Wednesday, November 26, 2008

Best Explanation in One Sentence - Mises Economics Blog

Whether you agree or not, this line is so awesome I have to include it...

Best Explanation in One Sentence - Mises Economics Blog:
"'If the money is used to prop up failing companies, that's particularly bad since it is an attempt to override market realities, an attempt that is about as successful as trying to repeal gravity by throwing things up in the air.'"
And it does serve as a good reminder throwing good money after bad is not an answer. Changes to prevent the same problems from happening again must be made or else the bailouts will create more problems (notably inflation, dwelling deficits, and a worsened morale hazard problem).

How Scientists Helped Cause Our Financial Crisis

Garbage in, Garbage out. Models are not reality. Models only help explain reality and therefore help our understanding of a reality that is generally too complex to fully grasp.

These ideas are taught in every stats, econometrics, and finance class worth its weight. On every test students use (indeed sometimes overuse) "data limitations", "it uses historical data", and "surprises (or black swans) can occur that would make our model incorrect" as problems with such and such model. And yet somehow, quantitative geniuses (or at least the traders and managers who relied on the models) seeming forgot (uh, looked the other way?) and ignored the problems.

So how did so many smart people seemingly forget? In part they were paid to forget (bonuses, promotions for big successes with little accounting for risks taken--for more of this see Taleb's "Fooled by Randomness".

Scientific America and ClusterStock look at this issue in How Scientists Helped Cause Our Financial Crisis
"In retrospect, the financial planning by our most sophisticated financial institution looks incredibly stupid. Merrill Lynch never included in its plans the risk that its counterparties could demand more collateral. Citigroup proceeded to dive headlong into the mortgage market on the assumption that a national housing decline was impossible. Everyone, it seems, failed to guard against the risk that they might be forced to sell assets to raise capital during a downturn. So it's worth asking: how did so many rich guys get so dumb?"
Scientific America quoted in the same piece:
"The causes of this fiasco are multifold—the Federal Reserve’s easy-money policy played a big role—but the rocket scientists and geeks also bear their share of the blame....The government bailout has already left the U.S. Treasury and Federal Reserve with extraordinary powers. The regulators must ensure that the many lessons of this debacle are not forgotten by the institutions that trade these securities. One important take-home message: capital safety nets (now restored) should never be slashed again, even if a crisis is not looming.

For its part, the quant community needs to undertake a search for better models—perhaps seeking help from behavioral economics, which studies irrationality of investors’ decision making, and from virtual market tools that use “intelligent agents” to mimic more faithfully the ups and downs of the activities of buyers and sellers....risk management models should serve only as aids not substitutes for the critical human factor. Like an airplane, financial models can never be allowed to fly solo."
Remember, models are representations of reality. Economic models, no matter how super, are no more reality than are super models are representations of the average Joe (or Jill or Jim or Jerry or Jane).

Schiff continues to believe that the worst is yet ahead.

Peter Schiff 'Opportunity of a Lifetime' in Gold Intl. Assets Not U.S. Stocks: Tech Ticker, Yahoo! Finance:
"Schiff believes have another 5 to 10 years of bear market action ahead as America struggles to come out from under a mountain of debt."
Clusterstock on the same:
"As discussed in the accompanying video, Schiff believes the recent dollar rally and commodity price weakness will prove temporary. Most troubling, he says the "economic crisis is only just beginning.""

Tuesday, November 25, 2008

A Reporter at Large: Anatomy of a Meltdown: Reporting & Essays: The New Yorker

A Reporter at Large: Anatomy of a Meltdown: Reporting & Essays: The New Yorker:
"For more than a year after he was appointed by President George W. Bush to chair the Fed, in February, 2006, he faithfully upheld the policies of his immediate predecessor, the charismatic free-market conservative Alan Greenspan, and he adhered to the central bank’s formal mandates: controlling inflation and maintaining employment. But since the market for subprime mortgages collapsed, in the summer of 2007, the growing financial crisis has forced Bernanke to intervene on Wall Street in ways never before contemplated by the Fed....These moves hardly amount to a Marxist revolution, but, in the eyes of many economists, including supporters and opponents of the measures, they represent a watershed in American economic and political history."

Thanks to MoneyScience for the link! VERY good stuff!

Baltimore Firm Delays IPO to Wait Out Risk -

Having just done IPOs in class, this was of special interest.

Baltimore Firm Delays IPO to Wait Out Risk -
"When Grand Canyon Education of Phoenix went public Thursday, it was the first U.S. company to have an initial stock offering since Aug. 8. On that day, Rackspace Hosting of San Antonio broke the longest IPO dry spell since 1975....Since August, at least 29 companies have canceled or postponed their offerings on U.S. markets, according to Reuters."

Jay Ritter has a fascinating look at IPOs by each month from 1960 to 2005. It is a spreadsheet and not labeled but the columns are month, year, average first day return for the month's IPO, and number of IPOs that month. From that data:





































Grand Average



Bell Ringing!

If you get a chance, be sure to catch the NYSE closing bell today. As part of St. Bonaventure's 150th anniversary celebration Mark Larry (the finance club president), Jeff Peterson (my chairman), and Sr. Margaret Carney (University President) will be ringing the closing bell today!

here is a video of the bell ringing.

Slippery! Proceed with Caution!

In WNY it has snowed every day for a week so the roads are pretty slick, but that is not what I meant. Economy:
"The Federal Reserve took two new steps to unfreeze credit for homebuyers, consumers and small businesses, committing up to $800 billion.

The central bank will purchase as much as $600 billion in debt issued or backed by government-chartered housing-finance companies. It will also set up a $200 billion program to support consumer and small-business loans, the Fed said in statements today in Washington."
It sure is a slippery slope. If you bail out one, then it just keeps going and going and going.

Which is not to say that in their shoes, I might not do much of the same. I think I probably would but sure would be reluctant to do so and we sure can not say they aren't trying!

Airlines and hedging back in the news from AVIATION WEEK

The good people over at Aviation Week seemingly still don't quite get it. Hedging is not supposed to be a money making operation. It is supposed to eliminate (or at least lessen) one form of risk. In this case, those airlines that locked in the price of Jet Fuel need not worry about it. True they are paying more than the spot price, but that always happens. When they made their decision, prices could have gone to $200 and then they would be writing what a great move it was to hedge.

Airlines Made Bad Bets in Fuel Hedging | AVIATION WEEK:
"With oil prices rising to levels near $150 per barrel and then unexpectedly falling by more than 60%, airlines had plenty of opportunity to make wrong bets on fuel. And many did. Ryanair, for instance, locked in fuel prices during the run-up that now mean the carrier has to pay far more than the spot rate. Air France-KLM, too, has been hurt. At current oil prices, the carrier's hedge book means it will pay more than at spot rates for the rest of the financial year, as well as in the next two. The airline in the past quarter took a €373- million ($466-million) financial charge related to hedges.
Note to class, this is a time when the airlines REALLY wish they had purchased call options and not futures. Why? (yeah that will likely be a test question.)

An important point to ponder, given the apparent correlation of fuel prices and the economy really makes the fuel prices the best thing to be hedging (ie. what is the real exposure?).

July 9th, 2004

Was just looking back over old newsletters (wish I had time to bring them back), and found this from July 9th, 2004.

" Fed Governor Edward M. Gramlich gave a great talk on the subprime mortgage market. This market, which is relatively new but has grown sharply, deals with making loans to those that are seen as being high credits risks. On one hand these loans “created new opportunities for homeownership and has allowed previously credit-constrained homeowners to borrow against the equity in their homes to meet a variety of needs. At the same time, increased subprime lending has been associated with higher levels of delinquency, foreclosure, and, in some cases, abusive lending practices. On a social level, one question is whether the gains afforded by these new market developments outweigh the losses.” His answer? “Despite the caveats, the net social evaluation of these trends is probably a strong positive. The 9 million new homeowners, more than half of whom are minorities and many of whom have lower incomes, suggest that credit and ownership markets are democratizing. Millions of lower-income and minority households now have a chance to own homes and to build wealth; and the vast majority of these new homeowners do not appear to be having credit problems.”

Uh, guess things didn't turn out quite the way we had expected. That said, even now I think the idea of opening financial markets to the poor is a good one, but clearly changes in the way these mortgages are marketed, sold, accounted for, and even how those selling them get paid must happen.

Kiyoshi Ito, 93, Mathematician Who Described Random Motion, Dies - Obituary (Obit) -

His name may not mean much to many, but if you ever took a PHD finance class there is little doubt you will ever forget him. Ito's work played a major role in the development of the Black-Scholes option pricing formula.

From the NY Times: Kiyoshi Ito, 93, Mathematician Who Described Random Motion, Dies - Obituary (Obit) -
"Kiyoshi Ito, a mathematician whose innovative models of random motion are used today in fields as diverse as finance and biology, died Nov. 17 at a hospital in Kyoto, Japan. He was 93....Mr. Ito is known for his contributions to probability theory, the study of randomness. His work, starting in the 1940s, built on the earlier breakthroughs of Albert Einstein and Norbert Wiener. Mr. Ito’s mathematical framework for describing the evolution of random phenomena came to be known as the Ito Calculus."

Monday, November 24, 2008

Two tests=little posting

No, I did not abandon ship. Just been busy. Had a test to give on Saturday and tonight (Monday) and still working with BonaResponds to build a house in Friendship. It is coming along pretty well!

Speaking of BonaResponds, we are starting a small micro-finance program where we will be lending to some of the people we are helping. If you want to give to a great cause (and yes it is a donation, we will continue to turn the money over, but for the time being we do not see it ever going back to donors), just let me know. Any amount will be used.

Also for any of you looking to spend some time helping people recover from Hurricane Ike, BonaResponds will be in Bridge City from January 5-17th. Come on down with us! See for more info.

Citi Field Bailout?

I have long had the view that one sure sign of a firm's pending demise is that they decide to buy stadium rights (uh sorry to anyone marketing this type of thing ;) ). Consider: Adelphia (had both Adelphia Court at St. Bonaventure and the dreaded Adelphia Coliseum in Tennessee), Enron (and the former Enron Field), do we add the new Citi Field to the list?

BTW There could be some rationale for this. Best guess an agency cost problem. Firms that feel important enough to buy stadium rights probably are forgetting the shareholders and the overconfidence leads to excessive risk taking.

BTW Here is some academic evidence that naming a field after your firm does not help firm's profitability.

It should be noted that the Citi deal is not done and maybe the bailout will save the firm and keep it named Citi Field. As a Mets fan, I just hope that it is not an omen of other large collapses!

Friday, November 21, 2008

Two Finance Professors in the news

Andrew Lo of MIT went in front of Congress recently. He suggested a team including some from academia to study what went wrong to prevent it from happening again. Of course, that is already happening at thousands of firms and hundreds of universities. (from MoneyScience)
"Professor Lo, described his idea that the US Government should set up a small agency, modeled along the lines of the National Transportation Safety Board, that would investigate hedge fund blow-ups"
Georgetown University: The Rise and Fall of Teaching Finance:
"Reena Aggarwal, a Stallkamp Faculty Fellow and professor of finance, says the recent U.S. financial crisis means that she is spending even more time researching the market. A growing fear of a global recession has the financial scholar keeping up with the market in an all-consuming way.

“The financial market is literally changing by the minute,” Aggarwal says. “There is a lot of fluff in the mainstream media right now about the status of the U.S. and international economies, but you really have to go much deeper to understand what exactly is going on.
and later:
"The weekly course topics I am teaching are changing – not by the day, but literally, by the hour,” says Aggarwal. “I have told the students to expect changes as we go along because the whole financial industry is going to look completely different now than how it has looked in the past.”

TIPS Strips, Redux - Seeking Alpha

SeekingAlpha has an interesting "interview" with a Barclay's expert (Mike Pond) on Treasury Inflation Protected securities. It covers many topics (from deflation to why TIPS Strips never caught on. Two things for class perspective that my students should definitely be aware of is the relationship between reinvestment rate risk and duration and the impact of liquidity on returns (and why if you are a long term investor, you may want to hold an illiquid security).

TIPS Strips, Redux - Seeking Alpha:
"TIPS are what Pond calls 'very backended': Their coupon is low, relative to the principal amount, and it's the big final principal payment which provides a large chunk of their total yield. So the reinvestment risk on TIPS is already lower than it is on most bonds....[currently] real yields on TIPS are ridiculously high. You'd be better off buying TIPS all the way out to 8 or 9 years than you would be buying Treasury bonds, just so long as inflation is greater than zero. And the higher that inflation gets, of course, the better off you'll be in TIPS.

Do investors really believe that the US will see deflation over most of the coming decade? Probably not: .... TIPS are much less liquid than Treasuries, and therefore trade at a significantly higher yield, despite the fact that their credit risk is identical."

Thursday, November 20, 2008

Market And Economic Records Falling One By One (And Not In Good Way)

Whether these are interesting trivia or important indicators will be left for history to decide, but there are some interesting records..

Market And Economic Records Falling One By One (And Not In Good Way):
"One of the interesting aspects of this unprecedented housing collapse, credit crisis, economic recession and market crash has been all the new records we keep seeing.....
* The S&P 500 hasn’t been this far below its 200-day moving average on a percentage basis since The Great Depression....
* CPI: U.S. consumer prices in October registered their largest single-month decline since before World War II. It is the largest monthly drop in the 61-year history of the data..."
There are more too. From Clusterstock but really from a number of sources.

BTW does anyone know fastest moves by minute of the Dow? I did a few fast searches and did not find anything.

Tuesday, November 18, 2008

With no IPO market, companies seek private investors | Deals | Reuters

With no IPO market, companies seek private investors | Deals | Reuters:
"Companies wanting to go public are opting for private placements to tide them over until they are mature enough to launch, DeFrawi, who heads InsideVenture, said in an interview. InsideVenture is a service that will begin matching investors with later-stage pre-IPO companies this winter.

On Tuesday, InsideVenture announced it has begun recruiting qualified institutional buyers, or QIBs, to be members.

'Everything will have to be done privately for the time being because the market is dead,' DeFrawi said. The U.S. IPO market has not seen a deal launch since early August, the longest such stretch in decades"
this week in class we will be discussing IPOs and SEOs so this is background reading for the class.

Quick update on Cuban's insider trading case

Two updates:

First Cuban has provided an update on his BlogMaverick page in which is is implied that Cuban never intented to keep anything confidential. From the MarketWatch:
"on Tuesday posted an email containing a purported transcript of a conversation between Chief Executive Guy Faure and Cuban's lawyers, in which Faure acknowledges that Cuban didn't explicitly agree to keep the content of their conversation confidential.'
The actual transcript from BlogMaverick:

"1) Q- We spoke earlier about you were telling Mr. Cuban in words or substance : “I have confidential information for you”.

A- Right.

2) Q- Do you recall anything Mr. Cuban said in response or reply to that statement by you ?

A- No, I do not."

Which is at least somewhat supportive of saying I will not keep it confidential.

And secondly, Professor Bainbridge has written on the case.
"My review of the complaint suggests that the SEC has a pretty good case, assuming they can prove out the facts alleged, and they get a court willing to give the rules a liberal construction on one key point.

The central legal issue in this case likely will be whether Cuban assumed a fiduciary obligation of confidentiality with respect to"
Thanks to Financial Rounds for the link to the Professor Bainbridge coverage (which is very good I must add!)

Three part interview with Ken French

Ok, it is official, Clusterstock is my new favorite blog site. They have a three part interview with Ken French.

The first part on why index funds are generally better than active stock picking is available here, the second part was on the folly of market timing. The third part is on the returns of commodities entitled that No, You Shouldn't Own Commodities -- Ken French: "
"Ken French, professor of finance at Dartmouth's Tuck School and the director of investment strategy at Dimensional Fund Advisors. There's no reason for most investors to own commodities. Contrary to popular belief, they aren't a good inflation hedge, and they don't provide a long-term real return that investors aren't already exposed to through normal stock ownership."

Peter Schiff: A prophet from the past?

A former student of mine (Charlie) sent this to me. Wow. Talk about getting things right! Peter Schiff was absolutely dead on.

Peter, I do not know you, but my hat is off to you. It is also a great reason why I NEVER watch financial talk shows.

I wonder if Laffer ever paid his penny.

The Public Payroll Always Rises -

One one hand government spending is in a Keynesian way seen as a means of keeping the economy growinging in an economic slowdown, but given the taxes and
The Public Payroll Always Rises -
"As the recession hits home, all across America businesses and families are having to make hard decisions about what not to buy this year, or whether they can afford a vacation or that plane trip home for the holidays. The exception is the government -- federal, state and city.

"New York City did witness a reduction in public employment in 2002 and 2003, during the last period of slower economic growth. But the city quickly resumed its habit of ever-growing payrolls, and they have kept growing rapidly in the years since -- to an estimated record this June 30 of 313,965 employees on the public dime, according to the Mayor's office. That's an increase of more than 40,000 public workers in a year when Wall Street has been enduring historic losses and laying off tens of thousands of people."
Which means that New York State Taxes will probably go up again, which will further slow the economy of upstate New York. (BTW recently New York State gave up the top spot in taxes, but we are still a solid #2)

Monday, November 17, 2008

Officials charge Mark Cuban with insider trading | Entertainment | Industry | Reuters

Officials charge Mark Cuban with insider trading | Entertainment | Industry | Reuters:
"According to the SEC, Quebec-based invited Cuban in June 2004 to participate in a private placement stock offering after he agreed to keep the information confidential.

When Cuban found out that the offering would dilute the holdings of existing shareholders and be sold at a discount to the market price, he became 'angry and upset,' the SEC said.

At the end of a call with's chief executive, Cuban said: 'Well, now I'm screwed. I can't sell,' according to the SEC's complaint."
And from The SportingNews:
" Stewart, like Cuban, landed on the wrong end of a civil action aimed at forcing her to fork over the money she saved by acting on inside information regarding a stock she dumped just before the price went south. Eventually, she forked over to the feds the $45,000 she saved by ditching the stock, along with three times that amount as a penalty for using inside information. Cuban may be approaching his own situation more prudently, getting "lawyered up" before talking to authorities and avoiding saying anything that could get him indicted (so far). "
You can say what you want about Mark Cuban, but he is a news magnet. Amazing. It will be interesting case to follow. (BTW You can see what Cuban has to say about it(not much) on his blog.)

Are partnerships coming back?

Mark Wilson who teaches Economics here at SBU has been advocating that a solution to the excessive risk taking and misaligned incentives is to return to partnership arrangements where the management would have more at stake.

Last week in Michael Lewis' epic "The End of Wall Street's Boom" piece the same idea was mentioned. Now Clusterstock investigates what Goldman would look like if it did go private:

Goldman Goes Private:
"Goldman spent most of its existence as private partnership. In a sense, by going private Goldman would be returning to its roots. But odds are that this time around, Goldman's partnership will be very different. These days even private partnerships are often far more open than the partnerships in the past, and openness might be exactly what Goldman needs if it is to survive.

University of Illinois law professor Larry Ribstein has been a pioneer in the study of how private partnerships have been used as alternatives to solving sticky problems of corporate management. Much of his work has centered on the problem of aligning managers' and owners' interests. He notes that the private partnership model popular in the private equity world might be very useful for Goldman here."

To Prevent Bubbles, Restrain the Fed -

In another article bemoaning the Fed, the WSJ reports some amazing statistics:

To Prevent Bubbles, Restrain the Fed -

First on the performance of the stock market:
"On Nov. 14, 2008, the Dow Jones Industrial Average closed at 8497.31. On Nov. 13, 1998, the adjusted (for dividends and split) close was 8919.59. There has been great volatility, but no net capital accumulation as measured by the Dow in a decade. Other indexes, such as the Nasdaq, tell a similar story. Capital has been invested but as much value has been destroyed as created."
Then on the relative size of the subprime market:
"In 2001, there was $190 billion worth of subprime loan originations -- 8.6% of total mortgage originations. In 2005, there was $625 billion worth of subprime originations -- 20% of the total. In the same period, the percentage of subprime mortgages securitized -- loans that were packaged and sold to investors -- rose from just about 50% to a little more than 81%. (These numbers all trailed off slightly in 2006.) The great easing in monetary policy ended (with a lag) when the Fed began raising rates in June 2004.

The subprime saga follows a familiar pattern. Easy credit begets a boom and then the inevitable tightening of credit bursts the bubble. What is not familiar is the scale of the devastation wrought in this boom-bust cycle."
To prevent this boom-bust cycle,the author (Gerald P O'Driscoll Jr.) calls for a return to some commodity standard. A view that I do not really hold, but can see why there are more calling for it and given evidence, I may not disagree with it as much as I would have a few years ago.
"Mr. Obama needs to stop the next asset bubble from being inflated by imposing a commodity standard on the Fed. A commodity standard (such as a gold standard) imposes discipline on a central bank because it forces it to acquire commodity reserves in order to increase the money supply. Today the government can inflate asset bubbles without paying a cost for it because the currency isn't linked to the price of a commodity."

Friday, November 14, 2008

Stocks For The Long Run, v. 3

Clusterstock mentions that real returns following a market peak have been very different than after a bottom.
Stocks For The Long Run, v. 3:
"If you invested at the 1929 peak, it took 29 years for the value of your shares to recover in real terms; if you invested at the 1968 peak, it took 24 years.

The takeaways are: 1) dividends have provided the lion's share of long-term stock market returns; real capital gains have been comparatively modest; and 2) if you invest at a peak, you probably won't see a real capital gain for a quarter-century."

Yield Spreads point to bad economic times ahead

In good times even the majority of low rated firms can make their debt payments, but in bad times these low rated firms are the first to get in trouble. Investors know this and the spread between low rated and high rated debt gets larger when the economy slows.

Thus, it is more than a little troubling that the risk premium has grown to historic levels. From Barron's:

Current Yield -
"THE STOCK MARKET IS PRICED FOR a recession, but the bond market is priced for a depression. So says Rob Arnott, the brainiac who heads Research Affiliates, an institutional advisory.

That's not hyperbole. Corporate bonds rated Baa or triple-B, the low end of investment grade by Moody's and Standard & Poor's designations, offer the biggest yield premium since the early 1930s, notes RBC Capital Markets.

That's a problem for pulling the economy out of the credit crisis, but an opportunity for investors."

Thursday, November 13, 2008

Warren Buffett Interview

Clusterstock did it again. They found another really cool article. This is the transcript of Buffett on CNBC:

That Awesome Warren Buffett CNBC Interview (courtesy of Clusterstock):
"It's a tall order to get up at 5am and speak for three hours and never say anything that isn't wise, charming, or funny....Full three-hour transcript here (with minor deletions), courtesy of CNBC. If you don't have time to read it now, save it for the weekend."
A few quick of Buffett's quotes:

Two short ones:
" know, you only find out who's been swimming naked when the tide goes out. Well, we found out that Wall Street has been kind of a nudist beach"

"...the country will be doing far better five years from now than it is now, but it won't be, in my judgment, it probably won't be doing better five months from now."
and two longer ones:

On Fannie Mae and Freddie Mac:
"...they also had an added problem in that they had a dual mission. The government expected them to promote housing and the stockholders expected them to raise the earnings substantially every year. And as the years went by, they emphasized the latter more and more. They started talking about "steady Freddie," and Fannie Mae said, `We're going to increase the earnings at 15 percent a year.' Any large financial institution that tells you that sort of thing is giving you a line of baloney. I mean, they may do itfor a while, but when they can't do it with operations, they do it with accounting and they cheat."
and one last one on regulation and management:
"... managing complex financial institutions where the management wants to deceive you can be very, very difficult. Or even when the management doesn't know what's going on, and--just take Bear Stearns. Bear Stearns had--I read it, anyway--750,000 derivative contracts. Now, you know, I could clone Albert Einstein, you know, and--many, many times and have him work 12-hour days for me and he would not be able to keep track of what's going on in an institution like that. It's--the ones that are too big to fail may be too big to manage"

I do have one question for CNBC. Why would you make him go one so early in the morning? Make this prime time.

A look at volatility: Levels, Surprises, and History By Risk Metrics's Chris Finger

Doomed to Repeat it? Over at RiskMetrics, Chris Finger has examined the volatility of the US stock market for over one hundred years. While lacking any grand slam home runs, it is an interesting article for a number of reasons.

Short version:
It starts by breaking the time period into two periods (1940-1945, 1945 to present) and like other researchers the author shows that the volatility has in fact declined over time. Finger then makes forecasts of volatility and looks for surprise volatility events (that is when the forecast is off by a bunch). This is followed by an event study on volatility. True to form given the surprise definition the event study finds a "right angle" in increased volatility. And since volatility is not ever increasing, this spike in volatility declines back to the longer run average overtime. This may help to estimate the duration of current high volatility levels.

Some look-ins:
"the recent peak of 70% is extremely high, though lower than the spikes after the crashes in 1929 and 1987, when volatility jumped to 95% and almost 120%. Today’s level is comparable to what we saw in the early 1930s"
"With this large set of residuals...we choose a threshold, and compare how many residuals we actually see of this magnitude to what our assumed statistical distribution predicts. For instance, the t-distribution predicts that over the history in question (about 30,000 trading days), we should see between 29 and 49 days on which the market loss is a five-standard deviation event or greater; there are in fact 32 such days."
Because volatility had already been high (and high standard deviations of the residuals), this increase in volatility has not been that surprising since February 2007.
"Like these other crises, the current one seemed to have begun with a surprise—the 7.8-standard deviation loss in February 2007.....Since February 2007, however, despite all that has happened and the historic run-up in volatility, there have been no large surprises: the largest was the fall on September 29, 2008, the day the US Congress rejected the first bank bailout plan. This loss was one of the twenty largest ever, yet registered as only a 3.7-standard deviation event amid the already high volatility."
In other words, this increase in volatility has been more like a flood than a tsunami. It began raining in February 2007 has largely not stopped. While the author finds little evidence of similar patterns in the past [a very important fact given the difficulty/impossibility of forecasting off one data point], the one time this seemingly happened does not give great hope for a quick volatility decline:
"...volatility has risen in an orderly way, with no true surprises. The run-up in volatility in 1931 is the best example of this phenomenon, and in that case, volatility stayed elevated for quite a long time: it spent more sixteen months over 35%, during which time the index fell by 50%.
Good stuff. Go on and read the rest of it at RiskMetrics (and if you are in my class, be sure to note the figures too. A picture tells a thousand words and this may help you make sense of it quickly.)

Wednesday, November 12, 2008

Accounting changes are coming, and I feel fine

With all apologies to REM It's the end of the world as we know it, and I feel fine.

A New Vision for accounting:
"Some of the major changes under discussion: reconfiguring the balance sheet and the income statement to follow the three categories of the cash-flow statement, requiring companies to report cash flows with the little-used direct method; and introducing a new reconciliation schedule that would highlight fair-value changes. Companies will also likely have to report more about their segments...Meanwhile, net income is slated to disappear completely from GAAP financial statements, with no obvious replacement for such commonly used metrics as earnings per share."
As the replacement for EPS, let me suggest cash flow from operations per share.

Now the final product is far from done and there are many detractors. From the same article:
"FASB, working with the International Accounting Standards Board (IASB) and accounting standards boards in the United Kingdom and Japan, continues to work out the precise details of the new financial statements. ...If the standard-setters stay their course, CFOs and controllers at every publicly traded company in the world could be following Kelly's lead as soon as 2010... "
The article then goes on to say that many do not want to see the changes. for instance:
"December CFO survey of more than 200 finance executives, only 17 percent said the changes would offer any benefits to their companies or investors"
Of course there will be problems, but a move to more transparency and cashflow measures will be a good step. Sure the new reports will at first be more difficult to create and there will be more line items, but it is important to remember that managers and accountants have a large investment in the current system and as a bunch not known for being enamored with change.

Further, managers in particular often have a vested interest in preventing transparency so that CFOs and accountants are against the new changes may say less about the changes and more that they are just REMMS that do not want to lose their informational advantages.

Read the entire CFO piece here.

* Thanks to MBA Depot for pointing this one out to me! Oh and I know I have used the REM reference before, but figured I have to give Michael Stipe some credit since I have been accused of looking like him. I feel really sorry for him!

The End of Wall Street's Boom - National Business News -

WOW!! Have some time? You may just want to drop whatever your plans were for this. It is that good. By Michael Lewis (he of Liar's Poker and Money Ball fame).

The End of Wall Street's Boom - National Business News - "The era that defined Wall Street is finally, officially over. Michael Lewis, who chronicled its excess in Liar’s Poker, returns to his old haunt to figure out what went wrong"

one and only one look-in:
"We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says."
What a great writer. You simply have to go read it.

And a HUGE thanks to ClusterStock for pointing it out--and giving long excerpts. Longer than I am comfortable giving--it has quickly become a mandatory morning read for me.

SSRN-Modeling the Economic Effects of Bank Regulation and Supervision by Bilin Neyapti, Gonca Senel

This one sort of surprised me. Short version: banks and economies improve with supervision.

SSRN-Modeling the Economic Effects of Bank Regulation and Supervision by Bilin Neyapti, Gonca Senel:
"...reveals that the higher the RS [Regulation and Supervision], the higher are per capita output, wages and credit, and the lower are the interest rates. Moreover, simulations reveal that bank profitability is higher under monitoring and it is also more highly correlated with RS the higher the level of development"
The paper is my Neyapti and Senal:

Cite: Neyapti, Bilin and Senel, Gonca,Modeling the Economic Effects of Bank Regulation and Supervision(July 2008). Paolo Baffi Centre Research Paper No. 2008-32. Available at SSRN:

Is Now the Time to Buy Stocks? -

In class just the other day we talked about Efficient Markets and concluded that while markets are exceedingly difficult to beat on a risk adjusted basis, it does appear that as we learn more perfect efficiency in the sense of a random walk, is not really the case. So it is a great coincidence that in the Wall Street Journal there is the following by the University of Chicago's John Cochrane.

Is Now the Time to Buy Stocks? -
"The correlation is obvious: When prices are low relative to dividends, subsequent seven-year returns are likely to be high. Stocks do not follow a "random walk." More deeply, price declines above and beyond declines in dividends over the following year have entirely rebounded. This finding is confirmed by 30 years of research, ranging from "behaviorists" such as Robert Shiller and Richard Thaler to "efficient marketers" such as Eugene Fama and Ken French, to "economists" such as John Campbell and myself. The same pattern also appears in price/earnings, book/market and other ratios, and in many other markets.

The interpretation is pretty clear too. In a recession, or following losses, many investors become more averse to holding risks. They want to sell. But we can't all sell -- a fact routinely ignored in much financial advice and commentary. Instead, prices must fall and prospective returns rise until some investors are willing to buy. Unsurprisingly, upward spikes in the dividend yield came in bad economic times.

Which means that there is some predictability in stock prices due to changing risk aversion levels that correlate with economic conditions. That is not to say that tons of people are correctly predicting these changes in aversion (and price levels) and does not change my view that largely passive investing (index funds or in some cases ETFs) are the way to go, but does help explain the long held view that stock returns tend to be too volatile relative to firms' dividends.

By the way the article also gives an always well placed warning:
"History is not a guarantee -- this time could be different."

Monday, November 10, 2008

The Lipstick index from NY Times

Pulse - Frown Fighters - Caption -
"...the Lipstick Index — that frivolous financial barometer that says cosmetics sales rise in direct relation to free-falling finances — has jumped."
From The Business Sheet:
"The gist is that women couldn't afford luxuries in the depression but wanted to buy something to treat themselves. Something small, cheap, and with a big impact. Lipstick. During the Depression sales went up"
Thanks to ClusterStock for this.

Reversion to the Mean - Capital Markets -

Wow. I did not see this one coming. It is from the Economist and reported on but is research by Deutsche Bank.

For the past 25 year Treasury Bonds have outperformed equities, even BEFORE this recent market collapse.

Reversion to the Mean - Capital Markets -
"...over the last 25 years. As the graph shows, Treasury bonds have actually outperformed riskier asset classes over the last quarter century. That is despite the long equity bull-market from 1982 to 2000....

Asset classes can go through long periods when they underperform, leaving them cheap and ripe for revaluation. That happened to Treasury bonds, which suffered four consecutive decades of negative real returns from the 1940s through the 1970s....It was one of the great historical buying opportunities.....Since 1900, the average annual return from Treasuries has been 4.6%, or 1.5% after allowing for inflation. In contrast, American equities have delivered 9.3%, or 6% in real terms.

The current poor performance of stock markets reflects, of course, a reversion to the mean after the excesses seen during the dotcom bubble, when the rolling 25-year annual return of US equities reached a remarkable 16%. On a 10-year basis, the return from equities has now slumped to minus 3.5% in real terms."

If my self-evaluation and stuff for the assessment group can wait a bit longer, I might have to check the data on this for myself. I can see a few years, but 25? Wow.

UVA: Sorry, Alumni, We Gambled Our Endowment And Lost

Few things are more humbling than the stock market (and maybe a speed workout on a quarter mile track). Case in point: many of the big time universities with Billions in their endowments (I always wonder why people give more to those that already have so much, but I digress) have seen much of their wealth evaporate.

From Clusterstock: UVA: Sorry, Alumni, We Gambled Our Endowment And Lost:
" endowments have been clobbered in the past three months, especially the ones that were trying to 'be like Yale.' (Overweight private-equity, hedge funds, commodities, and real-estate; underweight cash and bonds). The situation is so bad that some funds are resorting to fire sales"
Depending on your ilk, this story could be used to discuss Market Efficiency (even "smart money" loses), Behavioral finance (herding behavior), asset allocation, asset liquidity, private equity investments, and the limits of diversification.

BTW: I confess I had not read much from ClusterStock before today, but have been very impressed. Several very interesting articles. Check it out!

Bailout just keeps getting bigger and bigger

The government bailout continues to grow with seemingly no end in sight. First AIG gets both more money and more lenient terms.

A.I.G. Rescue Grows to Billion - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times:
"The Bush administration revised its rescue of the American International Group, raising the total amount to $150 billion, amid signs that the interest on its current credit line of more than $100 billion was putting too much strain on the ailing insurer.

The Treasury Department and the Federal Reserve said early Monday that they are abandoning the initial bailout plan and invest another $40 billion in the company. The government created an $85 billion emergency credit line in September to keep A.I.G. from toppling and added $38 billion more in early October when it became clear that the original amount was not enough."
It was a few week's ago when the shortfall became apparent and the question remains where does this all stop? And while it is easy to throw around numbers that start with a B, let's put this in perspective, that is approximately $500 for every US resident.

In addition to the more money, AIG was also granted more lenient terms. From the Treasury's press statement:
"The existing FRBNY credit facility will be revised to reflect, among other things, the following: (a) the total commitment following the issuance of the perpetual preferred shares will be $60 billion; (b) the interest rate will be reduced to LIBOR plus 3.0% per annum from the current rate of LIBOR plus 8.5% per annum; (c) the fee on undrawn commitments will be reduced to 0.75% from the current fee of 8.5%; and (d) the term of the loan will be extended from two to five years."
The extension is designed to "give AIG time to complete its planned asset sales in an orderly manner. Proceeds from these asset sales will be used to repay the credit facility." So we all have a vested interest in the sale going well, but any guesses what happens in the meantime? More investment?

Oh and lest you think we have seen the end of this (once the precedent is started it is very hard to stop), the WSJ reports that the new administration has signaled its intent to help the US auto industry. So get in line!

BTW the NY Times also gave a fast look around at what others were saying on this front. One look-in:
"Joe Weisenthal, writing on the Clusterstock blog, suggested that the “whole thing is being spun to make it sound like something other than just throwing more money onto the fire.”"

Sunday, November 09, 2008

Steve Horan on mutual fund fees

Steve Horan used to be a colleague at SBU and is still a friend, so when I heard he was on CNBC (even if only via a call-in) I was positive I was going to link to it.

So here is the video of his discussion on mutual fund fees from

Friday, November 07, 2008

3 'superbanks' now dominate industry - Economy in Turmoil-

In an article that quotes many financeprofessors, MSNBC looks at some of the controversy of making the strong stronger. A must must read for any money and banking class!

3 'superbanks' now dominate industry - Economy in Turmoil-

Some visual bites:
“Large institutions are impossible to manage prudently, let alone regulate,” says Amar Bhide, a professor at the Columbia Business School.

In fact, existing federal banking laws say that no bank can have more than 10 percent of the domestic deposit market — a threshold recently surpassed by all three superbanks.

When asked whether the government would take any action, a Justice Department official was noncommittal."

Now in fairness this consolidation had started LONG before the current crisis. For instance
"...the number of commercial banks and savings & loans in the United States has fallen in the past 20 years to 8,451 as of June, compared to 16,574 in 1988, according to FDIC data."
and as the article points out, this may be the lesser of two evils:
"Gregory F. Udell, Chase Chair of Banking and Finance at the Indiana University Kelley School of Business.

The risk of creating monopolies, he says, “is a lot less than the risk of having a lot of zombie institutions out there.”"

On the monopoly issue, one thing not mentioned is the idea that due to technology, small banks can at least provide the threat of competition.

Treacherous Sands For Adelson -

It is rare to find a better example of ratios and bond covenants than in this piece from Forbes.

Treacherous Sands For Adelson -
"Las Vegas Sands said in a regulatory filing that it doesn't expect to comply with its maximum leverage ratio covenant in the fourth quarter. That would trigger defaults that might force it to suspend multibillion-dollar development projects in the U.S. and Asia and 'raise a substantial doubt about the company's ability to continue as a going concern,' it said.

The question that needs to be answered is how much of that capital Adelson himself is willing and able to provide. Adelson, whose personal wealth is largely tied to his stake in Sands, has taken a painful haircut as his company's stock price has dropped 93.0% over the past year. .....if it defaults on its loans, lenders would be able to exercise their rights under the agreements, including bringing financing maturity dates forward."
and later in the article another great teaching point that casino and travel spending is from disposable income and hence more volatile:
"...the casino business has been struggling as consumers continue to curb spending due to the U.S. housing downturn, diminishing credit, rising food costs and recession worries. Sagging U.S. consumer confidence and spending power has hurt business in Las Vegas, "

Thursday, November 06, 2008

Black Swans and recent returns

Yahoo video of Nissan Taleb (Black Swan)

Yahoo has a copy of the video from CNBC on Taleb's performance of late. It also has a discussion of his holdings and strategy. Short version: it is VERY good!

Remember his Black Swan book is recommended reading for all my classes! (here are some other videos of Taleb)

Wall Street’s Pay Is Expected to Plummet -

A follow-up on last month's bonus discussion.

Wall Street’s Pay Is Expected to Plummet -
"Bonuses, which soared to record heights in recent years, could drop by 20 to 35 percent across the industry, according to a private study to be released on Thursday. Bonuses for top executives could plunge by 70 percent.

But to some, those figures, from the consulting firm Johnson Associates, demand the question: Why should Wall Street executives get any bonuses at all?....
and later

“Given this economic situation, how do you justify any performance bonus at all, is my initial point,” Mr. Cuomo said.

Bankers and traders have been rewarded for taking risks that Wall Street clearly failed to manage. “When you incentivize that type of behavior, you shouldn’t be surprised when you find very risky, overly creative, short-term, highly leveraged products,” he said."

Naked Short Selling Is Said to Decline - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times

To quote Paul Harvey, "Not why nor how.... "

Naked Short Selling Is Said to Decline - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times:
"According to data from three exchanges — including publicly available figures from the Nasdaq stock market — the number of stocks on the naked short-selling watch lists has fallen dramatically. The Nasdaq, for example, has just 56 stocks on its list, down from about 500 in September....Naked short selling, long a controversial practice, is a variant on short selling, which is legal. That involves borrowing stocks and selling them, hoping to buy them back at a lower price and profiting from the shares prices’ decline. In naked shorting, however, the investor doesn’t borrow the shares first."
not sure if the SEC crackdown or the falling prices and increased volatility was the cause.

FWIW this is included because it came up in conversation in class yesterday.

At the Supermarket Checkout, Frugality Trumps Brand Loyalty -

While many of you outside of SBU know I run BonaResponds, not nearly as many know I help out with my family grocery stores as well. In class we have mentioned several times that one way sales will decline as a result of the recession (and hence worsening it as well) is that customers will switch from more expensive items to cheaper store brand products. This trend has been noticeable at our four stores and now the WSJ provides more evidence of the same thing.

At the Supermarket Checkout, Frugality Trumps Brand Loyalty -
"Sales of private-label detergent rose 12% over the 52-weeks ended Sept. 6, to $189 million, according to market-data company Information Resources Inc., or IRI. Lower-priced brand-names are posting gains, too. Last week, Procter & Gamble Co. reported that volume sales of its bargain-priced Gain detergent rose 10% in the quarter ended Sept. 30, offsetting weaker results for the market-leading and pricier Tide.

Meanwhile, estimated retail sales of value-oriented Purex fabric softener, owned by Henkel AG, rose more than 60% over the past six months, the company says. 'We view the economic slowdown as an opportunity for our brand,' says Greg Tipso"
At least at our stores, this seems to be partially a mental story as much as anything else. I have never done it, but it would be fascinating to examine store brand vs name brand sales on a daily basis and see if it is tied to economic news and/or stock market performance.

SSRN-Costly External Equity: Implications for Asset Pricing Anomalies by Dongmei Li, Erica Li, Lu Zhang

In a paper that will definitely be mentioned in my corporate finance classes, Li, Li, and Zhang look at whether capital structure impacts pricing anomalies. They find they do. This at least is consistent with the idea that financial flexibility is important in choosing capital structure

SSRN-Costly External Equity: Implications for Asset Pricing Anomalies by Dongmei Li, Erica Li, Lu Zhang: From the abstract :
"...document that the value, net stock issues, investment, and asset growth anomalies tend to be stronger in financially more constrained firms than in less constrained firms. This effect of financial constraints is distinct from that of financial distress on anomalies. Intuitively, costly external finance makes marginal costs of investment more sensitive to investment in more constrained firms, giving rise to a stronger negative correlation between investment and the discount rate."
Two fast look-ins:
"Using bond ratings to measure costly external finance, we find that in the unconstrained sub-
sample consisting of firms whose bonds are rated, the value-weighted average return, CAPM
alpha, and Fama-French (1993) alpha for the high-minus-low investment-to-assets quintile are
−0.33%,−0.41%, and −0.14% per month. These estimates are either close to or more than halved in magnitude from their counterparts in the constrained subsample consisting of firms whose bonds are not rated. The differences across the unconstrained and constrained subsamples are all more than 2.8 standard errors from zero."
and also :
"[This] work adds to the literature that explores asset pricing implications of financial constraints. Lamont, Polk, and Sa´a-Requejo (2001) show that more constrained firms earn lower average returns than less constrained firms. Campello and Chen (2005) find that the bonds of more constrained firms earn higher ex ante risk premiums, which also covary with macroeconomic fluctuations. Building on Almeida and Campello (2007), Hahn and Lee (2005) study the effect of debt capacity on stock returns across constrained and unconstrained samples. Whited and Wu (2006) construct an index of financial constraints via structural estimation and find that more constrained firms earn insignificantly higher average returns than less constrained firms."
The take-away? It again seems that capital structure matters and that access to capital markets is an important consideration in both returns and in understanding anomalies.

Cite: Li, Dongmei, Li, Erica X. N. and Zhang, Lu,Costly External Equity: Implications for Asset Pricing Anomalies(September 8, 2008). Ross School of Business Paper No. 1111
Available at SSRN:

Wednesday, November 05, 2008

Looking for stock information?

In the SIMM class students are constantly making presentations on firms that I often know little about. In addition to the normal Yahoo and Google finance pages, I have been using Tickerpedia. It is really useful and super easy to use. (and no this is not a paid commercial! lol)..

To Treat the Fed as Volcker Did - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times

The NY Times points to an interesting BreakingViews article on the fed. Short version: The Fed is trying to do too much and some of the things (example maximum employment and stable prices) are seemingly at odds. A possible solution? Simplify it and have the Fed worry only about stable prices.

From the Fed's own website:
"...the Federal Reserve's duties fall into four general areas:
  • conducting the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices, and moderate long-term interest rates
  • supervising and regulating banking institutions to ensure the safety and soundness of the nation's banking and financial system and to protect the credit rights of consumers
  • maintaining the stability of the financial system and containing systemic risk that may arise in financial markets
  • providing financial services to depository institutions, the U.S. government, and foreign official institutions, including playing a major role in operating the nation's payments system"
From the NY Times: To Treat the Fed as Volcker Did - Mergers, Acquisitions, Venture Capital, Hedge Funds -- DealBook - New York Times:
"The president-elect should change the Fed’s legal structure and mandate so that it will maintain monetary stability, even if a person of Mr. Volcker’s stature is not running it, Breakingviews says. The objective should be to force even the feeblest political appointee to keep broad monetary growth in line with the growth of the economy. That means raising interest rates as high as necessary to keep consumer and asset price inflation low, it says."

Tuesday, November 04, 2008

Lending rates fall to pre-Lehman levels - Nov. 4, 2008

While the financial markets are getting some traction and the worse may be behind us, there still are issues to deal with. For instance, in last two days we have seen that while rates in the markets are returning to more normal levels, Banks are making it more difficult to get loans. This is probably what we want, but does come with the problem of potentially slowing the economy.

From CNN: Lending rates fall to pre-Lehman levels - Nov. 4, 2008:
"Libor rates have been trending downward since mid-October, when the Fed took the unprecedented move to flood 13 central banks around the globe with unlimited amounts of dollars. Libor, the London Interbank Offered Rate, is a daily average of what 16 different banks charge other banks to lend dollars in the U.K.

Less than a month ago, 3-month Libor was at 4.82%, and the overnight rate was at an all-time high of 6.88%. Lower rates are a major boost for the strangled credit market because more than $350 trillion in assets are tied to Libor"

But simultaneously Bloomberg and the BBC reported that a new Fed survey finds tougher borrowing standards.

BBC NEWS | Business | US banks cut back their lending:
"US banks have tightened up even more on lending, despite the Wall Street rescue deal designed to encourage the renewal of normal lending practices.

A quarterly Federal Reserve survey in October found 70% of banks tightened standards on prime mortgages while 60% had done so with credit card debt.

Some 95% of banks had tightened their standards for providing credit to large and medium-sized businesses."
And from Bloomberg:

``It has never been harder for businesses and individuals to get a loan from the bank,'' said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. ``Banks are turning away borrowers left and right.''

Some 95 percent of U.S. banks raised the costs on credit lines to large firms, and ``nearly all banks'' increased the spread on borrowing rates over the cost of funds on loans to large and mid-sized firms versus July, the Fed said.

``Higher fractions of banks reported having reduced both the maximum size and the maximum maturity of loans or credit lines to large and middle-market and to smaller firms,'' the survey said."

moreover this may, at least in the short run, negatively impact the economy. Interestingly, and predictably, real estate lenders have kept rates high there even as shorter term rates (driven in part by Fed and Treasury intervention) have fallen.

``The supply of credit is coming under ever increasing tighter conditions,'' said Fisher. This ``exacerbates the downward slippage of the economy.''

The Fed has reduced its main rate 4.25 percentage points over the past 14 months to 1 percent. Still, the average rate on a 30-year mortgage stood at 6.46 percent last week, up from 6.26 percent a year ago, according to data from Freddie Mac."

While not wanting to play political prognosticator (even on election day), it would not be surprising to see this be the area of next government action (meddling?).