Monday, October 31, 2011

Treasury considering floating rates notes.

Very interesting.  Yet another thing to cover in the bond lecture!  Of course higher interest rates mean that the Government's liability would increase (As Campbell Harvey of Duke notes in the article), but this is already the case with TIPS, so I would wonder to what degree investors would actually just substitute these new bonds for TIPS.

(reposted from financeprofessor)

Bank of America - up to no good.

Bank of America apparently just shifted a huge block of Merrill Lynch derivatives to a bank unit funded by federally insured deposits.   In other words, moral hazard reared its ugly head again and B of A took advantage of the Governments deposit insurance program to placate some counter-parties.  Nice work B of A.

In unrelated news, I've transferred all my bill pay stuff from my previously bankrupt bank to the local credit union.  I'll be closing my bank account this week.

Where are new freshman from?

An interesting web site that shows where freshman at major universities are from.  Link should take you to the NCSU page.

Best month in a decade

Turns out this past October was one of the best months for stocks in a decade.   Popular wisdom holds however that October is usually a bad month for investors.   However, I subscribe to Mark Twain's view of stock investing:
"October: This is one of the particularly dangerous months to invest in stocks. Other dangerous months are July, January, September, April, November, May, March, June, December, August and February."

Tuesday, October 25, 2011

Negative convexity in mortgage bonds

I love it when the real world behaves in just the way that I wrote on the class room white board!

Case in point: Mortgage bonds have negative convexity over certain ranges of interest rates.  This means that when rates fall the value of the bond falls instead of increases as would be the case for a typical bond.  The reason for this effect is refinancing by the homeowners whose mortgages make up the cash flows of the bond.  As these homeowners refinance, the amount of promised cash flows declines, and so does the value of the bond.   Interest rates matter here because lower interest rates result in more refinancing.

OK, so what is happening today?  Well, there are a lot of homeowners who can't refinance because they have negative equity.  So even though they see interest rates fall, they cannot take advantage of these lower rates, that is, until now.  President Obama's latest initiative to enable these under water homeowners to refinance will result in many mortgage bonds getting paid off early and, as a result, fall in value.

The FT has a great article on this which notes that only the mortgage bonds which had coupon rates that are above the prevailing mortgage interest rates suffered a price decline around the announcement of the plan - exactly as we would expect.

As noted in the article, part of this plan is basically paid for by a wealth transfer from the mortgage bond holders to households.

Lionization of small business

Much is made of how small businesses are the main source of job growth in the economy.  Turns out this is not really true.  Start ups create jobs (and also destroy jobs if the fail), but existing small businesses as a group don't contribute that much to the overall jobs picture.  As usual, my favorite finance blogger, Felix Salmon has the scoop.


Finance Professor raves about Dropbox - a great product and a very successful company that has mastered the freemium model.

I am one of the 4% paying customers - $100 per year to have all (I repeat ALL) my work instantly backed up and accessible anywhere is a great value.  I'm also a huge fan of evernote (another freemium service).

Monday, October 24, 2011

Tuesday, October 18, 2011

Stock market liquidity and volatility.

Felix Salmon asks "should we be worried about stock market liquidity?".  He cites a Wall Street Journal article that claims that as volatility increases liquidity decreases.   Felix correctly recognizes that this isn't really anything to worry about.  In fact the positive relation between spreads and volatility is very well documented (even in my own work - see table 5).

The question then seems to relate to high frequency trading and whether algorithmic trading is perhaps eating up liquidity.  Recent academic work in this area provides evidence that this is not the case.

Finally Felix notes that a investor who was trying to buy a $250 Million chunk of a $4 Billion company was apparently surprised when his buying pushed up the stock price.  Again, this is to be expected when you are trying to buy a 6%+ stake in a company.

I agree with Felix here - there really doesn't seem to be much of a story - despite what the WSJ thinks.

Sunday, October 16, 2011

Capitalists of the world unite

There's been a lot of talk about the Occupy Wall Street movement recently, but today, the Wall Street Journal Sunday edition printed a great article on why capitalists should be mad at Wall Street also.

(The article defines capitalists as anyone who invests money - which would include pretty much anyone with a 401K or retirement plan).

Why should capitalists be mad?  Well it all boils down to fees.  The finance industry is basically a fee based business.  When investment firms make loads of money it is usually because they earned fat fees.  (The other way they make money is by making levered bets).   Most investors are either clueless about the fees that they are paying or they think that higher fees somehow translate into better performance (they don't).   

Time to wake up and pay attention people.  The only reason to pay higher fees is because you want to put someone else's kids in a fancy private school.   As the article states at the end "you can search in vain for the customer's yachts."

The solution is simple - indexing.   

You shouldn't pay more than 0.6%  of your wealth in fees.  This includes mutual fund expense ratios.

Saturday, October 15, 2011

State pension funds - more underfunded.

The degree to which state pension funds are underfunded has increased, in part due to lower bond rates.  This is because the present value of the liability faced by a state should be estimated by discounting the promised retirement payments at something close to a risk free rate.  The risk free rate is very low so the present value of these liabilities is high.

Of course states continue to use 8% to present value these liabilities.

Friday, October 14, 2011

Market volatility and drug use.

Apparently Berlusconi (the Italian PM) wants to start drug testing traders.  He thinks cocaine use is causing market volatility.

Wednesday, October 12, 2011

Mutual funds without morals.

A must read for anyone who buys actively managed mutual funds.  Ron Elmer explains how mutual funds game the system by merging, closing or changing style to make their bad returns look good.

Yet another reason to index.   You do index don't you????

The Wall Street Journal has been running a circulation scam

I used to subscribe to the Wall Street Journal - it was an excellent newspaper.  Then Rupert Murdoch took it over in 2007.  I now get my financial news at breakfast time from the Financial Times.  I got tired of the pseudo sensationalism that started to dominate the paper.

Murdoch's company, News Corporation, is without a doubt, one of the most crooked, ethically bankrupt companies in existence.  The latest scandal that has emerged is the finding that the Wall Street Journal was buying up copies of its own paper to boost circulation numbers.  Full details are here.  In classic News Corp style, the initial reaction of the company was to deny it, and then, when this didn't work, go ahead and fire someone.

Let's not forget that News Corp is also still embroiled in the phone hacking scandal in the UK in which the "sister" publication of the WSJ, the News of the World, hired hackers to hack and delete phone messages from the cell phone voice mail of a missing girl.  In doing so, the parents thought that their daughter was still alive, because she was accessing her voice mail.  News Corp employees also hacked the phones of the relatives of deceased British soldiers, and also victims of the July 7 London terrorist attacks, as well as numerous phones of celebrities and politicians.  All this occurred with the full knowledge of senior News Corp officials.

Recently Rupert Murdoch has said that the focus by shareholders on the hacking scandal is "disproportionate".


It's hard becoming an investment banker.

My Colleague, Craig Newmark,  links to a great post on what it takes to become an investment banker.

Monday, October 10, 2011

Executive Stock Options

Ron Elmer who writes "Investor Cookbooks" has posted a lengthy discussion of why executive stock options are bad, and why, in his opinion, they should be outlawed.

He makes some very good points.  I have a few comments.

First, I fully agree that the big problem with Wall Street firms is that they converted from being partnerships to being publicly traded.  As Ron points out, when they were partnerships, risk management was everyone's business.  The banks became public largely because the existing partners wanted a way to cash out.  They benefited and risk management suffered.

Second, I disagree that options do not align incentives.  The example given assumes that a manager will exercise his options at some future date and convert the gains straight to cash.  The important thing to remember here, is that up to the time when he cashed in his options, his incentives were very much aligned.  In fact, well in the money options are very much like stock.

Third, I agree that options represent a huge unknown in compensation because we really don't have any idea what they will be worth 5 or 10 years.  But I think the issue here is with the quantity of options that are being issued, not the option per-se.  Firms seem to make very large option grants that end up being worth huge amounts in the future.

Finally, Ron alludes to the bigger question of whether US CEOs should make 300 to 400 times what the rank and file worker makes.  This ratio is higher in the US than for most developed countries and I am also pretty sure it is higher now than it was, say 30 years ago.  I don't know what the correct ratio should be, but 400 seems high.  Having said that, I note that movie stars and professional athletes make stupid amounts of money for doing stuff that seems pretty unimportant in the big scheme of things.

Thursday, October 6, 2011

B of A needs a new PR firm

Chief Exec of Bank of America states that "we have the right to make a profit" in charging a $5 debit card fee.  Sure you do B of A.  Your customers also have the right to change to another bank (or credit union).

Given the press that the Occupy Wall Street crowd has been getting recently, this probably wasn't the right time to say this.  B of A really needs to find a new PR outfit.

Damadoran on the current low risk free rate.

Aswath Damadoran has put together an excellent post on the current low risk free rate and the effect that it has on valuation.  His main point is that the risk free rate must be considered with the current expected risk premium.  When these are combined the result is relatively low valuations.   He also touches on another point which I'd like to emphasize.   In an equity valuation model we normally think of the risk free rate as only affecting the discount rate - so a lower risk free rate should result in a lower discount rate and thus a higher valuation.  But - and this is very important - the risk free rate also tells us a lot about the growth rate of the cash flows.  A low risk free rate implies low real growth and also low inflation.  Thus it will also reduce the level of future cash flows.  Failure to account for the two edges of the risk free sword is an example of inflation illusion.

Dilbert on MBAs

All I can say is that I have a Finance PhD and an MBA and I'm not making any money in the market either.