The Sovereign Ceiling

Let's say you're a well run company with a low debt to capital ratio and a high interest coverage ratio. Your bondholders sleep soundly at night, knowing that their principal and interest is coming back to them. However, you happen to be located in a country that is not known for its fiscal conservatism, such as Argentina. If your home country is only rated BBB by S&P/Moody's, what's the best rating your company can hope for?

The sovereign ceiling says that the private sector should not be able to borrow on better terms than the government, since the government has the most senior claims on the firm's earnings (priority ahead of both debt and equity). If the government runs into economic trouble, it may be more likely to expropriate assets. Additionally, the government's problems may reflect broader economic issues that will also impact the firm. Therefore, lenders should not offer better terms to a private company than they would to its host country. The country's credit rating is a cap on all firms' credit ratings.

A graphical representation of the federal budget

April 15 has come and gone, but that's no reason not to look at where all those tax dollars go (and all those Treasuries we sell). WallStats has created an image that does exactly that. Click on the image below to expand (it's quite large), or use the previous link for an interactive graphic.

The foreign profits tax "loophole"

Since it is April 15...Much political hay has been made about the supposed "loophole" that allows companies to defer US taxation on profits earned overseas until those profits are repatriated. Is this really a loophole, or is it simply consistent with how most profits on investments are treated? Consider the following.

Scenario 1: You're an individual investor and who buys a share of stock in Toyota in January for $100. Over the course of the year, the company earns $5/share in pre-tax profit. They pay corporate taxes of 20% on their earnings, so your share of the after-tax profit is $4. The local government collects $1/share in tax revenue. The company pays no dividend and reinvests those $4 profits into developing new products, hiring workers, expanding factories, etc. At the end of the year, your share is now worth $104. You haven't sold your share, so your profits are unrealized, and the tax you owe is $0, because although your investment is worth more on paper, you haven't actually received any cash. You have deferred your tax burden until you either sell the shares or receive a dividend.

Scenario 2: You're a corporation who buys a small company that owns several companies in Estonia for $100 million. Over the course of the year, the subsidiary earns $5 million in pre-tax profit. They pay corporate taxes of 20% on their earnings, so your share of the after-tax profit is $4 million. The local government collects $1 million in tax revenue. The company pays no dividend back to the US and reinvests the $4 million profit into developing new products, hiring workers, expanding factories, etc. At the end of the year, your investment is now worth $104 million. Your company in the US hasn't received any cash or profits and under the current system you wouldn't owe any additional tax on top of what the subsidiary already paid the local government.

However, if the tax laws were changed to make foreign income taxable, you would have to immediately pay US taxes on the entire $5 million, even though the parent corporation never received any cash from the foreign subsidiary - all the cash and profits were either paid in the first round of local taxation or reinvested in growing the company.

This is a highly simplified example. Obviously there is a distinction between normal foreign earned profits and truly abusive tax shelters in some countries that should be eliminated. But this example shows that foreign earned profits are not much different than profits earned on other similar investments. So is it equitable to treat them differently? Investors who have a 401k or IRA also take advantage of tax deferral - is that a "loophole"?

This paper talks about the impact of collateral levels on the economy, not just interest rates. I particularly like this quote:

"Over 400 years ago Shakespeare explained that to take out a loan one had to negotiate both the interest rate and the collateral level. It is clear which of the two Shakespeare thought was the more important. Who can remember the interest rate Shylock charged Antonio? But everybody remembers the pound of flesh that Shylock and Antonio agreed on as collateral. The upshot of the play, moreover, is that the regulatory authority (the court) decides that the collateral level Shylock and Antonio agreed upon was socially suboptimal, and the court decrees a different collateral level. The Fed too should sometimes decree different collateral levels."

Risk Management

Bling & your computer's input devices

If you've been watching late night TV commercials, or the afternoon fare on CNBC, you're probably convinced that this is the right time to invest in gold. Inflation is bound to return at some point. But how do you advertise your goldbug proclivities to friends and coworkers without actually spending $900/oz? The gold bullion wireless mouse is just what you need. It contains no actual gold, and can be purchased for around $35.

Divergence: Job losses and time to recovery

From a WSJ article on the job market. The interesting thing is at the bottom of the chart - the divergence between the percentage of jobs lost from peak to trough versus the number of months it took to recover post-recession. Until the most recent downturn, there is a clear trend of job losses becoming less and less severe (the great moderation?), going from 7.9% to 1.2%. In spite of this, the time to recovery shows the opposite trend, increasing from 18 months to 48 months.

Cap-and-trade market structure, lessons from the past

From an article in the JACF on Designing a US Market for CO2. Most interesting are the lessons learned from the US SO2 (sulphur dioxide)market, a successful cap-and-trade system that began in 1995. How did the market's design and structure affect trading and contribute to the massive price spike in 2005-2006 (see graph below)? Prices increased from $220/ton to over $1600/ton before declining back to $200/ton. One explanation points to a change in the EPA's regulations in 2005 (CAIR) that put a tighter cap on emissions starting in 2010 and tightening more through 2015. Since emissions credits can be banked, expectations of increased demand in the future should be reflected in the current price. However, this regulation was only supposed to increase the cost to ~$600/ton, and while it might explain the spike it cannot explain the subsequent drop. A second explanation relies upon a shortage of low-sulphur coal due to railroad outages. This shortage increased demand for allowances and correspondingly, the price. While the shortage might have increased demand in the short-run, credits were available that could have been drawn upon to reach a slightly higher price equilibrium rather than a massive spike. So why didn't anyone step in and sell their credits at a massive profit? The answer lies in the restricted float - a low number of credits available for trade - which is due to the way the market was designed.


First, the credits were initially distributed to natural shorts (e.g. a power plant that produces SO2) that expected to use them at some point in the future. Except for relative emissions reductions (a plant installs a better scrubber and thus needs fewer credits), most of the market participants will stay long the credits to offset their natural short exposure. Thus, incentives to trade are reduced and the market is less liquid. Lower liquidity means that small changes in supply or demand can have a magnified effect on price.

Second, the credits were distributed for free, and were held on the firms' balance sheet at zero tax basis. When a credit is redeemed, the increased value is recognized as a gain, but offset by the increased environmental liability from generating the SO2, so it's a wash for tax purposes. If a firm believed the price spike was temporary, it could sell some of its banked credits while prices were high, then buy them back once the market returned to normal, netting a profit. But this action creates a taxable gain today, while the liability is still off in the future. The potential gains from this arbitrage must be weighed against the acceleration of the tax liability.

Third, many of the firms with credits are publicly regulated utilities. If the firm were to profit from selling credits high and buying them back low, regulators might force the firm to pass the profits along to customers (rather than letting shareholders and management keep them). On the other hand, if the arbitrage failed and the firm lost money, regulators might view this as speculation and punish management for being imprudent.

Thus, the owners of SO2 credits failed to create a viable market for them. Note that financial intermediaries, such as the much maligned short sellers and speculators, could help provide liquidity to a market like this and thereby enable more efficient price discovery, reducing the risk of disruptive price spikes.

Law and Economics: The Bimodal Distribution of Lawyers' Salaries

A New York Times op-ed recently reminded me of the graph below, showing the bimodal distribution of lawyers' salaries: public service on the left, private law firms on the right. Time for more two year law schools? Lower biglaw salaries? People don't think of law firms as highly leveraged institutions but while they don't usually have much debt, they do have operational leverage from the partner-associate structure. Each associate is a fixed cost that has to be paid (debt) before the partner gets his earnings (equity). So a firm with 1:1 partner:associate ratio is about 50% leveraged. Of course, associates can be laid off during bad times, while debt is defaulted on.

Cross-listed Shares and the Bonding Hypothesis

A foreign company can issue shares on the US equity markets, if it agrees to comply with the US regulatory regime. The bonding hypothesis says that this improves corporate governance by forcing the firm to respect minority shareholder rights and increasing the amount of information that's disclosed about the firm. Thus, a company from a country with low investor protections can "bond" itself with the US, where investor protections are high. In turn, this could lower the firm's cost of capital and allow it greater access to capital markets. However, some challenge the bonding hypothesis because enforcement actions by the SEC against cross-listed firms are rare.

Encyclopedias and the Pace of Change

Last week, Microsoft announced that they are shutting down Encarta, the digital encyclopedia that was originally released on CD-ROM. A brief history:

• 1778-1993 (215 years): Encyclopædia Britannica rules the day
• 1993-2009 (16 years) Microsoft's Encata quickly takes over
• 2009-?: Volunteer-edited Wikipedia ascends to the throne

The question is, how long will Wikipedia reign? If the average lifespan of encyclopedia technology continues to shrink at the speed implied above, a challenger may already exist. Ironically, Microsoft helped force Britannica's capitulation by giving away free copies (excuse me, "bundling") of Encarta when you bought a new computer with the Windows operating system. Wikipedia's product managed to undercut them on price while offering greater value and a lower cost of production.

Trop50: An Orange Juice Ripoff

Tropicana (a wholly-owned subsidiary of PepsiCo) recently released a new juice drink product called Trop50. The sales pitch: it has 50% fewer calories and 50% less sugar than regular orange juice. I'm all in favor of reduced calorie/sugar beverages, but do the economics of this make sense?

I spotted a container of Trop50 at the store and although it is the same shape and price as the regular Tropicana ($2.96), the Trop50 package is 8% smaller by volume (64 ounces versus 59 ounces). The problem compounds when you flip the carton around and notice the statement "contains 42% juice." The back panel reveals that the primary ingredient is water, followed by reconstituted orange juice, then some vitamins, and finally stevia (a non-sugar "natural" sweetener). So Trop50 expects you to pay an 8% premium for a product that contains 58% less juice (58% more watered-down) than regular OJ?

Here's a cheaper alternative: fill your glass halfway with regular orange juice, then add water until it's full (cost per 12 oz serving: $0.28). Or, buy Trop50 (12 oz for $0.60), and pay a 117% premium for the 30 seconds it will save you in the morning.

The MBA Job Market for the Class of 2009

As of mid-March, anecdotal evidence from three schools: Emory (Goizueta), SMU (Cox), and Georgetown (McDonough) indicates that about 40-50% of the full-time MBA students set to graduate in May have accepted job offers. The pace of hiring is well below last year. First-year students (the class of 2010) are having an even tougher time securing internships for the summer.

In what could be mistaken for a headline from The Onion, Harvard Business School is launching a case study to determine why their case studies didn't keep us out of our current mess.

New York Times: Now the Long Run Looks Riskier, Too

From a recent New York Times article: a new academic study shows that equity investment volatility actually increases over time. Although there is evidence that returns are mean reverting, which reduces volatility over longer time horizons, the authors identify several other factors which more than offset this reduction in risk. These factors include uncertainty about future expected returns and estimation risk. Traditional portfolio theory uses sample statistics (e.g. the average return on stocks over the last 100 years) and assumes they represent the true population of possible values going forward. This approach leads you to believe that volatility of returns decreases as your investment horizon increases (i.e. the standard deviation of your portfolio goes down if you invest for 30 years instead of 1 year). In contrast, this study uses Bayesian statistics, which separates predictive variance (which includes parameter estimation error) from true variance (which has no estimation error).

If you estimate future stock market returns using historical averages, that average has some estimation error in it. As your time horizon increases, parameter estimation risk compounds which leads to an increase in volatility (rather than a decrease). To put it another way: traditional theory says that predictors are perfect and parameters are certain. This theory says that predictors are imperfect and parameters are uncertain. Over time, these imprecisions and errors add up to substantially increase the volatility of your portfolio. The authors use 206 years of data to calculate that the volatility of your stock portfolio over 30 years is about 1.5 times greater than it would be over 1 year. Their conclusion is that stocks are less appealing than they would appear to be under the traditional view of historical risk and return.

Consider: if you started investing in 1979 through 2009, would you have done better in 20 year treasury bonds (rolled over each year) or the S&P 500 with reinvested dividends? An upcoming study (Bonds: Why Bother?) shows that regardless of which month you started in, treasuries outperformed stocks over this period. This is further evidence that the conventional wisdom, that stocks are "safe" as long as you're holding them for 20 years, is wrong. In reality, it doesn't matter how long you plan on holding stocks, they're inherently risky. They may still be a good investment, but you are not guaranteed a higher return just because you took more risk.

Problems with the cost of capital estimation in the current environment

If you're going to value something based on its discounted cash flows, you're going to need a weighted average cost of capital (or an equity cost of capital) to apply to those cash flows. Duff and Phelps recently released a paper discussing the difficulty of determining the cost of capital in today's environment. Some of the problems they address:

Treasury yields (the risk free rate in CAPM) are temporarily low due to liquidity concerns and a flight to quality, understating risk. It is difficult to decompose treasury yields into components of real return, inflation expectations, and reinvestment risk.

The expected equity risk premium (ERP) has increased greatly (as evidenced by the massive decline in stock prices). However, they claim the equity risk premium ranges from 3.5% to 6.0% throughout the business cycle, which seems extremely low to me. We are not in a normal business cycle here, so I think the forward-looking ERP must be higher than 6%.

Declines in financial stocks and companies with high leveraged have outpaced the broader market, leading to a misleading beta calculation that implies risk has actually declined. Beta measures the covariance of a stock's returns with the market's returns. The market had become overweighted with financial stocks that dragged the index down as they declined. So if you compare a non-financial company's stock covariance to the pre-crash market versus its post-crash covariance, it will appear to have decreased, leading to a lower beta. They recommend using a sum beta calculation to correct for this.

Highly levered companies will probably be unable to sustain their debt loads going forward. The cost of capital needs to reflect likely changes to the capital structure over time. Alternately, you could use an approach like adjusted present value (APV) which separates out the value of the tax shields.

Companies operating with substantial losses may not be able to take advantage of the tax shield on interest in the period when it is paid. So the after-tax cost of debt capital may be inappropriate.

Their final recommendation is that any cost of capital calculation must also pass the reasonableness test. Most of these issues stem from the fact that finance theory attempts to use past data to predict future performance. That becomes increasingly hard to justify during times of discontinuous change, such as the one we're experiencing now. For more information, the authors of this paper have published a practitioner's guide to the cost of capital, available at Amazon.

Regressions everywhere you look

Is there anything more enjoyable than putting your feet up, opening Excel, gathering data, and running regressions? Of course not. Let's take a look at household energy consumption as a function of cooling degree days (CDD). Cooling degree days are calculated by subtracting 65 from a day's average temperature. For example, if the day's high is 90°F and the day's low is 70°F, the day's average is 80°F. Eighty minus 65 is 15 cooling degree days. There's a similar measure for heating degree days. This data is used for a variety of purposes, including weather futures (derivatives tied to temperature allow utilities to hedge exposure to fluctuating weather). Recent data has put Dallas, TX squarely in climate zone five, with around 3200 CDD and 1800 HDD annually. Here's a nice graph of the country by climate zone:

1. CDD less than 2000, HDD greater than 7000
   
2. CDD less than 2000, HDD between 5500 and 7000
   
3. CDD less than 2000, HDD between 4000 and 5499
   
4. CDD less than 2000, HDD fewer than 4000
   
5. CDD greater than 2000, HDD fewer than 4000
   

When you regress the last two years of my monthly electricity usage in kilowatt hours against cooling degree days (standardized to a 30-day month for consistency), a clear trendline emerges. In the summer time, the air conditioner accounts for up to 80% of my electric usage. Based on the R-squared, CDD does a better job at predicting energy consumption than just plain temperature. In this case, an exponential regression has the best fit with the data. This makes sense, since the temperature transfer from the environment into the house is larger when the temperature differential between the two objects is higher. Therefore, extremely hot days will take a disproportionately large amount of energy to keep cool. Of course there are other variables, such as cloud cover, wind speed, humidity, etc. but this is a good start. It will be interesting to see if the cellulose insulation and radiant barrier foil I added to the attic last fall will have a statistically significant impact on energy consumption this summer.


Our gas bill is larger in the winter. This time, a linear regression of heating degree days against gas consumption in thousand cubic feet had the best fit with the data.

A graphical representation of social security's problems

Takeaway: in 1940, social security offered retirement at age 65 - but the average person didn't even live that long. 60 years later, social security's retirement age was unchanged, but the average person lived 75 years. No wonder the program is perpetually on the brink of insolvency. If a life insurance company operated this way, it would've gone bankrupt long ago. (As an aside, it would be interesting to examine purchasing power of social security benefits from 1940 versus 2000.)

This is from a 2003 paper on Demographics and Capital Market Returns that looks at the coming generational conflict between younger workers and older retirees as a result of the shifting "dependency ratio." This has serious implications for investors, who may see declining demand for stocks as people sell assets in retirement and not enough younger workers willing/able to purchase them. Their (optimistic?) conclusion is that retirement will be unaffordable at age 65 for most baby boomers, and therefore they'll keep working until their early 70s. The potential ameliorating effects of immigration, productivity, global trade, and social security reform are all discussed.

Personal investment preferences by country

Much has been said about Americans' low savings rate, usually less than 1% in recent years. As with most numbers that get a lot of press time because they sound impressive ($60 trillion in credit default swaps? Excuse me, but that's a notional value, not the actual value of the contracts), it's a misleading statistic. It doesn't count saving in 401(k)s and IRAs. It also gives too much weight to retirees who spend more than their income by selling assets in their portfolio. It doesn't account for the amortization of durable goods - if you buy a car, the entire cost is counted as spending in the year of purchase when in fact, you will likely use that car for several years. Depreciation on houses is also counted as spending and this "expense" increased substantially as house values rose. However, no credit was given to households for the appreciation of their real estate. Granted, a lot of that appreciation was phantom wealth, but even so, over the long term we should expect house values to increase roughly in line with inflation. If you're going to count non-cash expenses like depreciation then you should also count unrealized capital gains as income. Once you correct for all of these factors, Americans' savings rate is actually several points higher than the reported number.

So how do Americans invest their savings compared to citizens of other countries? Here's a graph from a slightly dated report on household investments by country. Not surprisingly, we have the highest proportion of our wealth tied up in equities.


More detailed statistics on US household investment preferences is available from the Census:

Spending in retirement: The 4% rule

Bill Sharpe et. al. prepared an interesting analysis of The 4% Rule (At What Price?) that examines the traditional advice given to retirees: plan on spending 4% of your initial 60% stock/40% bond portfolio every year in retirement to acheive a >90% success rate (confidence interval) of having enough money for the rest of your life. The 4% rule is parroted by many retail investment advisers - and therefore, "it behooves us to be familiar with the rule’s approach, features, and flaws." They find that this strategy, while popular, is suboptimal in terms of overpayments and surpluses (i.e. you are paying more than you need to or spending less than you could). Common modifications to the plan, such as adjusting spending depending on market returns (also known as the glide-path strategy), don't do much to remedy the situation. Part of the problem lies in the fundamental mismatch between the cash flows - the investor seeks a constant stream of payments while the portfolio's returns are variable.

The authors make an interesting comparison between the risky investor that buys stocks and bonds versus one that guarantees his retirement spending by buying zero-coupon inflation-index government bonds (TIPS). For the very risk averse investors, this 100% TIPS portfolio provides the highest utility and dominates other investment strategies. This is an application of financial economics. Investors that are willing to take on more risk with a stock/bond portfolio can still achieve a higher utility by moving away from the 4% rule. But the riskless portfolio provides a minimum cost option that all other investment/spending plans should be judged against.

What does all this mean? Basically, that blind adherence to the 4% rule is inefficient. Unfortunately the paper stops short of developing a new framework that takes into account investors' preferences. However, it does conclude that once surpluses or overpayments are identified, they can be appropriately valued, which is the first step towards improving the spending and investing decisions.


This graph plots the static 4% rule at point A for an investor that has $100 to pay for a retirement plan. You can clearly see that an individual would prefer other points under the curve. Depending on their risk tolerance, they might move up and obtain a higher utility for the same cost, or move to the left and get the same benefits for less cost.

What is the purpose of the capital markets?

1. To allow for the efficient allocation of capital across industries, and by extension, society as a whole.


2. To enable income smoothing over time by letting some borrow from future earnings for consumption today and others lend today in the hopes of higher consumption in the future.

Objective 401k ratings

BrightScope has a website where you can search for evaluations of employer's 401k plans. They provide an overall rating as well as a comparison to the peer group on dimensions such as employer match, investment options, and participation rate. Perhaps the most interesting number is the average account balance by employee, which ranges from a few thousand dollars to close to a million.

Personal Finance with Zvi Bodie: The Conventional Wisdom is Wrong

Here's a nice set of videos from my favorite finance professor, Zvi Bodie, where he challenges the conventional wisdom about stock market investing. For a more thorough discussion of his safe investment philosophy, I recommend his book: Worry Free Investing. It's written for a non-academic audience and is fairly accessible even if you're not familiar with CAPM. The first chapter is available as a sample from Bodie's website here.

The next bubble to burst: higher education

Bloomberg and the New York Times recently confirmed what I have believed for several months now: higher education is the next bubble to burst. Applications at non-Ivy League schools are declining. Private college expenses have increased at a rate far above inflation for too long, and households are no longer willing nor able to tap an inexhaustible supply of home equity to pay $150,000 for a bachelors degree that will not even guarantee a decent wage. Meanwhile, colleges felt the wealth effect as endowments rose and they embarked on grandiose construction plans, often building dorms that would fit in better at the country club than an educational institution. A recent study of university salaries found over 200 presidents making more than $500,000 per year.

As with most things in our economy over the last few years, all of this growth was fueled by cheap debt. An investment in education became one of the most highly leveraged investments you could make (100% financing implies an infinite debt-to-equity ratio). Just as people believed house prices could never go down, they felt that any college degree was worth its price. Obviously, not everyone should be an accountant - but you can justify the $150,000 price tag for an accounting degree much easier than you can justify $150,000 for an art history major. The long-term trend will be massive trading-down in the market for education: those considering private schools will switch to quality in-state public universities, and those who formerly considered state schools will move down to community colleges. Ivy League schools will always be in demand, but they'll have a harder time affording the financial aid they have committed to maintain an economically diverse student body. State universities that have unnecessarily committed to becoming a research institution will also have to scale back their plans.

Ultimately, a return to rational pricing is a good thing. Higher education was becoming unaffordable for an increasing percentage of households. State universities need to focus on their core mission of providing affordable high quality undergraduate education.

A review of Wal-Mart's $2.97 wine: Oak Leaf Cabernet Sauvignon

Is it possible to produce and distribute a quality bottle of wine for under $3? California residents are probably familiar with Trader Joe's "Two Buck Chuck" but those of us further east were out of luck until recently. I spotted several varieties of Oak Leaf vineyards wine at my local Wal-Mart all selling for $2.97: Cabernet Sauvignon, Merlot, Chardonnay, Pinot Grigio, and Zinfandel. These wines sell for $2.00 in CA; supposedly the extra dollar covers added transportation costs. The economics of this wine are indisputable; consider how it compares to some other common beverages:

• 2 liter Coke: $0.02/oz
  
• Ocean Spray cranberry juice: $0.05/oz
  
• Oak Leaf wine: $0.12/oz
  
• Starbucks drip coffee: $0.17/oz

But is this something you'd want to drink? Or, I daresay, to serve to company? It's rare to find an opportunity for field research in culinary economics, so I picked up two bottles: a non-vintage Oak Leaf Cabernet Sauvignon (12.5% alcohol) for $2.97 and a 2006 Blackstone Cabernet Sauvignon (13.5% alcohol) for $8.97. Which would my guests prefer in a blind tasting?

All three preferred the Blackstone to the Oak Leaf. They commented that it had more fruit flavor, a darker color, and possessed a more substantial mouthfeel. The Oak Leaf's bouquet had a slightly earthy tone that not everyone was fond of. One person gave Oak Leaf a point for its lower alcohol content. Another felt that it was just a little too watered down. However, no one would object if they were served the Oak Leaf; everyone regarded it as a perfectly drinkable wine, especially when served with a meal (that is to say, Oak Leaf would probably not be a great choice for a cocktail party). The Oak Leaf would also be a fine choice for cooking or any kind of mixed wine like Sangria. Ultimately, while this wine delivers some value given its price point, it's not one I would regularly purchase.

Texas: A very sticky state

A new study from the Pew Research Center ranks Texas as the country's stickiest state, meaning that it has the highest percentage population of native born citizens who are still here (75.8%). Texas doesn't rank as high on the magnet scale, which measures how strongly it attracts transplants from other states, but this metric is somewhat distorted because the organic population growth and retention rate is so high, on a relative basis it dwarfs the immigration we do have.

A Week on Wall Street: Day 5

New York Federal Reserve

Truly staggering to see the Fed's balance sheet balloon up from ~$800 billion to +$2.5 trillion over the last few months. And I don't think that includes many of the loan guarantees (e.g. the government backstop of $300B of Citigroup debt) that have taken the form of off-balance sheet contingent liabilities. The Fed is still serving up hot steaming bowls of "alphabet soup" - more acronyms for funding programs than we know what to do with. Another frightening comment from our speaker: when the time comes to reign in all that liquidity, its going to be very difficult to do it in an orderly manner. Many of the outstanding commitments are tied to short term obligations, which will run off in due course. But what about mortgages that could take +10 years to amortize? If those securities are unmarketable, the Fed will have no choice but to hold them to maturity, leaving the money supply inflated for quite a while. Our speaker was also light on details about the Fed's exit strategy.

We toured the gold vault which holds the largest cache of gold in the US (larger than the US Bullion Depository at Ft. Knox). 80 feet below street level, the vault has a massive rotating door that forms a watertight seal at night to protect all the sovereign gold that we hold for other countries. This is a free service of the government. The vault looks nothing like what was pictured in Die Hard.

CNBC

Driving out to New Jersey, we tour the studio and meet with one of the on-air commentators from the news network that everyone loves to hate. Our host is one of the more reasonable talking heads and he comments on how a dedicated financial press is a relatively recent innovation (occurring the last 25 years).

Returning home, the flight was only at 75-80% capacity. Surprising, given the capacity cuts that have already taken place.

A Week on Wall Street: Day 4

Dynamic Credit Partners

This firm is an expert in dealing with CDOs, toxic or otherwise. Our host took us through the process of creating such an investment and explained how a bank could take $100 of bonds, repackage them to appeal to investors' different maturity/credit preferences, and create securities worth $102 (the $2 was kept as profit for the bank). We examined a pitchbook for one deal that went south rather quickly, the collateral in the CDO was 95% subprime residential mortgage backed securities (RMBS). Whoops! Although the pitchbook had several pages of boilerplate on the various risks of the investment, there was no real analysis of which risks were the most important. A possible justification for lawsuits - investors in the subordinated classes (e.g. below the A tranche) were not informed that their cash flows could be diverted to the senior tranches if the collateral was downgraded by the ratings agencies. This was surprising to me, because why should the lower tranches suffer as long as the collateral was still performing? But that's what the waterfall of cash flows called for. The CDO we looked at had 6 tranches, and currently 5 of those tranches were non-performing and completely worthless. The top-rated A tranche was trading for 7 cents on the dollar.

Barron's

It would be hard to mistake Barron's offices for the well-appointed accommodations of any of the investment firms we visited - it had the appearance of a threadbare newsroom. Tough times for the print media in general, and the financial press is no exception. Demographic shifts - the average age of a Barron's reader is over 50. There is no doubt that investors will keep getting older, but eventually they'll consume content in electronic form only. Bad news for Barron's (and the rest) - rates for online ads have always been less than print ads, but it was hoped the two prices would converge around the average of the two. Instead, they're converging at the substantially lower online rate. Maybe they can clawback some of this differential with better targeted ads?

Cowen and Company

Although business was holding up better than many other firms here, the outlook here was quite pessimistic. Expenses are being cut to the bone - as is prudent - but if everyone cuts expenses until "things start to turn around" it seems the entire economy could easily get trapped in a deflationary spiral.

Completely unsubstantiated rumor of the day: Madoff will plead guilty to everything - the only thing he wants in return is protective custody in jail for the rest of his live, because many of the billions of dollars he is alleged to have lost belonged to organized crime syndicates/drug cartels in South America and Europe. It is an understatement to say they are unhappy with his investment performance and would likely seek to have him killed in prison.

Random observation: under normal circumstances, labor is a cheaper input than capital. In recent history, capital became cheaper than labor, which led to rampant inflation of investment bankers' salaries. The huge profits recorded in good years were actually returns to capital, not labor, but bonuses were paid out anyway.

Overall mood: approaching maximum bearishness.

A Week on Wall Street: Day 3

New York Stock Exchange

It was a rare treat to go down to the trading floor of the NYSE for the opening bell. Although the vast majority of trading has gone electronic, they still have specialists for many stocks that manually open and close the trading day. The specialist we talked to seemed to base trading decisions on split second gut reactions and news events - there was no time for any kind of fundamental analysis or even technical analysis (one screen had a chart on it, but he didn't seem to rely on it much). Interestingly, these market makers get paid by the exchange for providing liquidity. There were also mad swarms of people running around writing down the expected opening price from the specialists, which was then sent upstairs. There is an electronic feed that provides similar information, but apparently this manual one is more accurate (one of the advantages of having a seat on the exchange is that you can get better pre-market information). Sadly, I learned that the funny looking colored jackets used to be used to identify different positions on the floor, but have since been made unnecessary (though many still wear theirs).
The NYSE gave us a sales pitch on how companies list on their exchange because they want to co-brand themselves. I'm skeptical that this is a prominent consideration when a company lists itself today - the increases competition with Nasdaq over fees has certainly had an impact on the NYSE. In the next 10 years, it would not surprise me if the trading floor was gone all together. Or, the room will be filled with actors hired by CNBC so they can still claim to be reporting from the middle of the action - a live shot of a room full of servers is less glamorous, but more likely where the real trading action is taking place.

WL Ross

It's not everyday that you get to meet a legend in the industry, so we were understandably impressed by Wilbur Ross and one of his managers. These guys were sharp. It is not an exaggeration to claim that before they make an investment, they know more about the company than its own CFO. They have the patience to wait and not bid up deals when dumb money is rushing in. They are also prudent about leverage - if a deal needs a ton of leverage to work, then you're probably paying too much for it. If they think it's an attractive opportunity, they'll consider restructuring an entire industry (such as the entire US steel market). If I could invest with anyone we met this week, it would be this firm.

Oppenheimer Funds

A quantitative fund manager and his team spoke to us about their fund. They have a multi-factor model with almost 100 inputs. They do a lot of back testing. They revise their model periodically. Overall, they seemed like intelligent guys. You'd think that all this fancy math would remove human emotion and mistakes from the investment process - but all of this quantitative analysis eventually came down to which factors they thought would best predict future performance. Given that their fund has been lagging its benchmark, I find it hard to believe that these guys have any edge in factor selection (despite their overall level of intelligence and sophistication). They were unwilling to engage in a discussion of active versus passive management, although they did mention that one of their small cap funds had about 1200 holdings in it (that sounds a lot like a closet index fund, with a higher expense ratio). A cynical observer might note that active management fees do provide for well appointed office space.

The old debate about active versus passive management really fascinates me. Generally, I believe that the market for public equities in the US is pretty efficient. It is exceedingly difficult to earn abnormal risk-adjusted returns of any substantial magnitude over the long run. The statistics regarding active mutual funds that fail to outperform the S&P 500 confirms this. Hence, most mutual fund companies are wasting their time (and their investors' money). However, when you get into active management the way WL Ross does it, the game changes. They have access to opportunities not available to a mutual fund because of their investment process, their investment opportunity set, their time horizon, and their access to deal flow. The stark contrast between Oppenheimer Funds and WL Ross made it very clear to me that one firm is positioned to take advantage of market inefficiencies, and the other, not so much.

Overall sentiment: trending towards bearish.

A Week on Wall Street: Day 2

MSD Capital

Among other things, this group manages money for Michael Dell. They have recently started buying equities again. An observation: bank debt is trading like equity, equities are trading like options, and options are through the roof. Future inflation is an inevitability. We will not end up like Japan because the American consumer does not want to save - this is rooted in cultural differences. We'll be more like Hong Kong after the last crisis, although their nation is primarily based on pass-through transactions, so not sure how relevant the comparison is.

Primus Financial Products

This company pioneered credit default swaps that didn't require them to post any collateral based on changes in the underlying contract. Just as the monoline insurers have been hammered, so has Primus. Despite having several billion dollars of negative equity under GAAP, Primus is still alive, primarily because they did not have collateral requirements. In theory, as long as actual defaults stay low, most of these mark-to-market losses should reverse out as the contracts mature. Their portfolio of CDS is in run-off mode and they're trying to reinvent their business model. Our speaker was not very bullish on the concept of a CDS clearinghouse - but I believe it is only a matter of time before CDS companies are regulated as insurance companies (they are basically the same thing).

S&P, Structured Finance Ratings

Originally on the agenda, S&P's lawyers cancelled our meeting at the last minute since they are revamping the method they use to rate structured financial products. The phrase "a day late and a (billion) dollars short" comes to mind. I am amazed that the NRSROs have any credibility left at all.

Overall sentiment: slightly less bearish.

A Week on Wall Street: Day 1

I had the privilege of joining a group of fellow finance MBAs last week for a trip to Wall Street. I don't know that there's ever been a better (worst?) time to visit Manhattan. Over the next five days I'll post my observations for each of our company visits. It was a great trip, and I really appreciated all of our speakers taking the time to meet with us. Disclaimer: These notes are my completely subjective recollection of the day's events and should not be interpreted as official statements by any of the organizations mentioned.

Wachtell, Lipton, Rosen & Katz

A partner from this law firm met with us and discussed the government's involvement in the financial markets beginning with the failure of Bear Stearns. His firm does a lot of work with M&A for financial services firms. A common theme throughout his remarks was that the government (i.e. the Fed and the Treasury Department) had forced many firms to accept a deals at the eleventh hour with verbal promises that they later reneged on. At the risk of sounding like a tinfoil hat enthusiast, it would not be an exaggeration to say "don't trust the government." As far as his investment outlook was concerned, he mentioned that he had moved his entire portfolio to cash and treasuries. On the plus side, this firm seems to have more work than it can handle (or at least, this practice area).

Deutsche Bank, Structured Products Group

This group creates options strategies to limit downside or lever upside. They'll either sell you the strategy and/or implement it for you, although I don't envy anyone trying to sell these products to retail investors (anything that sounds like "derivatives" is going to be anathema). If they put a package together for you, it will probably be with OTC options contracts, so be aware of the limited liquidity that accompanies such a program. I haven't heard of any bailouts for Deutsche Bank lately, but counterparty risk is also a concern for these one-off strategies.

Overall mood for day 1: moderately bearish.