expenses and that year-end bonuses are roughly two-thirds of compensation.
While I understand living in NYC and putting up with mega hours demands a premium (my reservation price would be in the millions), but given that bonuses are supposed to be paid for good performance, I have to agree with the following from Nell Minow:
``I'm just flabbergasted that the financial community has failed to show any sense of leadership on this issue "

Saturday, October 25, 2008

Citadel Chief Denies Rumors of Trouble -

In the Journal of Behavorial Finance 2004 Allan Kimmel wrote the following about financial rumors:
"In the contemporary financial marketplace, the consequences of speculation and decision making based on unfounded assertions and false rumors can be especially potent and undeniably dangerous."
Which is what makes the following NY Times story even more worrisome: the mere fact of the rumors coming so soon after other blow-ups may be enough to start another one and given the size, there could be a bit of trouble if true. Which in a way should probably be expected since while banks and investment banks have gotten in trouble this go round, there has yet to be any major hedge fund collapse.

Citadel Chief Denies Rumors of Trouble -
"As the stock market tumbled again Friday morning, the Citadel Investment Group, which rarely discusses its business affairs publicly, took the unusual step of issuing a statement to deflect rumors that it might be in trouble. The talk, Citadel said, was “categorically false.”

"Citadel runs some of the largest and best-known hedge funds.....

“The reason we worry about something like Citadel is that it’s so large that you’d worry about systemic risk,” said William Goetzmann, a finance professor at the Yale School of Management, who has studied hedge funds.

The industry has grown fivefold in size since 1998, when many funds hit trouble, most notably Long Term Capital Management. A group of banks bought Long Term Capital Management’s assets to prevent its losses from cascading through the industry.

This time around, however, it is less likely that banks have the strength to stabilize the financial system if a big hedge fund hits trouble. It is unclear what role, if any, the government might play."
Let's hope these rumors are just that. Unfounded rumors If so, the partners at the Citadel may want to read the rest of Kimmel's paper where he suggests "actions that can be taken to minimize the potentially harmful effects of financial rumors."

IPO VIEW-History no guide for IPO turnaround timing | Deals | IPOs | Reuters

IPO VIEW-History no guide for IPO turnaround timing | Deals | IPOs | Reuters:
"The market for initial public offerings is facing its worst drought in decades, and history gives few clues as to when the market will turn around.

The IPO market has typically reopened fairly soon after a slumping stock market begins rising again. But this time there will need to be an acceptance of sharply lower prices by issuers for there to be any kind of snap-back when the current bear market ends."
Later it quotes FinanceProfessors Reena Aggarwal and Dr. IPO himself Jay Ritter.
"There's not much to be learned from previous downturns as far as this IPO market is concerned," said Reena Aggarwal, a professor of finance at Georgetown University in Washington. "This time around, the credit markets have come to a complete halt.

"If triple-A paper can't be financed, if banks aren't making intraday loans to each other, you can't even begin to think about the IPO market."

NY TimesWeekend Business Podcast

Want to learn while you do other things such as laundry, household chores, driving? Listen to the NY Times Weekend Business Podcast. It gives a nice recap of the week, plus some investment advice from John Bogle (the founder of Vanguard).

Friday, October 24, 2008

At least some people know how to hedge!

Great story and had finance and world series ties.

Cashing in on hope - MLB - Yahoo! Sports: "Marger, a lifelong St. Petersburg resident and season-ticket holder since the team’s inception in 1998, stands to win $25,000 on a $100 bet he placed at Bally’s last November during a quick swing through Las Vegas.
“I figured they are my team, so it was worth $100,” he said. “I thought about it when I got there, and the odds were 200-to-one (that the Rays would win the World Series). I dilly-dallied for a day and the odds jumped to 250-to-one, so I went for it.”"
Now that the Rays are in the World Series, Marger knew what to do. He hedged. From the same article:
"I put down a bet on the Phillies before the Series,” he said. “If they win, I’ll take home $3,000. Had to do it, you know?” "
Thanks to Charlie for this link! (who like me is a Mets fan and wondering if we can get 250:1 odds soon.)

Deal Heavyweights on the Future of M&A - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times

Wouldn't you have loved to be there for this one?
Deal Heavyweights on the Future of M&A - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times:
"The panelists — Stephen Friedman, the retired chairman of Goldman Sachs and the current Chairman of the Federal Reserve Bank of New York; Martin Lipton, the founding partner of the law firm Wachtell, Lipton, Rosen & Katz; and Joseph Rice III, the founder and chairman of private equity firm Clayton Dubilier & Rice — took turns discussing the challenges and opportunities ahead, as well as reflecting on the current economic crisis."
Will give one look in:
"Mr. Friedman spoke at length about the current crisis, which he described as the greatest financial panic since the Great Depression. Part of the problem, he said, was that “people will play the way you pay them,” meaning that the incentive structures that were in place encouraged bad lending and faulty business practices. He said he blamed the banks, consumers and the rating agencies for playing a part in the financial debacle"
While the Panel discussion was on mergers and acquisitions (which have slowed dramatically and will likely remain slow--except in cases of consolidations and saving firms from bankruptcy), some key points in it carry forward to all parts of this meltdown. For instance Friedman's comments that "incentive structures that were in place encouraged bad lending and faulty business practices."

I think everyone knew (and some even understood) that incentives were in place to encourage risk taking. The problem was that many, myself included, gave the banks too much credit. We all failed to understood that the banks (both Investment banks and Commercial Banks) did not fully understand what they were getting into, and the banks did not have controls (offsetting positions) in place, and seemingly (see Greenspan's comments of yesterday) had never stress tested their models with data that considered data out of the recent good economic times. This blatant error has to fall on the shoulders of the Boards of Directors, the management, regulators, and dare I say auditors/analysts/rating agencies.

Without being adequately prepared, when the worst came (call it a black swan, call it a perfect storm, call it the worse case scenario), all of a sudden we had meltdown. (Now if you really want to consider the worse, what happens now if a natural disaster hits. Earthquake hits California, etc.)

This is why SIMM (our student managed real money portfolio) argued so long, and unfortunately unsuccessfully, to be allowed to hedge with derivatives and take short positions last semester.

Greenspan - Bad data hurt Wall Street computer models -

Greenspan - Bad data hurt Wall Street computer models -
"Greenspan told the committee. 'The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades a period of euphoria.'

He added that if the risk models also had been built to include 'historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.'"
The NY Times also added that SEC Chairman Christopher Cox
"told the committee that credit rating agencies gave AAA ratings to mortgage-backed securities that didn't deserve them. "These ratings not only gave false comfort to investors, but also skewed the computer risk models and regulatory capital computations," Cox said in written testimony.
The NY Times has about 10 minutes of the testimony. It cannot be embedded like the Youtube one below, but is much better.

Here is some video coverage of Greenspan's testimony:

Thursday, October 23, 2008

Emanuel Derman's Blog: A speech by Leo Melamed, reproduced here with his permission

Emanuel Derman's Blog: A speech by Leo Melamed, reproduced here with his permission: "Financial Innovation Conference Vanderbilt University October 16, 2008 Nashville

The Law of Selective Gravity By Leo Melamed

The first course:
"There is no way to sugar coat it: Current economic conditions have the earmarks not only of a severe U.S. recession but—dare I say it—the potential of a global depression. That is about as dire as it can get. However, for me, as tragic and ominous as that prospect may be, it does not represent the worst consequence of today’s global economic conditions. I fear in The Law of Selective Gravity—a cousin of one of Murphy’s Laws—which postulates that “An object will fall so far as to do the most damage.”"
and for dessert:
"I am lamenting that U.S. government officials were in such a state of panic that they abandoned market solutions in favor of Third-World sorcery like blaming speculators and banning short-selling. I am lamenting the fact that all the world’s capitalists have turned to the government for salvation. I am lamenting the fact that federally inspired rescue operations were so quick to surrender the fundamental free market principle that mistakes by the private sector must be borne by the people who made them. As Thomas Donlan of Barron’s remarked “The U.S. and Europe are racing down the trail marked by such economic leaders as Mexico, Argentina and Russia.”"
Jeff Peterson (my department chair) was at this conference and had mentioned what a great speech it was. Through MoneyScience I found it today...Thanks to Moneyscience and Emmanuel at Wilmott.

Update 10/29/08: video of the speech is available here.

Robert Shiller's Financial Markets Course at Yale - Spring 2008 - Video and Audio | Finance Focus | News & Blogs | MoneyScience

WOW! Now and then you get an email that changes your whole day for the better. That was what I just got from Jacob over at WOW. I definitely know what I will be doing! Watching and listening. It does not et much better. The opportunity to listen in on one of the most respected FinanceProfessors in the world!

From MoneyScience:
Robert Shiller's Financial Markets Course at Yale - Spring 2008 - Video and Audio | Finance Focus | News & Blogs | MoneyScience: "The good folks at Yale have recently made Professor Robert Shiller's Spring Financial Markets Course at Yale available to the Public as Video and Audio (mp3).

The Course took place in the spring, so events have overtaken us somewhat, but still you have an excellent introduction to Financial Markets from one of the pre-eminent Economists of his generation - with Guest Lectures from such luminaries as Carl Icahn and Stephen Schwarzman and Lawrence Summers."


Hedge fund withdrawls, leverage, and future job prospects

Citadel Hit Hard as Hedge Fund Withdrawals Continue - Seeking Alpha:
"The chief executive of a leading alternative investment manager said he expected the hedge fund industry to shrink by 50 per cent in coming months – with half the decline coming from withdrawals and half coming from investment losses.

Even if that prophecy only becomes partially true, that is a massive amount of deleveraging, unwinding, and liquidation. Forced selling is driving this market and will continue to do so"
More on the redemptions is available from Naked Capitalism which also correctly points out that the leverage that allowed more assets to be bought when money flowed into the funds, will result in more assets being sold when money flows out:
"Note that leverage figure is disputed....But even if that lower figure were true, redemptions of $150 billion would generate sales of $300 billion.
This semester my classes are exclusively upper level and grad classes, so regularly job prospects coming up in before and after class discussions. Over the past several years many of our graduates have one on to work at hedge funds so it is not surprising that some current students want to work in the field. Hence some coverage of jobs in the field is also warranted.

The Options Group estimates that 10,000 employees in the approximate 150,000 field will be laid off this year. From Bloomberg:

"Hedge funds may cut as many as 10,000 jobs this year as they struggle with their biggest losses in almost two decades, according to estimates by executive search firm Options Group.

The industry has already eliminated 3,000 to 5,000 jobs, out of an estimated 150,000 worldwide, Michael Karp, chief executive officer of the New York-based firm, said today in an interview. Layoffs may double by the end of 2008, he said.

``It's bad out there,'' said Karp, whose firm has tracked hedge-fund hiring since 1995. ``Generating returns is not easy at the moment and as funds look to cut costs, the best way is to let go of people.'"

Monday, October 20, 2008

Congratulations to Eugene Fama!

While I still think he should have won the Nobel Prize for Economics, at least this will soothe the pain. / Business education - Chicago professor wins Onassis Prize:
"Chicago finance professor Eugene Fama is the inaugural winner of the $250,000 Onassis Prize, which is awarded every two years by Cass Business School in London to acknowledge academic work in finance, shipping and trade"

In Hedging you win some and you lose some.

Southwest's infatuation with fuel hedges backfires - MarketWatch:
"Given oil's relentless ascent, investors have been dumbfounded that Southwest's hedging program wasn't universally used by other airlines, who unfailingly blame their weak financial performance in part on rising fuel costs.
Then came the crash. Oil is now trading at half the price it fetched just three months ago. Suddenly, Southwest's aggressive bet on the market went bad"
No it did not go "bad". Almost by definition hedges will lose money when the risk the firm is hedging moves in their favor. So airlines worry about jet fuel prices. Holding other things constant, airlines drop in value as teh fuel prices rise and vice versa. So, their hedges are designed to "lose" money when the firm can better handle the losses and make money when operations would otherwise be hurting. In doing so they allow the firm (Southwest in this case) to focus on what they do well (run an airline) and not worry about what is outside of their control (price of fuel). The hedges are not designed to make money 100% of the time.

The AP had some more details and did come a bit closer to the story:

"The fuel-hedging deals at the core of Southwest's numbers include options to buy fuel in the future at below-market prices. They succeeded again in saving the airline money on its largest single expense.

Southwest's fuel spending jumped 52 percent, to $1 billion, but the airline paid less per gallon than did other major U.S. airlines.

And while Southwest took a charge to write down the value of its hedges, it also recognized cash settlement gains of $448 million from fuel contracts, and included that money in its net income."

So if I am reading this correctly, the loss was an accounting write-down, while the savings are cash saved.
A good deal in my book! But even if I am not reading it correctly, hedging (as opposed to speculating) is still the way to go in my opinion!

Saturday, October 18, 2008

Financial Crisis Provides Fertile Ground for Boom in Lawsuits -

Gee, who could have seen this coming? ;)

Financial Crisis Provides Fertile Ground for Boom in Lawsuits -
"Accusations of executive excess, accounting fraud and lack of disclosure are far more credible now, since bad bets on real estate and securities linked to home loans have caused some of the biggest and most prestigious financial firms in the country — Lehman Brothers, the American International Group, Fannie Mae, Freddie Mac — to collapse, sell parts of themselves at fire-sale prices or suffer outright government takeovers. A legal argument rarely used in investor lawsuits is tempting: res ipsa loquitur, or the thing speaks for itself.
and later
"...One factor contributing to litigation is the rapid availability of information about corporate mistakes and losses...."
Interesting. The last quote gives us yet another reason why managers often have conflicting incentives when it comes to transparency. Does anyone know of a study that examines this? Maybe lawsuits or CEO turnover as a function of information transparency? If so please email me. if not and want to write one, please email me. :)

Car dealers demand more cash for down payments -

When articles say that banks will quit lending it is really too simple. Banks are in the business of lending and they will not all stop, but what they will do is to cut back and not lend as much. Here is an example of how this is affecting car loans.

Car dealers demand more cash for down payments -
"Tighter credit standards are forcing many car buyers to put down more cash up front to get a loan.

The average down payment last month was $3,108, up 42% from $2,194 in the same month two years ago, reports"

SSRN-Audit Firm Tenure and the Equity Risk Premium by Jeff Boone, Inder Khurana, K. Raman

While accounting based, it had financial ramifications and deals more with governance, so I going to mention this here. I am working on a paper about auditors and in some background reading just stumbled upon this paper by Boone, Khurana, and Raman. Quite interesting. The abstract does a wonderful job catching the essence of the paper:

SSRN-Audit Firm Tenure and the Equity Risk Premium by Jeff Boone, Inder Khurana, K. Raman:
"....Based on prior research, whereas the “auditor learning” argument predicts that audit quality will change in only one direction (i.e., improve) with tenure, the “auditor-client closeness” argument suggests that audit quality may decrease beyond some (albeit unspecified) length of tenure due to impaired auditor independence and objectivity.....we find that the equity risk premium decreases in the early years of tenure but increases with additional years of tenure. These findings persist after we control for well-known risk factors and company characteristics that have been shown in prior research to be related to the cost of equity capital"
Which will definitely make it into the section of my Corporate Finance classes on governance.

Boone, Jeff P., Khurana, Inder K. and Raman, K. K.,Audit Firm Tenure and the Equity Risk Premium. Journal of Accounting Auditing and Finance, Forthcoming
Available at SSRN:

Friday, October 17, 2008

General Growth, Mall Owner, May Be Facing a Sale - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times

Want a case study on how the credit crunch can affect non financial firms? Consider General Growth a REIT that financed its acquisitions with debt but now is in financial difficulty of its own.

General Growth, Mall Owner, May Be Facing a Sale - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times:
"...financing strategy, with debt equal to more than 70 percent of its capitalization, raised fears that General Growth, a real estate investment trust based in Chicago with more than 200 shopping centers, had become overleveraged — fears that have now been borne out."
While business itself was pretty good, the debt that is coming due is too much for the company.
"In a conference call...on July 31, Mr. Bucksbaum said that mall occupancy during the second quarter was 93.2 percent, a record. The company has remained largely unaffected by the wave of recent retail bankruptcies....

But the company has $8.5 billion in debt coming due before the end of 2010, most of it in the form of maturing mortgage loans. Refinancing the debt is considered highly unlikely because of the credit squeeze and the decline in retail real estate values stemming from the economic downturn."
"....the company dismissed its longtime chief financial officer and suspended its dividend. Moody’s Investors Service, Fitch and Standard & Poor’s have reduced the company’s credit ratings.....

General Growth said it was exploring a variety of options, including the sales of individual properties and partnerships with other companies, to “align the market value of the company’s common stock more closely with the intrinsic value” of its shopping malls.

The company has also postponed $1.1 billion of projects....

Despite these efforts, Rich Moore, a retail REIT analyst at RBC Capital Markets, predicted that another large shopping mall operator, or a combination of rival companies, would end up buying General Growth."
As is always the case, debt makes good times great, and bad times horrible. Here is just another example. Too bad it had to happen to a cycling enthusiast whose family business goes back to the family grocery store! (and with ties to Cedar Rapids too!)

Thursday, October 16, 2008

Banks’ Bailout Unlikely to Crimp Executive Pay -

Kevin Murphy is one of my all time favorite professors, so when he gets quoted in the NY Times, it is definitely going to make the blog!

Banks’ Bailout Unlikely to Crimp Executive Pay -
"“The Treasury’s plan seeks to take aim at the eight-figure pay packages given to Wall Street executives that have enraged so many Americans in the wake of the country’s financial collapse.

....Congress’s record of regulating executive pay has been unblemished by success,” said Kevin J. Murphy, a finance professor at the University of Southern California, pointing to perverse outcomes of past efforts.

When Congress limited the tax deductibility of cash salaries to $1 million, for example, it simply led to an explosion in stock options used as compensation and even higher total payouts."

Wednesday, October 15, 2008

Black Swans Worldwide:
"Investors advised by ``Black Swan'' author Nassim Taleb have gained 50 percent or more this year as his strategies for navigating big swings in share prices paid off amid the worst stock market in seven decades."
and later:
"``I am very sad to be vindicated,'' Taleb said today in an interview in London. ``I don't care about the money. We're proud we protected our investors.''

For more on Taleb's book see here: The Black Swan: the Impact of the Highly Improbable by Nassim Nicholas Taleb. Wow. Not only does Taleb explain what I have wanted to say (some things just happen out of the blue and by their very nature are unpredictable) but he does so in a funny, entertaining, and remarkably sticky. Taleb sets much of what we rely on on its head. For instance, you will never think of stats the same way—you will find yourself thinking more about tails Not only does this way of thinking have huge financial implications (consider managing a large fund, you may be hedged against things you can think of, but not other Black Swan events), it also should have implications in many many walks of life. For instance, before BonaResponds goes to a disaster area, we concede we can not prepare for what we did not know. Rather than plan for an infinite number of eventualities, we plan to be flexible enough to adapt to whatever happens. The same is true in most businesses, armies, governments, and even many personal dealings. VERY good and important book. BTW Be sure to read the Prologue. Even if the rest of the book were not included, I would have been happy with my purchase BEFORE page 1.

The Economic Naturalist: in Search of Expl

thanks to Brandan for pointing this out to me!

Friday, October 10, 2008

Academic perspective? or incessant rambling?

Trying to step back and answer some of the questions people have been asking over the past few days in particular. They will not be particularly formal and clearly I have no idea of anything in the future, but since I keep getting asked, at least this MAY cut down on that.

1. Why should the government do anything? They don't when other companies go out of business.

A. Well, maybe the government should not do anything. I am not sure what I would have done, but given the size and severity of what is happening, I do think I would have intervened.

Some very good cases can and have been made for letting markets sort this out. Indeed, I am a big free markets believer too, but (and this is always dangerous to say), things are different this time. Most notably when a store or even large manufacturing firm goes out of business, they only marginally impact the overall economy. But banks, by being a provider of liquidity for many businesses and people, can help spread the problem. For instance from a 1994 paper by George Kaufman in the Journal of Financial Services Research.
"Contagion is a term used to describe the spillover of the effects of shocks from one or more
firms to others,l It is widely considered to be both more likely to occur in banking than in
other industries and to be more serious when it does occur. Bank (depository institution)
contagion is of particular concern if adverse shocks, such as the failure or near-failure of
one or more banks, are transmitted in domino fashion not only to other banks and the
banking system as a whole, but beyond to the entire financial system and the macroeconomy...."
Limited intervention now may limit the severity of the problems and thus in the long run mean less intervention is needed.

2. Has there ever been anything like this?

Yes and no. Yes to the degree that markets collapse, yes. For instance from 1929 to 1932 the US markets dropped by nearly 90%!
From the BBC:
"In two days the Dow Jones industrial average fell by 25% (ending on Black Tuesday, 29 October).

The volume of stocks traded set a record that was not broken for 40 years.

When it finally reached its record low in July 1932, the Dow Jones had fallen 89%, and it did not recover to 1929 levels until 1954"
Similarly the recovery in Japan was long and difficult with even today, 18+ years later, the market at only a fraction of its 1989 peak.

But there are differences. Take the US for instance. Homeownership is at record levels (and real estate prices have fallen in many areas). Stock ownership by individuals (through mutual funds, retirement plans, or just in regular accounts) is MUCH higher than during even the crash of 1987. So we just do not know the wealth effects we will see of the estimated 8 trillion dollars in the US (remember that is just equities and does not include real estate losses) or approaching $30 trillion worldwide in stocks. Will people stop spending so much? Almost assuredly.

3. What caused it and who is to blame?

Many things and many people. Unfortunately there is no single answer. Among the things, we loosened credit to allow more people to own their own homes. This while good in and of itself, helped to spur a real estate bubble. A colleague Giles Bootheway pointed out at a recent forum on the subject, this was added to by the low rates the Fed maintained well after (too long?) 9-11.
As things often do, one thing lead to another and in many places homes kept going up in value. This led to people thinking that prices would always rise. This then led to banks believing the same (they definitely should have known better) and making loans with very little low downpayments and with clauses that often increased the required payments after a few years. When the economy slowed only marginally, this led to many sub-prime borrowers not being able to make payments.
As these mortgages are been combined into new securities, the owners of these (often the larger bank and if not the larger banks often had put provisions so we liable) saw asset values drop. As this happened, they both sold other things to get cash (which drove other assets down) and largely quit making loans.

4. What is next?

No idea. We are not going to be out of this for a while. Sure the correlation between market returns and teh economy is low, but I have a very tough time not imagining at least a fairly pronounced recession.

That said, there will be many other impacts as well. Regulation will surely increase. My guess is that serious talk of privatization of social security will be tabled for years. There will be many law suits. Bond rating agencies, audit firms, and others will no doubt be the target even if undeservedly so.

Also it is very likely that risk premiums will be higher as a large percentage of the population (and not just those involved in finance) realize the limitations of diversification and that markets do not always go up.

5. What should I do now with my own portfolio?

Well if I could answer that one do you think I would be giving away info like that!? lol....Won't touch it Sorry.

I do feel bad for you, but if misery loves company, it is largely happening to everyone. This collapse is global with many indexes are down much more than those in the US. Moreover, the ones I really feel bad for are those who just retired or are nearing retirement. Last night at the store I heard of one recently retired man who is already trying to reenter the workforce as he does not feel he had enough set aside now that his portfolio is down by almost a quarter (which could have been much worse!)

No Shelter in This Storm - Floyd Norris Blog -

Floyd Norris in the NY Times gives some perspective on enormity of this collapse. Amazing. Just a few of the countries (he lists nearly 50 countries):

No Shelter in This Storm - Floyd Norris Blog -
"Singapore, down 45%
India, down 58%
Indonesia, down 50%
Malaysia, down 39%
New Zealand, down 46%
Philippines, down 50%
Pakistan, down 49%
Vietnam, down 61%"
And in a related piece, the BBC lists countries and shows what each is doing to combat the collapse. (ht to Luma on FB!)

Definitely more evidence that correlations increase in bad times (the Butler-Joaquin idea again)

Iceland suspends stock trading, creates new bank: Financial News - Yahoo! Finance

Iceland suspends stock trading, creates new bank: Financial News - Yahoo! Finance:
"Iceland suspended trading on its stock exchange for two days and took control of the country's largest bank -- the third to be placed under its protective umbrella -- on Thursday as it grappled with a banking crisis that is threatening to engulf the entire country"
A few days ago a friend emailed and asked about class and what we were covering about the collapsing market. He then suggested I really should be teaching how to live off the land (implying a total collapse of the financial infrastructure).

Apparently he gave the same advice in Iceland where the prime minister said essentially the same thing!

From Bloomberg: Iceland Premier Tells Nation to Go Fishing After Banks Implode
``We are too small a country to sustain such a big banking system,'' he said in an interview. ``We have fantastic resources and an abundance of green energy and we will now utilize that and the other resources we have, the ocean and human capital

Thursday, October 09, 2008

Presidential Address by Ken French

In spite of the market collapse that is going on, classes can not devote all of our time to it. So here is a video of Ken French's 2008 presidential address to the AFA.
Presidential Address: "2008 Presidential Address: The Cost of Active Investing
by Kenneth R. French"
It is really good. The paper which he talks about was mentioned back in March. Here is the blog article about it from then.

This is required for all my MBA courses as well as SIMM our student run investment fund.

SNL on the Bailout

Thanks to Financial Rounds for some humor.

Wednesday, October 08, 2008

Coordinated rate cut plus In praise of Bernanke

Of course the Fed Cut rates early this AM. As part of a multi-central bank move to stem the spillover from the liquidity induced meltdown. Most would agree that such a cut was only a matter of time and definitely needed (I would have gone a full point at least), but

First the News: From NY Times.
"In an extraordinary move that reflects the gravity of the financial turmoil, the world’s central banks on Wednesday announced coordinated interest rate cuts as they try to restore confidence in the economy.

Included in the move to cut rates were the Federal Reserve, the Bank of England and the European Central Bank as well as those in Canada, Sweden and Switzerland."

Yesterday I was asked what I thought of Bernanke's handling of the situation. I said while I may disagree about some small items, the worst I can say about him is that he has done things largely as I would have done. Thus, I liked seeing others (yeah I am biased) agree with my assessment at a time when it is all too easy to criticize him. Again from the NY Times.

In Praise of Bernanke - Economix Blog -
"The Federal Reserve’s rate cut — part of a coordinated international effort — has put Ben Bernanke front and center for yet another day. Over the past couple of years, Mr. Bernanke, the Fed chairman, has come in for a fair bit of criticism. Some of it has been justified, I think.

But it’s also worth taking a moment to consider how well prepared he is for his current task. He spent his career studying the lessons of the Great Depression and, to a lesser extent, Japan’s 1990’s slump. (And his fellow economists have enormous regard for him and his work.) He now finds himself having to put those lessons into practice. His qualifications by no means guarantee that he’ll succeed. But it’s hard to imagine anyone who is more qualified to try to minimize the damage from the current crisis."

Housing Pain Gauge: Nearly 1 in 6 Owners 'Under Water' -

Housing Pain Gauge: Nearly 1 in 6 Owners 'Under Water' -
"The relentless slide in home prices has left nearly one in six U.S. homeowners owing more on a mortgage than the home is worth, raising the possibility of a rise in defaults -- the very misfortune that touched off the credit crisis last year.

The result of homeowners being 'under water' is more pressure on an economy that is already in a downturn. No longer having equity in their homes makes people feel less rich and thus less inclined to shop at the mall."
Even with the slide in real estate, the 1/6 number is hard to believe. You figure some fairly large percentage has house paid off, others close. It would be really fascinating to see the numbers on that. I am sure they are out there.

As for the numbers they do give, look at Southern California, Las Vegas, and Miami. Wow.

How to Unfreeze Bank Lending -

The WSJ proposes a plan whereby bank debt would be guaranteed for a period of time. One of the better ideas out there, but still worry about the moral hazard problem. Is 10% enough? See below.

How to Unfreeze Bank Lending -
"...the Federal Reserve should guarantee most of the short-term borrowing of well-capitalized banks for a small fee.

....Here's how the guarantee might be structured to dovetail with the federal bailout bill and constrain moral hazard. A bank could borrow up to a specified percentage of its tangible capital, with a Fed guarantee for a limited period such as three or six months. This limit should be designed to give enough time for new sources of lending to be generated by the federal purchases of troubled assets. The Fed guarantee would cover a large portion, say 90%, of the principal of these loans only in the event that the borrowing bank becomes insolvent. The non-guaranteed portion of these loans would give lenders the incentive to make intelligent choices and monitor the borrowers."
Which is better than anything I can think of with the exception of the lower rates, lower rates further, loer rates still further while increasing the money supply in ALMOST any way possible. (Which is not without its own potential problems).

Tuesday, October 07, 2008

Yahoo! Personal Finance

Yahoo! Personal Finance:
"With more super-sized banks in business, fewer failures could still dump a big bill on the Federal Deposit Insurance Corp.... The FDIC's potential liability is rising under a provision of the bailout that increases the deposit insurance limit to $250,000 per account, up from $100,000.

Using statistics from the S&L crisis as a guide, Mason estimates total deposits in banks that fail during the current crisis at $1.1 trillion. After calculating gains from selling deposits and some of the assets of the failed banks, Mason estimates the clean-up this time will cost the FDIC $140 billion to $200 billion.

The FDIC's fund currently has about $45 billion -- a five-year low -- but the agency can make up for any shortfalls by borrowing from the U.S. Treasury and eventually repaying the money by raising the premiums that it charges the healthy banks and S&Ls."

Investing myths laid bare by this bear market

Not sure how much of the whole article is worthwhile, but a few of the so-called myths are interesting: | Business | Investing myths laid bare by this bear market:

The article starts off with a section on Cramer talking about his recommending Wachovia just before it collapsed (uh, remember Bear?), but in this case he blamed the CEO who Cramer believed did not have the correct info. It should be noted that Cramer did apologize in this case.

From this the jump to the idea that even the CEOs did not know what was going on is very possible. Which leads (at least I think that was the connection) the author to write that
"Complex financial derivatives such as credit-default swaps and collateralized debt obligations were not valued properly because they were not subject to the same visibility as publicly traded securities."
At least partially true. Without a doubt everyone involved in derivatives did not know what risks they were exposed to. This is in part because of a lack of transparency, but also because of the high leverage that many derivatives contain where a small move yields very large value changes.

Want another so-called myth according to the article?
"Global diversification myth.

We also learned that global diversification in recent years has been little help to investors. There was a time when markets around the world went in different directions, while economies in different countries did their own thing. But for years now it's been a global economy and markets increasingly move up and down in unison. When it comes to the world bourses, it is monkey see, monkey do. What you do get by investing abroad, however, is foreign-currency exposure, and that does add diversification.

Which while partially true is not exactly news. It does fit very well with the 2002 Butler and Joaquin article that showed that correlations increase in down markets.

Interesting stuff. Not sure if I would have used the term myth, but some good points.

Salon Radio: Notre Dame finance professor Richard Sheehan - Glenn Greenwald -

On my way to do a radio interview on the economy and I did some Google searches to see what other finance professors had been saying. Here is one from a while ago with Richard Sheehan of Notre Dame. Sheehan is a critic (or at least was as of Sept. 23) of the bailout.
Salon Radio: Notre Dame finance professor Richard Sheehan - Glenn Greenwald -
"The question that I would love to hear someone ask Paulson, is: can he state definitively how much in credit reverse swaps is currently outstanding? Or, how much in CDO's is currently outstanding? The numbers for those types of financial instruments, the credit reverse swaps, you could be talking in excess of 45 trillion dollars. So, 700 billion there, could be just a drop in the bucket. And that is the part that should scare me, that should scare you, that should scare any taxpayer; that it's not clear that, even with the magnitude of the proposal out there, if Paulson is right, worst case scenario, he doesn't have enough bucks out there to do what he thinks he can do."

There is audio as well.

Fed to buy massive amounts of short-term debts: Financial News - Yahoo! Finance

Fed to buy massive amounts of short-term debts: Financial News - Yahoo! Finance:
"The Federal Reserve, invoking Depression-era power under 'unusual and exigent circumstances,' will buy 'commercial paper,' a short-term financing mechanism that many companies rely on to finance their day-to-day operations, such as purchasing supplies or making payrolls." Worldwide

Wow. This is about as interesting as Money and Banking can get! But fortunately this is really interesting! Stealth easing. Nice new term! Worldwide:

"The central bank used power granted under last week's financial-rescue legislation to effectively set a floor under its main interest rate that's lower than the 2 percent target set by policy makers last month. The Fed may now pay interest on bank reserves while it floods financial markets with liquidity, pushing down the overnight lending rate by about 0.75 percentage point to 1.25 percent.

``Absolutely, it's a stealth easing,'' said John Ryding, "
"By paying interest on reserves, the Fed can pump more cash into the financial system without worrying the overnight lending rate will drop to zero at the end of each day as banks withdraw excess reserves. The move doesn't preclude a further reduction in the target rate by the Federal Open Market Committee."
Told you it was interesting! While we can argue about whether it is too little too late, any increase in liquidity that they can offer is definitely a step in the right direction!

Strategies for a liquidity crisis. | Banking & Finance > Financial Markets & Investing from

Wow.....great article. Published 10 months ago, but as relevant now as then.

Strategies for a liquidity crisis. | Banking & Finance > Financial Markets & Investing from
"The longer-term danger from a liquidity crisis is a prolonged deleveraging or debt-deflation process such as the U.S. experienced in the 1929-1933 Depression, or that Japan experienced for more than a decade from 1990. Federal Reserve Board Chairman Ben Bernanke has studied these episodes as much as anyone on the planet and regards them as the result of monetary policy failures."
and later
"Deleveraging's impact Debt deflation means trying to deleverage--"trying" because everybody cannot sell their positions at the same time without causing asset values to fall faster than borrowings, which implies imploding net worth and thus higher leverage ratios. It is analogous to the famous "paradox of the thrift" where everyone tries to save more but the deficiency of aggregate demand that results causes a drop in income and savings despite the higher savings rate."
On that upbeat note I am going to go to sleep. Wake me when this is over. lol...

BTW if you are local, I am part of a forum of finance and economics professors as well as bankers and others that will be doing a round table on Wednesday at 12:30 in the Dresser Auditorium in the Murphy Building on SBU's campus (Far west side of campus). It is free and open to the public.

Is this a repeat of Japan 1989?

We talked about the similarities in class today. Here is an article that looks at the US now and Japan in the late 1980s, early 1990s. It is an eerily similar scenario. | Business | Can U.S. escape zombie economy's clutch?:
"Banks were lending money and there was almost this excessive euphoria and panic that if you didn't buy a home you would be priced out of the market forever."

Overinflated real estate prices. Easy loans and credit leading to speculation. Financial deregulation of banks that encourages more liquidity. Market chaos as the bubble bursts."

What did the Japanese government do?

"To prime the economy, Japanese lending rates went down as far as 0.1 per cent – effectively zero – but even that did little to help the moribund market.

In a similar vein, the U.S. government has tried to prime the pump by sending out rebates for families and tax breaks for businesses, while the Federal Reserve has lowered the overnight lending rate to ensure more liquidity.

Let's all hope this one is not as bad!

Thursday, October 02, 2008

Warren Buffett interview

Charlie Rose interviewed Warren Buffett on his GE purchase, the current "meltdown", and more. Sort of long, but well worth watching! He calls this the "Economic Pearl Harbor".

Buffett to Invest Billion in G.E. - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times

GE has been busy strengthening their balance sheet (i.e. delevering). Whether this is just prudent planning for volatile times, or a signal that they fear we have not seen the worst yet, is anyone's guess, but parrots a phrase my finance students heard nearly everywhere we went on our recent NYC trip: "cash is king".

In GE's case, they made two sales. The first was a sale of perpetual preferred shares to Warren Buffett and then the second was a seasoned equity offer that sold at a discount.

From Bloomberg:
" General Electric Co. raised $12.2 billion by selling 547.8 million shares at a discount of 9.2 percent to yesterday's closing price, giving it more cash to fund operations in the worst U.S. financial crisis since the Great Depression....The sale dilutes the value of GE stock by about 6 percent to 7 percent, Citigroup analyst Jeffrey Sprague said in a note to investors yesterday. He rates GE a ``hold/medium risk.'' ``While this was clearly a difficult step to take, it should give GE more operating and strategic flexibility,'' Sprague said in his note."
The article goes on to say that GE also suspended its Buyback plan which is consistent with the widely acknowledged view that buyback plans are more likely to be cut than dividends.

and on to the Buffett deal:

Buffett to Invest Billion in G.E. - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times:
"...G.E.’s concessions to Mr. Buffett are steep. The perpetual preferred stock carries a dividend of 10 percent, and can be repurchased after three years at a 10 percent premium. Berkshire Hathaway will also receive warrants to buy $3 billion of common stock at $22.25 within the next five years."
A very fast look at the NUMA option calculator suggests that these options are worth nearly a billion dollars themselves! (used 60% as volatility based off of this article rather than actually computing using any LEAP implied volatilities)--if you use the historical standard deviation-for which a case could be made since the warrants have longer term life, the value drops to less than $500m). Thus, the warrants alone are worth at least 16% of the initial investment of $3b.

I am not sure what any of this means to future tests of Buffett's ability to "beat the market". On one hand because of reputation and wealth is being granted investment opportunities that the typical investor does not have. Thus to be held accountable to the "market" portfolio seems an unfair advantage. But on the other side, investing in a risky time, clearly makes performance measures that are based on historical metrics (be they Standard deviation or beta) incorrect.). So, since I am not sure what to say, I will merely say that Buffett is doing nothing here to hurt his reputation as the one of the world's best investors.

Bank Limits Fund Access by Colleges, Inciting Fears -

Getting closer to home. Just another example of how contagion rears its ugly head and problems can spread quickly through the global economy.

Bank Limits Fund Access by Colleges, Inciting Fears -
"In a move suggesting how the credit crisis could disrupt American higher education, Wachovia Bank has limited the access of nearly 1,000 colleges to $9.3 billion the bank has held for them in a short-term investment fund, raising worries on some campuses about meeting payrolls and other obligations.

Wachovia...agreed this week to sell its banking operations to Citigroup, has held the money in its role as trustee for a fund used by colleges and universities and managed by a Connecticut nonprofit, Commonfund.

On Monday, Wachovia announced that it would resign its role as trustee of the fund, and would limit access to the fund...."
Before anyone asks, I have no idea and am not involved in any way with SBU's finances, other than through our student run money in SIMM (Students in Money Management). For the record on that, the donated portion is down approximately 14% since its summer high. The $100,000 of University endowment money which we gained access to over the summer is still in cash. [Somewhat related, last week the University filmed a tv commercial featuring SIMM, I have a copy but am not sure how to share it.] Stay tuned