Dec 31, 2008

Home value indexes

The S&P Case-Shiller index of home values posted an annual drop of 18% (high: Phoenix -32.7%, low: Dallas -3.0%) yesterday. But what goes into an index of home prices?
  • Which geographic regions are covered
  • Property value weighting (do more expensive homes have a larger impact on the index)
  • Are appraisal values included rather than just sales transactions
  • Are houses financed with subprime mortgages and/or non-conforming loans (jumbos) included
  • Should foreclosed homes sales be included, given that they may not represent a normal transaction

Here's the Wall Street Journal's look at several different home value indices from November.

Dec 30, 2008

Google Trends

This link to Google shows search terms that are experiencing a rapid rise in popularity. Sort of, if you took the first derivative of search words, which ones are increasing the fastest.

Dec 28, 2008

Christmas spirit and the number of shopping days

It's often reported that a longer shopping season (the number of days between Thanksgiving and Christmas) translates into higher retailer receipts. But does this make sense? Just because Thanksgiving falls a few days earlier doesn't mean your gift list increases. With fewer days, one might reduce their trips to the mall but make more purchases on each trip, leaving the total amount spent unchanged. But a longer shopping season does increase the opportunity for impulse purchases.

This paper from 2005 found that a longer shopping season increased per capita retail sales by $6.50 per additional day over the relevant range, and the effect is most noticeable in electronics, apparel, food, and general merchandise. The author studied the November-December shopping season and deflated results based on October sales to adjust for the strength of the overall economy at that time to arrive at excess sales. Interestingly, increased sales in the holiday season don't translate into reduced spending in January, and since the total amount of household wealth is unchanged, the deficit must come out of savings.

Dec 27, 2008

Confirmation bias in web forums

If you believe that low-cost, buy-and-hold, index investing is the way to go, read the Bogleheads forum (named for John Bogle, founder of Vanguard).

If you want to daytrade your way to happiness with Jim Cramer, checkout the Online Traders Forum.

And if you have a love for shiny things coupled with a distrust of fractional reserve banking policy, the Kitco Bullion Dealers forum is the place for you.

Dec 25, 2008


Normally when a publicly traded company wants to issue more equity, they call up their investment bankers and put together a large follow-on offering. The stock price usually declines when this is announced since analysts interpret equity issuance as a sign that management believes the stock is overpriced (rational managers buy back their equity when it's cheap, issue more then it's pricey).

The equity markets being what they are right now, some firms are turning to dribbles to issue small amounts of equity without all the fanfare associated with a follow-on offering. This avoids depressing the share price due to a rapid increase in supply, allows the firm to be a bit more squirrelly with its disclosure, and gives the firm more control over the timing of share sales since they blend in with the normal trading activity.

Dec 24, 2008

Pension plans, firm risk, and the cost of capital

This Times article discusses some firms that are dealing with the impact of shrinking pension plan funds. Another one at Bloomberg mentions a $230B decline in pension plan funding just in October and November of 2008, reducing funding levels from 97 percent down to 80 percent.

Unless you are in a very countercyclical industry and/or your stock has an extremely low beta, it's likely that your pension plan returns are going to be correlated with your overall business. So right as the economy tanks, your business slows, and the value of your pension assets declines - this is what's happening right now to many firms. That's one argument against putting all your pension funds in high risk, high return equities.

Zvi Bodie published an interesting paper that explored another reason not to invest pension funds in risky assets: Do a Firm's Equity Returns Reflect the Risk of Its Pension Plan? He argues that the market beta for your stock reflects the risk implicit in your pension plan assets. Even though these funds are technically segregated, most analysts combine all assets and liabilities when looking at the firm as a whole. This makes sense, as the company is still on the hook to pay its retirees even if the pension's investments decline in value. Therefore, the observed firm beta in the market may overstate the true risk of the firm's operating assets, which would lead to a higher discount rate than is warranted for capital budgeting projects. In turn, this could lead to incorrect rejection of positive NPV projects.

Maybe they should just put all the pension funds in fixed income?

Dec 23, 2008

The best site for buying and selling cheap MBA textbooks

You'd think that MBAs would understand better than anyone the value of a free market to set prices. Do you really think the campus bookstore, with their monopolistic, rent-seeking tendencies and overhead expenses is really going to sell you a textbook at the lowest price possible? And at the end of the semester, are they going to give you top dollar for your buyback? Unlikely.

Enter, the pure intersection of supply and demand, with an excellent selection of textbooks.

Granted, there are a few drawbacks. You don't get instant gratification, so you might not have the textbook in time for the first day of class (you overachiever!). But can't you just borrow a copy from one of your classmates? And if you decide to drop a class after you've ordered the text, you're subject to market forces when you remarket that asset.

Dec 17, 2008

The myth of the Ford Pinto

This article raises some interesting points about the much maligned Ford Pinto. Statistically, it appears that the car was no more dangerous than other cars in the same class, which all suffered from design flaws that reduced safety (though different flaws than the Pinto's behind-the-axle gas tank). The value placed upon human life by Ford was provided by a government agency seeking comments on the potential impact of new safety regulations, not developed internally. And court rulings at the time recommended that firms use economic cost-benefit analysis to determine the appropriate balance between cost and safety. While Ford deserved criticism for an unsafe design, the reality of the situation is much more complicated than the oft-repeated story would lead you to believe.

Dec 14, 2008

Hawaii: Days 7 & 8

Saturday is our last full day here. We started off at 6:30AM with the Kanaio coast & Molokini snorkeling tour with Blue Water Rafting. Despite the early morning it was totally worth it. Great lava flows along the coast as well as excellent snorkeling, especially at Molokini island. There was a little chop on the ocean so the ride was a bit rough, but if you're interested in an adventure it's not a problem. On the way back, the captain got a radio call from another tour boat that whales had been spotted, so he turned the boat around and took us back out. Saw three whales and a pod of dolphins. Dinner was excellent fish ka-bobs at Pita Paradise in Kihei. They were made with opakapaka (snapper) which I liked more than the ono we had the night before.

Sunday we checked out, did a little shopping in Wailea and then drove north. Stopped at the Iao Valley State Park to see the Iao Needle which was cool. Lunch at McDonalds was a McTeri burger - basically a burger with teryaki sauce.

Dec 12, 2008

Hawaii: Day 6

The clouds have disappeared so we drive up to Haleakala Crater. At 10,000 feet, the air is noticeably thinner and we're above most of the clouds. Fantastic. After driving back down the mountain (43 switchbacks!) we stop at Maui Taco for lunch. Ok, they have locations in the continental US but the burrito seems more authentic here. The rest of the day: Wailea beach and the amazing saltwater infinity edge pool at the Marriott. Funnily enough, I run into one of my MBA classmates who happens to be here on vacation.

Dec 11, 2008

Hawaii: Day 5

First day in Maui is disappointing due to the weather - constant rain. I hear they're getting it worse on Oahu. Most of the fun stuff to do here is outside, normally not a problem except for times like this. We drive to the Bailey House museum which provides a nice perspective of old Hawaii. Despite the rain, we head to the Ioa Valley State Park but find that the road up the mountain has been closed due to the weather. Given the runoff coming down a nearby creek, seems sensible. Back to the resort for the afternoon and then a nice dinner at Cafe O'Lei Kihei.

Dec 10, 2008

Hawaii: Day 4

Wednesday started off a bit later than Monday and Tuesday as we started to adjust to the new time zone. We grabbed some malasadas and coffee at Leonard's Bakery. They're similar to doughnuts in that they're fried dough, but they are doughier - maybe more egg and yeast. No hole in the middle, and covered in sugar or cinnamon sugar (fillings optional). Then to the Honolulu Academy of Arts for a tour of their exhibits. 45 minute flight to Maui then check in at the Marriott Wailea Resort. Dinner time at Da Kitchen in Kihei; big portions and low prices; great fried mahi mahi.

Dec 9, 2008

Hawaii: Day 3

Another early morning wake-up took us to Cafe Kaila for breakfast where we found a nice change of pace from Waikiki. Then we drove north on the Kamehameha highway to the Dole pineapple plantation and enjoyed the tour of their garden and trainride through the pineapple fields. Continuing north, we stopped at Haleiwa beach to crash through the giant waves and watch the surfers further out. Lunch was Giovanni's shrimp truck and shaved ice from Matsumoto's. In the afternoon we headed up to the Polynesian Cultural Center in Laie. This complex is clearly one of the island's biggest tourist traps, but they overcame my skepticism and I actually enjoyed the island exhibits as well as the dinner and Luau. Worth doing once but I probably wouldn't go back. The only downside was the hour long drive from the north shore back to Waikiki in the dark.

Dec 8, 2008

Hawaii: Days 1 & 2

We landed in Honolulu on Sunday and proceeded to baggage claim and ground transportation, waiting for our Advantage rental car shuttle to arrive. We waited, and then we waited some more. Finally calling them and getting through the generic prompts, we were informed that they had filed for bankruptcy 2 days ago and closed the Honolulu location. I guess their rate really was too good to be true.

Checked into the Marriott Waikiki Resort and managed to get a nice upgrade to a 22nd floor room (Paoakalani tower) with a partial view of the ocean and Diamondhead as well. The reception desk said that their traffic is definitely down for this time of year, must be the slow economy. They wanted an obscene $25/night for parking but I found out on TripAdvisor that we could park at the Banyan for $10 and it's literally across the street. After driving around some more, found a free "Shell" parking lot next to the Waikiki Zoo - even better. The hotel also wants $13/day for internet access, but I can pick up a free wifi signal on our balcony.

Spent Sunday afternoon recovering from the 9 hour flight by walking up and down Kalakaua Avenue and checking out the beach. Dinner at Tiki's Bar and Grill in the ResortQuest Waikiki. Nice ambiance and decent food but a bit overpriced for what you get. Did not find poi to be all that great. Must be an acquired taste.

Monday, woke up at 5AM due to the jet lag and decided to climb Diamondhead before the sun came up. First, a quick breakfast at McDonald's (they offer a Polynesian platter with Spam, or a burger with teriyaki and a pineapple). Scurried down the mountain and drove to Pearl Harbor and took the ferry out to the USS Arizona memorial. A moving experience and well worth it. We arrived at 8:30AM and were able to get on the 9AM tour. Definitely a place to visit early as the wait was stretching much longer once the tour groups started to show up. Headed to Chinatown in the afternoon and it was pretty much what you'd expect. The rest of the afternoon was at the beach. Tonight, dinner at the Hula Grill Waikiki was the best meal so far. Great food, service, and ambiance. And compared to some of the offerings on Waikiki, a decent value as well.

Dec 7, 2008

SMU Law has top bar passage rate in Texas

Southern Methodist University's Dedman School of Law had the highest bar passage rate for the July 2008 exam, according to the Dallas Morning News. Another feather in the cap for SMU!

Dec 6, 2008

Looking on the bright side

Yesterday's jobs report was quite dismal. But here are three reasons the economy is not as bad as it could be (from a comment on another blog):
  • We're not in a trade war with Europe (Smoot-Hawley)
  • We do NOT have a famine (Dust Bowl)
  • We do not have wholesale collapse of the banking system (50% of banks failing)

You could probably argue that last point, but still.

Dec 5, 2008

Jeremy Grantham Speaks

He's not a household name like Jim Cramer but his company, GMO, does have $107B in assets under management, so the self-described "perma-bear" Jeremy Grantham probably has some idea what's going on in the financial world. He started telling investors in 2006 to avoid risk because things were going to get ugly. Jeremy's 3Q'08 newsletter is available here. I had the opportunity to hear him speak recently, along with another GMO portfolio manager, and wanted to capture some of their thoughts in a very disorganized fashion here:
  • A dim view of future prospects for humankind, very Malthusian. Basically, there will be too many people and resources will not increase fast enough, so standards of living will drop.
  • We're going to write off wealth equal to 1.5 times GDP ($20T) with a 60% peak-to-trough decline for the stock market.
  • If you looked at the entire world's balance sheet, we had leveraged $50T of assets with $42T of debt (80% leverage!). Now those assets are only worth $30T, but the amount of debt hasn't declined and remains stranded out there. How are we going to get rid of it? Inflate it away or offload it to the government.
  • 2003-2007 was one of the biggest suckers' rallies of all time.
  • The ratio of median house price to median family income was more than 3-sigma above its long term average when Ben Bernanke said that the housing market has never declined. Now it's going to overcorrect on the downside. A housing bubble is much worse for the country than a stock bubble, because it's easier to get leverage and the majority of people who own houses will be affected by it.
  • The UK housing market is in a similar situation, but UK banks have yet to take a single writeoff for loans there.
  • Fair value for crude oil is about $75, but it will trade between $32 and $150.
  • What we have seen is the result of a "risk bubble." As investors' perceived risk decreased due to low volatility, they decided to increase risk back to their tolerance level by increasing leverage.
  • In 1981, debt was about 125% of US GDP. Now it is 300% of GDP. Increase credit will probably lead to more frequent credit bubbles.
  • In the 1970s, the price of treasuries implied 11% inflation for 30 years. We know how that turned out. Today, the price of treasuries implies 2% inflation for 30 years. Is that any more likely?
  • The efficient market camp couldn't be more wrong. Buy and hold investing is a joke. Every asset bubble over corrects by 50% below the long term trend. We're not there yet. If you had a 3-sigma increase in asset prices based on a random walk model, you'd never get a similar 3-sigma decrease directly following it on the way down. Yet this is what every bubble looks like.
  • Things can get so beaten down that even on bad news, they recover. Example: June of 1932 had terrible news every month, yet the market went up 100%.
  • Japan's great recession in the 1990s was remarkable because unemployment never became a big problem.
  • Most interesting was his prediction in September 1998 that the S&P 500 would have a real return of -1.1% over the next ten years. It turned out to be +0.1%, but that is still pretty close. His 1998 forecast also correctly tagged emerging markets and REITs as the biggest winners over the decade. Here's his forecast going forward. He likes high quality US stocks (low volatility, low debt), emerging markets, and commodities.

His associate also spoke about some of the unintended consequences we're seeing in the fixed income markets right now.

  • In 1997 when LTCM blew up, the spread between on the run and off teh run treasuries had increased from 5 bp to 15 bp. In October of 2008, that spread had widened to 100 bp. There were basically $20 bills available to be picked up by any arbitrageur.
  • Earlier this year there was a rally in Fannie Mae's bonds and some assumed it was because their financial health was improving. What actually happened was that the fed started accepting FNM bonds as collateral, so traders were buying the debt at $0.80 on the dollar and then using it to borrow $0.96 from the discount window.
  • AIG's first bailout was at LIBOR+800 bp, a punitive interest rate. A few weeks later when the government opened their commercial paper facility, AIG said "can we use that?" and then proceeded to pay off several billion of L+800 debt with much cheaper government backed CP. The government was arbitraged against itself.
  • The federal reserve now has $3T on its balance sheet. So far, this hasn't contributed to inflation. Most of that $3T is short term. However, there is talk of the fed buying longer term assets. This presents a problem once the economy recovers, if they are stuck holding longer term assets that may have gone bad, they will not be able to easily sell them and take money out of circulation. This could lead to problems controlling inflation down the road.

Dec 4, 2008

Hedge funds: short on original ideas

A month has passed since the massive short squeeze on Volkswagon, which briefly made the company the most valuable in the world (by market cap). As hedge funds have reported results since then, it has been interesting to note that many of them were playing this same trade and were caught trying to close out their positions at the same time (they took a bath), even funds whose established strategy had nothing to do with German automaker equities. Why would

This presents a problem for an endowment or pension fund (or even a fund of funds) that diversified its investments across several HFs that are supposed to play in uncorrelated market spaces. When things go bad, they go bad across several HFs at the same time as correlation = 1.0 just when it hurts you the most. Not to mention that it seems antithetical to the original premise of HFs - that they're supposed to be hedged against risk in one position by an offsetting position somewhere else.

Will hedge funds stop telling all their friends about their trades to encourage massive piling-on?Unknown. But it's an interesting contrast to private equity shops that try to keep their deals as quiet as possible until the last possible moment, lest more bidders show up at the auction.

Dec 3, 2008

Volatility strikes the S&P

Using data downloaded from Yahoo Finance, I looked at the value of the S&P 500 over the last 25 years, from 12/1/1983 to 12/1/2008, and counted the number of days where the index changed by more than +/- 4.0%. Here are the results (years not listed had zero occurences):

1986 1
1987 7
1988 2
1989 1
1997 2
1998 3
2000 2
2001 4
2002 6
2008 27

Quite a jump in 2008! And 26 of those 27 moves came in the 3rd and 4th quarters of the year. This is a crude measure of volatility compared to something like the standard deviation of returns or the VIX, but certainly one that individual investors can easily identify with. And we still have a month to go...

Dec 2, 2008

Microsoft pays customers $180 million to use its search engine

You're the world's largest software company, but you can't get people to start using your search engine as Google becomes more firmly entrenched every passing day. How do you get them to come to your site instead? Microsoft has decided that cold hard cash is the answer, and they have the funds to back it up. Since June, they've been pushing a cashback promotion with its product, discussed in great detail at Fatwallet.

The normal cashback program offered discounts around 2-5% for purchases made from merchants through the site and presumably they helped foot the bill for the cashback. More unusual was the 35% cashback offered on almost any eBay purchase. This led to many sellers touting the cashback in their item descriptions, since it came at no cost to them and increased the amount buyers were willing to bid. I don't see any reason why eBay would pick up the tab for this, so that leaves Microsoft writing a lot of checks. Here's a very rough estimate of how much they've spent on this promotion so far:
  • A search on eBay for "" turns up over 30,000 items with an average price around $500 (items featuring the discount probably skew expensive - not much point in saving 35% on a $20 purchase)
  • With an average 20% discount (it's ranged between 8% and 35% since the summer), that's $100 paid in cashback per item
  • Assume items listed turn over every 3 days, over 6 months that's 60 times sales
  • 60 x 30,000 x $100 = $180 million in cash paid directly to consumers

Granted, this is a back of the envelope calculation. There are certainly items that will qualify for the cashback that don't feature "" in the description which would increase the amount paid. The average cashback and velocity of sales may also vary from what I've assumed. As if the legitimate users weren't charging enough cashback, I'm sure others have been gaming the system by buying items for resale (gold bullion, gift cards) or setting up fake auctions under multiple accounts.

How many companies have the resources to make almost $200MM in cash payments to entice customers to use something as ephemeral as a search engine? A bank may spend a couple hundred to acquire a new retail customer, but at least they're protected by some switching costs. Has "Helicopter Ben" taken over Microsoft's marketing department? They're is throwing money at this problem, demonstrating the seriousness of their predicament, but I don't see the long term payoff from it.

Well, it's probably still cheaper than buying Yahoo at $31/share ($44B market cap).

Dec 1, 2008

Securitization and the real estate bubble

Some researchers at the University of Chicago recently revised an interesting paper regarding The Consequences of Mortgage Credit Expansion. A few of the possible explanations for the growth in subprime mortgage lending:
  • Income growth prospects: borrowers are earning more, so they can afford more credit
  • House price appreciation expectations: houses are appreciating faster, so lenders are more willing to take on credit risk since the more valuable collateral reduces their loss given default
  • Supply of credit growth: securitization enabled mortgage originators to sell loans to other entities, increasing their capacity to make more loans

Their study of zip code level data finds that in spite of flat or declining incomes and stagnant house prices, lending increased substantially from 2002 and 2005. Over that period, credit provided to subprime zip codes doubled and since 2006, the foreclosure rate for those same areas is three times as high as neighboring metropolitan areas. They cite securitization as the main force behind the expansion of subprime credit, a supply-based explanation. There may also be some moral hazard at work here: increased securitization is much more prevalent among subprime zip codes and default rates increase much more rapidly for loans originated in areas of high securitization.

The next question is: why did securitization increase so much? They leave that for another paper, but it might be related to technological innovations in risk management, demand from GSEs like Fannie and Freddie, or the flood of capital into the US during this time period.

Nov 28, 2008

Liar's Poker and the end of Wall Street

Michael Lewis wrote a couple of great books: Liar's Poker, which chronicled his time on Wall Street, as well as Moneyball, which covers the art of statistics & strategy in major league baseball. Recently he published an update on the current malaise affecting Wall Street, which is a very good read. Worth it just for the computer-generated picture of a supine bull in the street.

Here's a short excerpt:
Eisman stuck to his sell rating on Lomas Financial, even after the company announced that investors needn’t worry about its financial condition, as it had hedged its market risk. “The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.

The article also points out that credit quality on fixed income investments associated with consumers always strengthen in March and April. Why? Tax refunds.

Nov 27, 2008

What are they looking for: VCs versus LBOs

Neither one is looking so hot in this environment, but nonetheless...

Venture capitalists' desired investment characteristics:
  • The size of the potential market
  • The technology (feasibility, barriers to imitation)
  • The management team

On the other hand, leveraged buyout shops are looking for:

  • Demonstrated profitability
  • Strong and predictable cash flows
  • Readily separable assets
  • Strong management team
  • Non-high-tech products

Nov 26, 2008

Externalities in Energy and Credit

Why would the owner of a wind farm sell electricity to the grid at negative prices? This has been occurring with some frequency on the Texas electrical system in 2008. Partly this has to do with the isolated nature of the Texas grid and ERCOT, but the explanation also involves:

  • A producer of electricity might continue to produce & sell power at a price below his marginal cost of production (even at zero) if there are added costs of shutting the generator down and restarting it when spot rates increase again.
  • If a producer has low marginal costs and is receiving a subsidy based on production, then they may be incentivized to keep producing ever after the price becomes negative. If the producer knows that they will get a $35/MWh production tax credit then they'll keep the wind turbines running.

I wouldn't mind a few free kwh on my next electric bill, but a policy that essentially pays people to consume electricity seems a bit counterintuitive. While we can argue about the necessity of providing subsidies for renewable energy sources, this particular example highlights the unintended consequences that can result from even a well-intentioned policy.

It is somewhat reminiscent of the reaction to the Fed's commercial paper facility. Initially only the top rated A-1 paper could be purchased under the program. Of course, this resulted in A-2 issuers being at a disadvantage in the marketplace because no one wanted to buy their paper anymore, when they could get a government guarantee for a small premium. The CP facility basically crowded out other creditworthy borrowers who couldn't afford the 500bp spread.

Nov 25, 2008

Uncommon investment structures: tontine

I spotted news of Tontine Associates, a Connecticut hedge fund that is down +65% this year. But what's a tontine? Apparently, it's an investment vehicle which combines features of a group annuity, group life insurance, and a lottery. Each investor buys a share, and the funds are then invested, which pay dividends. As the investors die, the shares are redistributed among the surviving members until the last one collects the principal. Turns out this is no longer widely used because:
  • People realized they could sign children up for it early and collect dividends for much longer than expected. A similar problem has been encountered by defined-benefit pensions as average lifespans have increased substantially.
  • Investors were incentivized for killing each other to bolster their own share
To some extent, this structure still exists today in the form of joint tenancy with rights of survivorship. You might also remember an episode of the Simpsons involving Grandpa Simpson and treasures from WWII that featured a tontine.

Nov 24, 2008

Somali Pirates and Regressions

Shipping companies are having a rough go of it. First it was the crash in the Baltic Dry Index which may have pushed rates below operating costs, let alone debt service payments. If importers can't get letters of credit and trade financing, there's going to be less demand for shipping services. Then there was the increasing risk of highly levered firms being running into technical default due to declining volumes and lower collateral values based on the secondary market for cargo ships. Just when things couldn't get any worse, Somali pirates entered the picture.

Fortunately, we have researchers who studied this issue and summarized their results in a paper: Is Maritime Piracy Random? They cross-referenced a global registry of 350,000 ships against reported acts of piracy from 1996-2005 to develop a regression indicating the likelihood of attack based on flag of registry (country) and ship type. They find that pirates are non-random and tend to prefer Asian ships, especially fully loaded chemical/product tankers because they sit lower in the water, making them easier to board.

I'm not sure this tells us what should be done about pirates, but it does give us some indication of their modus operandi. One rationale cited by a Somali pirate is that illegal overfishing off the coast has destroyed what used to be a viable source of income for many. When you have a boat and you can no longer support yourself with fishing, what else are you going to do with it? Interestingly, the Asian financial crisis of 1997 was cited as a factor behind increased piracy in the region at the time. I guess pirates are the latest countercyclical asset, along with Spam (the meat, not the email) and the 99 Cents Only Stores.

Nov 22, 2008

Somali Pirates and TARP

This has been making its way around the web, but was too funny to pass up:

*Moody's upgrade Somali Pirates to AAA

Nov 21, 2008

Did short sellers deserve the blame?

Much has been made of short sellers role in pushing the price of stocks down, and while there are probably cases where one firm was unfairly targeted, do short sellers deserve all the blame they've received for stock market declines? The Bloomberg graph below shows the S&P500 index versus the monthly NYSE open short interest over the last three years. Up until September 2008, the trend is obvious, that shorts increased while the index decreased. Now that many forms of short selling have been regulated or eliminated, has the market bounced back? Unfortunately not. Even though short interest dropped by 50% in October, stocks continued their decline. This is even more disappointing when one considers that to close out a short position, the investor has to repurchase the shares, leading to an increase in net buyers as short interest drops.

Academic research shows that increasing short interest is correlated with stock price declines and poor operating performance, so shorts are well-informed and help with price discovery. Short sellers may also be good at detecting accounting manipulations. Moreover, banning shorts may not do anything to boost stock prices, and in fact could have the opposite effect if removing short sellers decreases the liquidity of the market.

Nov 20, 2008

Cost savings from plug-in hybrid

The New York Times just reported on a couple of plug-in hybrid vehicles, such as the GM Volt and the Tesla Roadster. One interesting fact is that the Tesla gets approximately 100 miles per 32 kilowatt hours (kWh). So how would your annual fuel cost vary between a 25MPG conventional gas engine and the plug-in? The chart below compares annual fuel costs for someone who drives 12,000 miles over a range of electricity and gas prices.

As of today, I'm paying $0.14/kWh for electricity and $1.75/gal for gas, so my annual costs would be $538 for the plug-in and $840 for the conventional. With $300 savings per year, it is hard to justify the price premium on a plug-in (the Tesla is over $100,000, the Volt is estimated to cost over $40,000). Of course, fuel is only one part of the total cost of ownership for a car, and plug-ins may become cheaper as the technology matures.

Nov 18, 2008

SMU MBA ranked 18th by BusinessWeek

The new BusinessWeek rankings are out, and Southern Methodist University (Cox) was ranked 18th in full-time MBA programs, which puts us in the same league as a lot of other very strong schools. Finally, our full-time program has received the same level of recognition as our part-time and EMBA programs! This is certainly exciting news and I hope the added attention enables us to continue attracting great students and building the school's brand. I have no doubt that SMU was the right choice for me, as it has opened so many doors over the last two years. As with most investments, the more you put into your MBA the more you will get out of it, and this program has certainly helped me maximize my ROI from graduate school.

Nov 17, 2008

Don't cash that mail-in rebate check

The credit crunch has claimed yet another unlikely victim: Continental Promotions Group (CPG) filed for chapter 11 bankruptcy on 11/14/08. Never heard of this company? You've probably done business with them before - they handled mail-in rebate fulfillment for companies like Canon, Sears, Costco, Home Depot, and many others. If you've recently received a rebate check from them, you should hold off on cashing it until you can contact the manufacturer or vendor and find out what the new rebate process is. Trying to cash the CPG check will likely be returned, resulting in no money for you plus a hefty fee. You could also run into bounced check fees if your balance drops too low after the check is returned in a few weeks.

So what does this have to do with the credit crunch? Let's look at the rebate process:
  • Retail customer submits rebate to CPG
  • CPG receives rebate request
  • CPG requests & receives payment from product manufacturer
  • 8-12 weeks later: customer receives rebate check

My theory is that CPG made bad investments with the manufacturer's funds that they were supposed to be holding in escrow for those 8-12 weeks; bascially, trying to take advantage of the float. If they started chasing yield by putting those funds in supposedly safe assets that turned out to be risky (auction rate securities, Lehman commercial paper, the Reserve money market fund, etc.) then they could've easily run into a liquidity crunch. It's entirely possible that they were just poorly managed, but I doubt they would've been putting those funds into short-term treasuries when they could get a few more basis points by taking on just a little risk. Either way, they were brought down by bad working capital management.

It's unclear if this is a positive or negative sign for the remaining rebate fulfillment companies, such as Dallas based Parago. With the holiday shopping season starting to ramp up and many retailers projecting dismal sales, rebates will probably be part of the marketing promotion to get customers to shop. But retailers and manufacturers who relied on CPG may not have enough time to establish a new program before it's too late. If holiday sales are down as much as forecast, there could be further shakeouts in the fullfillment industry, since they are generally paid based on volume of rebates processed.

Nov 14, 2008

The negative wealth effect

The wealth effect is an economic concept that says consumers will increase spending given a real or perceived increase in their assets. The same effect works in reverse if consumers feel they have lost value. One estimate says that GDP will decline $0.05 over the next two years for every $1.00 of wealth that is lost. If the equity markets have lost $4T and consumers perceive a similar loss in evaporated home equity (some think it could be three times as much) then that is $8T up in smoke. This translates to about $400B of disappearing GDP, which is enough to decrease GDP by 3%. I think the effect could be even more pronounced right now, given that holiday spending is about to begin. If retailers can't make it into the black this year due to lackluster sales, there could be a spill-over effect into other sectors of the economy in 2009, further worsening our economic condition.

Nov 12, 2008

Private equity deal flow & returns

Private equity firms aren't seeking 10 or 20% returns. They want to buy businesses with fully-capped (unlevered) returns around 30% and cash on cash returns (levered) in the neighborhood of 50%.

How many deals does a PE shop have to look at before they find the ones they want to fund? The deal flow funnel below gives you some idea of the process and the attrition rate.

Nov 11, 2008

Hybrid securities

Here's a nice payoff graph that illustrates returns to a bondholder, equityholder, as well as someone who's in the middle - perhaps the purchaser of a hybrid security like a convertible bond. Note that the steep decline on the left hand side of the graph reflects the increasing risk of default as the firm value approaches zero.

Nov 10, 2008

Legitimate reasons to hedge

The best criterion for determining if risks should be hedged: does the hedge increase firm value? From an HBS paper - what are some of the imperfections that make risk management relevant?
  • Costs of financial distress
  • Variability of investment needs such as R&D expense
  • Taxes: progressive or convex tax functions, or diminished value of tax loss carryforwards
  • Transactions costs: can the firm hedge at a lower cost than an individual
  • Asymmetric information flows between managers, owners, and debtholders
  • Poorly diversified managers (if value added by retaining managers > cost of hedging and there is no other contractual way to reduce managers' risk)

Nov 7, 2008

Auction fees: Christie's vs. eBay

Your great aunt passes away and as the sole beneficiary in her will, you decide to auction off the estate at Christie's. Your aunt had impeccable taste, so the collection is filled with works by the Old Masters (none of that post-modern nonsense) and is worth about $100MM. What's the auction house's cut?
  • 25 percent of the first $50,000
  • 20 percent of the next $50,000 to $1 million
  • 12 percent of the rest

At roughly $12.1MM in commission, that seems a little steep to me. Maybe you can work a better deal at a competitor - what kind of final value fees would eBay charge?

  • 12 percent of the first $50.00
  • 6 percent of $50.01 to $1000.00
  • 2 percent of the rest

Ignoring the listing fees and some other small charges, eBay only wants $2MM - quite a bargain. Of course, you'll have to have positive feedback, and there is some question whether the hordes on eBay will appreciate your collection enough to pay top dollar.

Nov 6, 2008

Number of the day: 86 million

Barrels of oil consumed globally per day in 2008. 2009 could be the first year since 1983 where we see lower total demand.

On a somewhat related note, here's the word of the day:

Bete noire (noun)

1. An object or abstract idea that has the potential to cause great harm.
2. A flourless dark chocolate cake.

[From the French for dark beast]

Nov 5, 2008

Industry reading materials

How do we bridge the gap between academic research and industry? These two resources are a good start.

The Journal of Applied Corporate Finance (published quarterly)

The Financial Analysts' Journal (published bimonthly)

Nov 4, 2008

Nov 3, 2008

Crude oil in contango

Contango is the term to describe a commodities futures price that is greater than the spot price. This graph from the Wall Street Journal shows how strongly contangoed the price of crude oil has become. Perhaps the days of $60/barrel oil are not long for this world.

Nov 1, 2008

Finally done with October

I don't know if there was anyone out there who actually made money in October, but if so, my hat is off to you. People are probably thinking this story sums up the inner workings of the market...

"Once upon a time, in a village, a man appeared and announced to the villagers that he would buy monkeys for $10 each. The villagers, seeing that there were many monkeys around, went out to the forest and started catching them. The man bought thousands at $10 and, as supply started to diminish, the villagers stopped their effort. He further announced that he would now buy at $20 for a monkey. This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The offer increased to $25 each, and the supply of monkeys became so small that it was an effort to even find a monkey, let alone catch it! The man now announced that he would buy monkeys at $50! However, since he had to go to the city on some business, his assistant would now buy on behalf of him. In the absence of the man, the assistant told the villagers. "Look at all these monkeys in the big cage that the man has collected. I will sell them to you at $35, and when the man returns from the city, you can sell them to him for $50 each." The villagers rounded up all their savings and bought all the monkeys. They never saw the man nor his assistant again, only monkeys everywhere! Now you have a better understanding of how Wall Street works."

Oct 29, 2008

Warren Buffet on the quants

Warren Buffet has been preaching the dangers of derivatives such as credit default swaps for quite a while now. When asked about this in an interview recently, he responded:

"All I can say is, beware of geeks . . . bearing formulas."

Perhaps AIG should have been paying more attention?

Oct 28, 2008

Movies: The King of Kong

The King of Kong: Fistful of Quarters was a great documentary that came out in 2007. The movie taps into universal themes of good versus evil, played out on the classic video game arena. Full of archetypes: Steve as the mild-mannered hero, Billy as the mullet-wearing, hot-sauce vending villan. As one reviewer pointed out, "the competition is so intense because the stakes are so low." Video games are not the focus of the film, but rather, the stage upon which the characters alight. Highly recommended.

Oct 27, 2008

Marginally attached workers

The most commonly reported unemployment statistic is the total unemployed as a percentage of the civilian workforce (U-3), which stands at 6.1% as of September 2008. However, the Bureau of Labor Statistics publishes other measures of unemployment, such as the U-6, which adds both "marginally attached workers" and those employed part-time for economic reasons. How are these groups defined?

Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past. Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not looking currently for a job. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule.

So it would seem that the conventional measure of unemployment doesn't fully capture our employment situation. The U-6 sits at 11.0% as of September 2008 and the following graph from the Wall Street Journal shows how the U-6 (labor underutilization) has changed over time. The graph on mass layoffs is also interesting, I had to look up the explanation of the previous spike in 2005 - it was attributed to damage from hurricane Katrina that led to layoffs, primarily in the southern states that were affected by the storm. To put the data in absolute rather than relative terms, the BLS has another report that indicates the number of workers who left the labor force due to discouragement over job prospects increased from 276,000 to 467,000 year over year for September.

Oct 25, 2008

The downside of hedging

The graph below shows the spot price of natural gas. In Texas, because our power grid is relatively isolated from other states, and because +60% of our power generation is driven by natural gas, our electricity rates are highly correlated with the price of NG. Those of us on a month-to-month electric plan saw huge increases in the spot rate for electricity, going from $0.10/kwh to $0.205/kwh in August. The seemingly endless increases led me to sign a one year contract for wind energy at $0.145/kwh on the day indicated on the graph. Of course, no sooner than I had locked in my rate (with a cancellation fee if I leave) than the price of NG entered a freefall. I don't mind paying a little extra for "green" electricity but this just illustrates one of the risks inherent in hedging. Homeowners in the northeast are reporting similiar frustrations after they locked in heating oil prices over the summer and now the spot rate has fallen precipitously.

On the other hand, a friend of mine sold the mineral rights to the natural gas under his house for a tidy sum right around the same point in time. He had resisted the company's initial offers until they increased their bid. Now that NG prices have collapsed, the company has stopped buying homeowners' mineral rights. Some of his neighbors held out too long, and now there is no deal for them at any price.

In a broader sense, when we enter into a financial transaction, it's worth taking a moment to think about who is sitting on the other side of the table. What do they know that I don't? For share of stock that has been sold during the recent market turmoil, an equal number of shares were purchased at the same price.

Oct 24, 2008

Brooks Brothers spreads holiday cheer, conspicuous consumption

The Brooks Brothers holiday catalog arrived in our house today, and although I generally like their store, there were a couple of problems with it. First, it's a full month before Thanksgiving. Not even Halloween yet, and already they're hawking Christmas goods. Second, given the doom & gloom in reported the economy, are shoppers really in the mood for a $15,000 Christmas tree made of 250 silk ties in colors of your choosing? That only works out to $60/tie - you'd think they would offer a quantity discount during this lean holiday season. Neiman Marcus can get away with filling their holiday catalog with items that most people could never afford to buy - I'm not so sure that marketing strategy will work for Brooks Brothers.

This year, I am going to eschew the $15,000 tie tree and focus on the essentials when it comes to gift-giving. Consider instead the genuine American alligator belt for $898. At least that way you can rationalize your materialism - you're buying American.

Oct 23, 2008

Today, we're all Keynesians. What if we all are?

Adam Smith used to be the dominant economist, promulgating his notion of the invisible free hand of the markets that set supply and demand at equilibrium. Then along came Keynes who said that the government should engage in extra spending during recessions because markets take too long to correct on their own.

Today, we are faced with the possibility of a global recession and countries are trying to navigate their way through it. Unlike past crises, the US dollar is no longer the absolute reserve currency of the world. Other countries have built up substantial foreign reserves over the past two decades, as demonstrated in this graph (2008 data point is as of March):

The graph begins in 1979 since that is when Deng Xiaoping began his program of the four modernizations. As of September 2008, China's foreign reserves were reported at $1.9T, with an estimated 70% of that being held in US dollar denominated assets such as treasuries. This balance has accumulated over the years as China has bought dollars and sold yuan to keep their currency undervalued which makes their exports more competitive. However, now that economic growth is slowing, it is possible that China will take a page from the Keynesian playbook and use sell their reserves to generate yuan, which would then be spent in their local economy. This plan could have an enormous effect on the dollar - can you imagine what the exchange rate would be if $1.3T of treasuries were sold? Even if the liquidation was conducted in an orderly fashion, it could easily lead to a crash in the value of the dollar.

Oct 22, 2008

Accretive and dilutive acquisitions

The Wall Street Journal reported the following on 10/21/08 regarding Exelon's unsolicited bid for NRG:

NRG should push for better terms. Yet persuading Exelon to play ball could be tough. Based on enterprise value, Exelon is offering roughly 6.5 times 2008 Ebitda. Having also taken a battering, Exelon's own multiple is only about seven times, so there is little room to sweeten the deal before it starts looking dilutive on that measure.

What does it mean to be dilutive? In an all-stock deal, if a company acquires a target with a lower P/E ratio, it must be accretive to earnings. Basicially, the target firms earnings a "cheap" enough that the buyer can add them to its own and still come out ahead. In the case above, if Exelon increased the price paid for NRG, that would imply a higher multiple, and if they acquired a firm at a higher multiple than their own (with an all-stock deal) that would be dilutive to earnings, which is viewed negatively by investors. For lack of a better measure, the change in earnings is used as a proxy for value creation (accretion) or destruction (dilution) as a result of the merger. There is a good illustration of this concept at this link.

Oct 21, 2008

The Indonesian Seaweed Bubble

It appears that no commodity was immune from the rapid increase in prices this year - not even seaweed, which went through its own bubble in Indonesia. After more than tripling, the price has come back down to earth, leading to calls for government intervention and fingers pointed toward speculators. Sound familiar?

You can read the whole story at this Wall Street Journal Link. The seaweed is used to make carrageenan, a common food additive that acts as a thickening agent or provides texture. You'd be surprised how many products at the supermarket contain this ingredient.

Oct 20, 2008

Mergers and Acquisitions Accounting

Through 1999, firms engaged in M&A activity could choose between the purchase method and the pooling of interests method. When a buyer acquires a target, it usually pays more than the book value of the equity it acquires. Under the pooling of interests method, the financial statements of the two firms are combined at existing book value. Therefore the buyer does not have to reflect the difference between the purchase price and target book value. Under the purchase method, the target firm's assets and liabilities are adjusted to fair market value. If there is still a gap between the purchase price and the FMV of these items, goodwill is created for the balance. The goodwill is either amortized or tested annually for impairment. Either way, goodwill can reduce accounting income, which is not a problem under the pooling of interests method. Prior to the change in the accounting standard, managers seemed to prefer pooling of interests for this reason.

Interestingly, firms that used pooling of interests were not required to retroactively restate their financials after the rule changed, so they continue to benefit from it today.

Oct 18, 2008

Credit crunch explanations

As near as I can tell, this is the public's perception of different explanations for the credit crunch.

Oct 16, 2008

Common accounting adjustments

What are the primary adjustments that most analysts make to reported financial statements?

  • Capitalize operating leases
  • Capitalize in-process R&D
  • Convert pooling acquisitions to purchase accounting

Oct 14, 2008

Earnings Mangement: Real Versus Accounting

When someone mentions earnings management, I tend to think of accounting adjustments at the end of the quarter. Over-accruing an expense in a good period or recognizing sales earlier in a bad period. To the extent GAAP permits legitimate discretion in these areas, there is substantial evidence that managers take advantage of these items to manage earnings.

However, there is another way to manage earnings that involves real value rather than just accounting optics. A CFO may decide to delay funding a value creating project (positive NPV) if he feels that he is at risk for missing his earnings estimate. While manipulating accounting results does not affect the true economic value of the firm, delaying a good project or investment can have a negative effect on firm value.

Publicly traded firms are not the only ones who are subject to this short-term thinking, as private firms may also prioritize quarterly earnings in order to prepare for an IPO or to secure favorable terms for debt financing.

Oct 11, 2008

Pareto's sub-prime mortgage mess

I just saw a report on JP Morgan's residential loan portfolio that stated about 80% of the 3Q08 losses were from California and Florida, despite the fact that loans from those states only make up about 37% of the portfolio in question. This is primarily due to 2006 and 2007 vintage loans. It's not quite at the 80/20 ratio that the Pareto principle would suggest, but it does suggest that the law of the vital few is at work in the current mortgage mess.

Oct 10, 2008

GM and Chrysler Merger: Too Big to Fail?

Take two struggling companies and somehow merge them together to magically solve all their problems and make them stronger than either would be on their own. Do this while incurring the expenses of a costly integration and all the confusion that comes with it. Right. I suspect the real motivation for the merger is an attempt to become "too big to fail." Either company could be a viable competitor on its own if it were willing to accept the harsh reality and make some changes. Here is my armchair quarterback advice for fixing the American automakers:

1) Cut redundant brands and focus marketing support behind a few winners rather than diluting it across 20 brands.

2) Get out of ridiculous union contracts that pay workers to clock in and perform no labor (the "job bank" program). If they need to declare BK to renegotiate these contracts, so be it. You have to reduce supply so you can stop relying on huge discounts and fleet sales (which kill resale, further reducing retail demand).

3) Same recommendation for their contracts with captive parts suppliers like Delphi. Everything needs to be opened up to the market and rebid. Even in a brand new Chevy Cobalt, the radio looks like something out of the early 90s - quality may have improved but you'd never know it by looking at a dated instrument panel.

4) The dealer network needs to be reduced. This is tough but necessary, their sales volume just can't support the number of dealers out there.

5) Move their corporate headquarters out of Detroit. They've developed myopia from living there for too long, believing that Americans will always support their products. If they ever visited the west or east costs (even in Texas the Toyota Tundra is giving the F150 a run for its money) they'd realize that their brands are just one of many in the marketplace.

If Toyota, BMW, and Honda can profitably make cars in the US, there no reason the American brands can't.

By the way, we (the American taxpayers) agreed to lend them another $25 billion in a bill that was passed shortly before the bailout package went through. It didn't get much press coverage after the fact, but we are now subsidizing their broken business model.

Oct 3, 2008

Are you a bad enough dude to rescue the economy?

Does anyone remember Bad Dudes, an old Nintendo game from the 1980s? The premise was that the President had been kidnapped by ninjas, and you had to go rescue him. Very plausible, no? One of the title screens featured a particularly memorable line inquiring about your badness vis-a-vis the spectacular nature of the task before you. In light of today's events, I have crafted my own 8-bit NES homage to the title screen.

$700 billion of mortgage backed securities have been kidnapped by Henry Paulson. Are you a bad enough dude to rescue the economy?

Google circa 1960

Aug 9, 2008

Movies: Man on Wire

Far and away one of the best movies I've ever seen. The story is so incredible that it could only be a documentary.

Aug 8, 2008

Word of the day

In honor of 8/8/08: the word for the infinity sign (the sideways numeral 8) is lemniscate.