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?

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.

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.

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.

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.

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.

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.

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.

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.

Credit crunch explanations

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

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
  

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.

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.

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.

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.

Google circa 1960