Jan 31, 2009

Is your city becoming a hard-money lender?

The Wall Street Journal reported this week that some cities in California are providing subsidized loans to struggling auto dealerships. Even if you believe it is the government's job to finance private enterprise, this is a terrible way to do it. Why is this such a bad idea?
  • Municipal bondholders will be forced to take on more risk than they were expecting, pushing prices down and yields up. This will increase the city's cost of borrowing. Higher interest expense means higher taxes or a reduction in city services.
  • Rather than diversifying its risk, the city has concentrated it even further. Since it depends on tax revenues to operate, if businesses fail then taxes will decline. After making a loan to a struggling business, it's in even more trouble if things go bad - it will lose both the tax revenue as well as the principal on the loan. So the risk of financial distress for the city has increased (is this really a good time to be taking on more risk?).
  • The city is essentially engaging in interest rate arbitrage - using its strong credit rating to borrow cheap (plus taking advantage of the federal tax exemption) while lending to extremely risky businesses at below-market rates. If you found out that your city was using tax revenues to buy junk bonds, would you approve of that? This is no different. Actually, this is worse, because at least junk bonds might be fairly priced - the loans in this article are at below market rates, so the "investors" (the city's taxpayers) are not even getting a fair risk/return trade off.
  • The city doesn't have the resources to properly underwrite, monitor, or enforce collections the loans like a normal bank. A bank has departments that deal with all of these issues and as a result, can provide those services at a lower cost than a city that has to develop them from the ground up.
  • When things go bad, the city will face a lot of pressure to avoid calling the loan and foreclosing on the business. It creates a rat's nest of tangled political issues that will result in poor economic decisions being made.
  • It encourages a "race to the bottom" among cities to offer lower tax rates to prop up uneconomical or inefficient businesses while forcing the tax burden on the successful ones.

Jan 24, 2009

S&P 500 returns and the normal distribution

One of the fundamental assumptions in modern finance's asset pricing models is that returns follow a normal (Gaussian) distribution. The histogram below shows the annual percentage returns on the S&P 500 from 1926-2008, grouped by 5% increments, overlaid with the normal distribution curve. Note the fat tail on the left that includes the two worst years, 1931 and 1937.

Until last year, many assumed that these data points could be ignored because "things were different" after WWII, so they proceeded to fill their VaR models with mean returns and standard deviations calculated post-1945. My finance textbook, published in 2006, discusses the differences between 40-year returns and 80-year returns and decides that the 40-year returns, (which exclude the 1930s) are more appropriate for our purposes. The book states that "it appears that observed fat tails are largely due to older history" and "we have more confidence that the more recent averages better estimate expected returns for the near future." Then 2008 dropped a -37% return on us. It will be interesting to see how they address this issue in the next edition.

Jan 22, 2009

Businesses that will fail in 2009

The NYT has described one here. A new startup is going to assemble blog postings and print them in a free weekly paper, supported by advertising. Let me see if I can find all of the problems with this business model as compared to a traditional newspaper or a blog.
  • Cost of printing and physical distribution (blogs are virtually free)
  • Low responsiveness (blogs can be updated instantly)
  • No fact checking or editing (a real newspaper provides those, at least)
  • Environmental impact (blogs use less resources)

Basically, The Printed Blog has taken the worst parts of the newspaper business model and combined them with the worst parts of the blog model. And they're going to launch this in the worst economic environment in recent memory. Right.

Jan 21, 2009


Scott Adams seems to have a better understanding of basic economics than most people these days.

Meanwhile, Bill Watterson has succinctly captured the ethos of the American automakers' management:

Jan 20, 2009

The winner's curse

This can occur in an auction where the bidders have incomplete information about the true value of the item they're bidding on. If the average of all the bids equals the item's true value, then whoever wins the bid must have overpaid for it, since their bid was the highest, and therefore above average. So the tendency is for the winning bidder to be the bidder with the highest misestimate of value.

Unrelated: In honor of the inauguration, here's some presidential trivia - who was the only U.S. president to successfully pay off the national debt? Andrew Jackson, in 1835. Unfortunately, the panic of 1837 (brought on by massive banking failures) and subsequent depression put an end to that, as the national debt increased ten times in the first year of the depression.

Jan 18, 2009

Generational risk taking

A recent paper from Berkeley investigates how the risk you take as an investor may be affected by the economic environment you grew up in. Everyone has heard the stories of those who lived through the depression who refuse to trust banks. This paper finds that people who lived through strong stock market returns have an increased percentage of their wealth invested in stocks. Similarly, those who lived through times of high inflation are less likely to invest in bonds. Early experiences of macroeconomic shocks can color someone's investing philosophy for years to come, although they do show that people are still subject to recency bias, although it fades away over time. This approach supports behavioral finance, which runs counter to the traditional theory that all individuals are rational and evaluate past information (historical average returns) equally.

Going forward, will young investors over the last decade return to investing in stocks after the above average volatility experienced starting in 2000? Or will we have to wait for the next generation for the great bull market?

Jan 17, 2009

The promise of equity investing: oversold to the public?

The conventional wisdom for personal investments is that the longer you have until you need the funds, the more risk you can afford to take. A young person with many years until retirement should put a larger percentage of his asset allocation (mix of stocks, bonds, and cash) into riskier asset classes such as equities. If we examine portfolio statistics, this appears to be a reasonable suggestion - while the S&P 500 may be up or down 40% in a year, over 10 or 20 years the average annual return approaches a more reasonable number, and the standard deviation of returns (how much do returns vary each year compared to the mean) also decreases. Since the standard deviation represents risk, people believe they are taking less risk by holding for the long term.

The problem here is that an individual is concerned with his portfolio's terminal value much more than the average of his returns. That is, when you retire in 40 years, how much real purchasing power does your 401(k) provide? Unfortunately, as time increases, the dispersion of your portfolio's terminal value increases, rather than decreases. This means the range of possible values, both extremely high and extremely low, is wider. The mean (expected) value looks pretty good, and there is a lot of upside, but if you end up in the bottom 3 sigmas, you may be disappointed. See graph from John Norstad below.

My argument is not that investors should eschew stocks in favor of something else. It's that average investors may not be fully informed about the risk that they are taking, and may be misled by the apparent effectiveness of time diversification. The investment community has put the best possible spin on portfolio statistics, but may not explain the nuances to an unsophisticated investor. Now that the primary burden of providing for one's retirement has been shifted from social security and pensions to 401(k)s and Roth IRAs, it is more important than ever that people understand what is going on in those accounts.

A detailed explanation and some other arguments are available here. He gets into some other interesting considerations, such as utility theory and the options pricing model. Regarding the latter - if the risk of stocks really declined the longer you held them, put options on the S&P 500 (the right to sell the index at a guaranteed price) should cost less the further out in the future they mature. This is basically a form of portfolio insurance - you buy the option and ensure that you will receive at least a certain price for your stocks. But we observe in the marketplace that the cost of such an option increases with the time to maturity. If you tried to insure the value of your portfolio for the next 10 years this way, it would be prohibitively expensive.

Jan 14, 2009

Word Clouds

There's an interesting web application at Wordle, which allows you to easily create word clouds from text or a blog feed (RSS or Atom). Options include the font, colors, shape, and layout. Here's a word cloud created from a Wall Street Journal article on how banks are going to need more capital.

Jan 11, 2009

Words of the day

Antediluvian (adj.)

1. Extremely old and antiquated.
2. Occurring or belonging to the era before the Flood (as told in the Bible).

[From ANTE + Latin dīluvium, meaning flood.]

Logomachy (noun)

A battle of words.

[From the Greek logos (words) + makhe (battle).]

Terpsichorean (adj.)

Relating to dancing.

[From the Greek terpein (to delight) + khoros (dance).]

Jan 6, 2009

Early derivative contracts

Aristotle wrote about Thales of Miletus, a man who lived around 600 BC and was perhaps one of the first people ever to speculate on commodity prices using options. During the winter, he surmised that the olive crop would be plentiful this year, and bid on the right to use the olive presses during the summer, after the harvest came in. Since it was the off-season, there were no other bidders and he secured the call option quite cheaply. When the crop arrived as he predicted, there was great demand to make olive oil, and he was able to sell the options to the farmers for a tidy profit. This paper discusses in more detail the fair price for an olive press option, applying the Black-Scholes pricing model.

Jan 5, 2009

Refiners' stock prices and the crack spread

The crack spread is a rough measure of an oil refiner's gross profit margin. It measures the difference between the cost of inputs (crude oil) and outputs (gasoline, fuel oil, diesel, etc.). Normally this ratio is expressed as 3-2-1, where 3 barrels of crude yield 2 barrels of gasoline and one of heating oil, although other ratios are also possible. The term "crack" refers to the process of breaking the hydrocarbon molecules in crude oil through the application of either a catalyst (cat cracking) or hydrogen (hydrocracking). Another interest fact: a high complexity refinery can actually output 5-10% more material by volume than it consumes as inputs due to volumetric expansion as lighter molecules are produced.

Since the crack spread is a measure of profitability, one might expect that refiners' stock prices are highly correlated with it. The strange thing in 2008 was that refiners were much more highly correlated with the overall stock market (represented by the S&P 500) than the crack spread. The crack spread even became negative at one point in the year - why would refiners continue to operate only to lose money on every barrel they refine? The answer is that they had hedges which locked in input or output prices at levels other than the currently observed spot prices.

Jan 4, 2009

Your state's credit rating

Where does your state fall on the credit rating scale? Interesting that the east coast has a string of AAA ratings, while the west has a cluster of states with no general obligation government bonds at all (those appear to be the states with low population densities). Also noteworthy: states can't declare bankruptcy, while cities and municipalities can. Yields on munis have certainly become more attractive, but I'd look to GO bonds over revenue bonds tied to a specific source of income (they lack the full faith and credit of the governmental entity). From an article in Fortune.

Jan 2, 2009

The 4.4% of the S&P500 that stayed in the green

Only 22 of the 500 stocks in the S&P500 finished 2008 in positive territory. Not surprisingly, we see Wal-Mart, the Dollar stores, and McDonald's on the list, plus several biotech/pharma companies. UST, which sells smokeless tobacco and wine (what a great flavor combination), also posted a gain due to its impending buyout by Altria. A few chemical companies are on the list, probably benefiting from lower oil prices. H&R block made the cut (chalk that one up to death and taxes). And of course Autozone - when the economy slows, people do more car maintenance themselves.

The oddball on this list is Pulte - the news for homebuilders only became more negative during the course of the year. However, it had already been beaten up so badly by the end of 2007 (losing 70% of its value that year) that it was able to stay mostly flat in 2008.

Jan 1, 2009

Firstlight Financial: closed for business?

Firstlight Financial was a leveraged lender started in April of 2007 by a former GE officer, Ron Carapezzi, who took a lot of GE Commercial Finance staff over to the new firm. Ron and several other employees were graduates of GE's Financial Management Program (FMP). The company provided senior debt, second lien and mezzanine debt, structured financings and equity investments. Peaking at over 60 employees, layoffs were reported in April of 2008, reducing headcount to about 15.

Recently I noticed that the website is no longer working, and there is no answer at the listed phone number. Another victim of the credit crunch?