Friday, February 27, 2009

Can Talk of a Depression Lead to One? - News Analysis -

Robert Schiller is a busy person! In the NY Times, he addresses the idea that constantly dwelling on the bad, becomes a self -fulfilling prophecy.

Economic View - Can Talk of a Depression Lead to One? - News Analysis -
"The attention paid to the Depression story may seem a logical consequence of our economic situation. But the retelling, in fact, is a cause of the current situation — because the Great Depression serves as a model for our expectations...reducing consumers’ willingness to spend and businesses’ willingness to hire and expand. The Depression narrative could easily end up as a self-fulfilling prophecy.

The popular response to vivid accounts of past depressions is partly psychological, but it has a rational base. We have to look at past episodes because economic theory, lacking the physical constants of the hard sciences, has never offered a complete account of the mechanics of depressions.

The Great Depression does appear genuinely relevant. The bursting of twin bubbles in the stock and real estate markets, accompanied by huge failures of financial institutions and a drop in confidence, has no more recent example than that of the 1930s....To understand the story’s significance in driving our thinking, it is important to recognize that the Great Depression itself was partly driven by the retelling of earlier depression stories. In the 1930s, there was incessant talk about the depressions of the 1870s and 1890s; each of those downturns lasted for the better part of a decade."

Thursday, February 26, 2009

Dilbert on Gov't bailouts

Ok, technically it is Dogbert, but...

Short version, the top dog gets it all!

Thanks to Footnoted for this.

General Motors Lost $85 Million Every Day

For perspective from Clusterstock :
"Running General Motors is like lighting a $1000 bill on fire every passing second"
General Motors Lost $85 Million Every Day:
"GM's total loss for the fourth quarter of 2008 was $9 billion. It's hard to imagine any number that large, so we decided to break it down...Minute: $58,333 In short, with every passing minute GM loses slightly more money than the average American household makes in a year."

It really is hard to imagine.

Wednesday, February 25, 2009

Strategies - The Index Funds Win Again -

Strategies - The Index Funds Win Again -
"Kritzman... set up his study to accurately measure the long-term impact of all the expenses involved in investing in a mutual fund or hedge fund. Those include transaction costs, taxes and management and performance fees....Then he calculated the average return over a hypothetical 20-year period, net of all expenses, of three hypothetical investments: a stock index fund with an annualized return of 10 percent, an actively managed mutual fund with an annualized return of 13.5 percent and a hedge fund with an annualized return of 19 percent. The volatility of the three funds’ returns — along with their turnover rates, transaction fees and management and performance fees — was based on what he determined to be industry averages.

Mr. Kritzman found that, net of all expenses, including federal and state taxes for a New York State resident in the highest tax brackets, the winner was the index fund....Expenses were the culprit. For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.."

7 Courses Finance Students Should Take

We have a mid-term break next week at SBU. Then registration for the fall semester starts. Thus it makes sense to ask: What classes should a finance student take?
A current student (Brendan) forwarded me this. It is from Investopedia:

7 Courses Finance Students Should Take:
"Executives in search of well-rounded finance students look for certain skills, and studies have revealed that these executives want schools to place more emphasis on quantitative, strategic, critical decision-making and communicative skills - skills that are sometimes best developed in classes outside of business schools. If you want to get the best possible preparation for the finance world from your undergraduate education, put some thought into which classes to take that may fall outside the finance curriculum.... John Graham, a finance professor at Duke University's Fuqua School of Business and John O'Brien, finance professor at Berkley's Haas School of Business recommend the following areas of study:

  1. Mathematics....

  2. Accounting....

  3. Economics...."
The rest of their list is here.

So what classes do you suggest?

My official list: Economics, stats and econometrics, much math (be it calculus, Linear Algebra, or whatever, it will help), a public speaking class, a writing or composition class, accounting, and computers (be it programming (the ability to think like a programmer is arguably more important than the language you learn), and writing. Oh and finance courses ;) .

That said, you should also try to learn in every class and in every encounter. For instance, in history, in foreign language classes, and even when listening to the radio. You can pick up financial insight. Which may be my biggest suggestion: learning finance does not stop when you leave the classroom. You should learn MUCH more out of the classroom than in. So whatever class you do register for (be it a required class, an elective, or if you are not registering for any class) take a look at it through financial eyes. Finance is all encompassing so you will be able to use that knowledge both in your career and your life.

Business leader David Campbell speaking at SBU

One of the better things about teaching at a University is that you constantly get new ideas and meet great people. This week we had David Campbell on campus. Who is David Campbell? From my announcement:
"Mr Campbell has also served as a member of the Board of Directors of Tektronix, M&T Bank, MRO Software, Gibraltar Industries, and PowerSteering software, and Niagara University and SUNY-Buffalo, as well as civic positions including Chairman of Roswell Park Cancer Institute Council, the Buffalo United Way campaign, and the Erie County IDA and Chamber.

Recognitions include an honorary doctorate from Niagara University, citizen of the year from The Buffalo News, and inclusion as a Fellow in the first year awards of the Purpose Prize.

He gave two lectures this week. The first which was aimed at the campus-wide audience focused on HODR, the benefits of volunteering, and the challenges of running a volunteer organization in challenging economic times. (The first speech is available on the BonaResponds blog.)

The second lecture was tailored to business students (and faculty!). He talks about the current economic problems (he thinks unemployment will go above 10%), governance, auditing, regulation, globalization, and what students (and others) can do to "wait out" the recession.

Both are very good. Thank you very much David! We really appreciate your visit!

Tuesday, February 24, 2009

REFLECTIONS ON A CRISIS Daniel Kahneman & Nassim Taleb, Moderated by John Brockman

Fascinating. Take a look at the video.

Edge: REFLECTIONS ON A CRISIS Daniel Kahneman & Nassim Taleb, Moderated by John Brockman:
"View the complete 1-hour HD streaming video of the Edge event that took place at Hubert Burda Media's Digital Life Design Conference (DLD) in Munich on January 27th as the greatest living psychologist and the foremost scholar of extreme events discuss hindsight biases, the illusion of patterns, perception of risk, and denial.....

Two men sitting on the stage. Left. Daniel Kahneman, 74, bright-eyed, Nobel Prize winner. Right Nassim Taleb, 49, former Wall Street banker, best-selling author. Both speak on the future of Digital Life Design Conference (DLD) in Munich on the financial crisis, about the beginning--mainly they talk about people. They say it is due to human nature, that the crisis has broken out. And they choose harsh words in discussing the scale of the disaster."

Thanks to Mark for this one! He used it in class today. Thanks for sharing!

Financial Quote of the day

"...outwardly and according to its balance sheer, the [Knickerbocker] Trust Company was flourishing..."

Herbert Satterlee

From the Panic of 1907: Lessons Learned from the Market's Perfect Storm by Robert F. Bruner (yes from Darden) and Sean Carr (also from Virginia)

Interestingly, this was the "panic" that resulted in a Fed. From Wikipedia:

"The resulting Panic of 1907 exacerbated an ongoing decline in the stock market that saw the Dow Jones Industrial Average lose 48% of its value from January 1906 to November 1907. The banking crisis is also seen as the final straw that led Congress to form the Federal Reserve System in 1913"

Monday, February 23, 2009

Shiller: House Prices Still Way Too High

As people across the globe hope that real estate prices are done falling, Yale's Robert Shiller suggests we may not be real close to the bottom yet.

From Clusterstock and from Financial Sense:

"The median value of a U.S. home in 2000 was $119,600. It peaked at $221,900 in 2006. Historically, home prices have risen annually in line with CPI. If they had followed the long-term trend, they would have increased by 17% to $140,000. Instead, they skyrocketed by 86% due to Alan Greenspan’s irrational lowering of interest rates to 1%, the criminal pushing of loans by lowlife mortgage brokers, the greed and hubris of investment bankers and the foolishness and stupidity of home buyers. It is now 2009 and the median value should be $150,000 based on historical precedent. The median value at the end of 2008 was $180,100. Therefore, home prices are still 20% overvalued. Long-term averages are created by periods of overvaluation followed by periods of undervaluation. Prices need to fall 20% and could fall 30%....."

Shiller's Interesting video discussing real estate prices. For instance, prices still well above average and a look at rental prices (which never went up much to start with):

Shiller House Prices Still Way Too High: Tech Ticker, Yahoo! Finance:
"Yale professor Robert Shiller stopped by recently to discuss Obama's housing fix, I also asked him about the housing market in general.

Specifically, where are we in this historic price collapse? Finally nearing the bottom?

Not a chance, said professor Shiller--unless the government finds some way to miraculously levitate prices again.

Despite the 25 percent nationwide decline since the 2007 peak, U.S. house prices have still only fallen halfway to fair value. So whatever you think of Obama's plan, don't count on a quick housing-market turnaround."

Oh, and lest you think Schiller is just some idiot financeprofessor, remember he called the internet bubble and the Real Estate Bubbles long before the general market collapsed.

Sunday, February 22, 2009

After Losses, a Move to Reclaim Executive Paychecks -

This will almost assuredly not happen, but it would the kind of ex-post settlement that we keep mentioning in class.

After Losses, a Move to Reclaim Executive Paychecks -
", with a public backlash against excessive pay and taxpayer lifelines extended to crippled companies, the idea of recouping compensation, known as “clawback,” is gaining traction.

Currently there is no legal mechanism for forcing the regurgitation of past pay, so such efforts would need to be bolstered by new legislation. Clawbacks also promise to be a hot-button issue at shareholder meetings in coming months."

Saturday, February 21, 2009

Endowment Director Is on Harvard’s Hot Seat -

What goes up, sometimes goes down too!

Endowment Director Is on Harvard’s Hot Seat -
"....the endowment is on the verge of posting its biggest loss in 40 years. With much of its money tied up for the long term, it is scrambling to meet some obligations.

Harvard has frozen salaries for faculty and nonunion staff members, and offered early retirement to 1,600 employee.....

[Years ago] Lawrence H. Summers, then Harvard’s president, had raised the possibility of locking in interest rates that appeared to be at historic lows, a plan the university adopted....All went well at first. But in the second half of last year, interest rates plummeted, and Harvard turned to the endowment to meet hefty collateral calls, which could rise to $1 billion if rates remain weak....

The endowment was squeezed partly because it had invested more than its assets, a leveraging strategy that can magnify results, both good and bad. It also had invested heavily in private equity and related deals, which not only lock up existing cash but require investors to put up more capital over time. "
Now the overall portfolio loss (21%) really is not bad, so I am not sure what the hullabaloo is, but from a teaching perspective, seeing that cash needs must be accounted for and planned for is a valuable lesson (as is the effects of leverage).

SIMM is looking better and better!

Modified Internal Rate of Return

Spreadsheets at Work: Rating Your Own IRR - Technology -
"...might you be vulnerable to the weaknesses long pointed out — if too often ignored — by researchers who have warned that IRR calculations often contain built-in reinvestment assumptions that improperly improve the appearance of bad projects....the MIRR function permits both a finance and reinvestment rate to be associated with the stream of cash outflows and inflows in our investment evaluation example"
An article on MIRR (Modified Internal Rate of Return)!!??! Wow. Talk about your exciting articles. Yeah, ok, too much, but given anyone who is doing any capital budgeting (which is essentially everyone if you think about capital budgeting as nothing more than making decisions about what assets you want to have) should know the limitations of their tools (IRR in this case) and better technologies (MIRR in this case), it is a worthwhile read! Especially if you are in my classes since it now make MIRR and IRR instantly testable for any upcoming exam.

BTW it also has a really useful example that could be used in class.

A populist revolution?

A few weeks ago I commented to a friend that everyone seemingly was in a bad mood. We talked about it and figured it was in large part the result of a added stress from the poor economy. We speculated what would happen next and if people were already in a bad mood, how much worse might it get if this dragged on for years.

So now about two weeks later and already the stress is showing more and more. For instance, you probably saw what is being called the Rick Santelli's Tea Party. Here is the clip from CNBC:

Video -
"CNBC's Rick Santelli and the traders on the floor of the CME Group express outrage over the notion they may have to pay their neighbor's mortgage, particularly if they bought far more house than they could actually afford,"
And here is the same from YouTube.

That was interesting. I did not expect a populist revolution led by people NOT wanting a mortgage bailout.

Then tonight I was listening to the radio and a new song by John Rich came on. It is entitled shutting Detroit down. The basic theme is that Wall Street got itself into this mess, and Wall Street can get itself out of this mess.

What is next? Class warfare?

Incidentally, The White House taking this seriously enough that he has invited Santelli to DC to talk about things. Wow.

Friday, February 20, 2009

Will there be any "green" in a Green Economy?

Not sure if this has much finance content. More of an editorial. Sorry, but I dislike when a major variable is left out of the analysis of things.

From Clusterstock: Green Economy Not Yet Ready For Primetime... But It Will Be Soon:
"The WSJ throws around some scary subsidy numbers, saying the government pays too much for renewable energy, and its still not cheap. The Journal says that if we try to hit Obama's mandate for 25% of our energy from renewables we will kill manufacturing. The high price of alternative energy means factories will go under as they struggle to pay the outsized electricity bills....The flaw in this argument is the time frame: Obama only wants to raise our current level of alternative energy consumption from 1% to 10% over the next four years. And then hit the 25% mark by 2025....Also, as long as we keep investing in green technology, technology improvements should rapidly reduce the cost of green power. In the next two years, for example, solar power could reach grid parity"
Let me state up front that I am biased. Not because of any stock holdings. Not because I have forgotten all of my economics (at least I hope not!) But because as a runner/cyclist/outdoors aficionado/citizen worried about the future, I really hope "The Green Economy" takes does well. Why? For a reason that both the WSJ and Clusterstock seemingly ignore: the externalities of traditional energy sources.

Externalities are those costs that the user of the product do not bear. For instance, I can drive around all day in a car that pollutes the atmsophere and yet most of that cost of pollution falls on others. Externalities are notoriously difficult to measure so often we assume them away. But they are real and in any economically correct discussion must be included.

All energy comes with costs. And it is definitely true that "Green" sources have externalities as well (locally there is a major controversey about wind power right now). But I believe (and this is something that can not be proven since we each may have different probabilities on future events) that the expected present value of the externalities from "Green" energy appear to be lower than those of other sources of energy.

Of course this is just my opinion and your mileage may vary.

To compare differing power sources, we really want to be comparing apples to apples and this is not being done.

The question that needs to be answered convincingly is whether government subsidies (which are easily measurable) are greater than or less than the the externalities (largely not measurable) that accompany more traditional energy sources?

What are these "difficult to measure" externalities? To name a few: pollution (carbon and other), reliance on oil from politically sensitive areas, drilling in pristine wilderness areas, risk of spills, poor diversification of supplies (if I could steal from Taleb "over optimized") which leads to excessive volatility etc.). These externalities are generally not priced in oil (and hence oil is priced "artifically" low), so oil is used more than is strictly optimal in an economic sense.

But "what about nuclear?" some may say. "Look at France. They use much nuclear and have had very few problems" And at some point these nuclear activists have a point. But while the unpriced costs are different, they still exist. The easiest is to understand is the risk of a catastopic event (meltdown etc.). Oh sure the odds are low, but remember Black Swans do happen. And the true cost of that has to be borne in advance.

Why should it be borne in the present you ask? Doesn't this appear to be very similar to the idea of paying large bonuses for good earnings when looming off in the distance was a financial meltdown? Only if the costs are considered a priori will be make the correct decisions. Or in simpler terms, just because something has not happened, does not mean it won't. And if it can, we have to include that in our decisions today.

[Here the reader can flash back a few years to an imaginary conversation at a large investment bank: "Look at Bear Stearns. They take big risks and are heavily levered and they have had very few problems. The cost of debt is lower than the cost of equity. Why don't we do the same? "]

So what should be do? I do not know. I do not think anyone knows for sure, but I will argue long and hard that externalities (both current and future) are as much a cost as the billions of dollars of subsidies for green energy and should be factored into any analysis. Otherwise we are comparing apples and kiwi fruit.

Thursday, February 19, 2009

Wall Street Journal to Convene Financial Leaders for Its Future of Finance Initiative - MSNBC Wire Services -

Wall Street Journal to Convene Financial Leaders for Its Future of Finance Initiative - MSNBC Wire Services -
"The Wall Street Journal today announced it will host the 'Future of Finance Initiative,' a working session that brings together top leaders and thinkers in global finance to identify the basic principles on which a new financial system must be reconstructed. The Journal's financial editors and reporters will moderate the discussions, which will be held March 23-24 in Washington, D.C."

The Future of Finance Initiative will feature the following financial leaders:
(Long list including:
* Robert E. Rubin, former U.S. secretary of the Treasury, director
and former senior counselor, Citigroup Inc.
* Myron S. Scholes, Frank E. Buck professor of finance, emeritus,
Stanford Graduate School of Business
* Robert J. Shiller, Arthur M. Okun professor of economics, Yale

Finance Test Questions

Studying for a test? Want to test yourself on a finance? This hopefully will be a way to do that.

It is a wiki-page that will allow anyone to post questions and answers to share with others. This will allow professors to have more test questions for their tests and students the opportunity to study by quizzing themselves.

FinanceTestquestions » home:

And remember if you are one of my students and you submit questions that are accepted, you will get 2% added to your test score. (and hopefully you will also get the question correct ;) )

Please no copyrighted material.

Behavioral Personal Finance: Customers' Fixation On Minimum Payments

Anchoring is a term often discussed within the realm of Behavioral Finance. Like its closely related sibling heuristics (or using rules of thumb), Anchoring may lead us to expect that a stock price will go back to a previous high just because we remember it being there. It also can give high priced stocks the appearance of being better than low priced stock. Here is an interesting look at what I guess I would call Behavioral Personal Finance.

Customers' Fixation On Minimum Payments Drives Up Credit Card Bills:
"The research, by University of Warwick Psychology researcher Dr Neil Stewart, is to be published in Psychological Science, in a paper entitled “The Cost of Anchoring on Credit Card Minimum Payments”. It focuses on the psychological phenomenon of “anchoring” in which arbitrary and irrelevant numbers bias people's judgments. The research reveals that anchoring affects the way people repay their credit card bills. For those people who make only partial repayments of the outstanding balance (about 35% of card holders), the suggested minimum payment on the credit card statement acts as an anchor and lowers the actual repayments people choose to make."

BTW here are some more behavioral finance posts if you are interested. If you are interested in the field (and I have no idea how you would not be!), Wikipedia has a pretty good intro, but if you have just a bit more time both Jay Ritter and Behavourial (Martin Sewell) have excellent "primers" on the field. (HT to

Warren Buffett speech to MBA Students from a few years ago

In my financial case class (Fin 402) we will be doing a case study on Warren Buffett. In class I mentioned the video presentation of Buffett and Bill Gates when he was at the University of Nebraska. I went looking for it and I found this one. It is very good. It is a talk he gave at the University of Florida. Definitely recommend watching. It is long (over an hour) but well worth it. Have it on as you do something else.

He talks about integrity, why you have to like your job, the unimportance of money for happiness, his misgivings about Beta, barriers to entry, valuation, and much more. (He even has a final test question, mmm, wonder if I should use it!)

FRB: Speech--Bernanke, Federal Reserve Policies to Ease Credit and Their Implications for the Fed's Balance Sheet--February 18, 2009

What a great recap of the Fed's actions over the past year or so. Great read. It is Bernanke at his best.

FRB: Speech--Bernanke, Federal Reserve Policies to Ease Credit and Their Implications for the Fed's Balance Sheet--February 18, 2009:
"We live in extraordinarily challenging times for the global economy and for economic policymakers, not least for central banks such as the Federal Reserve. As you know, the recent economic statistics have been dismal, with many economies, including ours, having fallen into recession. And behind those statistics, we must never forget, are millions of people struggling with lost jobs, lost homes, and lost confidence in their economic future.....Traditionally the most conservative of institutions, central banks around the world have responded to this unprecedented crisis with force and innovation"

He goes on to explain what the Fed has done and why. For instance:
"Policy innovation has been necessary because conventional monetary policies, which focus on influencing short-term interest rates, have proven insufficient to overcome the effects of the financial crisis on credit conditions and the broader economy. To further ease financial conditions, beyond what can be attained by reducing short-term interest rates, the Federal Reserve has taken additional steps to improve the functioning of credit markets and to increase the supply of credit to households and businesses--a policy strategy that I have called "credit easing"

He also addressed a fear that "easy" money will lead to inflation.
"Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed's lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time. However, at some point, when credit markets and the economy have begun to recover, the Federal Reserve will have to moderate growth in the money supply and begin to raise the federal funds rate. To reduce policy accommodation, the Fed will have to unwind some of its credit-easing programs and allow its balance sheet to shrink."
This is an excellent read. Dare I say required for any Institutions or Money&Banking class?

BTW Does anyone have video or audio of this? (Thanks anonymous!)
The video (about 24 minutes) is here.

Wednesday, February 18, 2009

Quote of the day

From Ronald Reagan:
"You cannot legislate the poor into freedom by legislating the wealthy out of freedom. What one person receives without working for, another person must work for without receiving. The government cannot give to anybody anything that the government does not first take from somebody else. When half of the people get the idea that they do not have to work because the other half is going to take care of them, and when the other half gets the idea that it does no good to work because somebody else is going to get what they work for, that my dear friend, is about the end of any nation. You cannot multiply wealth by dividing it."
My department chair sent me this one. Good stuff! thanks Jeff!

Greenspan: Nationalize The Banks

I am not as high on nationalization as the article appears to be. Still think we need an "exit strategy" but ....

Greenspan: Nationalize The Banks:
"Alan Greenspan has jumped on the bandwagon.

(Okay, Greenspan doesn't have the power to implement this solution, but he used to).

Importantly, Greenspan also suggested that bondholders should take a hit--which they should. In typical Greenspan fashion, he didn't say this directly. He said we need to protect 'senior' bondholders. Which means we can go ahead and hose the junior ones."

Tuesday, February 17, 2009

Catching up Newsletter style

Several stories I want to point out, but will do all in one post

The mention of the NY Times podcast had some of you thinking about other finance podcasts. Here are two that were sent plus NPR's
John Mason writes at SeekingAlpha about the problems in the banking sector and concludes that regulators too deserve some of the blame:
"A liquidity crisis and a solvency crisis are not the same and should not be compared with one another. A liquidity crisis the Federal Reserve System can do something about. A solvency crisis is beyond the ability of the Fed to resolve. However, the Federal Reserve and other regulatory bodies, through their responsibility for the examination and oversight of the banking system, can help to prevent a liquidity crisis by doing a deep and thorough review of the books of financial institutions and hold these financial institutions to the standards of “good” banking practice. This effort is a first line defense against a failure of banks that could lead to a contagion amongst financial institutions"
ClusterStock reports on withdrawals from the Stanford Bank which is beginning to look eerily similar to a run on the bank after reports of fraud at the Antigua based bank.
"Depositors of Stanford Bank, the offshore bank, that may possibly be a Ponzi scheme, are pouring onto the Island of Antigua to claim their cash."
Remember the recent article from Pablo Fernandez on Equity Risk Premiums in text books? He now has another that looks at not the text books but is a survey of what financeprofessors actually use (I did fill out the survey with an answer of now use 6%, down from about 8%)
"The average Market Risk Premium (MRP) used in 2008 by professors in the USA (6.5%) was higher than the one of their colleagues in Europe (5.3%), in Canada (5.4%), in the UK (5.6%) and in Australia (5.9%). The dispersion of the MRP was high. 15% of the professors decreased their MRP in 2008 (1.5% on average) and 24% increased it (2% on average). 66% of the professors used a lower MRP in 2007 than in 2000 (22% used a higher one). The average MRP used in 2007 was 1.5% lower than the one used in 2000.
Only a week before we have a Bloomberg representative coming to class to teach a class on using the Bloomberg machine (last semester everyone in my Students in Money Management class earned their Bloomberg Certification in either Equities or Fixed Income), it seems that Bloomberg and other high end data providers are feeling the bite of the recession as well.

For now at least, Sirius seems to be financed sufficiently to avoid bankruptcy. From MarketWatch:

"Shares of Sirius XM Satellite Radio doubled Tuesday morning on news that John Malone's Liberty Media has agreed to invest a total of $530 million in the the beleaguered radio company, allowing it to avoid a Chapter 11 bankruptcy filing."

At, Frank Shostak reminds us of the problems associated with increasing the money supply too quickly:
"It is apparent that we've learned nothing from several millennia of monetary destruction. The persistent demonstration that capital, not paper, is the basis for prosperity has fallen on deaf ears. Daily, we face the sad spectacle of government officials, pundits, and even Nobel laureates telling us that printing money is the answer to an economic downturn"
And finally, the UnknownProfessor at FinancialRounds reminds me that while teaching at a small school has many benefits, pay is definitely not one of them. He lists the AACSB report of business school professor's pay. (FTR here even finance professors are under the average for the lowest of any filed at other accredited schools. )

Lessons From Japan in Stemming a Crisis -

Lessons From Japan in Stemming a Crisis -

A reminder from Japan: Don't coddle the banks, act swiftly, and force the banks to write off bad debts.
"I thought America had studied Japan’s failures,” said Hirofumi Gomi, a top official at Japan’s Financial Services Agency during the crisis. “Why is it making the same mistakes?”"
and later
"... Japan’s financial system did not start to recover until late 2002, six years after the crisis broke. That year, the government ...ordered a tough audit of the country’s top banks.

Called the Takenaka Plan...initally, banks lashed out at Mr. Takenaka....

But Mr. Takenaka stood firm. His rallying cry, he said in an interview on Wednesday, was, “Don’t cover up. Don’t distort principles. Follow the rules.”"

Monday, February 16, 2009

Legacy of a Crisis - A Generation Shy of Risk -

Your Money - Legacy of a Crisis - A Generation Shy of Risk -
"You did what you were supposed to do. College. Graduate school, maybe. Bought a home. Invested in mutual funds.

And now? You have student loan debt. Your degree has not shielded you from unemployment (or the fear of it). The house is worth 20 percent less than two years ago, and your retirement portfolio is down 40 percent from its peak."

As a result, will investors invest less in the stock market? Buy fewer (and smaller?) homes? Demand a larger risk premium? Take on less debt? Save more (and thus spend less)?

The answer to all of these seems to be yes. What that means over a longer term horizon is much less clear.

The NY Times's Ron Leiber gives us a look at changing risk aversion levels with a very well timed disclaimer:
"I’m not sure we can say for sure whether there has been some permanent change in attitudes toward risk. It’s easy to overestimate the extent to which the world — and our perception of it — has changed in the middle of a crisis. But this one has not lasted long. And its duration does not come close to matching the period in the 1930s that left a permanent imprint on so many people’s financial habits."

One other look-in on the risk of turning away from equities:
" The problem with their approach, according to Mr. Brosious, is that by investing conservatively they are probably guaranteeing themselves a smaller return and a more meager standard of living in retirement.
Oh course this can be changed by saving more, but that means spending less, which means slower recovery.

BTW sort of thrown into the article is a nice (short) recap of the book “Are You a Stock or a Bond?,”
“The idea is that we should focus on our human capital and invest in places where our human capital is not,” [the book's author] Mr. Milevsky said. “It’s not about risk tolerance or time horizon but about what you do for a living.”As a tenured professor, he invests entirely in equities. Other people with bondlike characteristics who are far from retirement could take similar risks, and withstand 2008-level losses, because their incomes are fairly stable. Those who have more stocklike careers, however, probably ought to invest a bit more conservatively, in both their retirement accounts and in their primary residences.

BTW #2: this article is also discussed as part of the NY Times Podcast (12 minutes) that also talks about what the stimulus plan may mean for individuals. However I can not link to it. It is on the left side of the article.

Quote of the day

On Presidents' Day I chose one who served as president shorter than any other. William Henry Harrison.

From Infoplease:

"The prudent capitalist will never adventure his capital . . . if there exists a state of uncertainty as to whether the Government will repeal tomorrow what it has enacted today."

I did not know he ran on a platform that included the re-establishment of a national bank!

The Case for Nationalizing the Entire Economy - TIME

As a Western New Yorker (where it is both hilly and winter about 10 months a year), I know all about slippery slopes. That is what always comes to mind when nationalization of banks is discussed. The following is from Time. I do not know where the author (Doug McIntyre is from), but it must be both mountainous and cold). That said, he absolutely nails the big problem with nationalization.

The Case for Nationalizing the Entire Economy - TIME:
"Bank ownership becomes more complex when a firm owned by the government does something materially different from what its competitors in the private sector do.... The relationship between a national U.S. bank and private banks both inside and outside the U.S. causes a series of inequities within the system. A government-controlled bank might offer mortgages at extremely low rates, rates so low that they clearly do not take into account the level of home loan defaults. From a policy standpoint, it may make "sense" to do that to help buttress the housing market. But, to some extent that moves the government's control of the credit system from nationalizing banking to nationalizing the home lending system. The government could decide to apply the same principles to consumer credit loans and business lending.

It may just be a better idea to nationalize the entire economy and be done with it."

These behavioral differences (and even worse incentives than the executives had) is why question #4 scared me so much last week.

Sunday, February 15, 2009

Crude oil is getting cheaper — so why isn't gas?

Basis risk is something that many do not understand at first. That should change with this example!

From Yahoo: Crude oil is getting cheaper — so why isn't gas?: "
"Right now, in an unusual market trend, West Texas crude is selling for much less than inferior grades of crude from other places around the world. A severe economic downturn has left U.S. storage facilities brimming with it, sending prices for the premium crude to five-year lows.

But it is the overseas crude that goes into most of the gas made in the United States. So prices at the pump will probably keep going up no matter what happens to the benchmark price of crude oil."

Suppose you were hedging gas prices using West Texas Crude futures. The fact that the two prices do not move in unison is what we call basis risk.

Friday, February 13, 2009

How current PE ratios stand up historically - MarketWatch

From MarketWatch:
How current PE ratios stand up historically - MarketWatch:
"Here's today's investment pop quiz: Where do price/earnings ratios stand today relative to several months ago, as well as to the beginning of this bear market in October 2007?.....

Based on earnings on an "as-reported" over the trailing 12-months, the p/e ratio for the S&P 500 index stood at around 20 at the stock market's top in October 2007....the comparable p/e ratio as of Thursday night, based on data from Standard & Poor's, is 29.1.

How can this be, you might ask? The answer is simple: Earnings in this bear market have fallen even faster than has the market itself. And no matter how fast the "p" in the ratio is falling, the ratio has to climb if the "e" is falling even faster.

Indeed, today's p/e ratio is higher than 97.8% of the monthly readings dating back to 1871, according to data compiled by Yale University Finance Professor Robert Shiller."

Which deserves a wow!

Thursday, February 12, 2009

Roubini: Nationalizing Banks Is the Best Way to Go: Tech Ticker, Yahoo! Finance

Roubini : Nationalizing Banks Is the Best Way to Go: Tech Ticker, Yahoo! Finance:
"...paradoxically nationalization may be a more market friendly solution of a banking crisis: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions provides a fair upside to the tax-payer. It can also resolve the problem of avoiding having the government manage the bad assets: if you selling back all of the assets and deposits of the bank to new private shareholders after a clean-up of the bank together with a partial government guarantee of the bad assets (as it was done in the resolution of the Indy Mac bank failure) you avoid having the government managing the bad assets.
Good point later as well:
"...also resolves the too-big-too-fail problem of banks that are systemically important and that thus need to be rescued by the government at a high cost to the taxpayer. This too-big-to-fail problem has now become an even-bigger-to-fail problem as the current approach has lead weak banks to take over even weaker banks."
This is largely consistent with what we discussed a few weeks ago in class.

Cows and the financial crisis

More cows
How random is it that I just happened to post some cow pictures to my flickr account this week? and then Clusterstock posts the following description (using cows) to explain the AIG collapse. LOL...

From Clusterstock:

"You have two cows.

John Paulson borrows one cow so he can sell it for $100. He gives you $10 as collateral.

You buy your neighbors cow for $100, which you finance by taking out a $90 loan from the bank and use John's $10 to make up the rest."
Read the rest of it here. Pretty funny!

Financial quote of the day

Today is Lincoln's Birthday:

"The government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the government and the buying power of consumers. By adoption of these principles, the taxpayers will be saved immense sums of interest. Money will cease to be master and become the servant of humanity."

As quoted at from

Is he calling for monetizing the debt? Might not want him as out next Fed Chair.

How the Crash Will Reshape America - The Atlantic (March 2009)

The current recession will have lasting impacts. That much is certain. No one knows for sure what that impact will be. We have seen what happens when all scenarios are not considered (remember "Real Estate prices can only go up"?), so the following by Richard Florida from the Atlantic is worth considering.

How the Crash Will Reshape America - The Atlantic (March 2009):

A bunch of look-ins, not in the same order as the article, but retaining the same message:

History teaches us:
"..most big economic shocks ultimately leave the economic landscape transformed..."

"Big international economic crises—the crash of 1873, the Great Depression—have a way of upending the geopolitical order, and hastening the fall of old powers and the rise of new ones."
Ouch, that hurts...
"“One thing seems probable to me,” said Peer Steinbr├╝ck, the German finance minister, in September 2008....“the United States will lose its status as the superpower of the global financial system.” You don’t have to strain too hard to see the financial crisis as the death knell for a debt-ridden, overconsuming, and underproducing American empire—"
NY City will be hurt, but it could be worse...
"All in all, most places in Asia and the Middle East are still not as inviting to foreign professionals as New York or London. Tokyo is a wonderful city, but Japan remains among the least open of the advanced economies, and admits fewer immigrants than any other member of the Organization for Economic Cooperation and Development, a group of 30 market-oriented democracies. Singapore remains for the time being a top-down, socially engineered society. Dubai placed 44th in a recent ranking of global financial centers, near Edinburgh, Bangkok, Lisbon, and Prague. New York’s openness to talent and its critical mass of it—in and outside of finance and banking—will ensure that it remains a global financial center....
The crash's impact on the financial sector:
"Thomas Philippon, a finance professor at New York University, reckons that nationally, the share of GDP coming from finance will probably be reduced from its recent peak of 8.3 percent to perhaps 7 percent..."
And domestically:
"It is possible that the United States will enter a period of accelerating relative decline in the coming years, though that’s hardly a foregone conclusion—a subject I’ll return to later. What’s more certain is that the recession, particularly if it turns out to be as long and deep as many now fear, will accelerate the rise and fall of specific places within the U.S.—and reverse the fortunes of other cities and regions."
How much of this will come true? Will any of this come true? Only time will tell.

Wednesday, February 11, 2009

Financial Quote of the day

"Let Wall Street get a nightmare, and the whole country has to help get them to bed again"
Will Rogers (1879-1935) as quoted in Dean LeBaron's Book of Investment Quotations .

Sirius XM shares drop on reports of possible bankruptcy - MarketWatch

Real world example for yesterday's class...(ok so I was a few hours late ;) )

Sirius XM shares drop on reports of possible bankruptcy - MarketWatch:
"Shares of Sirius XM Satellite Radio Inc. dropped 31% in morning trading Wednesday on reports that the company could be close to filing for bankruptcy protection.
The shares were down 3 cents at 8 cents. The stock traded in the $4 range two years ago.
Sirius XM is working with bankruptcy lawyer Mark Thompson of Simpson, Thatcher & Bartlett, and Joseph Bondi, a restructuring expert, to set up a Chapter 11 filing that could come in the next few days
Bankruptcy costs (both the direct costs : lawyer fees etc. and the indirect (messed up incentives, loss of reputation, etc) are a subset of the larger financial distress costs. Which amazingly enough is exactly what we talked about in Finance 402 yesterday.

More videos

YouTube - bionicturtledotcom's Channel

Sometimes I am torn as to where to put material; should I post it to the main FinanceProfessorblog or to my FinanceClass blog (which is really just aimed at my own students). I had originally intended to use these only for the latter, but a recent comment about using videos being fun cued me to make it available to everyone. So if you are in my class I apologize for the cross posting.

From FinanceClass Blog:
"...people learn in different ways and maybe this is your way. Additionally some of them (especially the material from Bionic Turtle is flat out excellent) are very good.

Enjoy and have fun with them!

YouTube - savingandinvesting's Channel

And a little more technical lessons from Bionic Turtle.

The stuff from BionicTurtle is HIGHLY recommended. I just spent probably an hour just watching them myself. And while some or the "art" of finance is missing in that you still need to see the big picture etc (whole idea of not just using a model blindly), the material is really good!!

UCLA Anderson School of Management | Knowledge Assets | UCLA Anderson Faculty Highlights

WOW! Occasionally I am still blown away by how many amazingly good resources are available online. This is a great case in point. UCLA's Andersen School of Management has made many of their faculty available to us.

UCLA Anderson School of Management | Knowledge Assets | UCLA Anderson Faculty Highlights

I really don't know where to start, but here goes. I just watched these and a few others. All good. All Recommended. I am picking these since they fit my class the best, but by all means watch them all!

William Ouchi on Corporate Governance in the US.

Sanford Jacoby and Emily Nason on governance in Japan and the US.

John Hughes on information asymmetries and how to impact the cost of capital it must impact on systematic risk (which is based on his paper with Liu and Liu that is available here). Richard Roll on Real Estate prices and interest rates.

Tuesday, February 10, 2009

Wisdom of Crowds Videos

We are doing market efficiency in class and these are a great way to get exposed to some of the ideas we will be discussing.

From PBS:

An interview with James Suroweicki:

Ten questions the House Financial Services Committee could use from the NY Times

GREAT stuff here....Andrew Sorkin provides 10 questions that those receiving bail out money should answer. The questions are great, but even more than that, he sets the stage well with his lead in. Indeed, some of them might make the basis for some good essay test questions ;)

DealBook Column - Up Next for Big-Shot Bankers - A Public Flogging - "
"On Wednesday, eight chief executives of big banks will make their way to appear at a Congressional hearing in front of ...the House Financial Services Committee. Here are 10 questions members of the committee might consider asking":
From question number 5:
"Much has been made of the subprime debacle. But few seem to be willing to talk about another looming crisis: credit card debt. People like Nouriel Roubini, the professor who has predicted much of this crisis, have estimated that you could have losses of as much as $3.6 trillion, which would bankrupt the industry. What do you make of that number? And since credit card defaults are correlated to employment, what happens if unemployment goes as high as 10 percent or more? What is the highest unemployment level that you’ve used in your forecasting models? And do you have adequate reserves for your worst-case situation? If your assumptions are wrong, what happens?"
From question number 7 which seems to call for the same type of partnerships that my colleague Mark Wilson has been saying are needed:
"Your compensation structure has been “heads I win, tails I win” for you and many of your employees, despite putting your firm and the nation’s fiscal health in jeopardy. What’s the right model? And how do you feel about forcing your employees to risk their own money, not just the firm’s, when they make a trade or participate in a transaction that puts shareholder capital at risk?"
I also really like questions 1,2,8 but find question number 4 is horribly scary and why I fear government bailouts/equity stakes etc.

What is finance for? - Columns -

Sort of in light of the Adam Smith quote, the following article looks at the main roles of finance. It is generally something that we forget or take for granted (often rushed through on the first few days of an introductory finance class) but it serves us all well (myself included) to stop now and then and remember what finance is here for.

From Nirvikar Singh is a professor of economics at the University of California, Santa Cruz:

What is finance for? - Columns -
"Discussions on how to improve regulation of the financial sector often are limited by starting from current institutions, and thinking of adjustments to these institutions. Boundaries between institutional categories, determined by historical legacies, are often taken as given. A more productive approach to considering regulatory reform could be to first answer the question, “What are the economic roles of financial institutions?” (invariably some form of intermediaries)

What roles do financial intermediaries play? Here are seven examples."

• Economizing on the costs of completing and implementing transactions.
• Matching buyers and sellers.
• Economizing on search costs.
• Providing expertise.
• Smoothing the market.
• Providing reputation.
• Transforming products.
Singh expounds on each of the seven showing what are the strengths (bringing buyers and sellers together) and weaknesses (many assets to not trade, experts are blinded by pay etc), and discusses how regulatory changes should take these facts into account.

Good stuff! Well worth a read.

Financial Quote of the day

From Adam Smith whose most famous work, The Wealth of Nations, was published in 1776, but still resonates today.

Adam Smith Quotes:
"It is not by augmenting the capital of the country, but by rendering a greater part of that capital active and productive than would otherwise be so, that the most judicious operations of banking can increase the industry of the country"
Quoted is from

Which in the language of class says that Financial Intermediaries exist to lower transaction costs.

Becker and Murphy Say the Short-Term Benefit of the Stimulus Package Will Be Less Than Expected -

The Wall Street Journal has an interesting look at what the impact of the stimulus package might actually be.

Becker and Murphy Say the Short-Term Benefit of the Stimulus Package Will Be Less Than Expected -
"...our conclusion is that the net stimulus to short-term GDP will not be zero, and will be positive, but the stimulus is likely to be modest in magnitude. Some economists have assumed that every $1 billion spent by the government through the stimulus package would raise short-term GDP by $1.5 billion. Or, in economics jargon, that the multiplier is 1.5.

That seems too optimistic given the nature of the spending programs being proposed. We believe a multiplier well below one seems much more likely"
They list five other points as well including:
"The increased government spending in the stimulus package is supposed to be only temporary, until the economy returns to a full employment level, but probably won't be.

The evidence of past expansions of government programs is just the opposite. Once created they tend to survive and grow over time, even when the increases initially were said to be temporary. The underlying reason for this is that interest groups develop around new and expanded programs, and they lobby to keep and expand those programs."

Which is not to say the current stimulus plan should or should not be passed, but merely that the benefits may be less than hoped.

BTW As Becker is a Nobel Prize winner in economics. So his words carry some additional weight.

Monday, February 09, 2009

Muslim investors profit by adhering to faith

This past week in my Problems in Finance class we did a fast review of international finance (I miss teaching that class BTW). In it we did not get to speak about many of the differences based on religion, so I was pretty excited to see this article from the San Francisco Chronicle that will provide me an excuse to mention that strict adherence to the Quaran does not allow lending and borrowing.

Muslim investors profit by adhering to faith:
"Their renunciation of the interest-based economy kept them away from investments in financial services companies, whose stocks have collapsed, and out of traditional mortgages.....Dow Jones Islamic Market Indexes, which represent benchmarks for Islamically correct investment categories, have been outperforming their non-Islamically compliant counterparts by 3 to 4 percent in key indexes.
Of course one year does not mean that much, but it does show that at least last year forgoing debt, for whatever reason, was a good thing!

BTW If you are interested in this, here is a page of notes on Islamic Finance that I used back when I did teach International Finance. I have not touched it in a long time.

Cramer's Star Outshines His Stock Picks -

I get more questions every year from students is on Jim Cramer than any other topic (well except "will this be on the test"). Most such questions come in two main flavors: "what do you think of Cramer" or "did you see Cramer talking about ....".

My stock answer is that while I think he is a really smart and hard working person, I have my reservations that anyone can consistently outperform the market and further most of the evidence suggests he can not.

My points were strengthened by Barrons this week:

Cramer's Star Outshines His Stock Picks -
"The guy is a hardworking genius with a word of advice for everyone...many words of advice, actually. He dispenses thousands of Buy/Sell recommendations a year.....From May to December of last year....Cramer's Sells "made money" by outperforming the market on the downside by as much as five percentage points (depending on the holding period and benchmark). His Buys, however, lost up to 10 percentage points more than the market."
But the article went on to discuss much more. For example Cramer's "prepared buys and sell recommendations" did (SLIGHTLY) better than the lightning round picks. Which might be because of more rigorous analysis but the differences (especially on buys) makes any theory speculative.

Further, recent price movements appear to be a factor in what stocks get discussed and their recommendations. While I am usually not a fan of charts, this one may show why he does not do very well; his buy recommendations are usually for stocks that have gone recently (while his sells are for those that have gone down).

All in all a good article and definitely worth reading.

Two past FinanceProfessor blog articles on Cramer that are of interest:

1. A Barron's article showing his stock picking was not not much better back in 2007.
2. A tirade (which turned out quite prophetic) from 2007 saying that rising rates and falling real estate markets were going to cause a major problem with liquidity.

Unrelated to Cramer but one tidbit in the article that I am looking forward to using in class: Seems like an easy way to do event studies that could be used in several classes. Stay tuned on that!

Quote of the day

I did not do any of the weekend so we can get two today:
"I contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle." -Winston Churchill
As quoted by Five Million Dots.

"It is common sense to take a method and try it.
If it fails, admit it frankly and try another.
But above all, try something.--FDR"
As quoted at Famous Quotes

Sunday, February 08, 2009

An imperfect hedge: the case of Metallgesellschaft

If you have had me for MBA 610 you know in the "what can go wrong" with derivatives part of the class we usually discuss Metallgesellschaft. It is a classic case of when an imperfect hedge can really hurt you. I just stumbled upon this six minute explanation of what caused their problems that is very good.

Friday, February 06, 2009

SSRN-Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis by Ran Duchin, Oguzhan Ozbas, Berk Sensoy

Durchin, Ozbas, and Sensoy look at Corporate Investment after the Subprime Mortgage Crisis and find much proof that the liquidity crisis is reducing capital spending.

SSRN-Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis by Ran Duchin, Oguzhan Ozbas, Berk Sensoy:
"We study corporate investment in the wake of the sub prime mortgage credit crisis that began in summer 2007. The crisis represents an unexplored negative shock to the supply of credit for non-financial firms. We find that corporate investment declines significantly following the onset of the crisis. The decline is greatest for firms that have low cash reserves (or high net debt) or are financially constrained, i.e. more likely to face difficulties raising external capital. These results are robust to controls for industry- and firm-specific investment opportunities. We also find that 'excess' cash, as defined by previous work, is positively related to post-crisis investment, suggesting an important precautionary savings role for seemingly excess cash that has not been emphasized in the literature. Overall, our results suggest that an important channel for the effects of the sub prime crisis on the real economy is a tightened supply of credit for non-financial firms."

Thursday, February 05, 2009

SSRN-The Equity Premium in 100 Textbooks by Pablo Fernandez

So which is it? In class this week we have been discussing CAPM and the question has some up a few times as to what is the market risk premium. I guess we are not the only ones who have some uncertainty on this issue. Pablo Fernandez shares with us his working paper on the issue.

SSRN-The Equity Premium in 100 Textbooks by Pablo Fernandez: "[I review] 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and find that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages.

Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premium and Implied equity premium."

A look in:

"... The average is 6.6%. Figure 1 is in line with an update of Welch (2000), who reports
that in December 2007, 90% of the professors used in their classrooms equity premiums between 4% and 8.5%, and with Fernandez (2008) who reports that in June 2008 finance professors in Spain used equity premiums between 3.5% and 10% (average 5.5%).

Figure 1 of the paper is very interesting:

After this he goes on to show what each author has used for the Risk Premium in different editions of the book.

So if you are not sure which premium you should use, I guess you are not alone. What do I use in class? Usually 6% but this follows a discussion of why risk premiums may change (transaction costs, increased/decreased risk aversion, more/less volatile economy).

Interesting work. Must have taken a while to go through 100 text books.

Financial Quote of the day

This one, which was right on, is by Susan Schmidt Bies (Fed Governor) speaking at a risk Management Conference in December of 2004. Seemingly many financial institutions did not get the message.

FRB: Speech, Olson—Qualitative aspects of risk management—December 7, 2004:
"Although the importance of the quantitative aspects of risk measurement may be quite apparent...the importance of the qualitative aspects may be less so. In practice, though, these qualitative aspects are no less important to the successful operation of a business.... Some qualitative factors--such as experience and judgment--affect what one does with model results. It is important that we not let models make the decisions, that we keep in mind that they are just tools, because in many cases it is management experience--aided by models to be sure--that helps to limit losses."

Wednesday, February 04, 2009

More evidence that correlations increase in bad times

In the typical "wow what great timing" yesterday as we were talking about correlations and diversification in class, SeekingAlpha ran the following article:

Opportunities in a High Correlation World -- Seeking Alpha:
"One of the most striking features of 2008 was the fact that correlations between most asset classes went up substantially: everything declined at the same time. One of the principal motivations behind diversifying is that all of your holdings will not decline at the same time. Declines in one class will be buffered by gains in another—or at least lesser losses in others. This effect has not provided much buffer in 2008."
The article provides some very interesting correlation matrices (uh, that sentence may never have been written before!) showing how correlations went way up as market prices went way down.

This is not the first time that has happened. In fact, it seems to be the norm. Butler and Joaquin (2001) showed the same thing. From their paper Are the Gains from International Portfolio Diversification Exaggerated? The Influence of Downside Risk in Bear Markets:
"The fundamental rationale for international portfolio diversification is that it expands the opportunities for gains from portfolio diversification beyond those that are available through domestic securities. However, if international stock market correlations are higher than normal in bear markets, then international diversification will fail to yie ld the promised gains just when they are needed most...."
This does not mean to not diversify, but rather to realize that diversification may not be enough and that in bad times, you have to expect all assets to more together more. This can help explain why puts (that move in opposite directions) and cash are in such demand during bear markets.

New feature: Financial Quote of the Day

I am sure I won't do one every day, but seems like something fun to do for a while, so here goes:
"It is wonderful how preposterously the affairs of the world are managed. We assemble parliaments and councils to have the benefit of collected wisdom, but we necessarily have, at the same time, the inconvenience of their collected passions, prejudices, and private interests: for regulating commerce as assembly of great men is the greatest fool on earth."
* Benjamin Franklin as quoted in Dean LeBaron's Book of Investment Quotations, page 119.

U.S. Plans to Curb Executive Pay for Bailout Recipients -

U.S. Plans to Curb Executive Pay for Bailout Recipients -
"The Obama administration is expected to impose a cap of $500,000 for top executives at companies that receive large amounts of bailout money, according to people familiar with the plan.

Executives would also be prohibited from receiving any bonuses above their base pay, except for normal stock dividends. "

Well, this will definitely make Federal Bailout money less desirous.

Tuesday, February 03, 2009

The WSJ gives us another history lesson

I love history. I love seeing the similarities across the ages and then seeing them (Need a "for instance"? I am currently ristening to American Creations right now on the US constitutional convention of 1787. In it James Madison (who was 5 ft 4 and seemingly taller than his statue at JMU) argued that the way to solve problems with sectional thought in voting which would lead to excessive political swings was to make the republic larger. This is much the same argument many (including myself) have used to say that more hedge funds (not fewer) may (if there is sufficient diversity of opinions and strategies) reduce market volatility.)

Which is a very long-winded way of saying, the WSJ seems to be doing the same thing this week. After looking at what prolonged the Great Depression they turn their attention to looking back at past financial crises to see what we can learn:

Opinion: Expect a Prolonged Slump - by Carmen Reinhart and Kenneth Rogoff:
"...when one compares the U.S. crisis to serious financial crises in developed countries (e.g., Spain 1977, Norway 1987, Finland 1991, Sweden 1991, and Japan 1992), or even to banking crises in major emerging-market economies, the parallels are nothing short of stunning...

...Financial crises, even very deep ones, do not last forever....negative growth episodes typically subside in just under two years. If one accepts the NBER's judgment that the recession began in December 2007, then the U.S. economy should stop contracting toward the end of 2009. Of course, if one dates the start of the real recession from September 2008....

In the typical severe financial crisis, the real (inflation-adjusted) price of housing tends to decline 36%, with the duration of peak to trough lasting five to six years. Given that U.S. housing prices peaked at the end of 2005, this means that the bottom won't come before the end of 2010, with real housing prices falling perhaps another 8%-10% from current levels....

Perhaps the most stunning message from crisis history is the simply staggering rise in government debt most countries experience. Central government debt tends to rise over 85% in real terms during the first three years after a banking crisis. This would mean another $8 trillion or $9 trillion in the case of the U.S.

Interestingly, the main reason why debt explodes is not the much ballyhooed cost of bailing out the financial system, painful as that may be. Instead, the real culprit is the inevitable collapse of tax revenues that comes as countries sink into deep and prolonged recession. Aggressive countercyclical fiscal policies also play a role..."

They go on to briefly discuss differences this time around, but (to me at least) the similarities dominate.

NOTE: Past history rarely repeats itself exactly, but there are enough similarities to learn a great deal from it.

Sweden’s Fix for Banks - Nationalize Them -

In class last Thursday the idea of temporarily nationalizing banks came up. I promised to show how it could work using Sweden's experience from the 1990s. Then I proceeded to forget to post it. So in a better-late- than-never moment, here is an article from the NY Times.

Sweden’s Fix for Banks - Nationalize Them -
"With Sweden’s banks effectively bankrupt in the early 1990s, a center-right government pulled off a rapid recovery that led to taxpayers making money in the long run.

Former government officials in Sweden, many of whom come from the market-oriented end of the political spectrum, say the only way to solve the crisis in the United States is for the government to be prepared to temporarily take full ownership of the banks.

Sweden placed its banks with troubled assets into a so-called bad bank, where they could be held and then sold over time when market and economic conditions improved. In the meantime, it used taxpayer money to provide enough capital to allow banks to resume normal lending."
As discussed last week, a key to this is making it temporary AND making sure there is a real downside (loss of jobs, no bonus, or loss of equity) for those who are taking the risks.

Monday, February 02, 2009

What caused the Depression? Opinion: Policies Prolonged Depression -

Here is hoping that we learned our lesson since the 1930s.

The WSJ ran a good op/ed piece by Harold L. Cole and Lee Ohanian describing how government policies helped create the Great Depression. As we ponder what the role of government should be in helping the economy to recover from the current recession, politicans could do much worse than to read this!

Opinion: Policies Prolonged Depression -
"Why wasn't the Depression followed by a vigorous recovery...? It should have been. The economic fundamentals that drive all expansions were very favorable during the New Deal. Productivity grew very rapidly after 1933, the price level was stable, real interest rates were low, and liquidity was plentiful. We have calculated on the basis of just productivity growth that employment and investment should have been back to normal levels by 1936....

So what stopped a blockbuster recovery from ever starting? The New Deal. Some New Deal policies certainly benefited the economy by establishing a basic social safety net through Social Security and unemployment benefits, and by stabilizing the financial system through deposit insurance and the Securities Exchange Commission. But others violated the most basic economic principles ... choked off powerful recovery forces.....The most damaging policies were those at the heart of the recovery plan, including The National Industrial Recovery Act (NIRA)....covered over 500 industries.... created a code of "fair competition" which spelled out what producers could and could not do, and which were designed to eliminate "excessive competition" that FDR believed to be the source of the Depression.

These codes distorted the economy by artificially raising wages and prices, restricting output, and reducing productive capacity by placing quotas on industry investment in new plants and equipment....Our research indicates that New Deal labor and industrial policies prolonged the Depression by seven years."

And it should be noted that this was not a knee jerk reaction to the current recession; Cole and Ohanian published their famous work which is the basis for for the current WSJ piece in the Journal of Political Economy in 2004.

Not coincidentally I am finishing up The Forgotten Man by Amity Shlaes who largely comes to the same conclusion and paints a picture of FDR as a really bad economist to say the least.

The Future of Securities Regulation by Luigi Zingales

Luigi Zingales has been in the news a bunch lately. He has testified to Congress, been on NPR, in Forbes, in The Economist, and the Wall Street Journal to name just a few (and these have all been since September!!!)

Which is to say when Luigi Zingales speaks (or writes) on the Future of Securities Regulation it makes sense to take note.

(On the paper that follows he only allows two paragraphs quotes so the review will be short, but by all means read the whole thing.)

SSRN-The Future of Securities Regulation by Luigi Zingales:
"....I propose a series of reforms that center around corporate governance, while shifting the focus from the protection of unsophisticated investors in the purchasing of new securities issues to the investment in mutual funds, pension funds, and other forms of asset management....three main areas of intervention.
  1. First, a reform of corporate governance aimed at empowering institutional investors to nominate their own directors to the board....a new Glass-Steagall Act, which...will separate mutual fund management from investment and commercial banking...
  2. The second goal should be the protection of unsophisticated individuals with regard to their investments. The minimum this protection entails is enhanced disclosure....
  3. The third goal should be that of reducing the regulatory gap between public markets and private markets. The recent trend of migration...suggests that this differential is excessive. This migration should be stopped not only by deregulating the public market, but also by introducing some disclosure standards in the private one."
(note the numbers (1,2,3) were added to help the reader and are not in the actual paper).

Good stuff! I highly recommended reading it all!

An I^3 Paper!(Interesting, Important, and Informative)

BTW: even if you are not interested in regulation, the figures at the back of the paper are excellent and could/should be included in many classes from Investments to Macroeconomics, Money and Banking, Financial Institutions, and even Corporate Finance.

Cite: Zingales, Luigi ,The Future of Securities Regulation(January 29, 2009). Chicago Booth School of Business Research Paper No. 08-27; FEEM Working Paper No. 7.2009. Available at SSRN:

The Copyright I guess is to Zingales himself, but I could not find it on the paper but he asked the copyright be mentioned. I would say it is his, but I will check and edit this when I know.

Sunday, February 01, 2009

SSRN-The January Effect - A New Piece for an Old Puzzle by Jason Fink, Kristin Fink, Jonathan Godbey

You probably have all heard of the January effect. It is the historical fact that stocks have done better in January than in other months. That much all researchers agree on.

Why? That is a very good question. Some seems to be taxes, some size, but now Fink, Fink, and Godbey find that the age of the firm also matters. Specifically young firms out perform old firms in January even after controlling for size and other factors.

SSRN-The January Effect - A New Piece for an Old Puzzle by Jason Fink, Kristin Fink, Jonathan Godbey:
"For decades the finance profession has noticed the tendency of equity prices, most noticeably for small stocks, to rise in value in the month of January. The small stock January effect appears to have been significant over the last thirty five years. However, we demonstrate that even after controlling for both the size of the firm and systematic factors, young firms experience significant and abnormally positive January returns. This age effect has several possible sources, including firm level information uncertainty in January or increased investor demand related to young firms."
Now I can say this about the paper since the authors are friends of mine and if you can't pick on friends who can you pick on? Uh, Good timing.

How so? Well the paper came out in October. I waited with the intent of using in in January as soon as the market turned up. So what happens? I will let CNN tell you:

" It was the worst January ever for the Dow industrials and S&P 500, according to Stock Trader's Almanac data.

The Dow lost 8.8% and the S&P 500 lost 8.6% in the month.

The Nasdaq's loss of 6.4% was eclipsed by last January's loss of 9.9%. That 2008 loss was the worst in the tech average's history, going back to its inception in 1971."

Oh well. Maybe next year. OR (and this is stated entirely without proof since as far as I know there is not a "new firm" index), given the average age of firms in the NASDAQ is less than that of the DOW and S&P 500, maybe it supports the paper even more.