FRB: Speech, Bernanke--The Coming Demographic Transition: Will We Treat Future Generations Fairly?--October 4, 2006

More on the changes that may be brought about by the retiring of the baby boom generation. This is from Fed Chairman Ben Bernanke.


FRB: Speech, Bernanke--The Coming Demographic Transition: Will We Treat Future Generations Fairly?--October 4, 2006:

Short version: increase savings to increase productivity. And rely on FinanceProfessors to save the day ;) Ok, so maybe that was added.

Some highlights:

"In coming decades, many forces will shape our economy and our society, but in all likelihood no single factor will have as pervasive an effect as the aging of our population."

"The fiscal consequences of these trends are large and unavoidable. As the population ages, the nation will have to choose among higher taxes, less non-entitlement spending, a reduction in outlays for entitlement programs, a sharply higher budget deficit, or some combination thereof."

* Because there will be fewer workers, it is widely expected that Real GDP will decline. Bernanke suggest this problem can be lessened with higher investment now:

"Although some adverse effect of population aging on future per capita output and consumption is probably inevitable, actions that we take today....have the potential to mitigate those effects. One such action would be to find ways to increase our national saving rate. If the extra savings were used to increase the nation's capital stock--the quantity of plant and equipment available for use by workers--then future workers would be more productive, ameliorating the anticipated effects on per capita output and consumption."

This could be done by lowering deficits:

"If, as a nation, we were to accept the premise that the baby-boom generation should share at least some of the burden of population aging, what policy steps might be implied? As I have already noted, from a broad economic perspective, the most useful actions are likely to be those that promote national saving. Perhaps the most straightforward way to raise national saving--although not a politically easy one--is to reduce the government's current and projected budget deficits. "

* This would almost assuredly involve reducing entitlement programs:

"Reform of our unsustainable entitlement programs should also be a priority. "

* And convincing consumers to save more now:

"Increasing private saving, which is the saving of both the corporate sector and the household sector, is likewise desirable.... Unfortunately, many years of concentrated attention on this issue by policymakers and economists have failed to uncover a silver bullet for increasing household saving. One promising area that deserves more attention is financial education.... which may be useful in helping people understand the importance of saving and to learn about alternative saving vehicles. "

See I told you that FinanceProfessors would come to the rescue!!!!

Save early, save often! Pass it on.

Will stocks go Boom?

Canada's National Post gives us all something to worry about it its series on the impact of an aging labor force. In the second part of the series, the paper examines whether as baby boomers retire if they will drive down stock prices.

Will stocks go Boom?:

"In the United States, for example, the ratio of workers to retirees is expected to fall to just 2.6 in 30 years, from 4.9 today. In Japan, the ratio of retirees to active workers is expected to fall even further, to one to one by about 2050.

In other words, the number of potential stock buyers will soon begin a steep decline....No less an authority than Jeremy Siegel, the famous Wharton finance professor and author of Stocks For The Long Run, has sounded the alarm, calling the ageing population the most critical issue facing the developed world."

What about the impact on finance? Not only will the changing workforce impact pension funds, social security, and health care costs, but it will likely drive down the stock market as the boomers end saving and begin to draw down their portfolios.

Now before you panic, the coming tidal wave of retirees in the developed world may be offset by other factors (notably foreign investment as more lesser developed countries develop and formerly impoverished people become investors) but it is something to consider and "gameplan".

Most likely outcome? As baby boomers age they will shift money out of stocks and this will be a factor that keeps returns lower than their historical averages. Which means we should all lower our projected returns. This unfortunately means we will have to save more for a comfortable retirement be it personally, in corporate pension funds, or in government sponsored "social security" accounts.

And if this analysis is wrong and the market continues to earn higher than historical norms? We will have set aside more than needed and you will have more money in your portfolio than expected, which is not the worst thing in the world!

Some past articles on this topic:
Will bomers drive down markets? (October 2004)

Porterba on impact of Boomers (November 2004)

USATODAY.com - Easy credit can mean long-term hardship for college students

I am torn on this one. On one hand it is inarguable that many people (including no doubt a higher percentage of college students) do get into financial difficulty stemming from excessive use of credit cards. However, the ban on marketing of the credit cards on campus does seem a tad much. Credit cards do have their upsides as well: they help build credit and lower transaction costs.

On the other hand, many 18 year olds are not ready for credit cards and do succumb to overspending.
From USATODAY.com :

Easy credit can mean long-term hardship for college students: "College students tend to have less financial experience than older adults, making them more susceptible to these pitches....Nearly a dozen states, including New York and California, have made it harder for card companies to market on public campuses. And a growing number of colleges, on their own, have begun to impose restrictions."

Of course the credit card companies do not want to lose this market.

So what to do? If you are a college student who is mature enough to use (and not misuse) a credit card, I would recommend highly getting one to build credit and for ease of use. However, get one with no fee and pay off the bill completely every month. If you find this progressively more difficult to do, stop using it until it is paid off.

Financial Rounds: Who are My Picks For the Nobel Prize in Economics

It's that time of year again: time to bet on who will be the next Nobel Prize winner in Economics. The Unknown professor over at Financial Rounds does a good job with his two picks.

Who are My Picks For the Nobel Prize in Economics:

"....speculation seems to be heating up for who will get the next Nobel Prize in economics. I'll cast my vote for Eugene Fama of the University of Chicago for his earlier work on market efficiency (and later work on size and market-book effects which seem to contradict his earlier work). If he gets the nod, there's a good chance that his coauthor Kenneth French would share it with him.

A second choice would be The U of Chicago's Richard Thaler"

I would add Michael Jensen although I would say he is more of a long-shot. In reality, and economics (as opposed to finance) person more regulalry wins it. Stay tuned.

BTW does anyone know if there is still a decision market for this prize? I did not see one at Tradesports.com does not have one and the Nobelpreisborse seems to be out of business .

But I do see at Tradesports that the Buffalo Bills are the biggest up mover on the over/under wins market. (yeah, I know it is only 6.5 wins, but still, they are up and playing well, so I will take it!)

Amaranth update

Interesting. Things could have been worse.

Bloomberg.com: U.S.: "The New York Mercantile Exchange told Amaranth Advisors LLC that the hedge fund's natural gas bets were too big a month before the trades led to a $6 billion loss, said two people with knowledge of the meeting.

Amaranth unwound some of its natural gas positions after the warnings, according to the people, who asked not to be named because the communications were confidential."

Also from the same Bloomberg story:
First the predictable politcal intervention:

"Members of Congress .... want greater authority for the Commodity Futures Trading Commission to monitor energy trading, especially on the all-electronic Intercontinental Exchange Inc.

And then an update on Brian Hunter the Amaranth trader responsible fo "the biggest-ever hedge fund loss" ....is "no longer works at Amaranth, the Financial Times reported earlier today, citing unidentified people close to the matter.""

Time to throw a penalty flag

First, the good part: Tuesday Morning QB does a great job of laying out the issue and demonstating one problem with boards setting pay .

From last week's TMQ which appeared on ESPN.com: Page 2 : The five-month NFL forecast:

"Much news and sports commentary focuses on the ever-larger paychecks of professional athletes. But even Peyton Manning is a day laborer compared to the modern Fortune 500 CEO....Over his last five years at the helm, he got $162 million, even as Pfizer earnings faltered. Carol Hymowitz of the Wall Street Journal reported that the head of Pfizer's "compensation committee" defended McKinnell's windfall on grounds of market forces in executive pay -- which in this context appears to mean, "CEOs at other companies are picking shareholders' pockets, too."....McKinnell's pay for his tenure atop Pfizer equates to $130,000 per work day."

and slightly later:

"...consider that executive income usually is rubber-stamped by boards of directors whose members may be engaged in self-dealings with the firm, or who have a self-interest in rising CEO pay. As Julie Creswell noted in the New York Times, "Five of the six active Home Depot board members are current or former chief executives of public corporations … CEOs benefit from one another's pay increases, because compensation packages are often based on surveys detailing what their peers are making....The board members know the more they inflate CEO pay, the more they themselves will be able to pilfer from their own shareholders"

Ignoring the use of the word 'pilfer', this is a well-presented valid point. However, Easterbrook's next point deserves a yellow penalty flag and further review:

"Recently the Business Roundtable released a study purporting to show that CEO pay rose 9.6 percent annually from 1995-2005, while stockholder returns rose 9.9 percent in the same period. So things aren't so bad, eh? The Business Roundtable said the study 'sets the record straight.' The Business Roundtable is, by its own description, 'an association of chief executive officers of leading U.S. companies.' As Gretchen Morgenson, dean of Wall Street journalists, laid it out in the New York Times, the study systematically understated the income of CEOs... 'The study counts only the value of the options and restricted stock received by executives on the dates the awards were made.'"

Uh, wait, isn't that what we should be doing?

True, we should take into account the non normality of the stock distribution (induced both by rewriting underwater options and by the now famous back dating of options) which causes the Black-Scholes formula to understate the true value of the grant, BUT the value at grant is what we should consider. We can debate whether the Black-Scholes formula is correct or not, but theoretically the value at grant (again presuming a fair grant) is what matters.

Moreover, while it is true that the Business Roundtable is made up of CEOs, that should not be grounds for dismissal. The actual study does have several valid, and overlooked points. Notably that medians should be used, that the media "sometimes summarizes the pay practices for all CEOs from only the very largest companies", and the seemingly inarguable point that "pay statistics should be referenced accurately and applied responsibly".

Like other things, I will take the bad with the good. Overall
Tuesday Morning QB is still my favorite sports article. Its author is Gregg Easterbrook who is a former Buffalo School teacher and who wrote the Progress Paradox, does a great job weaving many topics together in a funny, witty manner. That said, I guess I can no longer count TMQ as "finance reading". LOL.

Continuing the inflation theme

Continuing the inflation theme:

While inflation can obviously lead to many problems, there is an important bias that must be considered (especially when you think of inflation measured by government statisticians.) As the NY Times so aptly points out, this problem can be illustrated with the humble snow-blower.

Life Is Better; It Isn't Better. Which Is It? - New York Times:

"...the benefits of the snow blower, namely more free time and less health risk, are largely missing from the government'’s attempts to determine Americans'’ economic well-being. The same goes for dozens of other inventions, be they air-conditioners, cellphones or medical devices...."

Why? In part because new inventions, or improvements of existing items, can take years to show up in official indicies.

Again from the NY Times:

"The cellphone and the air-conditioner also improved middle-class life, and also took years to get into the inflation numbers, by which point their prices had plummeted. Wal-Mart’s effect on prices is another blind spot in the index, which considers something sold at a discount to be lower quality (and, therefore, not truly a bargain) than something sold at full price...."

The result? Official inflation numbers are overstated. Not only does it enter our mental math on whether we are better off or not than past generations (we are contrary to what some will tell you), it has become a campaign issue, and can have major implications to cost of living adjustments (COLAs).

Best advice, realize CPI and other government inflation indicies overstate the actual inflation rate.

BTW be sure to look at the NY Times Graphic that shows how large of impact the inflation bias can have on "real" income.

And you think the Fed has it tough?

Post WW I Germany often is the example of hyperinflation used in Money and Banking texts, but for a more timely example you may want to consider Zimbabwe.

BBC NEWS | Business | Zimbabwe's inflation tops 1,200%:

"Zimbabwe's annual inflation rate continues its upward surge, reaching a record high of 1,204.6% in August, and adding greater strain to the economy."

Why is hyperinflation such a problem? Ignoring the impact it has on debt holders (they would get paid back with money that is next to worthless), try to imagine how inflation like that would affect your own behavior.

No longer would you hold any cash, you would want to spend any check immediately, you would want to be paid on a daily basis, etc. You forgo money and the economy falls back in to a barter system. All of this is inefficient and takes a toll on the economy.

More importantly, those who had saved money (especially in fixed income investments), will see their savings evaporate. This creates a sense of panic and increased risk premiums.

As people take their money out of banks, that source of capital disappears. This too hurts the economy and often leads to further government borrowing (which gives the central bank the incentive to monetize the debt).

Further, the sense of uncertainty and decline in value of the currency leads to hoarding of supplies (and accompanying shortages).

Which is a long winded way of saying that hyper-inflation is not merely "moving the decimal place" but that it does have serious economic repercussions.

The sleuth who exposed backdating scandal

I always like to see finance professors in the news!

Philadelphia Inquirer | 09/21/2006 | Sleuth who exposed backdating scandal:

A few "look-ins":

"From his second-floor office at Iowa's Tippie College of Business, [Erik] Lie spent months analyzing data to demonstrate how companies were illegally and retroactively timing, or backdating, stock option grants to fatten bonuses paid to top executives.

"He's uncovered a scandal that has just mushroomed," said Adam C. Pritchard, a former attorney at the Securities and Exchange Commission and now a law professor at the University of Michigan.

and later in the article:

"'The Enron stuff is very sexy, but that type of fraud was not pervasive,' said Andrew Metrick, a professor of finance and corporate governance at the Wharton School in Philadelphia. 'This is widespread, pervasive. I think when this is all said and done, the total amount of dollars that we'll find have been stolen from the corporate till is larger here than any other case we've seen.'"

Read the entire article here.

Basketball superstar meets superstar investor

I'd guess it was a pretty big tip for the waitress!

LeBron shoots the breeze with Letterman, Buffett - NBA - Yahoo! Sports:

"A few days earlier, James had lunch in Omaha, Neb., with billionaire Warren Buffett. ...James, who signed a three-year, $60 million contract extension with the Cavaliers in July, may have been seeking some off-the-court business advice from Buffett, the self-made billionaire investor.

Last year, in an interview with The Associated Press, James said one of his primary goals was to 'be the richest man in the world.' James, who will turn 22 in December, already has endorsement deals worth an estimated $150 million.

Buffett sported a full Cavaliers uniform, complete with a jersey bearing his name, during his lunch with James....James ordered a bacon cheeseburger, french fries and an Arnold Palmer, a drink concocted of lemonade and iced tea. Bubarek said he topped off his meal with an Oreo cookie milkshake delivered by a Buffett staffer."

HP Spy Scandal Hits New Weirdness Level: Financial News - Yahoo! Finance

This just keeps getting more bizzarre! Like I said two weeks ago, I want movie rights!

HP Spy Scandal Hits New Weirdness Level: Financial News - Yahoo! Finance:

"Not only did investigators impersonate board members, employees and journalists to obtain their phone records, but according to multiple reports, they also surveilled an HP director and a reporter for CNet Networks Inc....

They even snooped on the phone records of former CEO and Chairwoman Carly Fiorina....

And in a twist that might seem preposterous if it happened in a movie, The New York Times reported that HP consultants considered hiring spies to pose as clerical or custodial workers at CNet and The Wall Street Journal"

Breaking Down Silos at Yale

While curriculum discussions generally bore me, this one is the exception for the size of the changes and the potential ramifications. Yale's business school has done a major facelift to its offerings. Some look-ins thanks to Business Week:

Breaking Down Silos at Yale:

"...not just at Yale, but at any of the curricula that you would look at any of the major business schools, they were broken down by functional silos: a course in marketing, a course in accounting, a course in organizational behavior. But if you talk to any leader of a major corporation, they will tell you that the real value to be added is in working across those silos, and the disciplinary delivery got in the way of educating students in a way that could maximize their ability to add value to the organizations of which they are a part."

and also:

"We now offer a course on the customer rather than a course in marketing, a course on the investor rather than a course in finance. All of them are multidisciplinary in both their design and their delivery. And then we have a course called the integrated leadership perspective at the end which sort of brings together all the different perspectives."

While I am not taking any position on the new design, I will say that even in a traditional finance class it is important to understand the other functional areas. Indeed, every class I teach starts with that discussion AND it is yet another reason why no matter what your major is, there really are no "blow off" classes. You just never know when the material from a class is going to be valuable later in life.

Deja vu all over again? Hedge Fund Shifts to Salvage Mode - New York Times

As Yogi Berra would say "Deja vu all over again." Amaranth's troubles may be more serious than previously thought. Indeed, they have the potential of being the next Long Term Capital Management.

Hedge Fund Shifts to Salvage Mode - New York Times:

"Last night, as it had been since the weekend, Amaranth was locked in negotiations...in an effort to sell its energy portfolio to try to keep the fund company afloat.

At the same time, it was working with commodity exchange officials to reassign trades to try to minimize disruptions to the market.

The fund’s investors, locked into their holdings by Amaranth’s stringent liquidation terms, awaited further word on the status of the fund’s holdings, while regulators and traders watched for signs that the hedge fund’s losses might disrupt markets beyond those relating to energy"

Sound familiar? Hedge fund does well, then bets go bad, and suddenly the fund (and possibly market) is in trouble. Sure sounds like we've seen this one before.

Another similarity? Among the reported causes is the fact that it looks like El Nino is returning which keeps temperatures lower and hence leads to less demand. Once again, something that many people would have left out of their models.

FRB: Testimony, Braunstein--Non-traditional mortgage products--September 20, 2006

Sandra Braunstein is the Fed's Director of Consumer and Community Affairs. She spoke before a Senate Subcommittee today. The comments largely focued on the truth in lending law, but also discussed various "non traditional morgtage instruments and the Fed's efforts to assure that borrowers know what they are getting into.

FRB: Testimony, Braunstein--Non-traditional mortgage products--September 20, 2006:

"Nontraditional mortgage products have increased the range of financing options available to consumers and have grown in popularity over the past few years. With traditional thirty-year fixed-rate loans, consumers have equal monthly payments that are sufficient to cover the accrued interest and pay down the principal. In contrast, interest-only loans allow consumers to defer the payment of principal and make only interest payments for an initial period. Option-ARMs allow consumers to make 'minimum payments' of less than the accrued interest, which causes the loan balance to increase ('negative amortization').

Some consumers may benefit from these products and the more flexible payment options, for example, consumers with seasonal or irregular income. For consumers who expect their incomes to increase, the initially lower monthly payment with these loans may enable them to purchase homes that they otherwise might not be able to afford. But these loan products are not appropriate for everyone, depending on their individual circumstances. When monthly payments increase, sometimes substantially, consumers may face 'payment shock.' Thus, it is important for consumers to have the information necessary to understand the features and risks associated with these types of mortgages...."

Later:

"The Federal Reserve plays several roles and engages in various activities to ensure that consumers understand credit terms and the options available to them when they are shopping for mortgage credit."

She concludes:

"The Federal Reserve is actively engaged in efforts to ensure that consumers understand the terms and features of nontraditional mortgage products. Improving federally required disclosures under TILA is one aspect of this endeavor. We are also pursuing other opportunities, such as consumer education publications and interagency regulatory guidance that will include recommended best practices for depository institutions. We expect the Board will continue these efforts over time as mortgage products evolve in response to consumers' changing needs."

Teaching note: this would be a great fit for an institutions, money and banking, or commerical banking class. Or even a real estate class.