Tuesday, March 31, 2009

SSRN-Do Japanese CEOS Matter? by Sanghoon Ahn, Utpal Bhattacharya, Taehun Jung, Giseok Nam

eWhen comparing CEO pay across countries it is always important to realize what the CEO is bringing to the table. For instance, it has long been speculated that Japanese CEOs (Shachos) do not add as much value due to the decision making process where more consensus building is done than in the US.

Now Sanghoon Ahn, Utpal Bhattachrya, Taehun Jung, and Giseok Nam look at the long term impact of new CEOs on Japanese firms. The finding? CEOs in Japan do not matter that much.

SSRN-Do Japanese CEOS Matter? by Sanghoon Ahn, Utpal Bhattacharya, Taehun Jung, Giseok Nam:
"There seems to be no long-run positive change in performance or policies after a shacho change, even when the shacho change is non-routine. Finally, in trying to explain firm performance or policies, we attempt to separate a firm-fixed effect from a shacho-fixed effect, and are unable to disentangle a shacho-fixed effect. We are thus left to conclude that shachos do not positively matter in the Japanese corporation in this decade of a stagnant economy."

News Analysis - For U.S. and Carmakers, a Path Strewn With Pitfalls - NYTimes.com

First off, I realize there are no easy answers here. None. People will lose jobs. People will lose their investments. But that said, it REALLY scares me when governments (any government) interferes with the running of a company (any company).

News Analysis - For U.S. and Carmakers, a Path Strewn With Pitfalls - NYTimes.com:
"He [Obama] made it clear that the White House would oversee, and heavily influence, decisions about what plants to shutter, what brands of cars to abandon and how much workers and managers will be paid.

And with no edge to his voice, he left hanging the threat that he might yet force G.M. into a quick, managed bankruptcy, if it was the fastest way to remake the company. That message was directed at G.M.’s reluctant bondholders, an unsubtle warning that they must negotiate to get 16 or 20 cents on the dollar — or risk getting far less.

Mr. Obama did not nationalize the company, at least in any technical sense."
I guess GM had is coming when they asked for government money. Money rarely comes without strings attached. But this does set a very scary precedent (yeah I know, steel makers in the 1950s). Dictating how a firm is run, who runs it, and how they are paid. Let's hope this does not catch on.

And yes, I know some so called experts are claiming this is good (and indeed it is better than what France did with Peugeot where as a condition of government money job cuts were outlawed). But the GM example is so bad that it could have lasting a deleterious effects on the economy for decades to come. (Take an extreme case, suppose you are a food processor that is federally inspected. Does this Federal inspection count enough that they could dictate business dealings, pay, who runs the firm?)

NOTE: This is not saying the government moves are right or wrong. Replacing the CEO may well be needed, but it should be the Board of Directors decision. The only way I see this not being a problem is to claim they are already in effective bankruptcy and the government is merely playing the role of a bankruptcy trustee that is operating in the best interest of creditors.

Monday, March 30, 2009

What a depression might look like

From the WSJ via Yahoo.

What would a depression be like today?
"There is no consensus definition for 'depression.' Harvard University economist Robert Barro defines it as a decline in per-person economic output or consumption of more than 10%, and puts the odds of a depression at about 20%.
This 20% number is much higher than some other economists are predicting. For instance:

"Paul Kasriel of Northern Trust put the odds of a depression at just 1% because of the aggressive lending by the Federal Reserve and the fiscal stimulus just beginning to hit the economy. "There are just too many powerful countercyclical policies in place that will prevent the worst-case scenario," he says.

But still, what if it did happen. What would it be like?

It would not be as bad as the 1930s. Why? For one thing we have more "safety nets" and for another point we are starting at a much higher level.
"There were no unemployment insurance, no food stamps, none of the automatic things that maintain some income for people who are out of work," says former Massachusetts Institute of Technology economist Robert Solow....
and later:
"...spending on food accounting for a little less than a tenth of a typical family's disposable income today, compared with a little less than a quarter in 1930, a modern depression wouldn't hit people in the stomach as the Great Depression did."
If anyone knows of an "Alternative History" piece on this, if could be really interesting!

Market timing (or do you want something else to worry about?)

Today's lesson showing the difficulty in market timing comes from the good people at the Pension Benefit Guaranty Corporation. It seems that just prior to the market collapse they decided to go INTO stocks.

From the Boston Globe:
Pension insurer shifted to stocks - The Boston Globe: "
Just months before the start of last year's stock market collapse, the federal agency that insures the retirement funds of 44 million Americans departed from its conservative investment strategy and decided to put much of its $64 billion insurance fund into stocks."
Since September that have been quiet as to their losses (yeah, no transparency here either, do you see a pattern?), but given their assets are no doubt down and their potential claims are up (firms going bankruot etc), it has the look of a bad situation (and probably many billions more of bailout money).

Again from the Boston Globe:
"...analysts expressed concern that large portions of the trust fund might have been lost at a time when many private pension plans are suffering major losses. The guarantee fund would be the only way to cover the plans if their companies go into bankruptcy.

"The truth is, this could be huge," said Zvi Bodie, a Boston University finance professor who in 2002 advised the agency to rely almost entirely on bonds. "This has the potential to be another several hundred billion dollars. If the auto companies go under, they have huge unfunded liabilities" in pension plans that would be passed on to the agency."

Trivia aspect of story: "Charles E.F. Millard, the former agency director who implemented the strategy" was "a former managing director of Lehman Brothers...."

Stakeholder Governance: A Bad Idea Getting Worse by George Dent

Every corporate course starts out with a discussion of the the Nexus of Contracts and why it is that shareholder based models are superior to any other model (Short explanation: as residual claimants they are on the sloped section of the payoff graph and thus have best incentives to monitor).

The following article by George Dent reiterates this and reminds us (and US) that investment can go elsewhere.

SSRN-Stakeholder Governance: A Bad Idea Getting Worse by George Dent:

From the abstract:
"The traditional objections to stakeholder governance remain valid: the interests of stakeholder groups clash not only with those of the shareholders but also with each other, and acceptable means for choosing representatives of stakeholders other than employees have not been discovered. Stakeholder governance would impair economic efficiency: maximization of shareholder wealth remains the best proxy for maximizing the benefits of private enterprise to society. Beyond the traditional problems with stakeholder governance, economic developments make it an even worse idea. Capital has become more mobile, and the U.S. is no longer so dominant a venue for investment; many countries (notably China and India) have now entered the competition for capital, and corporate governance in many countries now treats investors better than the U.S. does. Instituting a serious stakeholder role in corporate governance now would send capital fleeing abroad, with great resulting damage to the American economy."
For clarification: stakeholder governance is that which gives stakeholders other than shareholders an active role on boards. For a more rigorous defense of shareholder based governance see Tirole 2001.

Cite: Dent, George W.,Stakeholder Governance: A Bad Idea Getting Worse(March 2009). Case Western Reserve Law Review, Vol. 48, 2009; Case Legal Studies Research Paper No. 09-9. Available at SSRN: http://ssrn.com/abstract=1368947

Sunday, March 29, 2009

This Is Going To Blow Your Mind: YouTube EDU! | Simoleon Sense

This Is Going To Blow Your Mind: YouTube EDU! | Simoleon Sense

Simoleon Sense was right! It is a list of university videos of lectures etc. GREAT stuff! BTW along these lines, the SBU School of Business just started a new Blog and a YouTube Video channel. Check in now and then.

SBUSchoolofBusiness blog
You can now follow what is going on at the St. Bonaventure University School of Business!

No longer will you have to lose contact with your favorite school upon graduation. Nor will you have to wonder what other faculty and students are doing at the School of Business.

Content will be updated regularly, so check back often. Or better yet subscribe! It's free and you get a daily email whenever the blog is updated.

Intel Announces That Its Stock Is Wildly Overvalued (INTC)

When companies sell stock, it sells a signal to the market. Henry Blodgett interprets the recent Intel stock sale announcements:

Intel Announces That Its Stock Is Wildly Overvalued (INTC):
"Why would a company with $13 billion of cash and $5 billion of free cash flow file to sell $1 billion-worth of stock at $15 a share?

That's right!

Because it thinks the stock is wildly overvalued."

Friday, March 27, 2009

South Park's take on the Economic Crisis

I did not see this on TV, but several of my students brought it to my attention. HILARIOUS!

YouTube - South Park - Episode 1303 - Margaritaville (HQ) - Part 1/3: "Randy steps forward with a solution to fix the desperate financial state everyone finds themselves in. The town gets behind him and everyone starts to live a life that no longer depends on any economy at all."

There are three parts of it on YouTube (the other parts are linked on the right). You can also see the whole thing on SouthParkStudios.com

The third one, linked below, is at once hilarious, repulsive, and silly. REMEMBER IT IS A CARTOON. No Chickens were killed in the filming of the episode.

Regulation and going public

This week in my MBA class we covered IPOs and discussed that even before the economic crises that is dominating all aspects of the financial world, the number of IPOs was down significantly from 1990-1998 levels. We then discussed the increased cost of government regulation as a likely cause.

This same point was mentioned by Bill Gurley in the following Seeking Alpha article:

Dear Mr. Geithner: Do Start-Ups and VCs Really Need More Regulation?
"I have no idea how effective Sarbanes has been at reducing fraud (it obviously did not prevent our current economic malaise), but I do know one thing, Sarbox created a significant burden and tax on small companies that desired to tap into America’s public capital markets, and one that could have long-lasting negative impact on the long-term success of startups and innovation in America.

It’s pretty simple: Sarbanes-Oxley costs $2-3mm to implement, and is also a huge burden on a company's IT and development staff (taking away from feature expansion and product improvement). For a company doing $50mm in revenue with a 10% pre-tax operating margin, you only have say $6mm in after-tax earnings to report. These new Sarbox costs effectively cut your total profitability in half, which has a huge impact on valuation.

Of course, what this in fact causes is companies to feel the need to be much, much larger before they even try to go public. Notably, IPOs have been systematically reduced post-Sarbox"
This view is supported in academic literature by Piotroski and Srinivasan who find
"...we find that the listing preferences of large foreign firms choosing between U.S. exchanges and the LSE's Main Market did not change following the enactment of Sarbanes-Oxley. In contrast, we find that the likelihood of a U.S. listing among small foreign firms choosing between the Nasdaq and LSE's Alternative Investment Market decreased following the enactment of Sarbanes-Oxley. The negative effect among small firms is consistent with these marginal companies being less able to absorb the incremental costs associated with SOX compliance."

International Listings(January 1, 2008). Rock Center for Corporate Governance at Stanford University Working Paper No. 11. Available at SSRN: http://ssrn.com/abstract=956987

WTO: protectionism on rise, endangering recovery - International Herald Tribune

WTO: protectionism on rise, endangering recovery - International Herald Tribune:
"The world is slipping dangerously into protectionism, threatening to strangle global economic recovery, the World Trade Organization said.

In an alarm bell to WTO's 153 members, Director-General Pascal Lamy said free trade has suffered 'significant slippage' this year as countries have erected new barriers to imports in the form of tariffs, subsidies and other measures designed to protect domestic industries."

Thursday, March 26, 2009

Where’s the Plan, Wall Street? - DealBook Blog - NYTimes.com

Where’s the Plan, Wall Street? - DealBook Blog - NYTimes.com:
"For the last several months, Americans have looked to Washington to lead them. But where’s the leadership on Wall Street

It’s worth noting that most Wall Street C.E.O.’s are being advised by their legal and public relations teams to keep their heads down or risk provoking more public outrage. But there is the flip side to that coin: reasoned leadership may generate a reasonable response, helping the industry pre-empt what it fears most — additional government regulation.

So in that spirit, here’s a five-point plan to refashion Wall Street"

It is an interesting article. All 5 points deserve consideration. Unfortunately I have a faculty meeting to go to, so I will only give one look-in:
"One of the most important markets that may have to be reformed is the market for credit default swaps — those insurance plans that investors can buy to protect themselves from an institution’s defaulting. There’s good reason for the insurance to exist: If you are a client of a firm or own its debt, swaps are a smart way to make sure you are left with something if the firm collapses. But investors are allowed to buy swap protection even if they have no exposure to the firm. That means they are not buying the insurance to protect themselves, but rather as a speculative bet. In this case, it’s the equivalent of buying insurance on someone else’s house.

And that’s a problem. It creates an incentive to burn that person’s house down, or even whisper that it is practically a tinderbox."

First ETF To Mimic Hedge Funds Set To Launch - News In Focus

I am excited about this! If for no other reason it is good to talk about something other than gloomy regulations.

First ETF To Mimic Hedge Funds Set To Launch - News In Focus:
"The first exchange-traded fund designed to replicate hedge fund strategies is set to launch on Wednesday.

After receiving a final green light from the Securities and Exchange Commission at midday, the IQ Hedge Multi-Strategy Tracker ETF (NYSE: QAI) should start trading by day's end, according to IndexIQ Advisors LLC.

If it's able to truly mimic popular fund-of-hedge funds, the new ETF could provide the first real challenge to a fee structure critics characterize as highly exorbitant."

And note the last sentence. Gee, markets do work. If hedge fund fees are too high, competition comes into the arena.

Oh and how will it work?
"The benchmark for QAI resembles a fund-of-funds portfolio since it includes six different types of hedge fund strategies. The idea is to capture the entire hedging universe rather than singling out one or two strategies. The ETF includes hedging strategies covering long-short; global macro; market neutral; event driven; fixed-income arbitrage and emerging markets."

Wednesday, March 25, 2009

Hernando de Soto Says Toxic Assets Emerged From a Shadow Economy - WSJ.com

When in doubt, blame the accountants?

Why? As Hernando de Soto points out, there are trillions of dollars of off balance sheet obligations that can not be easily accounted for.

Without a doubt regulators and law makers deserve much of the criticism for allowing this to happen, but at the root is a failure in information systems (and by this I mean accounting and not IT).

Hernando de Soto Says Toxic Assets Emerged From a Shadow Economy - WSJ.com:
"These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property."
Now of course, the accountants were only following the law and as such can only be blamed so much. But maybe if FASB or some other accounting group remembered that their ultimate objective should be to reduce information asymmetries and improve management decisions and not rote compliance and tax avoidance, they would have realized that all liabilities and not just traditional debt obligations should be accounted for in a manner that is accessible both internally and externally.

Investors need to know. Managers need to know.

BTW The small excerpt of the WSJ op/ed piece by Hernando de Soto does not do it justice. Read the whole thing. It is very well thought out.

Update: (about 30 minutes after posting this originally). I just heard from an accountant saying that this was at least partially required. To which I will only say that we can still not figure out actual liabilities this far into the process. It is a problem. Maybe one of ignorance, but at some point the presentation has to improve to make the true risk more easily understood.

Update 2: More evidence that accounting needs to get a wake-up call....From the same day's WSJ in an article on stress-testing banks:

" Remember, 19 of the largest financial firms have been asked to submit to stress tests detailing the adequacy of their capital.

Talk about irony. Financial markets are in disarray today because leading firms chose to bury complicated instruments in their books. The results were opaque balance sheets that hid the considerable use of leverage, and proved misleading both to investors and examiners. These same firms are now being required by regulators to use these misshapen accounts to make far-ahead predictions."

Again, the accounting numbers were and are inadequate.

Atlas Shrugged in Real Life

Ok, I can't make this stuff up. Ayn Rand's Atlas Shrugged is so life like that it is now as if reading (or in my case ristening) to a script.

Background: Atlas Shrugged is a novel written in 1957 by Ayn Rand. In it, in response to a largely governmental caused "emergency" the top leaders of the business world give up and just walk away in response to taxes, regulation, and other confiscatory governmental policies. Indeed, it seems that whoever is in the hottest spotlight, is the next to go.

So without further comment, a letter from Jake DeSantis announcing his resignation from AIG.

From the NY Times
"The following is a letter sent on Tuesday by Jake DeSantis, an executive vice president of the American International Group’s financial products unit, to Edward M. Liddy, the chief executive of A.I.G."

"DEAR Mr. Liddy,

It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:"


"After 12 months of hard work dismantling the company — during which A.I.G. reassured us many times we would be rewarded in March 2009 — we...have been betrayed by A.I.G. and are being unfairly persecuted by elected officials. In response to this, I will now leave the company and donate my entire post-tax retention payment to those suffering from the global economic downturn. My intent is to keep none of the money myself.

.... I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down."
The only difference now between now and then, is that DeSantis (unlike Galt, Wyatt, Dannager, et al) left an explanation.

BTW if you have not read the book, I can not give it a higher recommendation except to say it is in my Top Ten (maybe top five) of all time.

Thanks to ClusterStock/Business Insider.

Tuesday, March 24, 2009

'Dump the Dollar' Campaign Shows China's Discomfort with Treasuries Holdings -- Seeking Alpha

Again stealing a page from the recently deceased Paul Harvey, Today's news of most lasting consequence may be this:

From the BBC:
"China has increased the pressure on world leaders just days before the G20 world summit by calling for an overhaul of the global financial system.

Chinese officials want a new global reserve currency and reforms of international financial institutions to give developing nations more power."

From Seeking Alpha: 'Dump the Dollar' Campaign Shows China's Discomfort with Treasuries Holdings -- Seeking Alpha:
"Emerging markets, led by China and Russia, plan to jointly challenge the U.S. dollar’s role as the world’s sole benchmark currency at the April 2 meeting of the Group 20 nations - a move that underscores the currency’s weakness and fading support around the world....

Zhou called for the “re-establishment of a new and widely accepted reserve currency with a stable valuation” to replace the U.S. dollar - a credit-based national currency. The central bank governor noted that the International Monetary Fund’s Special Drawing Right [SDR] should be given special consideration.

Created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system, the SDR was redefined in 1973 as a basket of currencies. Today the SDR consists of the euro, Japanese yen, pound sterling, and U.S. dollar."

Have to think about this for a while. While you can definitely see why other countries might want this, its impact on the US would be more detrimental. On the plus side longer term it may force us to keep budget deficits in check etc. So all is not bad, but that said it is clearly a slap in the face that politically, if not economically.

U.S. Stocks Jump, Capping S&P 500’s Best 10-Day Gain Since 1938 - Bloomberg.com

U.S. Stocks Jump, Capping S&P 500’s Best 10-Day Gain Since 1938 - Bloomberg.com:

Writing on the heels of yesterday's near 500 point run up, Bloomberg reports that as measured by the Dow, the market has its "steepest two-week gain since 1938".

In case you wondered what followed in 1939 and later, it was a very choppy market. In part no doubt due to WW II. Here is a chart from Yahoo.

But lest you forget how far the market has fallen, consider these facts from the same Bloomberg article:
"The S&P 500 is still down 47 percent from its October 2007 record and the MSCI World is lower by 51 percent from its peak...."
But every mountain climbing expedition has to start somewhere and so far so good for stock investors.

DealBook Column - If Goldman Returns Aid, Will Others? - NYTimes.com

DealBook Column - If Goldman Returns Aid, Will Others? - NYTimes.com:
"Goldman Sachs is planning to give back its TARP money soon. Very soon, actually...Goldman’s sudden urgency to return the money stems, in part, from the uproar over A.I.G.’s bonuses last week, and the criticism of Goldman over revelations that the firm had been the largest recipient of government money as a counterparty of bets placed with A.I.G. It’s also paying a hefty 5 percent interest payment to taxpayers for that money.

“It’s just impossible to run our business in this environment,” said one senior Goldman executive who insisted on not being quoted by name for fear of crossing the Treasury Department."
Which appears to be good news, but then the authors add this to the piece:
"If Goldman succeeds in returning our money, it could put pressure on other banks to give their money back, too, lest they appear weak."
Which indeed is true. But rather than a cause for celebration (being a strong bank is good), the article takes the position that instead of managing to be a stronger bank, some weaker banks will just give the money back to appear strong when still actually weak. (In other words giving the money back is too inexpensive of signal.)

This is true. And it is a problem, but a problem I would rather have than that of strong banks appearing weak to protect the weak banks.

Why the sudden urgency to pay back the Feds? Possibly the conditions for accepting the money are too onerous.

"And then there is the simple matter that Wall Street and Washington make strange bedfellows.

Paying back the TARP money would probably give Goldman Sachs a bigger lead over its rivals. With a Yankees-like payroll, it will continue to be able to steal the best talent from weaker firms that still have TARP money and are subject to restrictions on pay and the like.

“The guys who have the least chains around them will be able to run the fastest,’ said Meredith Whitney, the banking analyst."
Unintended consequences. Remember them. Propose a bill to tax at 90% bonuses at firms receiving Federal money and suddenly firms no longer want that money.

Monday, March 23, 2009

Nobel Winners Spence, Krugman Clash on Geithner Plan Prospects - Bloomberg.com

Nobel Winners Spence, Krugman Clash on Geithner Plan Prospects - Bloomberg.com:
"Geithner’s plan “will certainly help,” Meltzer, 1997 winner of New York University’s Money Marketeers Distinguished Achievement Award, said in a telephone interview today. At the same time, “the Congress has really clobbered the rule of law, and that has terrible implications for the future,” he said....

The plan is aimed at financing $500 billion to $1 trillion in purchases of illiquid real-estate assets, using $75 billion to $100 billion of the Treasury’s remaining bank-rescue funds. It also will rely on Fed financing and guarantees from the Federal Deposit Insurance Corp.

Treasury left some details to be announced later, including the precise amounts investors would be required to put up for each type of asset and the terms of loans that the Fed would provide."

Benoit Mandelbrot and the wildness of financial markets: Scientific American Blog

Benoit Mandelbrot and the wildness of financial markets: Scientific American Blog:
"In a lecture at Columbia University this week, famed fractal pioneer Benoit Mandelbrot once again inveighed against traditional economic theories...many economic models ignore dramatic jumps, whether in a commodity's price or in an index such as the S&P 500, treating them as outliers. But real-life economic systems, Mandelbrot said, are 'dominated by details'—the extreme cases, and specifically the outer 5 percent, are just as important as the rest of the data. To prove his point, Mandelbrot showed a graph of the S&P since 1985, overlaid with the same data minus the wild swings that constitute the outliers. The two graphs were completely different, implying that to ignore the extreme cases is to ignore reality"
Thanks to SimoleonSense

Administration Seeks Increase in Oversight of Executive Pay - NYTimes.com

Everyone knew more regulations would be coming, and here is a sneak peek from the NY Times

Administration Seeks Increase in Oversight of Executive Pay - NYTimes.com:
"It will propose that many kinds of derivatives and other exotic financial instruments that contributed to the crisis be traded on exchanges or through clearinghouses so they are more transparent and can be more tightly regulated. And to protect consumers, it will call for federal standards for mortgage lenders beyond what the Federal Reserve adopted last year, as well as more aggressive enforcement of the mortgage rules."
Good idea. Transparency is good and if a market can be developed for these securities, the marking to market problem is largely reduced. However, it is a big IF.

and later:
"The officials said that the administration was still debating the details of its plan, including how broadly it should be applied and how far it could go beyond simple reporting requirements. Depending on the outcome of the discussions, the administration could seek to put the changes into effect through regulations rather than through legislation."
Red Flag thrown (note the red flag here is a US football analogy and was not originally intended to have any bull fighting reference. That said, as Monk just pointed out, maybe it would have been more appropriate on two levels.). It seems that further review is called for here. Transparency is good. For regulators and companies. Why not allow it to be debated publicly?

And the later:

"One proposal could impose greater requirements on company boards to tie executive compensation more closely to corporate performance and to take other steps to ensure that compensation was aligned with the financial interest of the company.

The new rules will cover all financial institutions, including those not now covered by any pay rules because they are not receiving federal bailout money. Officials say the rules could also be applied more broadly to publicly traded companies, which already report about some executive pay practices to the Securities and Exchange Commission. "

Ignoring for a second the SEC's past failures with respect to executive pay and again stressing that transparency is good, it is difficult to swallow mandates telling shareholders what they have to do. For instance, I do not understand requiring pay to be tied to performance. If shareholders want to give a straight salary they should be allowed to do so. If a manager does a great job and yet the economy is bad so that the stock falls anyways (but not as far as it otherwise would have), that manager should be rewarded. This is a can of worms that I do not think I want government regulators dictating.

and later still :
"Administration officials are also debating how tightly to supervise hedge funds. A broad consensus has emerged among regulators and administration officials that hedge funds must be registered and more closely monitored...But officials have not decided how much the funds will have to disclose about their investments and trading practices. The officials spoke on condition of anonymity because the regulatory plan was still being formulated...."
Notice also the article is no longer questioning if hedge funds will have to disclose their investments and trading practices but "how much" they will have to do so. While knowing the risks is important, for hedge funds their trading practices are their trade secrets. Disclosing these is somewhat the equivalent of ending patents.

Somewhere I fear Atlas just shrugged.


No excuses. Go read SimoleonSense's Blog. Ridiculously good content this past week.

From the interview with Buffett's biographer, to Michael Lewis on AIG, to his weekly roundup. Just can't miss it. Becoming one of my first reads of the day!

Friday, March 20, 2009

SSRN-Sorting Out Downside Beta by Thierry Post, Pim Van Vliet, Simon Lansdorp

If you ask investors about risk, maybe one in 10,000 (?) will say I am really worried about MAKING too much money. Most are worried about losing money. Yet by defining risk based on differences from a mean (variance) we are inherently saying that making too much money and losing too much money are both equally scary propositions.

And because CAPM uses variance in its calculation of Beta, it too gives equal weight to both upside and downside movements.

Since at least the late 1950s the idea of semivariance has been tossed around and discussed occasionally (with some papers on it--see the introduction), but has never really been pushed very hard.

That may change. A new paper by Post, Van Vliet, and Lansdrop tests a downside beta (essentially how the returns move in down markets) and finds that the downside beta adds explanatory power to the model even when the other usual stuff (size, momentum, value) are included.

SSRN-Sorting Out Downside Beta by Thierry Post, Pim Van Vliet, Simon Lansdorp:

"Downside risk, when properly defined and estimated, helps to explain the cross-section of US stock returns. Sorting stocks by a proper estimate of downside market beta leads to a substantially larger cross-sectional spread in average returns than sorting on regular market beta. This result arises despite the fact that downside beta is based on fewer return observations and therefore is more difficult to estimate and predict. The explanatory power of downside risk remains after controlling for other stock characteristics, including firm-level size, value and momentum."
How do they do this? Much like testing beta, they create portfolios based on the downside beta (thus hopefully accounting for any firm specific noise) and then test "out-of sample" using "data from 1926 to the present".

Interesting stuff!

Post, Thierry, Van Vliet, Pim and Lansdorp, Simon D.,Sorting Out Downside Beta(March 2009). ERIM Report Series Reference No. ERS-2009-006-F&A. Available at SSRN: http://ssrn.com/abstract=1360708

Thursday, March 19, 2009

What March Madness taught me about finance

As I told my class I always feel guilty this time of year. I just filled out the annual NCAA March Madness bracket.

I did not fill it our according to top picks, nor even most popular picks, nor by going by the betting line. Why? Because picking upsets is fun.

So what does this have to do with finance? It might explain why investors pick "glamor" stocks or stocks that are seen as exciting. The investor wants to talk/brag about it. (Same argument can be used as to why some investors select socially responsible investments even though the return may be lower.

Is it wrong? No, just remember that you are maximizing your utility and NOT your expected returns.

Want to play too? here, just started a new group. If you want in, click here.

Madoff accountant Friehling charged with lying about numbers - Mar. 18, 2009

Madoff accountant Friehling charged with lying about numbers - Mar. 18, 2009:
"David Friehling, accountant for Bernard Madoff, was released on $2.5 million bond after turning himself in on Wednesday to face charges that he 'rubber stamped' the Ponzi schemer's books.

Friehling was charged with securities fraud, aiding and abetting investment adviser fraud and four counts of filing false audit reports to the Securities and Exchange Commission, according to the U.S. Attorney for the Southern District and the Federal Bureau of Investigation."

Wednesday, March 18, 2009

SSRN-Fair Disclosure and Investor Asymmetric Awareness in Stock Markets by Zhen Liu

This one needs to be sold just a little, but then is a really cool insight. It deals with Reg FD. The "if I tell anyone, I have to tell everyone" rule.

But first imagine you are a student in a class that is reviewing for a test. You are aware of a great way to ask a question for the test, but are a bit unclear about it. However, you know you are ahead of the rest of the class on the topic and doubt the rest of the class has even considered it (so in effect you asking the teacher would be also 'tipping them off'). What do you do?
A. Ask the teacher and while gaining total information, lose some of your competitive advantage.
B. Sit there quietly so as not to tip off the rest of the class and then research it more on your own.

If you chose B, you will totally understand this next paper!

SSRN-Fair Disclosure and Investor Asymmetric Awareness in Stock Markets by Zhen Liu:
"The U.S. Security and Exchange Commission implemented Regulation Fair Disclosure in 2000. The regulator aims to reduce information asymmetry among investors, and expects public forums to subsume the forbidden information channel of selective forums....when a participant is aware of more uncertainties than are other participants, with zero incentives to share the insights, he would search information privately rather than raising questions in public forums. This causes inefficient information production compared to 'unfair'' selective disclosure.
More from the introduction:
"At first glance, fair disclosure seems the best remedy for the information asymmetry caused by selective disclosure, without sacrificing the availability of high quality information. However, practitioners have argued that the regulation has produced some undesirable side eeffects: 1. The ambiguous definition of material information makes issuers reluctant to provide "immaterial" information in private . 2. Professionals may be unable to obtain information because of ineffective technology utilized in public communications. 3. Professionals 'with the most perception, intuition, or experience are not willing to share their insights with other investors under fair disclosure, so that less information can be revealed."
One more look in:
"Compared with small investors, financial professionals have significantly more resources and incentives to acquire both information and awareness. Our first major assumption is that small investors are unaware of some relevant uncertainties that professionals are aware of, and professionals know it. This is widely observed and empirically supported by the literature on small investors' behavior.

The other major assumption is that at public forums, when professionals ask critical
questions, small investors are able to know as much as professionals know. The potential free rider problem certainly reduces the incentives of professionals to ask critical questions."

Definitely a good insight and one I never considered before.

Liu, Zhen,Fair Disclosure and Investor Asymmetric Awareness in Stock Markets(March 12, 2009). Available at SSRN: http://ssrn.com/abstract=1358637

All That Twitters May Not Be Gold, Analysts Say - DealBook Blog - NYTimes.com

All That Twitters May Not Be Gold, Analysts Say - DealBook Blog - NYTimes.com:
"The analysts said that monetizing Twitter “would be difficult at best and likely unsuccessful.” People who sign up for free services tend to resent a company for trying to wring revenue from the business later. Subscription fees are out of the question, they said, and advertising-based revenues don’t seem to have yielded enough cash flow to make a Web 2.0 property viable."

BTW in a recent Portfolio article, Evan Williams the CEO of Twitter talked about some of his plans to make money with it.

So while Twitter does not yet generate cash, it will likely in the future. So how to value it? One way is to see what past firms in similar situations have done.

If you are in my class you know that the last case of the year that you present must be one you select yourself. Given that many of you may still be looking for a case, may I suggest you consider the valuation of Twitter? It could not be any more timely, would be able to tie in Venture Capital firms, and get a good history lesson on how other Web 2.0 firms have become profitable (or not). Sounds like a fun case to me! (BTW be sure to read some of the comments below the NY Times article, especially Ray's)

Disclaimer: I really like Twitter. I use it personally (some), for BonaResponds (MUCH more), and even just started for my family's grocery store chain Park and Shop. I really like getting messages from professional cyclists, authors, friends, and others BonaResponds have worked with. So I am biased. But I have to think there is value there.

Tuesday, March 17, 2009

Half Of Hedge Funds Will Go Bust

From FT via Clusterstock.

Half Of Hedge Funds Will Go Bust:
"...poor investment performance for some, and asset value erosion for many more, have shrunk collections from management and incentive fees. It would come as no surprise if at least half of the entities in this space were to disappear in the next two years, either through mergers or failures.

Traditional investment managers are not immune to this rash of institutional shrinkage and consolidation. For some, the collapse in worldwide equity prices over the last 15 months has already shaved off about half of their operating revenues, rendering their current cost structure overwhelming and threatening the retention of talented staff."
Wow. That would be a large consolidation even with takeovers.

Unintended consequences of "Too Big to Fail" and other possible changes in regulation

Unintended consequences.

People mean well (yes even politicians and regulators) when they clamor for new rules and regulations to solve this crisis or that. But what they often fail to realize is that their actions have unintended consequences. For instance, from the Wall Street Journal seemingly in response to Bernanke's recent comments that some institutions are too big (important) to fail.:

Congress Is the Real Systemic Risk - WSJ.com:
"A company that is designated as systemically significant will inevitably come to be viewed as having government backing. After all, the designation occurs because some government agency believes that the failure of a particular institution will have a highly adverse effect on the rest of the financial system. Accordingly, designation as a systemically significant company will in effect be a government declaration that that company is too big to fail.....As a consequence, the effect on competition will be profound. Financial institutions that are not large enough to be designated as systemically significant will gradually lose out in the marketplace to the larger companies that are perceived to have government backing, just as Fannie and Freddie were able to drive banks and others from the secondary market for prime middle-class mortgages. A small group of government-backed financial institutions will thus come to dominate all sectors of finance in the U.S."

SSRN-Financial Openness and Productivity by Geert Bekaert, Campbell Harvey, Christian Lundblad

A couple of really cool findings in this one:

1. Openness and market liberalization are good for economy as well as capital markets. In fact the factor productivity increase dominates.
2. The overall gain of the "openness" offsets risk of economic crises.

SSRN-Financial Openness and Productivity by Geert Bekaert, Campbell Harvey, Christian Lundblad:
"Financial openness is often associated with higher rates of economic growth. We show that the impact of openness on factor productivity growth is more important than the effect on capital growth. This explains why the growth effects of liberalization appear to be largely permanent, not temporary. We attribute these permanent liberalization effects to the role financial openness plays in stock market and banking sector development, and to changes in the quality of institutions. We find some indirect evidence of higher investment efficiency post-liberalization. We also document threshold effects: countries that are more financially developed or have higher quality of institutions experience larger productivity growth responses. Finally, we show that the growth boost from openness outweighs the detrimental loss in growth from global or regional banking crises."
So the next time someone comments that globalization is bad as it increases economic crises, you now have evidence to the contrary:

First fund's 85th birthday shows why mutual funds will survive | Seattle Times Newspaper

I did not know this. Sort of trivia, but sure it will be mentioned in some classes.

Business & Technology | First fund's 85th birthday shows why mutual funds will survive | Seattle Times Newspaper:
"On March 21, 1924, the paperwork to create the first open-end mutual fund — the Massachusetts Investors Trust — was filed; the fund began taking money in July of that year.....

Their idea was simple: professional management and diversification at a reasonable price.

Most of the oldest funds have somehow died off long ago, but the Massachusetts Investors Trust, run now by MFS Investment Management, is still adding to its legend.

The fund (MITTX) has survived everything from the Great Depression to the creation of the Securities and Exchange Commission to the start of fund rankings and ratings through the evolution of exchange-traded funds, the Internet bubble, the bear market of 2000 and now to a downturn....

A $1,000 investment in 1924 into the Massachusetts Investors Trust would be worth roughly $1.2 million today; a $10,000 investment would be about $11.5 million.

That's an annualized average return in the high 8 percent range...."

Monday, March 16, 2009

SSRN-Stock Market Liquidity and the Rights Offer Paradox by Edith Ginglinger, Laure Koenig, Fabrice Riva

Class preparation yields another cool find!

The Right's paradox has been discussed for the three decades (See Smith 1977). In a single sentence, the paradox is why so few firms use rights issues when they appear cheaper (at least at first glance). Over the past 32 years, researchers have documented some costs of rights issues that are not apparent at first glance.

This research is further supported in a new working paper by Ginglinger, Koenig, and Riva. From their abstract:

SSRN-Stock Market Liquidity and the Rights Offer Paradox by Edith Ginglinger, Laure Koenig, Fabrice Riva:
"...using a database of French SEOs. We first document higher direct flotation costs, but also improved stock market liquidity after public offerings and standby rights relative to uninsured rights. We find that blockholder renouncements to subscribe to new shares and stock market liquidity are important determinants of flotation method choice. After controlling for endogeneity in the choice of flotation method, we find that public offerings are cost effective and more liquidity improving than standby rights whereas an uninsured rights offering is the best choice for low liquidity, closely held firms. Our results provide new insights as to why firms choose public offerings despite apparently higher costs."

Cite: Ginglinger, Edith, Koenig, Laure and Riva, Fabrice,Stock Market Liquidity and the Rights Offer Paradox(March 13, 2009). Available at SSRN: http://ssrn.com/abstract=1359094

This will definitely be included in upcoming class notes!

60 Minutes - Video, Reports, Profiles, Interviews - CBSNews.com

60 Minutes - Video, Reports, Profiles, Interviews - CBSNews.com: "
In a rare interview with a sitting Fed chairman, Ben Bernanke tells Scott Pelley what went wrong with America's financial system, how it caused the economic crisis, what the Fed is doing to help fix it and when he expects the recession to end...."

Short version: financial sector must be stabilized, he expected recovery to end later this year.

Watch CBS Videos Online

Bear Stearns: The Fed's Original 'Systemic Risk' Sin - WSJ.com

One year ago.

Bear Stearns: The Fed's Original 'Systemic Risk' Sin - WSJ.com:
"...the Federal Reserve saved Bear Stearns from bankruptcy. The central bank's agreement to invest $30 billion (later reduced to $29 billion) in Bear's opaque securities greased a sale of the firm to J.P. Morgan Chase. For the first time since the 1930s, the federal government was putting taxpayers at risk to rescue a Wall Street investment bank. To this day, the government has not explained precisely why....

Was there a formula that regulators used to measure systemic risk? .... Still, more data might help explain how the also-ran among Wall Street's major banks could possibly have dictated the fate of the American economy.

Oddly, given that this is a question of finance, government explanations following the Bear deal involved lots of adjectives and very little math....Fed Chairman Ben Bernanke described "fragile" financial conditions. Timothy Geithner, New York Fed president at the time, also saw "fragile" conditions, as well as a "fragile" economic situation and a "fragile time in global financial markets." Mr. Bernanke, when describing the "interconnectedness" of Bear Stearns, said that regulators decided to act "given the weakness and the fragility of many markets."

SSRN-Modigliani and Miller Meet Chandler: Organizational Complexity and Capital Structure by Alberto Manconi, Massimo Massa

In a new working paper, Manconi and Massa (a new M&M) show that firms with more complex structures (and hence more opaque) rely less on equity financing.

Why? Probably (like Myers and Majluf's 1984 pecking order paper), the debt financing comes with better investor protections and if investors are not sure of what they are getting, this protection is more valuable.

SSRN-Modigliani and Miller Meet Chandler: Organizational Complexity and Capital Structure by Alberto Manconi, Massimo Massa:
"We show that organizational complexity is strongly related to stock market-based measures of information asymmetry - i.e., Amihud's (2002) illiquidity, Llorente et al.'s (2002) information asymmetry coefficient, the number of analysts tracking the firm, and the equity bid-ask spread. In line with the predictions of the pecking order theory, firms characterized by a more complex organizational structure resort less to equity and more to debt financing, have higher leverage, display a higher investment-cash flow sensitivity and hold more cash to finance future investment."
Manconi, Alberto and Massa, Massimo,Modigliani and Miller Meet Chandler: Organizational Complexity and Capital Structure(March, 14 2009). Available at SSRN: http://ssrn.com/abstract=1359762

Saturday, March 14, 2009

Is Rand Relevant? - WSJ.com

I am ristening to Atlas Shrugged in my car and was talking to a collegue about it on Thursday. I said I was pretty sure the book was written last week and that she spent much time on campus to research the book. Now obviously not, but it is so timeless that after fifty years it is still just as fresh as ever.

This is from the Wall Street Journal.

Is Rand Relevant? - WSJ.com:
"'If you understand the dominant philosophy of a society,' Rand wrote elsewhere in 'Capitalism: The Unknown Ideal,' 'you can predict its course.' Economic crises and runaway government power grabs don't just happen by themselves; they are the product of the philosophical ideas prevalent in a society -- particularly its dominant moral ideas....

Why do so few protest the endless regulatory burdens placed on businessmen? Because businessmen are pursuing their self-interest, which we have been taught is dangerous and immoral. Why did the government go on a crusade to promote 'affordable housing,' which meant forcing banks to make loans to unqualified home buyers? Because we believe people need to be homeowners, whether or not they can afford to pay for houses.

Rand said ...-- selfishness, rather than being evil, is a virtue. By this she did not mean exploiting others à la Bernie Madoff. Selfishness -- that is, concern with one's genuine, long-range interest -- she wrote, required a man to think, to produce, and to prosper by trading with others voluntarily to mutual benefit."

UPDATE (3/15/09) Charlie sent the following from the Economist:

"Whenever governments intervene in the market, in short, readers rush to buy Rand’s book. Why? The reason is explained by the name of a recently formed group on Facebook, the world’s biggest social-networking site: “Read the news today? It’s like ‘Atlas Shrugged’ is happening in real life”. The group, and an expanding chorus of fretful bloggers, reckon that life is imitating art."
From which I went to the Facebook group and to this link of articles and videos from AynRand.org. Definitely worth a look!

27 Visualizations and Infographics to Understand the Financial Crisis | FlowingData

27 Visualizations and Infographics to Understand the Financial Crisis | FlowingData:
"27 Visualizations and Infographics to Understand the Financial Crisis"

Really good!!!

Friday, March 13, 2009

China’s Leader Says He Is ‘Worried’ Over U.S. Treasuries - NYTimes.com

US Treasuries are risk free. We assume that all the time in finance classes. (For instance see CAPM). Now China is calling that into question.

China’s Leader Says He Is ‘Worried’ Over U.S. Treasuries - NYTimes.com:
"Speaking at a news conference at the end of the Chinese parliament’s annual session, Mr. Wen said he was “worried” about China’s holdings of Treasury bonds and other debt, and that China was watching United States economic developments closely... To be honest, I am definitely a little worried.”

He called on the United States to “maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.” "
While anything (and everything) is possible, I think I would be more worried about inflation that would leave the money worth less.

FinanceProfessor.com: Insider trading case of the decade

Long term readers of the blog may remember this story from 2006:

FinanceProfessor.com: Insider trading case of the decade: "You have to read this! It has everything any insider trading case could want---from a retired seamstress, to classified ads placed to hire accomplices, to the theft of advance copies of BusinessWeek, to strippers, to Russian baths. (I am not making this up!)

From the Globe and Mail:

'The case is “one of the most extensive insider trader cases in this district in decades,” Michael Garcia, the U.S. Attorney for the Southern District of New York, said during a press conference.'"

the rest of the coverage is here.

Why do I bring this up again? This week in class we were talking about insider trading and Mike (one of my students) pointed out that this had just been on TV as part of CNBC's American Greed series. CNBC itself has a slideshow and some background on the show and it will replay again so you may want to set your recorders.

In the meantime, HULU has the show:

YouTube - Jon Stewart vs Jim Cramer Interview Fight on Daily Show

While there was much hype in the days leading up to the show, the actual interview was pretty good. Jon Stewart vs Jim Cramer. Here is the link from The DailyShow for the entire episode.

Some talking points:

* Stewart's main point seems to be that while Cramer and CNBC claim to be looking out for investors, in actuality they are are nothing more than entertainment at best and accomplices at worst.

* It is interesting to see the discussion on Short Selling and the way that Cramer (and by inference other hedge fund managers) essentially lied to drive the price down. I would have to think the SEC might be interested in this.

* Stewart maintains that the financial media plays a role in governance. They dropped the ball.

* Cramer was good in admitting that success (year after year of 30% returns) changes our view and we forget that things go wrong.

* Line of the day from Stewart: "We are both snake oil salesmen, but I let people know I sell snake oil.:

* Line of the day from Cramer: "No one should be spared in this environment."

The whole interview (unedited) is also available. Here is the 3rd part:

Thursday, March 12, 2009

Warren Buffett's Regulatory Forebearance

Ending marking to market is not the solution (it is the equivalent of ignoring a problem). This came up in class today, I totally agree. It is not perfect, but at least will keep the balance sheets somewhat accurate (ok, more accurate than they would be if we end marking to market).

Warren Buffett's Regulatory Forebearance:
"...proposals to solve this problem have focused on either attempting to have the government inflate the market value of the assets, inject new capital into the banks or obscure the accounting rules so banks can go on pretending the asset values haven't dropped. None of these will work. Buying the assets has proved impossible, the capital injections have their own problems and fiddling with the accounting rules risks making investors even more skeptical of bank balance sheets.

So what do we do? We should simply ease the capital requirements

....Yesterday Holman Jenkins pointed out that Warren Buffett supports it as well. Maybe if we start calling it the "Buffett Plan..."

Fast Look around

A fast look around:

Uh, really? 45% of wealth destroyed? No way. Maybe of easily traded wealth, but if speaking of overall wealth this from the CEO of Blackstone just has to be an exaggeration.
""Between 40 and 45 percent of the world's wealth has been destroyed in little less than a year and a half," Schwarzman told an audience at the Japan Society. "This is absolutely unprecedented in our lifetime."
Genentech (a stock that SIMM used to hold) agreed to be bought out by Roche after an 8 month battle. From CNN:
"Swiss drugmaker Roche Holding AG (ROG.VX) said Thursday it sealed a friendly deal with Genentech Inc. (DNA) to buy the 44% of the U.S. biotech company that it doesn't already own for around $46.8 billion, after raising the offer price to $95 a share....The agreement ends a nearly eight-month battle, in which Genentech repeatedly rejected Roche's offer."
Forbes reports that the world has 332 fewer Billionaires than last year. This has yet to create a call for Billionaire conservation programs, but is interesting fodder for newscasts everywhere.
Oh and Buffett is no longer the richest. That falls back to Bill Gates.
"Bill Gates lost $18 billion but regained his title as the world's richest man. Warren Buffett, last year's No. 1, saw his fortune decline $25 billion as shares of Berkshire Hathaway fell nearly 50% in 12 months. Mexican telecom titan Carlos Slim Helú maintains his spot in the top three but lost $25 billion."
Fannie Mae and Freddie Mac are disasters. The best analysis I have seen of just how bad they are comes from the BusinessInsider at ClusterStock.
" Over the years and spread across millions of home buyers, that 25 basis point savings adds up to a lot of money. With Fannie and Freddie holding or guaranteed mortgages on 31 million homes worth about $5.5 trillion at the end of 2008, borrowers would have saved over $10 billion in 2008. The numbers change from year to year. But last year Daniel Gross reported in an article for Slate that Professor White believes it could add up to more than $100 billion in current dollars over the years.

Comparing that $100 billion savings against the government's pledge of $400 billion in financial support for Fannie and Freddie raises the question of what good these companies ever did. The drawings on that pledge are still less than $60 billion--around $45 billion for Freddie and $15 billion for Fannie--but are expected to exceed $100 billion by the end of 2009. If further drawings come to pass it will mean that even using the most optimistic estimates for the interest rate savings provided by Fannie and Freddie, the companies have been huge costs for taxpayers with no net tangible benefits."

How Much Is $1 Trillion:
"If someone says they want to spend another $1 trillion on anything, just think that your taxes would have to double to pay for it. That makes the mind-boggling sum a lot clearer."
And last but not least again from ClusterStock, the Economic Crisis hits TV is a look at how the news is coming into TV shows.

The best clip is from the Simpsons:

Madoff Life Prison Term Means Inmate Blame for Crash (Update1) - Bloomberg.com

From Bloomberg:
Madoff Life Prison Term Means Inmate Blame for Crash (Update1) - Bloomberg.com:
"Madoff is likely to be looking at decades behind bars, given the severity of the charges, said Alan Ellis, a Mill Valley, California-based attorney and co-author of “Federal Prison Guidebook....“He’s looking at well over 20 years, probably at least 30,” said Ellis, former president of the National Association of Criminal Defense Lawyers in Washington, D.C. “That’s a life sentence for him.”"

Alan Greenspan defending, well, Alan Greenspan and more

Alan Greenspan defends his reputation in the Wall Street Journal. The defense is largely that sure long term-rates were too low, but that was because long term rates (which people used to make real estate decision on) quit moving with short-term rates (which the Fed had some control over).

In his words:
"There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. "


"The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments."

"U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance."
Which is no doubt true, but the Fed must still bear some of the fault as had it seen the dangers more clearly, the warning could have been sounded to the banks to tighten credit standards. ANd to further defend the Fed, at least as early as May of 2005, Fed governor Roger Ferguson commented on (and in hindsight looks remarkably clairvoyant) the potential impact of Real Estate prices on the overall economy:
"Clearly central bankers would benefit from a better understanding of asset price movements--particularly more extreme movements--so that we do not mistakenly facilitate in some way potentially harmful outcomes.....The past decade has been marked by episodes of financial volatility that have had the potential for trouble at a systemic level. Linkages between financial markets and real economic outcomes have become more complex, periodically presenting policymakers with surprises and puzzles.... A particular phenomenon that touches on all these issues is the movement of asset prices, especially the prices of equities and residential real estate. Because these assets are the most widely held by the general public, price changes, even when not exceptional, can significantly affect the macroeconomy. Rising asset prices support household consumption, whereas falling asset prices damp consumption. In a scenario of collapse, the damage to balance sheets and private wealth could go as far as undermining the soundness of the financial system and threatening stability of the real economy. Apart from such outcomes, policymakers might also take special interest in asset price movements because it has been alleged that badly designed or poorly implemented policy (even if well intended) sometimes has helped feed unsustainable movements in asset prices...."
It is noteworthy that he was speaking on the impact of the money supply and not interest rates and that he also mentioned that in a global economy, the central bank of any country is limited:
"Among other complications is the possibility that financial globalization may be changing the links between liquidity and asset prices. Movements in asset prices across countries now appear to be more synchronized. This synchronization could arise in a number of ways.... it also is quite possible that greater international diversification of portfolios now allows developments affecting assets in one country to spill over into markets of others--both at the level of particular industries and more broadly. If synchronization of asset price movements comes about mainly in this way, the suggestion is that excess liquidity in one country could move asset prices in another, perhaps significantly, even if liquidity was well contained in the latter."

Which is consistent with Temple University's Ken Koplesky in The Economic Policy Examiner:

"We need to understand the implications of the high savings rates in Japan and China. The opposite side of the US deficit on current account is savings exceeding domestic investment in countries like China and Japan. How did this influence the onset of the world-wide recession? Are they the principal cause in the sense that very high savings in China and Japan were responsible for very low long-term interest rates, which in turn induced very risky lending/borrowing behavior?”"

Which I guess is my defense of Greenspan as well. There was a real estate bubble. Should the Fed have done more to prevent it? Definitely. But its options were not without costs and even when tried (raising short term rates) of little success.

If it were 2004 all over again, what would you do if you were the Fed?

(Gee wouldn't that make a great essay question?!)

$1.3 million per job? For real?

Old Europe Is Right on Stimulus - WSJ.com:
"The White House estimates of 3.6 million new jobs is based on an 'Old Keynesian' model on the impact of government spending, while the new models adjust for the rational behavioral response to the stimulus by businesses and consumers. The White House figures, by economists Christina Romer and Jared Bernstein, also assume zero interest rates for a minimum of four years. The alternative assumes, more reasonably, that as growth returns interest rates will also rise What the four economists [Cogan, Cwik, Taylor, and Weiland] found is that the Administration's estimates for stimulus growth were six times as high as they could produce under a modern Keynesian simulation. By their estimates, the stimulus would produce, at most, 600,000 jobs and add perhaps 0.6% to GDP at its peak. That's nowhere near a multiplier of 1.5 and suggests the $800 billion would have been better devoted to business tax cuts or fixing the financial system. That's $1.3 million in spending per job, for those keeping score at home."
The paper on which much of the article is written is "New Keynesian versus Old Keynesian Government Spending Multipliers" which is by John F. Cogan, Tobias Cwik, John B. Taylor, Volker Wieland.

Tuesday, March 10, 2009

THE FED: Big Banks Will Not Be Allowed To Fail, Bernanke Says

From CNN/Money: THE FED: Big Banks Will Not Be Allowed To Fail, Bernanke Says:
"Federal Reserve Board Chairman Ben Bernanke stressed Tuesday that major financial institutions would not be allowed to fail given the fragile state of financial markets and the global economy.

In a speech in Washington, Bernanke repeated that a sustainable economic recovery will 'remain out of reach' until the banking sector is stabilized....Bernanke said he hopes the view that the market can handle the failure of a systemically important firm is "no longer seriously maintained" given the power of the financial crisis in the wake of the collapse of Lehman Brothers and the government takeover of Fannie Mae and Freddie Mac last September. "It was the...collapse of banks and other institutions in late 1930 and early 1931 that made the Great Depression great...."
From the actual speech: FRB: Speech--Bernanke, Financial Reform to Address Systemic Risk--March 10, 2009:
"In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm, because of the risks such a failure would pose to the financial system and the broader economy. However, the belief of market participants that a particular firm is considered too big to fail has many undesirable effects. For instance, it reduces market discipline and encourages excessive risk-taking by the firm. It also provides an artificial incentive for firms to grow, in order to be perceived as too big to fail. And it creates an unlevel playing field with smaller firms, which may not be regarded as having implicit government support. Moreover, government rescues of too-big-to-fail firms can be costly to taxpayers, as we have seen recently. Indeed, in the present crisis, the too-big-to-fail issue has emerged as an enormous problem....
And later:
"In light of the importance of money market mutual funds--and, in particular, the crucial role they play in the commercial paper market, a key source of funding for many businesses--policymakers should consider how to increase the resiliency of those funds that are susceptible to runs. One approach would be to impose tighter restrictions on the instruments in which money market mutual funds can invest, potentially requiring shorter maturities and increased liquidity. A second approach would be to develop a limited system of insurance for money market mutual funds that seek to maintain a stable net asset value. For either of these approaches or others, it would be important to consider the implications not only for the money market mutual fund industry itself, but also for the distribution of liquidity and risk in the financial system as a whole.""

Merck to Buy Schering-Plough for $41.1 Billion - NYTimes.com

In a few weeks my MBA class will be focusing on takeovers. With this in mind, the Merck-Schering-Plough deal is a treasure chest of examples of various aspects of a takeover.

Merck to Buy Schering-Plough for $41.1 Billion - NYTimes.com: "Merck, the American pharmaceutical giant, will pay $41 billion to acquire a rival Schering-Plough, the two companies said Monday."

Teaching points:

Takeovers must be approved by the boards. (Of course sometimes we must elect a new board to get this accomplished)\
"...the deal had been unanimously approved by their boards."
Where is the synergy coming from?
"With the move, Merck is expanding its franchise in cardiovascular, respiratory and oncology drugs and shoring up its research pipeline, which includes a noted Schering-Plough product called TRA, a promising drug designed to prevent blood clotting. In addition, Merck will benefit from the worldwide reach of Schering-Plough...."
That one deal often triggers other deals:
"The deal marks the second major pharmaceutical deal this year. In January, Pfizer, the world’s biggest drug maker, bid $68 billion bid for Wyeth. And Roche, the Swiss pharmaceutical company, is pursuing a full acquisition of the biotechnology company Genentech, in which it already owns a majority stake."
How the deal will be structured and financed:
"Under the terms of the deal, Schering-Plough shareholders will receive 0.5767 shares and $10.50 in cash for each share of Schering-Plough. Each Merck share will become a share of the combined company. The deal values Schering-Plough at $23.61 a share, or $41.1 billion, a premium of about 34 percent based on Friday’s closing price for Schering-Plough.The 44 percent of the deal that is being paid in cash will be financed with a combination of $9.8 billion from existing cash balances and $8.5 billion from financing....The transaction will be structured as a “reverse merger” in which Schering-Plough, renamed Merck, will continue as the surviving public corporation."
Definitely will be covered in class! Stay tuned.

They Tried to Outsmart Wall Street - NYTimes.com

They Tried to Outsmart Wall Street - NYTimes.com:
"They are known as “quants” because they do quantitative finance. Seduced by a vision of mathematical elegance underlying some of the messiest of human activities, they apply skills they once hoped to use to untangle string theory or the nervous system to making money."

* "As Dr. Derman put it in his book “My Life as a Quant: Reflections on Physics and Finance,” “In physics there may one day be a Theory of Everything; in finance and the social sciences, you’re lucky if there is a useable theory of anything.”

* "Physicists began to follow the jobs from academia to Wall Street in the late 1970s, when the post-Sputnik boom in science spending had tapered off and the college teaching ranks had been filled....Things got even worse after the cold war ended....They arrived on Wall Street in the midst of a financial revolution."

*"Stock options, however, were where this revolution was to have its greatest, and paradigmatic, success....But it gets more complicated than that. For example, markets are not perfectly efficient — prices do not always adjust to right level and people are not perfectly rational....As a result, prices do not fluctuate according to Brownian motion. Rather, he said: “Markets tend to drift upward or cascade down. You get slow rises and dramatic falls.”
And so you do not get the impression that the quants are to blame:
"I regard quants to be the good guys,” said Eric R. Weinstein, a mathematical physicist who runs the Natron Group, a hedge fund in Manhattan. “We did try to warn people,” he said. “This is a crisis caused by business decisions. This isn’t the result of pointy-headed guys...who didn’t understand volatility or correlation..”
"The recent debacle has only increased the hunger for scientists on Wall Street, according to Andrew Lo, an M.I.T. professor of financial engineering"
VERY good read. Highly recommend reading it!

BTW this is also mentioned in the NY Times Science Podcast (which is remarkably interesting) even if they do not pronounce Scholes like anyone in finance but like "Skoles".

Monday, March 09, 2009

Simoleon Sense's weekly roundup

Trying to catch up from being gone last week got a bit easier thanks to Simoleon Sense's weekly roundup:

Weekly Wisdom Roundup #18 | Simoleon Sense:
"Here are some links to articles that didn’t make our front page. Several of the articles are very insightful I highly recommend reading them. As always, the articles are from different fields but should make you a more well rounded..."

Great stuff!

Free Book - Nassim Taleb Fooled By Randomness | Simoleon Sense

Simoleonsense.com has the following. WOW. Fooled by Randomness is my favorite of Taleb's books.

Free Book - Nassim Taleb Fooled By Randomness | Simoleon Sense:
"I hope you’re enjoying the free books and posts. Here’s another from Nassim Taleb this time it’s his book ” Fooled By Randomness” be sure to buy your own copy. (I’m not sure how scribd manages to post all these books with out getting in trouble)"

Economy worst since Great Depression, World Bank says - Mar. 9, 2009

How bad? Real bad.

Economy worst since Great Depression, World Bank says - Mar. 9, 2009:
"'The global economy is likely to shrink this year for the first time since World War II,' the bank said, noting that global industrial production, by the middle of 2009, could be as much as 15% lower than in 2008.

Based on those projections, world trade is on track to record its largest decline in 80 years, with the sharpest losses expected in East Asia."

From Warren Buffett (on CNBC):
""It's fallen off a cliff," Buffett said Monday during a live appearance on cable network CNBC. "Not only has the economy slowed down a lot, but people have really changed their habits like I haven't seen.....Buffett said he doesn't regret writing a commentary in the fall encouraging people to buy U.S. stocks, but he joked that in hindsight he wishes he'd waited a few months to publish the piece. Since that commentary appeared on Oct. 17, the Dow Jones industrial average has fallen from 8,852.22 to close at 6,626.94 on Friday."
and from the NY Times:
"Since the recession began, the economy has eliminated a net total of roughly 4.4 million jobs, with more than half of those positions — some 2.6 million — disappearing in the last four months alone. This rapid deterioration has prompted talk that some industries are being partly dismantled......For decades, the government has reacted to downturns by handing out temporary unemployment insurance checks, relying upon the resumption of economic growth to restore the jobs lost. This time, the government needs to place a greater emphasis on retraining workers for other careers, these economists say."
Interestingly several of my students hit on this last point in their essays for a mid-term.

Recipe for Disaster: The Formula That Killed Wall Street

I picked up the latest Wired in an airport this weekend. Great read!

Recipe for Disaster: The Formula That Killed Wall Street:

Some highlights:
"For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

His method was adopted by everybody from bond investors and Wall Street banks to ratings agencies and regulators. And it became so deeply entrenched—and was making people so much money—that warnings about its limitations were largely ignored.

Then the model fell apart."
The article goes on to show that correlations are at the heart of the problem.

"The reason that ratings agencies and investors felt so safe with the triple-A tranches was that they believed there was no way hundreds of homeowners would all default on their loans at the same time. One person might lose his job, another might fall ill. But those are individual calamities that don't affect the mortgage pool much as a whole: Everybody else is still making their payments on time.

But not all calamities are individual, and tranching still hadn't solved all the problems of mortgage-pool risk. Some things, like falling house prices, affect a large number of people at once. If home values in your neighborhood decline and you lose some of your equity, there's a good chance your neighbors will lose theirs as well. If, as a result, you default on your mortgage, there's a higher probability they will default, too. That's called correlation—the degree to which one variable moves in line with another—and measuring it is an important part of determining how risky mortgage bonds are."

I would highly recommend reading the entire thing that gets much more involved with the actual formula etc.

Thanks to Mark for the link.

Back from volunteering

I am back from a week (actually a bit longer) of volunteering in Galveston Texas with BonaResponds. It was a good trip. By no means was it my favorite BonaResponds trip, but it was still good. Much work got done. We had 44 people.

The work was spotty (especially later in the week) but in part great. We cleaned over 2 miles of road, gutted about 6 homes, helped drywall a home, helped roof and put up interior walls and ceilings at one home, helped put up siding on one house, helped rough wire a house, wrapped the exterior of one house, installed electric for RV parking, moved a family, painted several interiors, and sandblasted and painted 17 bunk beds.

All in all a productive week.

Galveston was different from most places we have been. Parts of the city looked normal while others looked horrible. Moreover, it was seemingly a ghost town once you got off the main streets. I am not sure what part of this is because it was a vacation area for many, and what portion of it is that people have just given up and moved on.

Galveston was also home to some of the worst housing conditions I have seen rivaling even the poor parts of New Orleans or East Biloxi.

Did we solve the problems of the residents? No, but for many, we did make things better and that is all we can really hope to do.

BTW If you ever want to get involved with BonaResponds, there is no need to be affiliated with SBU at all. Just let me know and I can make you aware of upcoming trips etc.

Largely cross posted on the BonaResponds blog too.