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Investments for dummies

Posted in investments by Scott Locklin on November 20, 2010 

 

Since I have a weblog, a trading skunkworks and occasionally work for people in the quantitative finance domain, I’m occasionally asked by friends and acquaintances about investments. “Should I buy gold?” “What do you think of investing in company X?” or my favorite, “where should I put my money?”
The fact of the matter is, I don’t know the answer to these questions, and compared to most people, I probably am an expert on such things. I’d say, in reality, very few people in the world really knows the answers to these questions, and if they know, they’re not going to be telling you. To really understand why, consider what you’re investing in when you buy a stock.
When you buy a unit of stock, you’re buying a legal contract entitling you to part of the profits of a corporation. What is a corporation? It’s a legal arrangement for providing goods and services to the public, and providing some vaguely defined way of sharing the profits with the owners. The owners being, the people who own stock in the company. The owners are protected from legal risk incurred by the actual agents of the corporation. In other words, if a Lockheed executive tries to bribe a congressman and actually gets into trouble for it, the shareholders won’t go to jail. This is socially useful in that the shareholders can’t be expected to be accountable for the tens of thousands of Lockheed employees. While shareholders are protected from legal indemnity, they’re not protected against the financial shenanigans of the agents of the corporation. This is something that people rarely think about: if the corporation they’re invested in is manned by criminals, they probably won’t realize any returns. Even assuming the agents of the corporation are honest, that doesn’t mean they’re not dumb, or at least optimizing a utility which isn’t aligned with that of the owners. For example: many companies will incur massive debts; debts which could eventually bankrupt the company. Accounting systems are also a bone of contention. While most American companies are reasonably honest, the way that the accounting is done is hugely relevant to how a company is valued.
There are a couple of ways ordinary humans think about stocks. They may think the idea behind the company which issued the stock is a good, see a stock going up in price, and so they buy into the trend. They may actually know something about the the company: perhaps they notice lots of other people lining up to pay $4 for a cup of sugary caffeine water at the local coffee house, and so, see it as a good investment. That’s all well and good, but if you don’t know about the company’s plans, the intimate details of it’s accounting methods, and who is running the joint, you really don’t know anything about it. If you’re buying on the trend, well, that can work too, but unless you’re willing to sit around and white knuckle the trend to its ultimate conclusion and time it well enough to sell at the top, you are just gambling. Not that there is anything wrong with that.
My investment advice: invest in the small businessman. I have a minor celebrity pal who did time in Los Angeles. As all Angelinos are required by local statute to have perfect teeth, Veneers are an extremely profitable business. My pal ended up learning all about the various pieces of machinery which can be used to make this sort of thing easier on a dentist, as he had it done to his own choppers, and he ended up investing in individual dentists. He would do stuff like invest in the machinery, invest in young dentists purchases of business partnerships (Dentists usually buy into a practice, in order to have access to equipment and a ready flow of customers) and share in the profits. Since dentistry is a virtually risk free proposition, my pal made a good deal of money off of such investments.
I can see people shifting uneasily in their seats already. How did my pal know these Dentists would pay up? Well, my pal pretty much had to investigate only the individual dentists he invested in. If you’re investing even in one equity, you’re investing in a whole lot of people -people you will never know, who may or may not be honest people who are working in your interest. My pal also had a lot more legal leverage over his investments, as he owned substantial fractions of their enterprise; far more than you’d own in a given equity. In that sense, his risk is a lot lower than someone blindly investing in stock of a company.
Most people never seem to think of this option: investing in small businesses. It does require some social skills and imagination, but it seems to me, for the average joe who doesn’t even understand the rigors of double entry book keeping, let alone the difference between an accrual and an operating cash flow, this is a better bet. Otherwise, you’re just gambling. Investing in the latest trend in the stock market seems the height of folly for the regular schmoe who can’t be bothered to understand even how a very small business works. I guess if you can’t be bothered to invest in a small business, something like public utilities makes a lot more sense than speculating in something you don’t understand.

scottlocklin.wordpress.com

CDS chart of the day, Portugal edition

Many thanks to my colleague Eric Burroughs for sending over this chart, showing how Portugal’s CDS curve has evolved over the course of this year:

The black curve is how Portugal looked in April: a pretty standard upward-sloping curve, with default more likely the longer you go out.
By June, however, with the onset of the Greece crisis, things looked very different. (This is the green curve.) Obviously default probabilities were higher across the board. But they were highest at the short end of the curve: 6 months to a year out. If Portugal could make it that far, markets were saying, then it would become steadily less likely to default thereafter.
Today, with the red curve, it’s very different yet again. The contrast from just a few months ago is striking: while the 1-year CDS showed the highest default probability back then, today it’s the lowest. The EU bailout of Ireland confirms that Portugal will probably not be allowed to default any time soon.
But then look at where Portugal’s CDS curve goes after that: straight up, to the point at which the country is now considered more likely to default at 3 years out, and on from there.
The implication is clear: any bailout now only serves to make a future default more likely.
Which is not, I’m pretty sure, the message that the EU is really intending to send.

blogs.reuters.com/felix-salmon

Will Ireland's bailout end the euro crisis?

Posted by Michael Schuman Monday, November 22, 2010 at 2:43 am

 

5 Comments • Related Topics: bailouts, banks, europe, greece, sovereign debt,

The government of Ireland sought a European Union-International Monetary Fund bailout over the weekend, finally succumbing to pressure from its fellow Eurozone members and panicked financial markets. That makes Ireland the second of the Eurozone's 16 members to require a rescue, after Greece got a $150 billion package in May. Ireland's will likely be smaller – perhaps $110 billion over three years -- though the final details are still being negotiated. Olli Rehn, the EU commissioner for monetary affairs, said the bailout of Ireland is “a critical step forward” to “safeguard financial stability in Europe.”
The Irish bailout will bring to a close weeks of rabid speculation about Ireland's fate that plagued financial markets throughout the world. But is the Irish rescue finally the end of the chaotic instability the Eurozone has experienced for more than a year? Will investor confidence be restored over the zone's future? Probably not, in my opinion. As has been the case throughout the euro crisis, Europe's leaders are dealing with only one part of a bigger problem, and only when their backs are against the wall.
The Ireland crisis followed a similar pattern to the Greek crisis earlier this year. For weeks, Ireland's ministers and their counterparts across Europe vowed that the country could go it alone and fix its own financial woes without EU aid, hoping that the Irish economy could muddle through until sentiment in financial markets improved. But as with Greece, investors didn't believe them. In Greece's case, the concern was the miserable state of the government's finances; in Ireland's, it's the burden of a floundering banking sector brought low by a property bust. But in both cases, the numbers were just too ugly. In September, the Irish government said its bank rescue plan would push the budget deficit up to a staggering 32% of GDP this year and balloon its government debt to 99% of GDP. So, as was the case with Greece, nervous investors kept hiking up the spread between Irish government bonds and benchmark German bonds to record levels, a sign that bondholders saw Ireland's debt as increasingly risky to hold. Finally, Ireland and the EU bowed to the inevitable – a bailout. “A small sovereign like Ireland faced with an outsized problem that we have in our banking sector, cannot on its own address all those problems,” Irish Finance Minister Brian Lenihan admitted.
Just as the Greek bailout failed to stem the euro crisis, I believe the Irish bailout will fail as well. That's because all of the underlying issues will remain in place. Sure, this time around, the EU has funds already committed to help Ireland – the $1 trillion rescue fund announced in May, which didn't exist during the Greek meltdown. But the availability of bailout money won't resolve the uncertainties inherent in the very nature of the EU's bailout scheme.
First, the success of the bailout will depend on the ability of Ireland's government to impose incredibly severe budget cuts, demanded by its Eurozone pals in return for the rescue funds. In other words, the Irish people will have to absorb years of economic pain to protect bondholders in Germany, the UK and France. As in the situation in Greece, my guess is that investors will continue to hold doubts as to whether that formula is viable. Concerns will persist over whether Ireland can politically or economically impose such austerity measures while the economy is contracting. That may keep investors nervous, as they are with Greece, that a restructuring of debt might still be waiting in the wings, an outcome that would force a haircut on bondholders.
Second, the bailout of Ireland, as with Greece, does nothing to help the economy out of its crisis, aside from preventing an outright default. The rescue scheme ignores the crucial ingredient of growth – without which Ireland will struggle to close its budget gap, resolve its banking crisis and pay off its debts. In fact, by forcing vicious austerity measures onto the Irish economy, the bailout will only make that turnaround more difficult.
To put it simply, the entire bailout mechanism forged by the EU leaves too many questions unanswered, and thus will keep financial markets jittery. That doesn't bode well for the fates of the Eurozone's other weak members, especially Portugal and Spain, whose bonds have also been punished recently. Spain's finance minister already came out to claim Spain is not Ireland. That foreshadows the possibility that events with Portugal and Spain could follow the same course we've seen with Greece and Ireland – a combination of denial, delay and investor doubt that causes a self-fulfilling deterioration in financial markets.
I'm not saying that Spain and Portugal will inevitably suffer the same fate as Greece and Ireland. Each economy is different, and hopefully investors will realize that. And there is a chance that Europe, by showing that it is committed to employing its $1 trillion fund, can stop the contagion at Ireland's shores. Perhaps officials in Spain and Portugal can implement the reforms to keep investors appeased.
But the case of Ireland shows that even reform might not be enough to hold off a crisis once markets get nervous. The government of Ireland has been universally praised for its upright handling of its banking crisis and budgetary woes, but that wasn't enough to save them.
Even more, the ad hoc way in which Europe is handling its debt crisis – acting only when pushed to the precipice, with a program in which the stronger Eurozone members impose pain on the weaker – isn't tackling the roots of that crisis. That's why all of the previous steps taken by the EU– the Greek bailout, the trillion dollar fund, EU reform proposals – haven't stemmed the crisis. What the Eurozone requires is a proactive effort to engage its problems in a more comprehensive way, helping the weaker members to resolve their debts and return to healthy growth, not just saddling them with further debt to prevent losses at European banks. Unfortunately, based on the evidence of the past year, Europe's leaders are going to continue to muddle through, hoping they don't have to do more than they've already done. I fear that won't be enough.

Read more: http://curiouscapitalist.blogs.time.com/2010/11/22/will-ireland%e2%80%99s-bailout-end-the-euro-crisis/#ixzz163Mfo38L

More on amateur economics

Nov 2nd 2010, 15:31 by R.A. | LONDON

I THOUGHT I made a pretty nice point on Sunday concerning the way amateurs fuel housing bubbles. I wrote then that it asn't amateur participation in the market that made prices bubbly; rather it was the influx in new amateurs, which allowed the Ponzi-like bubble to keep inflating. As evidence, I cited the unusual rise in the homeownership rate during the 2000s from 67% up above 69%. Unfortunately for me, Calculated Risk has gone and put up a chart that complicates the story:
As you can see, there's an even larger increase in the homeownership rate from the early 1990s to 2000, of nearly four percentage points, than we observe in the bubble decade. Now, this doesn't mean my earlier story was wrong (you thought I'd say that). Bubbles often begin with a "real" shift in fundamentals that generates upward price pressure. The tech boom began with a wave of investment in new, productivity-enhancing technologies. It could be that the housing bubble of the 2000s was rooted in an earlier fundamental shift.
Like what? The generation that fought World War II famously came home and produced a baby boom—an unusually large cohort of births between the mid-1940s and mid-1960s. From the early 1980s to the mid-1990s, these Baby Boomers were entering middle age and generating an echo boom of their own. Prime child-rearing age also happens to be prime homebuying age; the rate of homeownership jumps substantially as one moves from twentysomethings to thirtysomethings. In other words, much of the increase in the homeownership rate observed in the 1990s was likely rooted in a change in the composition of the population—from groups less likely to own homes toward groups more likely to own homes.
This increased demand would nonetheless have run up against supply limits to generate rising prices, and rising prices generated new enthusiasm for participation in the housing market. What turned this enthusiasm into irrational exuberance, however, was the massive credit growth of the 2000s and the innovations that increased the pool of potential homeowners. In the 1990s homeownership increased because more people were moving into the "typical homeonwer" category. In the 2000s homeownership increased because the "typical homeowner" category was broadened to include new people.
As it turned out this broadening was not sustainable, and when the pool of potential borrowers was finally empty the homeownership rate (and prices) fell substantially. What will be interesting to observe is whether some of the underlying increase in demand for homeownership is also reversed. Boomers are now approaching retirement age, and homeownership rates decline slightly among those over 65. The echo boomers are now young adults, but their household consumption patterns may be significantly different from their parents'. They're likely to marry later and have fewer children, and they may be turned off from homeownership by the crisis. Rates of homeownership could begin a long secular decline.
The effect of that decline on prices will depend on the extent to which existing supply can be shifted from owner-occupied to rented. Where this shift is slow to take place, the slump may persist for quite a long time.

theconomist.com/blogs/freeexchange

CDO lemons, a government fruit bowl

Posted by Tracy Alloway on Nov 01 12:51.
‘Asymmetric information’ in Collateralised Debt Obligations is not a good thing.
That much we know from Goldman Sachs’ Abacus 2007-AC1 CDO and, err, Goldman Sachs’ Abacus 2006-13 and Abacus 2006-17 deals. But a new Federal Reserve discussion paper takes the issue a step further to ask: could asymmetric information alone have caused the collapse of private-label securitisation?
The abstract:

A key feature of the 2007-2008 …financial crisis is that for some classes of securities trade has ceased. And where trade does occur, it appears that market prices are well below what one might believe to be the intrinsic value for that class of security. This seems to be especially true for those securities where the payouff streams are particularly complex (for example, CDOs). One explanation for this is that information about these securities’ intrinsic values is asymmetric, with the current holders having better information than potential buyers. We show how the resulting adverse selection problem can help explain why more complex securities trade at signi…cant discounts to their intrinsic values or do not trade at all…

The proving of the hypothesis is probably the least interesting thing in the paper. Authors Daniel Beltran and Charles Thomas find that “when market participants are pessimistic about the state of the economy in the future; the increased pessimism interacts with asymmetric information causing the CDO market to shut down.”
But what’s really worth highlighting here are the authors’ suggestions for fixing the so-called ‘lemon problem‘ in structured finance. And there are three of ‘em:

… The …first policy has the government buy relatively low value securities and commit to holding them until maturity. The government has no better information than any other buyer. What makes the government special, and hence provides a role for policy, is that it is the only agent that can credibly commit to not sell the securities before they mature. The policy is useful because after the government makes its purchase the market for the remaining securities reopens and these remaining securi- ties trade at prices closer to intrinsic values. Although this policy involves a cost to the government, the cost is smaller than the gains that arise from having the market reopen…

Tarp take-two then, government fruit bowl edition:

The second policy considered is the creation of a “bad bank” to purchase all of the securities tainted by the asymmetric information problem. Securities holders sell their securities to the bad bank for a given price. The bad bank …finances the purchases of these securities by issuing identical shares that entitle the owner to interest in the cash flows generated by all the securities in the bank. The bad bank keeps track of the cash flows of each security it purchased, which are used to calculate their ex-post hold-to-maturity values. After observing the cash flows of each security, the bank claws back money from sellers who sold securities that had ex-post values less than the original share price, and makes supplemental payments to sellers who sold securities that have ex-post values that exceeded the original share price. So long as participation in the plan is mandatory and the claw backs can be enforced, this proposal eliminates the asymmetric information problem in a way that is fair to all investors.

The final suggestion:

… The government could lower the appraisal cost by promoting disclosure of the individual mortgages underlying CDOs. Currently, information regarding the …rst generation assets (e.g. mortgages) underlying a particular CDO could be obtained, although at a considerable price, from a database provider such as Intex, which covers over 20,000 structured fi…nance deals. But some CDO structures are so complex that, even with knowledge of the underlying assets, investors would face an enormous computational burden when trying to compute their intrinsic values. Consequently, when market prices vanished for many structured …financial products, investors often pur- chased fair value assessments from third-party appraisers … To address the root of the asymmetric problem and resuscitate the market for private-label ABS, …financial regulators should encourage better disclosure of the underlying loans backing securities and potential conflicts of interest, increased investor due diligence, and reliable ratings or third-party appraisals.

While upping transparency is always an admirable goal, we wonder what forcing appraisal costs lower might mean for third-party valuation firms — many of which already have hefty government contracts for, say the Fed’s Maiden Lane portfolios.

ftalphaville.ft.com/blog

The neo-medieval trade

Posted by Joseph Cotterill on Nov 01 16:53.
Markit pointed out something interesting on Monday: there’s a record spread between their iTraxx Europe and SovX Western Europe CDS indices.
Chart via Bloomberg, click to enlarge:

SovX WE — which is filled with such wholesome sovereign goodness as Portugal and Ireland — has obviously had a few down days recently, on account of renewed troubles within its weakest members.
Not to mention possible EU treaty changes on deficit control that might favour sovereign debt restructuring in the long run. ECB board member Lorenzo Bini Smaghi seemed less than cheerful on the changes’ ability to force fiscal reform in a speech made on Monday, so there’s one to watch.
But how about the performance of the 150 investment-grade corporate credits housed inside iTraxx Europe, eh?
This does bring to mind a recent historical meditation by Citigroup’s chief economist Willem Buiter (emphasis ours):

Historically, before the 19th century, the norm everywhere (including in the countries that we now characterize as advanced economies) was that sovereign risk tended to be worse than the credit risk of leading merchants or private bankers…
The poor credit rating and performance of sovereigns in Western Europe before the 19th century should not come as a surprise, as prior to the modern age of broad-based income taxes and indirect taxes, the sovereign’s revenue sources were limited…
We would not be surprised, for instance, to see leading Spanish banks trading through the Spanish sovereign and we have already observed instances in which Italian or Greek companies had CDS spreads that were below those of the sovereign…

Although we’re probably just being dramatic.
Then again, Barclays Capital analysts had the clever idea last month of selecting European corporate credits demonstrating the lowest possible correlation to the SovX, in a bid to avoid volatility.
Click BarCap’s charts to enlarge:


BarCap don’t like financials, however, given their high correlation to their sovereigns. Bad news for the iTraxx Europe Senior Financials.
Beyond that — perhaps this is a trade going back to the future.

ftalphaville.ft.com/blog