The MBA Ass

Options are the DNA on Wall Street

2008-08-11T13:08:00.002-04:00

Ok, in one sentence, you have to read this article: click here.

Since the Bear Stearns collapse, there's been an ever increasing amount of talk about speculation and the impact that option traders and commodity, specifically, futures commodity, traders have on the markets. Well, this article certainly helps to support such arguments pointing-out that some investors made-out like bandits on the Bear collapse with a monstrous options bet not even the most bearish investors could have pulled-off without loosing a hell of a lot of sleep.

Apparently, some hedge fund companies placed million-dollar bets on put options with strike prices less than half of Bear Stearns' market share price at closing that day. If this doesn't smell like insider trading, then I don't know what does. The fact that this is the top headline today, the ones who were on the winning side of these trades are definitely sweating right now. You can be sure that regulators are going to be using a microscope in their investigation and if those gamblers (I mean traders) didn't lose any sleep before, then they're sure going to now!

Connection between writedowns and the economy

2008-07-25T12:47:00.002-04:00

We've all heard about the big financial institutions, especially the investment banks, reporting enormous writedowns. According to Bill Gross, the manager of the largest bond fund, the total writedowns across the financial system could amount to as much as $1 trillion. When you consider that there is about $5 trillion in home mortgage loans, that's a significant number; the question is, what does it mean for the economy as a whole.

Well, if you've every studied fundamental accounting, then you'll be familiar with the concept of balance sheets and balancing inflows and outflows. When a company writesdown some assets, then that necessarily means that it has reduced one part of its balance sheet that directly affects its liquidity and ability to raise additional capital, no to mention its ability to pay its bills. In order to offset that lost liquidity, the company will sell assets or reduce lending. Reduced lending, of course, is the equivalent to the tightening of monetary policy Federal Reserve, which essentially works to slow down the growth of the economy by making borrowed funds that much more expensive (i.e. higher interest rates).

To make things worse, we're only at the beginning of the story. Firms are still announcing more writedowns and the consensus is that we're still going to see at least double of what we've seen thus far. When you think about this in terms of a domino affect, then this is still the first part of the domino chain; only after the financial institutions perform the compensatory actions that they'll need to after the writedowns, will the economy begin to feel the full effects of what we're seeing reported in the financial press. Bottom line: we've still got a great deal of pain ahead of us and it will simply take time for there to be a real recovery - no matter what the folks on CNBC would like us to believe when the market rallies.

Writing the GMAT? Prepare to be Palm-Printed!

2008-07-22T16:25:00.003-04:00

Following the scandals that rocked the GMAT exam this year, it looks as though there will be a new step introduced to the MBA-application process: fingerprinting; well, palm-printing to be more precise. This article desicribes how the new technology will help affirm a test-takers identity and ensure that we are who we say we are when we sit down to write that all-important test. Looks like we're actually going to have to study now.

Employee Free Choice Act

2008-07-22T09:32:00.002-04:00

This is scary. I'll admit to getting in on this story just today, but it really looks as though that I may not be alone. I first heard about this bill on CNBC this morning and subsequently went looking around the web to find an article that I could read on the subject. The fact that it took me more than a minute to find one is worrying. This is a very important subject and it's not getting nearly enough attention if you ask me.

At issue is the ability of a company's employees to certify a union without the need for a secret ballot that is currently required by law. Under the new legislation, a union could be certified without the company ever knowing about the registration drive until it was all over. This is a big, BIG, deal. If you run a company or invest in one, you want to watch this closely. What's worrying, however, is that one of the articles that I did find refers to this as an "obscure" bill; how can this possibly be obscure? It has the ability to transform the business landscape ...and no, that's not an exaggeration.

Further empowering unions will dramatically affect companies nationally. On CNBC this morning, they were interviewing the founders of Home Depot and they put it very bluntly. To paraphrase, they explained that this bill, if passed, would mean that a union could become certified and then install arbitrators that would set the wage rates for the company. Notice, that management did not enter into this equation. Could you imagine what this could mean for some companies? Could you imagine being a fledgling business, struggling to survive against your larger incumbent competitors, and learning that your employees just certified a union and that you would now be told what to pay your employees? This is exactly the issue at hand and it deserves far greater attention than what is currently getting.

Fortunately, it appears as though there are more than a couple of organizations ramping-up advertising campaigns to educate the public about the bill and its consequences. The fact is that this has already passed the house and only remains to pass the Senate before becoming law.

Actions Speak Louder Than Words. Sorry.

2008-07-21T08:34:00.003-04:00

"Anybody can make loans. But banks are finding the problem right now is getting the money back." Can you say duhh? I mean, really; isn't that obvious? According to what we're seeing in the financial markets, it certainly does appear as though the banks have forgotten this fundamental principle. This article speaks to the efforts made by the Fed and Treasury to shore-up investor confidence in the financials, but when greater and greater exuberance among the banks is revealed, I don't think that any positive thinking can outweigh the market's pessimism.

Unfortunately for the government, actions speak louder than words and investors aren't going to jump back into the financials en mass before this industry demonstrates that it's learned something from this latest economic bubble and has very clear direction on how to surface once again. The government's efforts to combat speculation (or better phrased, manipulation) by short-traders and commodity futures traders and its support of Freddie and Fannie, are positive and likely necessary, but it's just not enough. These sorts of acts may keep us out of a modern depression, but they're sure not going to prevent a recession.

Almost comical, SEC's Chairman Cox's statements about how he intends to reveal unfounded rumors are just unrealistic. The markets already do a good job of uncovering untruths, but it simply takes time. Sometimes that required time is calculated in minutes and seconds, but in a global economy, this short window of time can represents billions of dollars traded worldwide. Again, such recognition by the government that rumours do possess the power to move markets is good and their intentions, too, are positive. That said, their ability to do anything about it is nil and beyond satisfying some concerns among unsophisticated investors, these sorts of statements will do nothing to help stabilize the markets or the economy. The unhappy truth is that it will take time. The economy didn't fall into this mess overnight and it won't recover that quickly either. Sorry.

Online Ad Slump?

2008-07-21T08:10:00.002-04:00

With a headline like "Google ad slump spreads abroad", this article is certainly a little deceiving. Yes, it's true that the ad sales of Google, Yahoo! and Microsoft have all been falling, but that's relative to staggering growth rates that they've all enjoyed in this segment over the past few years. Google, of particular note, has seen growth rates approaching triple-digits, so a fall to only double-digit rates is certainly newsworthy, but let's not kid ourselves; there are many businesses that would love to see these sorts of growth rates!

I do appreciate what this slowdown means for the markets and I certainly don't question that the earnings misses reported by both Google and Microsoft last week needed to be followed by consequential declines in their stock prices and I'm sure that Yahoo! will see the same result from its report tomorrow. That said, with the majority of the economy slowing to a crawl or beginning to move backwards, the growth rates of almost 50% at Google and even double-digit rates persisting at both Microsoft and Yahoo!, this is the last segment with which investors should concern themselves.

I can't help but be reminded of a 'Lying with Statistics' lecture in undergrad. Headlines like this one only confuse the markets and inject further volatility. Similarly, seeing a headline that oil prices have "plunged" following several days of record-setting increases is just ridiculous. Newspapers and TV networks do need to sell ads and these headlines do grab your attention, but I would hope that readers and viewers would just wise-up a little - enough to send a message to these news directors and editors that we're not that easily manipulated. ...at least my hope is that we're not that easily manipulated.

Fund Managers Still Believe in Financials

2008-07-21T07:56:00.002-04:00

For quite a while now, I've been looking for the bottom in the financials along with many others watching the market. This article about fund managers certainly seems to support my thinking, but also makes me glad that I haven't taken the plunge just yet. With the best fund managers seeing their portfolios hit by as much as 60% year-over-year, that represents a lot of explaining to investors.

Are these fund managers just fooling themselves? Are they just too stubborn to see what's going-on? Many believe that the financials have been unfairly pummeled by the markets. To some extent, I agree, but there's no denying that they deserve much of their stock price declines resulting from the CDOs and the continuing housing slump. That said, there I do also believe that investors have been so scared-off from this industry that the stocks have fallen harder than they should have. Of course, the question then becomes when will we see a bottom in the financial and when is the best time to get back in. Looking at the performance of the funds managed by the vest best of Wall Street, it would seem that even those in the know don't really know.

Fair Value, Insolvency and Stock Prices

2008-07-16T10:58:00.003-04:00

Is anyone else somewhat baffled by the latest concern about the solvency of Freddie Mac and Fannie Mae and the resulting impact to its stock price? Where was all this concern back in the highs of the dot-com bubble? Those companies were most certainly insolvent - besides the cash infusions they were getting, they had zero revenues and their assets consisted, for the most part, of instantly obsolete computer hardware. So, then, why is it then that Fannie Mae's and Freddie Mac's solvency is now such headline-making news and, apparently, the basis for its volatile stock price?

It ultimately must come down to future expectations. Dot-com stock prices rose because the expected earnings of those companies continued to rise - regardless of whether those expectations are well founded. Consequently, then, it would seem as though the markets are now implying that neither Fannie or Freddie would be able to meet its debt obligations with the lower future expected revenues on the depreciating assets that it still holds. Of course, when you add-in the guarantee of the government, this adds a whole new dynamic to the mix. With that guarantee, the earnings of these two institutions become almost secondary as the government could always, then, step-in to satisfy any claims when they arose. The question remains, however, why the question over its solvency continues to be such a significant question mark.

Could it be that the markets have learned their lessons from the dot-com era and are now looking at the balance sheets of the companies in which they invest ...before they invest? It's possible, to some extent, but I think that it's actually more likely that this is just another example of the markets grabbing onto any kind of headline-making news to justify trades in either direction. Speculators, making profits on their short sales and derivative positions love volatility and Freddie and Fannie have been their best friends lately. A savvy investors should, on the other hand, question the headlines as to what actual news they reveal. Nothing had changed since the week prior to these solvency headlines to today; the only revelation was that the financial journalists decided that it was now news. Was it because they didn't have anything else to write about? Maybe more simply, questioning a company's solvency sells papers and sells TV ads. As an investor, of course, you need to question the value of that information.

Common Sense that's not so Common

2008-07-16T10:04:00.003-04:00

If there is a silver lining to the current state of the financial markets it's that many of the events of the past few months will serve to fill a whole new generation of economic and financial textbooks - education future analysts and managers on what not to do. Last week, IndyMac became the second largest financial institution to be seized by the Federal Deposit Insurance Corporation (FDIC) after a run on the bank left it short on cash. Having seen its stock price fall from a peak of $50.11 in mid 2006 to a closing price of $0.28 on July 11, it certainly looked as though the markets could see what was coming, so why didn't the bank's managers?

IndyMac was, not surprisingly, [too] heavily involved in the so-called Alt-A mortgages and, of those mortgages, [too] heavily concentrated in California - the second worst hit real estate market in the U.S. Many now suggest that IndyMac could have avoided its collapse by altering its business practices when it began to see a peak in the real estate markets; of course, hindsight is 20-20 and we all seem wiser after the fact. That said, one of the first things that anyone learns when studying finance is diversification; how can the leaders of financial institutions like Bears Stearn and now IndyMac be so complacent in their responsibilities to diversify their businesses?

Even if you don't know anything about investing, you've probably heard the saying 'not to put all your eggs in one basket'. I personally don't believe that IndyMac could have fairly spotted a market peak and adjusted its business accordingly. I do believe that the use of not-so-common common sense could have very well avoided its collapse. Every market goes through cycles and investing too heavily in just one such market exposes you to those cycles. Diversification is your safety net by compensating you for losses in one market with gains in another; it's so simple. Personally, the management of firms who don't exercise this common principle should be punished in some way - it should not be the federal government (and tax payers, by corollary) who should be held responsible in such circumstances.

What a roller coaster for Fannie and Freddie

2008-07-16T09:43:00.003-04:00

Well, if you haven't heard about the roller coaster ride taken by Fannie Mae and Freddie Mac in the markets this week, then try this on for size. How about loosing 50% in its market cap in a matter of hours and then recovering to a loss of about 5% by the end of the same trading day. Then, of course, you must has what triggered all that volatility. The answer, unfortunately, doesn't exactly inspire a lot of confidence in the financial markets.

It comes down to your definition and interpretation of the government's guarantee of both Fannie and Freddie and, more simply, rumours and speculation. Rumours, probably more than anything, caused the massive swings. Rumours about both the institutions' abilities to raise capital as well as about what the government would do, exactly, to help protect investors. Secondly, there is now even more speculation about what any government support would mean for the U.S. government as a whole and how that could even more broadly affect America's financial markets and the continuing credit crisis.

With the Fed's credit window now opened to both Freddie and Fannie, many of the concerns have been calmed. As I write this post, actually, Freddie and Fannie are reallying - up almost double digits today. Nothing has changed, of course, from yesterday so your guess as to the cause of this rally is as good as anyone else's. That's the real problem; there's so much uncertainty that investors, and the markets as a whole, are too eager to grab on to any positive news and trade the hell out of it. If you've ever studied finance, then you'll remember reading about the efficiency of markets; the activity in Freddie and Fannie over the past month will no doubt go down in textbook history as an example of how inefficient the markets can be.

Freddie, Fannie and Implicit Federal Guarantees

2008-07-10T08:53:00.002-04:00

Freddie Mac and Fannie Mae have, between them, the worst of jobs in this particular market: making the mortgage loans that every other bank is running away from ...fast. Between these two companies, they guarantee about $12 trillion in loans. Yes, that's a 't'. What's curious about the current situation, however, is that although these two companies have the implicit guarantee of the federal government, the open market seems to have placed some question on whether that federal government would actually step-up when the time comes... as it may very well come.

Today, there's even a question of the companies' solvency. Solvency, as you know, represents a company's ability to repay all its creditors after liquidating all its assets. Consequently, there seems to be some question as to whether the assets of Freddie and Fannie actually outweigh the massive debts it now holds. Of course, with a guarantee from the Federal government, there would be no worry as the government could always, theoretically, print money to pay every one back. With the staggering sums at stake, however, some are questioning whether they will do so. How do we know that they're questioning this? Simple. Look at the premium that Freddie Mac just paid on its latest $3 billion debt issue - almost 3-quarters of a percent over the U.S. Treasury rate. That premium is a risk premium, of course.

One could, of course, take the opposite position on this and reap the rewards should the market have overreacted. The consequences of allowing Freddie and Fannie fail would overwhelm anything that could have happened from the failure of an investment bank such as Bears Strean, which the Fed has obviously stated could not fail. Similarly, then, Freddie and Fannie cannot fail. As such, the markets certainly appear to have seriously overreacted on their risk asssessment of these two companies. An investor prepared to take this leap of faith, however, could benefit from a staggering medium-term return should the Fed make its implicit guarantee explicit. So, where do you stand?

Alma Mater Networking Value

2008-07-09T14:54:00.002-04:00

I just read an interesting article over at Bloomberg that discusses the value of our alma maters as a source of connections (i.e. networking). Not surprisingly, of course, the article starts-out by discussing the premium value placed on the Ivy League schools like Harvard and Wharton whose names are tossed-around Wall Street on a daily basis. There's no doubt that graduates of these schools have wealth of networking possibilities due, simply, to the immense size of the alumni populations from such schools. What's really interesting, however, is what the author found about schools in general - ivy league or otherwise.

Simply, we're happy to help those who share something in common with us. It speaks to human tendencies in general, I suppose. Birds of a feather, right? Well, those of us who graduated from schools with less well-known alumni networks may be happy to hear that the bonds between alumni may be even stronger for the very simple reason that there are fewer people out there to take advantage of those networks. It makes a lot of sense, when you think about it.

Harvard, for example, has such an enormous alumni network that there is no doubt that thousands are looking to benefit from that network on a daily basis. Conversely, graduates of smaller schools may encounter a fellow alumni rarely; consequently, these rare encounters are all the more special and may thus result in that much more value to each member looking to benefit from these networks in some way. Hurray!

Fannie Mae's Debt Issue & Credit Yield Spreads

2008-07-09T14:41:00.002-04:00

Amid speculation that Fannie Mae doesn't have enough capital to weather the continuing credit crisis, it has gone ahead and issued $3 billion in new debt. What's interesting about this, however, is the yield (cost) at which it was issued. The new debt will yield 3.25% - a full 74 basis points above the equivalent U.S. Treasuries. Given that Fannie Mae, theoretically, has the backing of the U.S. government and, consequently, should benefit from essentially risk-free cost of capital, this suggests the investing community feels otherwise about its credit worthiness.

With all the talk about the ratings agencies and the validity of those ratings, I suppose it's not all that surprising to see investors making their own determinations about the credit risk associated with a particular issue. Moreover, when you think about it, shouldn't the market as a whole be better qualified to determine the risk associated with a particular security than a single ratings agency?

The capital markets serve as a pricing mechanism. The collective buying and selling of millions of investors every day works to determine the value that we, on average, associate to a particular security. Why, then, should we not use the power of the same distributed intelligence to ascertain the credit risk associated with a debt issue? To be fair, the markets already do this - using the ratings agencies as a sort of starting-point for their evaluation. My question, I suppose, is whether or not we actually need that starting-point.

Emerging Economies May Not Save Us

2008-07-08T10:50:00.004-04:00

As the US economy, as well as the Canadian and much of the European economies, sinks deeper into recession, many are pointing (maybe partly with great hope) that the emerging markets will bail-out the rest of the world by driving overall demand. Unfortunately, that doesn't seem to be the case with emerging markets not only showing signs of weakness, but showing signs of even more drastic declines than what the developed economies are currently experiencing.

This graph is sourced from Charles Schwab's latest webcast and presents a diffusion index of developed (lower chart) and emerging (upper chart) economic forces. Essentially, a downward sloping line is a bad thing and an upward sloping line is a good thing. What I find most interesting about these charts is the leader-follower dynamic that appears to be taking place. While most analysts and market watchers have been pointing to China and India as possible saviors of the global economy with their fabulous growth rates, it now looks as though the declines in demand from the developed economies is beginning to take its tole on their markets. Moreover, it would appears as though the declines that they are now experiencing are more severe than what the developed economies have seen.

Inflation appears to be the culprit here. While we've seen low single-digit rates, the developing markets (the blue, in the left-hand chart) are showing near-double-digit rates. More importantly, their pace of inflationary growth (the slope of the line) is noticeably more steep. This is primarily due to wage-pressures. While the US and other developed markets have not seen wages rise, this has not been the case in the developing economies. The rest of the world is facing much greater inflationary pressures than we are at home and this spells great trouble for them in the future.

So what does this all mean for us at home? Well, put simply, we can't rely on any other economy to help bail us out. We are in a global economy, to be sure, but that economy is by no means uniform. The rest of the world, especially the developing parts of that world, are only beginning to enter their own recessions and everything points to their troubles being worse than anything we will see domestically. On the whole, of course, this suggests a very slow and long recovery. While the developed markets may be better prepared to recover sooner, we are no dependent on emerging markets just as they are dependent on developed markets. As they are likely to sink deeper than we are, their economic pains will most certainly ripple through the rest of the world.

The Interpretation of Polls

2008-07-07T15:01:00.004-04:00

CNNMoney is reporting here that their latest opinion polls suggest 3 in four Americans believe that the economy is in recession. Besides the 'duh' factor that goes along with such a headline, I almost laughed when they continued to compare the 75% statistic with the 79% result that they got in a an April poll with the same questions. You guessed it, the article is positive wherein they suggest that the drop of 4% is a good sign of ...something.

Why is this laughable? Well, first off, this is an opinion poll and doesn't actually represent anything about the current state of the economy. Moreover, a drop of 4% in public opinion could be nothing more than an anomaly - especially a differential of only 4%! I do understand that the media is working its spin doctors to turn absolutely every bit of news into a positive headline, but this is getting to be a little ridiculous. Almost every business leader has not only been referring to the current recession as a given, but has gone on to suggest that we're in it for the long haul.

Blame Everyone. Accept No Blame.

2008-07-02T06:25:00.002-04:00

I find this almost funny at this point; comical, really. Moody's, who suggested that their triple-A ratings collateralized-debt obligations (CDOs) may have been incorrectly assigned due to a computer error is now ousting some employees along with an announcement that some may have violated internal policies to award unwarranted investment-grade ratings on constant-proportion debt obligations (CPDOs). Moody's has suffered a substantial hit to its credibility, to be sure, but do such tactics really work to reverse public opinion?

The media holds a very influential position in that it is often able to sway opinions in the general public. In this case, however, you're talking about a very specialized group with an intimate understanding of the companies involved and the business of credit ratings. Does media rhetoric really affect the opinions of investors who understand enough to question Moody's credibility in the first place?

Hang 'em High! GMAC & TopScore

2008-07-02T06:13:00.002-04:00

I'm apparently behind the ball on this story, but I've now been sucked in; I'm really curious to see how this plays-out. For those of you who are not yet aware, there was apparently a site, TopScore, that was publishing current test questions from the Graduate Management Admissions Test (GMAT) and as many as 6,000 test takers, according to GMAC, may have used the site's service to get access to those questions. The question, of course, is what happens to those test takers now.

Like many of you, I'm sure, I worked really hard to prepare for the GMAT years ago and I'm a little disgusted by the thought that others could have cheated. A test like the GMAT is highly dependent on the distribution of test results; your percentile score may be more important than anything else. Consequently, if there was a group with an unfair advantage over the rest, then their scores would not only be higher than they would be otherwise, but those scores would directly, and negatively, impact the other (honest) test takers. With the futures of prospective MBAs so dependent on their results on the GMAT, I, for one, hope that the cheaters get what they deserve.

Depends on what you mean by 'inflation'

2008-07-01T10:41:00.002-04:00

I was drawn to this article by its headline reporting that Warren Buffett, the billionaire investor and world's richest man, does not agree with Ben Bernanke's views on inflation and its medium to long-term impact on the U.S. economy. What I'll comment about, however, is the apparent distinction that the Fed makes between relative-price changes and what we would otherwise call inflation. Did you know that they made a distinction? I didn't!

Relative changes in prices are considered to be the result of the demand and supply forces that underly any market for a good or service. Inflation, more generally, is the resulting affect of a general change in price levels that causes our purchasing power to be reduced (assuming positive inflation, of course). What's interesting about this distinction, beyond the fact that such a distinction is even made, is that the Fed (and by the Fed, I'm really referring to Mr. Bernanke) believes that relative price changes are otherwise transitory and will not necessarily lead to inflation. The argument is one that I've written on before, simply that wages are sticky upward and that will mean subdued inflationary pressure. There is a problem with this argument though...

I do agree that wages are sticky and that will mean that inflationary pressures are somewhat tethered. That said, it would be difficult for anyone to argue that purchasing power has not been affected. Beyond the cost of fuel and the rising cost of food, consumer wealth is falling rapidly and this has a very real affect on consumption. As consumer wealth falls, they have less collateral and a generally lower willingness to spend. This, of course, must necessarily result reduced demand which will then result in slower sales, layoffs, even more bankruptcies, and ultimately even slower economic growth. So, my question, then, why does the Fed make such a distinction between relative-price changes and what we plebes call inflation if they both lead to the same thing?

Speculators & Scapegoats

2008-07-01T10:12:00.002-04:00

If you're like most people, then you could use a little brief on how the futures markets function and, ultimately, the extent to which a futures market can actually affect current spot prices. I found this article quite good for that purpose.

The article makes the connection that most articles and media reporters do not: inventory. Inventories are the key to affecting any market's spot price. Put simply, or put otherwise, the spot price does not is not affected by volume fluctuations, but rather actual changes in demand and supply. To affect the spot price for a commodity, be that oil or wheat, there must be a change in the amount supplied or the amount demanded. If you look at futures traders as shoppers in a store, then the number of shoppers really should have no affect on the prices listed on the shelves. Instead, only those actually at the checkout are having an affect - the ones taking delivery of their orders. So how do inventories come into play?

Use your own logic; if you wanted to corner a market on a particular good, then what would you do? You would try to buy-up as much of the supply as possible and then be able to set your own price; right? Right! Essentially, you would be driving-up demand and causing a shrinking supply in that good. This is exactly the counter-argument against blaming speculators for the rising oil prices because the vast majority of participants in the futures markets never take delivery, but rather roll-over their contracts days before they expire; they are not taking deliver and are not hoarding those barrels of oil in secret warehouses until they can sell it at a higher price that they set themselves. The number of barrels available has actually increased.

So, then, how do you explain the very apparent bubble in the oil price? Well, we should start by considering not the U.S. market, but the global market as a whole. As much as American's (and Canadians, for that matter) don't want to hear it, the rest of the world (the Middle East excepted) pay far higher prices than we do. One could argue, then, that the North American market prices are simply adjusting to the global prices. The question I'm sure you will ask then, of course, is why now and why so dramatically. The argument there will likely involve a lot of pointing at China and India as their economies continue to grow at near-double-digits. Unfortunately, there's a counter-argument to that as well given that the growth of those economies is not high enough to fully justify the growth in the price of oil. So, then, we've come full circle without really answering any question.

Is speculation affecting the market price of oil? Yes, probably. Are the growing economies in China and India causing an oil price spike? Yes, probably. Can either be blamed exclusively for the rising cost of oil? No. In today's global economy there is never one reason for anything; it is the interaction of many forces that results in what we see reported at the end of a trading day. The headlines will try to point to one cause or another, but the wise investor will look at all the headlines over a period of time and apply a weight to each factor to form a more comprehensive picture of what may actually be occurring and then plan accordingly. We all want a silver bullet solution, but we all also, for the most part, recognize that that's rarely the right solution.

What an Ugly June that was!

2008-07-01T09:41:00.002-04:00

It's July 1st and the headlines are pretty much dominated by news of how badly the second quarter closed. From the horrible IPO market performance, to the worst June recorded for the Dow Jones Industrial Average since 1930; that's right, we're talking about numbers we haven't seen since the great depression. From stocks to bonds, everyone is losing money. Well... not everyone.

Energy is the sole sector that's making money. Mining too, but the fact that that's spurred-on by coal mining predominantly, let's just call it energy. I suppose that that's not too surprising since everyone seems to agree that the rising energy costs, along with the weaker dollar, are responsible for the slowing economy. The question is, where do we go from here.

Banks want us to believe that we're approaching (or have hit) a bottom and that things will turn around soon. Brokers and traders are beginning to encourage people to get into the market to take advantage of the declines and prepare to reap the profits that will come from the market's climb. Personally, I believe that this is still quite premature. The credit crisis is widely seen as having caused the initial turmoil and from Buffett to Greenspan, the consensus is that we've yet to see the worst as far as the reported write-downs are concerned. Furthermore, the housing market has not yet recovered. Sure, the media is shining a bright spotlight on the nice markets in Florida and California that are seeing moderate recoveries, but this is likely more the result of foreigners entering the real estate market to take advantage of some deep discounts than it is a sign of a recover in the domestic market. The reality is that the U.S. is still slowing and that will have a domino affect on the rest of the world that is only beginning to show.

Unfortunately, the ugly June and Q2 is just the tip of the iceberg; this is a sign of what the near future holds and not a marker for the bottom that many would like us believe we've just hit. If you're looking for a silver lining, then consider this: wealth is not created or destroyed on the whole. If someone is loosing money, then someone else is making money. With so many loosing money, that should only mean that there are a whole lot more opportunities to cash-in. Happy hunting!

The Grass is Always Greener

2008-07-01T08:32:00.002-04:00

This is a funny story about how the ban against futures trading in the market for onions, introduced in the late 50's, may finally be repealed to help stabilize the volatility in prices... yes, I said stabilize. All this, while the news is rife with talk about how futures traders (a.k.a. so-called speculators) are blamed for the persistently climbing oil prices. So where's the truth? Do traders help stabilize or do they increase volatility in the markets?

The price of onions, apparently, has soared as much as 400% between October 2006 and April 2007; that puts the rise in oil prices to shame. This happened, of course, with no futures market at all so analysts have no choice but to put the blame on the good ol' forces of supply and demand. All that volatility came on the back of swings in the weather; as the supply of onions dried-up, the prices soared. It's just that simple. So why, then, can it not be the same for the oil market?

As with a lot of things in life, it's more than likely that the truth lies somewhere in the middle. You must recall that a futures market was introduced primarily for the purpose of stabilizing the commodities markets by providing producers, farmers for example, with a way to hedge against changing weather conditions and ensure themselves of a more predictable revenue stream against which they could plan their businesses. Again, as with many things in life, there's a downside. Just as the futures markets can stabilize prices, they can also exacerbate fluctuations.

There are two fundamental forces: demand and supply. Weather affects only one side: supply. Similarly the arguments about how much oil is in the ground are all arguments about supply. The futures market makes it easier for people to speculate on the future price of good and this, simply, drives greater demand for that product. Without a futures market, the only people who are buying a commodity are those who can take delivery - just as you would at a grocery store. The futures market allows you to place an order for, let's say oil, with the option of canceling your order before it comes time to pick-up your order. That's what people have labeled speculation. It's nothing more than higher demand with a fancy name. So, then, what does this all mean?

The introduction of a futures market in the market for onions or, similarly, the legislation against speculation in the oil futures market will not really resolve anything in the long-term. In each case, market participants are responding to the current market conditions without much consideration for how the market outlook six-months or six-years from now. A futures market does stabilize the prices in a market during times of turbulent weather and may actually increase volatility in times of stable market climates. The futures market is a synthetic market introduced by laws and regulations; whenever you introduce such legislation you have to take the good with the bad. For any benefit that comes from a law, there's bound to be some negative externality that balances the scales. The grass is not actually that much greener on the other side of the fence. Sorry.

What do Analysts Actually Consider?

2008-06-26T09:47:00.004-04:00

Many are pointing at Goldman Sachs this week and laughing a bit. A week ago, they suggested that the financials had hit (or were at least approaching) a bottom and that investors would be well to reinvest in the sector. A few days later, of course, they reversed their position and now recommend an underweight investment. My question has little to do with this particular recommendation or the financial sector, but rather how analysts could waiver between such extremes within such a short period of time. What is it that they look at?

It's certainly not the fundamentals! The fundamentals of a company do not change overnight and nor do they change within a week. Analysts are supposed to be the insiders who have a window into a sector, industry and a small group of companies - providing investors with greater clarity on a publicly traded company's viability as a going-concern. When I see such a respected firm reverse their position within such a short period of time, however, they come across as just another investor on the street that's watching the headlines on the ticker tape; they're just reacting to the latest news and speculation rather than actually investigating the underlying truths.

Competition & Deregulation Fight Stagflation Part 2

2008-06-26T09:30:00.002-04:00

Sometimes it seems as though there's a counter-argument for every argument; isn't it great! I just finished writing how competition and deregulation was working to prevent inflationary pressures from spiraling out of control and then I read this article that made me rethink my position, again. I still believe that competition and deregulation are in-fact working to keep those pressures under control, but I neglected to consider the effects of rising fuel prices on the extent to which that competition can take place.

There's no doubt that communications technologies enable for a great deal of competition in the services sectors, but that's going to have a lot less of an impact on the manufacturing side of the economy. Ultimately, manufacturers have too get their goods into a market before they can sell them there and the rising cost of oil has made that far more expensive. The result is that domestically produced goods are just a little more attractive and the demand for those goods, as a consequence, is just a little higher. This higher demand for domestic manufacturing empowers laborers just a little more and makes wage-hikes just that much more likely. As I've written before, rising wages is the key influential factor driving inflation.

So where do the scales balance? Good question; it's anyone's guess really. I will say that the forces of competition and deregulation are not going away, but the oil price bubble may very well disappear. What happens then?

Oil Prices: Speculative Bubble or Not?

2008-06-26T08:55:00.003-04:00

Yes, I know, it's not exactly an original headline, but the question does still persist. I'm certainly on the side of the argument that says it is a speculative bubble, but even I have my doubts about the extent to which the latest rise is due to speculation as opposed to real demand and supply factors. No one, for example, could argue that the supply of oil is not ultimately limited and that certainly has an effect on the price of oil. There is no doubt that the price of oil has to rise as the known sources of oil slows.

On the other side of the argument, my side, you balance the falling supply of oil with the rise in alternative fuel sources such as wind power that has received a lot of attention lately. Similarly, there's more talk about hybrids and plug-in hybrids among the automakers than ever before. As the cost of these alternatives fall, consumers will demand more of them and consequently require less oil (traditional fuel), which should drive-down the price of oil. As a result, you could argue that the force of dwindling supply is being countered by the rise in the availability of alternatives. The question then becomes, of course, which force is more powerful?

Actually, would anyone really question the suggestion that alternatives such as solar, wind and nuclear eventually outweigh the demand for oil? The cost of drilling and refining oil is only going to rise as the world's oil companies must search for less available reserves off-shore or in oil sands like those in Canada. By comparison, the improving technologies are only going to help drive-down the cost of the alternatives. The result almost certainly has to be that the demand for oil falls as the demand for the alternatives rises. The real question then becomes, of course, what is the timeline. Unfortunately, I don't have an answer for that, but I will say that I don't believe the current price of oil is sustainable and that a bet against oil will undoubtedly pay off in the long-term. I'm just not sure of my definition of 'long'.

Competition & Deregulation Fight Stagflation

2008-06-26T08:23:00.002-04:00

I just finished reading an interesting article that has caused me to rethink my position on the state of the economy and where it may be going. I've written before on how the current slowdown resembles what we saw in the '70s and earl '80s, but after reading this article, I'm reconsidering the affects that global competition may have on the ability of the U.S. economy to ever see the sort of rocketing inflation that we say a few decades ago.

It comes down to wages. If wages don't begin to rise (accelerate, actually), then inflation will remain relatively under control. This is an important fact to remember when you consider that a global economy means that nearly every sector, industry and individual business competes with international vendors willing to cut prices and snatch-away customers. The article uses the airline industry as an example, but the same logic could be extended to almost any market. Whereas airline ticket prices rose by more than one-third in the early '80s, they've seen less than a 2% rise even with the unprecedented rise in the cost of fuel. The reason? Competition and deregulation.

There are more airlines, even with all the trouble in the sector, than ever before. Travelers have more choice than ever before. The result is that airlines are left sitting between a rock and a hard place. With the rising cost of inputs to their operations, the decision is no longer whether or not to raise prices, but rather whether or not to continue operations at all. They are no longer able to raise prices because their competition won't. One of any competitor airlines that had been fortunate enough to hedge the cost of fuel earlier will have a cost advantage and will simply assume all customers should its competitors increase their prices. In economic terms, it suggests an inelastic short-term supply curve. What's interesting about this argument is that nowhere have I mentioned wages, which is traditionally considered to be the primary driver of inflationary pressure.

There's competition for jobs too. Just like there are more airlines fighting over travelers, there are more people fighting over jobs. Workers are less able than ever before to request a wage increase. There are fewer labour unions and those that do still exist are less powerful. Moreover, the ability to outsource leaves employers not with the decision to increase wages or lose employees, but rather whether or not to keep employees or outsource operations oversees where costs could be a fraction of what they are locally. The consequence of all this is that rapidly rising inflation may really be a historical artifact.

We've Only Seen One-Third of Writedowns?

2008-06-23T10:41:00.002-04:00

According to John Paulson, founder of the hedge fund company Paulson & Co., global writedowns stemming from the credit crisis may top $1.3 trillion, surpassing the International Monetary Fund's estimate of $945 billion. Who is Paulson, you ask? He's the guy who placed a bet on the speculative bubble in the sub-prime lending market, which has netted his fund a gain of a whopping 591% in the past year. This is the guy who saw the storm coming so you could say that he's got a fairly good insight into the breadth and depth of the sub-prime market.

$1.3 trillion in writedowns is three-times higher than the writedowns already reported. That's both a staggering total figure and worrying prediction for what the future holds for the global economy and financial markets. The U.S. economy has certainly taken the brunt of the immediate downturn, but as economic speculators are working diligently to maintain a positive attitude in the business press, the reality is that the downturn we've seen thus far is only the tip of the proverbial iceberg.

In a survey of hedge fund managers conducted at a meeting in Monaco last week, more than 80% said that the see the current credit crisis persisting for some time yet so Mr. Paulson is certainly in good company. Moreover, as much as 23% of those surveyed see the current situation worsening further before it gets better. What's interesting, is that it appears that these same hedge fund managers are watching the financial stocks like vultures circling; they waiting for the best time to buy the stocks that have been beaten-down by as much as half. If you're anything like me, then you will be watching the actions of these firms to insights into when, exactly, will be the right time to jump back into the banking waters where the opportunity appears to be astronomical.

If it's not one thing, it's inflation

2008-06-16T11:31:00.002-04:00

I wouldn't exactly call it breaking news, but it was good to see consensus among the G8 that inflationary pressures were now the biggest threat to economic growth worldwide. The credit crisis certainly has worked to send many of the largest economies into a tailspin, the US most notably, but the persisting pressure of higher oil and commodity prices threatens to keep these same economies from any sort of near-future recovery.

Oil hit $139.12 per barrel on June 6, 2008; an all-time high. Commodity prices, like wheat, for example, have seen prices double in the past year. On a personal note, I can confirm that I've seen the price of whole wheat flour literally double in a matter of weeks at my local supermarket. While commodity prices represent a relatively small proportion of household spending (food, in general, may only see single digit-increases), the combination of these rising prices with declining home equity and accelerating unemployment figures paints a very black picture for the future.

It's a positive thing to note the G8's consensus, but worrying still is what actions will result from that consensus. To slow inflation, central banks will begin to raise interest rates. While many would tend to agree that this is long-overdue, the current state of the world economy as generally weak and slowing, will likely mean that in doing so, the higher cost of capital will only affirm the recessionary tendencies and result in a very, very slow recovery.

More Information Is Always Better

2008-06-16T10:40:00.002-04:00

There's a lot of talk about the SEC and its persisting investigation of the ratings agencies. The good news is that, at least it appears at this point, investors will be winners now matter what the outcome.

I wrote earlier about the SEC's consideration of a plan to require the ratings agencies to make their research material available to others. This, of course, would allow others (hopefully individual investors as well) will be able to assess risk-and-reward profile for a given investment - just as the credit ratings agencies do. The advantage is that investors could become less reliant on the AAA-ratings and could review the actual data that goes into such a rating. With the agencies being blamed for having rated mortgage-backed securities as tripple-A (the highest investment-grade rating) that subsequently defaulted and resulted in hundreds of billions of dollars in losses and write-downs.

Now, there's news that the SEC will offer the ratings agencies a choice between two possible outcomes. The first, will be a disclosure of the underlying information as I described above; the second will introduce a new rating scale that would help identify mortgage-backed securities and distinguish them from corporate bonds. While certainly not providing as much information, this too would work to make investors more aware of where they were placing their money and that's never a bad thing. So, no matter what happens, at least its comforting to know that we, lowly investors, will ultimately win.

Ratings Agencies & Structured Securities

2008-06-16T10:08:00.002-04:00

The SEC's investigation of the ratings industry continues and the latest target on their hit list is the rating of structured securities. The headlines suggest that the Commission may go so far as to ban the three top ratings agencies. Moody's, the S&P and Fitch from rating such securities at all. All three of these firms help to advise investment banks on the design of such securities, so how can they be trusted (by investors) to also provide impartial evaluation of their risk-and-return profiles?

What's more interesting, and possibly valuable, to investors, however, is the SEC's suggestion that the ratings agencies be required to make available all the data that goes into the ratings so that other firm (and possibly private investors?) be able to make their own determinations based on the very same information. In my previous studies about statistics we were often presented with research papers that claimed one result or another based on some analysis. What I often found quite interesting, however, was when such papers were later refuted by further analysis of the same data by other analysts.

As is often said, statistics can be massaged to say almost anything that you want. I can't help but think that ratings agencies are simply statistical analysts with an especially bring spotlight on their research reports. Data mining, the practice of scouring through numbers to find a particular trend or pattern, is a well known practice; try it for yourself. If you use enough data, I promise you that you can find any patter or trend that you want to find if you look hard enough and make the 'appropriate' assumptions. I think that the skill to analyze data yourself is invaluable and the news that more data may be made available to the public at some time the future will only help individual investors willing to put in the time and effort to make up their own minds about an investment.

Rise in Unemployment Tops 22-year High

2008-06-16T10:00:00.003-04:00

Last week's unemployment figures unnerved the stock market, but we know - by now - that that unnerving didn't really last. It's hard to say what the market will react to at all, let alone to what it will react positively or negatively. The fact remains, however, that unemployment is rising faster than ever and this must have real economic impact regardless of what the stock market index figures say today or next week.

I was reading an article on the subject and it's sometimes worrying to see how an author or analyst will often look for data to confirm or undermine whatever the headlines say. For example, this latest jump in unemployment, which clearly spells negativity for the economy, was discounted by a researcher who found that similar occurrences in the past were followed by significant gains in the stock markets within the following 12-months. Should we, then, be excited by the news that more companies are cutting their workforces, more people are losing their jobs and consumer spending will ultimately be forced down?

Stock analysts lose 17% for Investors

2008-06-16T09:43:00.004-04:00

Just because it's such a powerful sentence, let me start with a quote from the article that I just finished reading...

Investors who followed the advice of analysts who say when to buy and sell shares of brokerage firms and banks lost 17 percent in the past year, twice the decline of the Standard & Poor's 500 Index.

From the perspective of someone studying toward their CFA (Charterd Financial Analyst) designation, this isn't exactly the most rosy news. What's even more worrying is the sector within which these analysts' recommendations performed the worst - their own: financials. The question is why?

I can't help but wonder what techniques are being used to analyze these companies that analysts track ...if they do use a consistent technique at all, that is. In preparing for my own career as an analyst, it is precisely on this skill that I spend most of my time working: designing my own style and set of tools used to determine what makes a good investment and what does not. The MBA Association, www.MBAAssociation.Org, just launched their Intrinsic Stock Analysis Tool on which I collaborated and I think that this is a great starting point for anyone interested in the field or anyone interested in investing their own money and having the desire to truly understand the fundamentals behind a stock's price.

What I find interesting is that analysts measure their performance based on their 'Buy' recommendations alone; but what about their 'Hold' or 'Sell' recommendations. If you were to buy the stocks they suggested that you buy, you would be up by 17%, but if you were to do everything that they suggested you do, then you would be down by about the same amount. This implies that the money you would lose would be roughly double what you would gain on the up-side. That's a hell of a lot of volatility!

I find it a little frustrating to follow CNBC's latest stock market game with prize money of $1 million for the traders that generate the greatest returns within the few weeks over which the game runs. While it's great to see such games entice new people to the field of finance, it's worrying to see the style of investment that is encourage: trading, not investing. Everyone wants a quick buck, and it seems no one is willing to spend the time to analyze and develop sound investment decisions.

Ratings Agencies Screw-Up & Get Paid Anyway

2008-06-06T09:02:00.002-04:00

With all the economic trouble that has resulted from the sub-prime debacle, a great deal of attention was paid to the ratings agencies that awarded high ratings to the debt instruments that later collapsed. In its investigation of the factors that led to this collapse, the New York Attorney General, Andrew Cuomo, also began an investigation into the credit ratings agencies themselves and a settlement in that investigation was just reached between the state and both Moody's and Standard & Poor's. That settlement, however, may leave some investors scratching their heads.

As usual, of course, no one admitted any wrongdoing. You may recall that I previously wrote that Moody's was quick to suggest that a computer bug had caused the ratings to be inflated in certain situations and it never assumed any of the blame otherwise. What is interesting about the settlement, however, is that it may mean greater revenues for these ratings agencies going-forward - yes, more money! The reason, however, actually makes sense.

It all comes down to incentives. Just as the top CEO's have a large part of their total compensation packages tied-up in stock options that align their interests with the performance of the company's earnings (that, of course, is a whole other story), the ratings agencies will be paid for initial analyses and assessments performed on new sub-prime issues. Currently, prior to the new rules, the ratings agencies were paid only if they were ultimately selected by the issuer as the final, official, ratings agency. This approach, of course, incentivized the agencies to give better ratings than they might have otherwise in order to win the business. Being able to earn some cash regardless of their ratings, therefore, should make them more willing to speak the truth ...of course, I'm not saying that they haven't been doing so in the past... you understand, right?

Marking-to-Market of Debt

2008-06-05T07:29:00.003-04:00

I came across an interesting article that discusses the application of a new FASB rule (Statement 159) that permits the marking-to-market of debt. You will recall that marking-to-market is the practice of adjusting the balance sheet valuation of an item, previously only assets, to reflect that current market values rather than the book value or original purchase prices. Well, Statement 159, introduced last year, allows this same practice for liabilities. Considering the declining creditworthiness of the banks, you can imagine what's happened to the yields and prices of the bonds that they have on their books - it's resulted in billions of dollars in illusory revenues.

Why illusory? Good question. Just like marking-to-market of an asset, it represents the accounting adjustment of unrealized gains or losses - this does not represent actual cash flows. The investment banks, having recorded several billions of dollars in such marking-to-market gains, have been quick to offset their losses from the write-down of collateralized assets that have declined to pennies on the dollar. The write-downs, too, are unrealized losses so why then would anyone question this practice? Again, good question.

The difference is in the marketability of the assets or liabilities; put differently, it comes down to whether or not you could actually sell the assets (or buy the liabilities) at the new market price. In the case of the assets, there's no question. There is a market for the CDOs, CMOs and other three-letter depreciating assets that we've come to know over the past year; it's only a matter of price - if it's low enough, then someone will be happy to buy it. The reason is simple: they're marked-to-market based on an expectation (probability) of how much of that asset represents bad loans - the reality may be very different from what the current market dictates and the buyer of these assets could gain substantially from the even a small variance from what is currently predicted. Of course, they're assuming a great deal of risk for that potential.

In the case of marked-to-market liabilities, however, the story is very different. The debt held by investment banks such as Merrill Lynch, Lehman Brothers and other depository institutions such as Citigroup has declined in value as a result of their lower credit ratings, which has caused yields on their bonds to rise and, consequently, their prices to fall. To realize this declining liability value, however, these institutions would need to retire the debt - i.e. buy the debt back from the issuer. The question is, who wants to sell it? Moreover, to do so, these same institutions would need to raise funds, now at a far higher rate, in order to buy the debt, which would increase their actual cash flows going forward. Consequently, no bank will do this and this is why it appears as though an accounting regulation has been twisted in such a way to offer these institutions a paper-out that only leaves analysts and investors like you and me scratching their heads trying to decipher what their financial reports are actually telling them.

Inflation, excluding the inflation.

2008-06-04T06:29:00.002-04:00

No one will be surprised by the fact that I, along with tens of millions of others, believe that inflation is being underreported by the government; I've written on it countless times in this blog alone, and if we've ever talked economics, then I'm sure the subject came-up. It's probably why this article really caught my attention and I'd recommend it to all of you who would like to know more on the subject.

The long and short of it is a comparison of the US economy with that of a couple dozen other countries - including many of America's trading partners. What's surprising is that US inflation rates have been a relatively consistent 3% to 4% lower than that represented by this benchmark group. Of course, economists would argue that this differential can be explained away as a result of greater productivity in the US, but do we actually believe that the US economy is more productive than India or China, for example?

Many of you know that there are two commonly-quoted inflation rates: the headline rate and the core rate, or what the author of this reference article calls the inflation, excluding inflation. Guess which one is the official rate? What you quickly notice after glancing at a graph such as the one below is that the difference between the official 'core' rate and the more realistic headline rate is growing - the greater the separation between the two, the more unrealistic are the figures being reported by the government, and more importantly for us investors, the less reliable are the valuations used to compute a stock or bond price!

Anyone who's taken a class in finance understands the importance of the inflation rate in the calculation of the price of any asset; it's absolutely critical as a starting-point including the risk-free rate to determine a real rate of return on investment. Without an accurate measure of inflation, we have no real idea of what our real return is - i.e. what the purchasing power is of our investment upon maturity.

The thing that I like most about this article is that the author doesn't present any of this as a conspiracy theory, but rather as an alarming warning to investors - cautioning us all about keeping this discrepancy in the back of our minds when making our valuation calculations and investment decisions. Now go... read it.

Entrepreneurship: Making The Most of Any Situation

2008-06-03T08:51:00.002-04:00

In reading an article about the latest spate of foreclosures hitting the state of New York, I came across a very interesting business - foreclosure bus tours. I realize that this isn't likely a new business, but it's new to me so I thought I'd mention it. What I find fantastic about this concept is the entrepreneurial spirit that seems to rise-up from any situation - no matter how bad it may appear to be.

The tours, that charge $75 per seat, take prospective buyers around the latest foreclosure filings. It's simply ingenious; they're fulfilling a growing need or interest and making money on it. Beyond just providing the transportation, they're also facilitating the buying process by bringing along mortgage brokers, home inspectors and even contractors to help those buyers make qualified decisions.

I can visualize the business model already. I can imagine that the bus company has brokers, independent home inspectors and contracts lining-up to come along on these rides as the resident experts on-board; moreover, I would hope, that they're paying a pretty penny for an exclusivity option.

It really is that simple. Spot the need and figure out how to satisfy it.

Is the downgrade of the financials warranted?

2008-06-03T08:06:00.002-04:00

In short, no. The downgrade of the investment banks just doesn't make sense. Why? Simple. With access to the Federal Reserve's credit facilities, the same facilities made available to the commercial banks, these investment banks have access to plentiful, and cheap, capital whenever they need. A credit rating downgrade, by definition, presumes that the ability of the entity being downgraded to satisfy its debt obligations has somehow worsened. The fact that these banks now have access to more, not less, capital directly contradicts this action by the ratings agencies.

So, then, why did they do it? Good question - I'm not sure I know the answer. The consensus, however, seems to be that the ratings agencies are late to the game and are now reacting to popular fears that have all but disappeared since the first fall-out from the collateralized debt obligation defaults and, more recently, swap defaults and associated insurance scandals. Furthermore, the spotlight that was placed on ratings agencies following the aforementioned collapse when they did has placed the integrity of their models and practices into question. It could very well be that they are now simply trying to follow the herd rather than lead.

Back to the Future: Stagflation

2008-06-03T07:22:00.002-04:00

The economy growing had been growing at 5%+ prior to the continuing rise in commodity prices; the country is engaged in a wildly unpopular war, which helps to worsen the growing budget deficit and ever-expanding foreign borrowing; the Middle East is in turmoil; the American dollar is in a free-fall with no bottom in sight due to a lax monetary policy; commodity prices are surging - oil having quintupled in the past half-decade alone. That's right, it's the early 1970s all over again!

The similarities between the current state of the economy and that of three-decades ago are eerie indeed; Dick Cheney is even in the white house - just as he was then under President Ford as his chief of staff and, as then, is often blamed for America's pursuit of so-called stability in the Middle East to help assure the flow of oil. Of course, with no oil actually emerging from Iraq, that's a whole other story. Thirty years ago we were in a very similar situation - it was called stagflation: slowing growth, rising unemployment and inflation. We recovered then at significant cost, which led to slow growth, high interest rates and high inflation for the better part of the following fifteen years. The question now is how will we get out of the current state of economic woes?

Fortunately, there is a growing consensus about what the solution is to get the global economy out of its current doldrums: technological advancement. Although it is an admittedly simplistic analogy, imagine if the cost of the war in Iraq had instead been invested in sustainable technologies - whether in food, energy, water or even climate change.

Assuring the flow of energy to America need not be as expensive as it has been. The cost of the war in Iraq is estimated at nearly one-half trillion dollars; yes, trillion! The cost of a nuclear power plant is less than $10 billion per reactor - not even counting the fact that the investment wouldn't be flowing across the border and would instead create jobs both during the construction and the following operation and maintenance. Of course this is just one example, but you get the idea.

The sheer numbers involved open the doors to tremendous opportunities for technological advancement. America is currently spending on its war in Iraq the sorts of dollar sums that could quite literally solve problems and answer questions that have caused impediments to scientific progress or, at least, slowed its progress. Science and technology can improve yields per acre - resolving any concern over food shortages. Science and technology can clean not only the drinking water, but also clean-up our lakes and rivers and prevent future pollution. Imagine how much better the world would be, let alone America. Imagine further how admired America would be as a leader in technological advancement.

Timing Losses & Financial Institutional Strength

2008-06-02T07:53:00.003-04:00

Let me tell you a story to prove a point. Assume that you loaned me $1,000 2-years ago (thanks, by the way) and I had not paid you any interest or principal ever since. Assume further that we met today to negotiate a settlement and I offered to pay you $200 as a one-time payment to satisfy the entire amount of the loan. The question: how much money did you lose and when did you lose it?

Those of you who are financial inclined are likely already doing some discounted cash flow calculations, but let's keep things simple; let's ignore the time-value of money. Many of you, then, are likely shouting a loss of $800 today, and I'm sure that many more of you would be tempted to agree, but to see why this is the wrong answer, we need to differentiate between paper-losses (accounting) and actual losses (cash flows).

From an accounting perspective, you, the lender, had created an account to represent the account loan and the expected future repayment. What is important to acknowledge, however, is that the $1,000 that you lent to me flowed out from your bank account 2-years ago - not today. Put differently, you have had $1,000 less funds for 2-years; my offer to repay you only $200 of the full amount does not represent a loss, but rather a positive cash flow today. Actually, it's as simple as:

-$1,000 :: cash flow out to me in the form of a loan

$0 :: cash flows from my repayment of principal and interest

+$200 :: cash flow from my repayment and settlement of the loan today

Now, I'm sure you're asking yourself why this revelation is important. Well, let's consider the banks that are scrambling for credit and new sources of financing in light of the so-called credit crisis spurred by the billions of dollars in write-downs. Ask yourself when those related losses actually occurred. Also, ask yourself whether the settlement of these debts at $0.20 on the dollar leaves more or less cash on the balance sheets of these banks. Notice, that I asked about whether this left more or less cash - I didn't ask about net assets. This is the difference between accounting losses and actual (cash flow) losses.

The interesting conclusion that many of you are now likely making is that the settlement of these bad debts is actually leaving these banks in a stronger, rather than weaker, financial position. So why are they scrambling to borrow from the Federal Reserves auction facilities? Good question. They certainly don't need the cash - their cash positions haven't changed! Only their accounting positions have changed. It is true that this does affect their ability to lend as it leaves them with fewer assets and collateral, but fears over bank failures is certainly unfounded. Now, as an investor watching the markets and seeing the tumbling stock prices of many, if not all, financial institutions, ask yourself if the broader market has misinterpreted the events over the past few months. Lastly, ask yourself the market's overreaction leaves you with an opportunity to profit from the rebound that is unquestionably going to happen - given enough time for the banks to restart their lending engines.

MBA Interest Surges In Slowing Economy

2008-05-29T07:19:00.002-04:00

What are more and more people thinking about as the economy continues to slow? You guessed it, school. The MBA is, of course, at the top of the list for many professionals who are looking to take advantage of the declining opportunities in the marketplace to prepare themselves with a business education - readying themselves for when the rebound come-around.

The MBA Tour, a worldwide tour that brings together between 20 and 25 business schools in one place, at one time, has grown in popularity; attendance was up 30% last year and Peter Von Loesecke, the founder of the Tour and MBA graduate from Cornell's Johnson School, believes that it will continue to grow even more rapidly as the economy worsens. It makes a lot of sense.

A graduate business education, like any other post-grad degree, requires that you take time away from your career and suffer the opportunity cost of that lost income in addition to the, sometimes, staggering tuition costs and related expenses. Clearly, then, the best time at which to take that on is when the opportunity costs are minimized. Whether they realize it yet or not, prospective MBAs are behaving like trained business people already; once they graduate, they'll understand the economics behind their prior motivations.

The Companies MBAs Love

2008-05-29T07:04:00.003-04:00

It's not much of a surprise really; you could probably guess many of the companies that made the list, but there's a great little article, here, that outlines the top-25 companies for whom new MBA graduates would love to work. What I would not have guessed, however, was that Google made the top spot - it's the #1 most desirable employer according to Universum, a research firm that publishes the list for Fortune.com.

Of course, I would have listed Google on the list as well, but maybe not as #1 - ranking McKinsey, or another big consulting firm, instead. Maybe this is a sign of things to come - a greater focus on business innovation rather that resume-prestige? On the other hand, maybe it's just a normal reaction to desiring the most talked-about names - Google certainly does qualify for that.

Disconnect Between Wall Street & Main Street

2008-05-28T07:21:00.002-04:00

I don't know about the rest of you, but I find it funny when I see two headlines, one after the other, that contradict themselves in evaluating the state of the economy. One will say something like "The stock market rallied today after news of..." and the other will read "Consumer confidence reaches all-time low." How can both be true?

Here's something to ask yourself: if unemployment is rising, people are losing their jobs. If housing prices are falling, home equity is likewise falling. Consumer debt, as everyone knows, is rising like at no other time in history. All these things point to far lower incomes, so where is the money coming from to support the stock market rallies? Wouldn't it make sense that the declining wealth of the masses would result in a withdrawal from the financial markets to help prop-up their other expenses - like food and shelter?

There's no doubt that the world, as a whole, is not suffering the same economic declines that the US has seen of late, but many indicators point to this only being a delayed. These economic woes are not exclusive to the US; in today's global marketplace, no one economy, especially one the size of the US market, stands alone in either a rally or decline. We grow and shrink together - like it or not. It could be, then, that investors in markets that have not yet seen declines in their own markets are pouring more of their money into the US as a bet on its ultimate recovery. There dollar is certainly undervalued compared to its historical average so that could be one reason, but it all just doesn't seem very clear. Any thoughts?

Bonuses & the U-Shaped Recovery - What to Expect

2008-05-28T07:00:00.002-04:00

On the bright side, the job losses on wall street are far less than they were following the dot-com bubble burst earlier this decade. While financial institutions shed about 17% of their forces, those same institutions have only cut about 3% during this latest downturn. Unfortunately, there's a downside to this story.

The downside is that many, if not all, are expecting many more cuts to come. You may have heard people referring to a U-shaped recovery; well, were only still on the left-side, the downward side, of that 'U'. It will essentially be a very slow downward slide that will see an increasing number of jobs lost before we hit the trough of this business cycle. Worst yet, it will be an equally slow climb back up. So, who among us are the most at-risk?

You guessed it; the higher your salary and/or bonus, the more likely you are to get a pink slip. It's no secrete that wages are the #1 expense for financial institutions and they're losing money like a leaky rowboat. To hedge those losses, their first act is to cut their expenses proportionally and the story seems to be that there are many more write-downs to come - more paper losses at these firms necessarily mean more job losses for those working there.

The best thing to do is to stay focused on your long-term career goals. Your career is not your job; it's the union of your experience and education. Losing your job does not represent a loss of your career; it provides you with the opportunity to explore areas that you haven't had the time to review in the past. Use every opportunity to enhance your experience and education and your career will continue to excel.

B-School Students Anticipating Hurt After Graduation

2008-05-27T07:03:00.003-04:00

With the up-coming graduation season, the pressure is mounting on graduates from business schools around the country (and the world, for that matter) to find the high-paying jobs that will help pay for those hefty school loans. Unfortunately, the economic turmoil of the past few months paints a hazy picture and after reading this article, it looks as though graduates are going to get an introduction to what they can expect as part of their graduation ceremonies.

I remember when I was graduating from business school and it's hard not to have lofty expectations. You've just spent a small fortune on an education that you sought purely for its ability to help boost your earnings expectations; all that, after leaving the workforce and suffering the opportunity cost of that lost income. A MBA is an expensive education, like most post-grad degrees, actually, and it's difficult to blame graduates for desiring the six-figure salaries that they've been trained to seek. The reality, however, may be a shocker and in listening to keynote speakers at their graduation ceremonies, graduates will have a window on what they can actually expect to face when they return to the real world.

The economy is hurting. Wall Street is laying-off thousands. Foreign markets are mounting pressure on almost every domestic sector. While getting a speaker who will motivate and inspire graduates may leave them with a warm and fuzzy feeling, it's unlikely to set proper expectations. Having graduated during the last economic slowdown, I personally feel that getting a realistic picture is far more valuable. These are highly educated and ambitious people; they don't need people to motivate them - they need people who will share their honest insights and it sounds as though that is exactly what they will get.

Of course it's an Oil Price Bubble!

2008-05-26T07:27:00.004-04:00

It's almost funny how the discussion over whether oil prices are spurred by speculation or market demand forces; of course it's a speculative bubble. Those arguing against this view are quick to point to China's growing economy and similar demands from India; there's no doubt that that is the case, but it's ridiculous to think that anything changed so drastically in either of those markets within the past year to justify the rising prices we see around the world.

Need some proof, no problem. How about the total notional value of over-the-counter commodities derivatives that have risen from $1.02 trillion in 2004 to a value of approximately $8.4 trillion by the end of 2007. Yes, there no doubt that some fundamental demand must be credited for part of this rise, but numbers are simply so staggering that suggesting a speculative bubble is not the primary culprit is simply irresponsible. So, assuming that it is a speculative bubble, why is that important? Good question!

The prices are now so high that they are actually affecting demand - rather than vice versa. Drivers are driving less; airlines are cutting flights and jobs as well as authorizing new fees for customers to cover the cost of rising fuel prices. Similarly, other commodities are rising (most notably wheat prices, which have doubled in the past few months) under pressure from increased transportation costs. All these rising costs mean one thing: a slowing economy. Given that many, including the likes of Mr. Warren Buffett, have publicly stated that we are already in a recession, this does not paint a rosy picture for our economic near-future.

Yes, inflation is also a big deal. With all these rising pressures the concerns over inflation have been rising as well. The only thing that has kept those inflation rates from jumping along with commodity prices has been the Fed's ability to retain the trust of its citizenry who appear to continue to believe it has things under control; this belief has led to stable wage prices. Basically, people don't believe that it's in their interest to demand higher wages because of the rising unemployment rates. That said, this won't last. As prices continue to rise, people will eventually have to demand more money in order to pay for that expensive gasoline and bread and, when they do, the Fed will lose control. Fed Chairman Ben Bernanke has received a lot of kudos for his efforts thus far, but if inflation isn't brought under control many believe that he will be faced with an economy similar to that faced by his predecessor Volker.

When inflation grew to double-digit-levels in the late 70s and early 80s, Fed Chairman Volker was forced to move interest rates even higher; this, of course, led to one of the deepest recessions since the great depression. Many now believe that we may be heading into a similar situation if the Fed doesn't begin to raise rates sooner rather than later. The Fed is enjoying low inflation expectations, but those expectations are beginning to show signs of upward movement and the Fed really does need to take this seriously.

Trusting the markets to manage themselves is wise, in theory, but the market won't keep itself out of a recession. The business cycle is a natural phenomenon and the only way to flatten that cycle is via fiscal and monetary policy. If the Fed doesn't do its job, the speculative bubble will lead to one of the worst economic slowdowns ever. Ask anyone who was invested in the markets during the bubble-burst of 2000 and you're likely to hear about their lessons learned. Well, this is another bubble; it's time to apply those lessons-learned and react proactively rather than reactively.

It's Not Mark-to-Market, but it's a start!

2008-05-26T07:13:00.002-04:00

The Financial Accounting Standards Board (FASB) has just announced a new rule that will make it tougher for the likes of MBIA, and other bond insurers, to hide losses until it's too late. Many have criticized the insurers following dramatic declines that saw MBIA, as an example, fall by more than half in less than one-quarter; the new rule will force such insurers to recognize faltering claim liabilities as soon as there is evidence of credit deterioration - not just waiting for a default.

As someone sitting on the side lines, I immediately thought that FASB issued the rule in response to the recent fallout from the CDOs and mortgage-backed securities, but ...apparently... FASB has been working on this for the past 3-years. This is particularly good news because it implies that the system works; everything takes time and the design of such rules is no different, but it's good to see the regualtory agencies adapting to the changing financial landscape.

I had mentioned before the simple power of marking-to-market and how this little task ensures that financial securities are recorded at their fair value. While the new rule doesn't go so far as requiring the bond insurers to mark their liabilities to market on an on-going basis, this is certainly a step in the right direction and will shed more light on what is actually taking place with these complex securities.

Market Efficiency, Trading Volume and Exchange Competition

2008-05-24T08:34:00.002-04:00

If you've ever read about market efficiency and the various theories about how markets operate, then you will forgive me for having been bored by the subject lately. What's always nice, however, is when you read something that brings an otherwise boring subject to life, which is exactly what happened today when I read about the New York Stock Exchange's declining trading volume figures in light of rising competition from smaller, higher-tech, markets.

Market efficiency theories essentially discuss how markets, exchanges in our case, react to the availability of new information. Ranging from weak-form to strong-form efficiency, these theories outline the extent to which, and how quickly, markets react to information that is both public and held by insiders alone. Technical analysts, for example, who solely rely on the data that markets provide are dependent on the quality and accuracy of that data; flaws in their representativeness of what is happening in the market can mean missed opportunities, or worse. So, why should increasing competition for the NYSE trading volume worry technical analyst? Lower trading volume.

Lower trading volume at the NYSE means less data. Less data, in turn, means that technicians have a less-than-whole picture of what is taking place in the markets. When the stocks in your portfolio trade on multiple exchanges, it takes much more effort to consolidate the information from the various markets to provide you with clear insights into what is taking place. The more disparate the trading volume, the less reliable your data.

Personally, this sounds like an ideal situation for the regulators to step-in. A competitive trading landscape is certainly important because it helps to lower the transaction costs that we all pay when we trade our stocks. An efficient market, however, is no less important once you understand the implications of what may happen when it's no longer there.

Scandals, they are good for something.

2008-05-24T07:56:00.002-04:00

Just as was the case with the bankruptcy of Enron, Worldcom and the like, the latest troubles underlying the capital markets will help to reveal some questionable behaviour that has otherwise gone unnoticed. Following the big scandals earlier this decade, newspaper headlines were jam-packed with executives on their way to jail and establishment of new laws and regulations like Sarbanes Oxley. With the spotlight now on acronyms like CDO, CDS and CMO, the next round of similar headlines is not far away.

I just read this article and it really drove-home how the big banks, in their take-no-prisoners approach to turning a buck, may have unwillingly taken those dollars straight out of the pockets of the people who could least afford to be separated from them. Jefferson County, Alabama, is the latest municipality at risk of bankruptcy and the cause are the swaps it purchased to avoid this very situation.

JPMorgan, Bank of America, Lehman Brothers and, yes, Bear Stearns, all sold interest rate swaps to Jefferson County to help them hedge their risk on loans purchased to finance the county's latest public projects. With interest rates going in just the opposite direction, it's left the County with the obligation to pay rates in the double-digits only weeks after paying as little as 3%. The county, now in dire straights, has hired its own independent analysts to review their swaps purchases and has been stunned to learn that the aforementioned banks collected as much as $100 million in excess fees by charging far and above the prevailing rates for the securities.

When our car is running well, we don't visit the mechanic. It's only when strange noises alert our attention to a possible problem, that we hire someone to figure-out what needs to be fixed. When you drive a domestic car, you can generally visit any mechanic and find the services you need at reasonable rates. When you drive an exotic, however, you need to visit specialists who will charge you far more for their expertise. The types of exotic securities being purchased these days require just such specialists and, unfortunately, these experts are taking advantage of their clients in much the same way an unscrupulous mechanic might. Fortunately, unlike mechanics, these financial institutions must answer to their regulators who will penalize them for these acts, but hopefully the buyers will learn from these experiences too. Being able to afford a Ferrari goes well beyond having the funds to pay its sticker price; don't be buy exotics, be it cars or financial instruments, unless you thoroughly understand how they work and have the funds to pay those unexpected bills.

Credit Spreads As Economic Indicator

2008-05-23T07:22:00.002-04:00

Remember the yield curve? Well, to freshen your memory, the yield curve is just the graphical depiction of the relationship between yields (required rates of return) and maturities. So, for example, the curve would tell you the kind of return demanded for their investment dollars when committed for a specific period of time (to maturity) - all else equal. While it might sound like a boring subject, it's actually quite interesting in what it can foretell about expectations for our economy.

Before we get to the credit spreads, you have to also remember that there's not just one yield curve, but many - one for each level of risk determined by investors (and generally based on the ratings issued by the big ratings agencies). The credit spread, therefore, is the vertical distance between two curves - i.e., the difference between the required rate of return demanded by investors in securities of equal maturity, but different levels of risk. Why is this interesting? Well, this difference, referred to as the credit spread, is an indicator of what investor's believe is the relative risk associated with lower-grade investments.

Imagine, for example, that investors believe that we're heading into, or are already in, a recession (I know, I know, how could anyone think that!). If you were such an investor, then you would likely believe that the lower-grade issuers of these securities were likely to see a slowing in their sales, cash flows and, ultimately, a weakening in their ability to satisfy their obligations to the investors in the securities they issued - yeah, that's you and me. Well, to accept that added risk, you would demand a higher rate of return and this would begin to shift-up the yield curve for securities of similar risk. As that yield curve shifts-up, the spread between it and the safer (investment grade) securities grows.

Ok, so now that you understand the mechanics at work, I'm sure that you can put one-and-one together and see how you can use the yield curve to evaluate what the economy is thinking. If you were to look at the yield curve today, however, you probably wouldn't find what you were expecting. While most people would agree that we're either in, or heading into, a recession, the yield curve doesn't reflect it. With a spread of only 46 basis points, down for a high of almost four times that just a few months ago, we're not seeing the affects of higher commodity costs, rising unemployment and record high foreclosures and bankruptcies. Does this mean that something in the mechanism is broken?

Well, possibly, but there's a silver lining to any dark cloud. Today's yield curve tells us that the average investor hasn't adjusted their expectations to what most others believe is our economic reality. As an investor, this information is golden. As an investor, you should always be looking for information about what will be, but hasn't yet been accounted for by your fellow investors. Doesn't this sound like what we're seeing today? So, the question is, then, what will you do about it? How will you position your portfolio to take advantage of what appears to be an arbitrage opportunity?

How Temporary is 'Temporary'?

2008-05-22T07:21:00.002-04:00

Freddie Mac, the government-chartered mortgage financier has had its accountants label approximately $32.4 billion worth of losses as temporary, allowing it to keep the associated losses off its income statement. With those losses representing as much as 20% declines in the face value of the mortgages, these losses would be the biggest ever experienced by the company. One has to ask, therefore, how long is temporary and when will these write downs come, if ever?

According to generally accepted accounting principles, Freddie can get away with this for as long as the rules are changed. What's really scary about this is the magnitude of the losses that are being hidden from investors relative to the company's assets. $32.4 billion is more than double its $16 billion in shareholders' equity and almost equally outweighing its market capitalization. Compared to its net assets of NEGATIVE $5.1 billion, the comparison is just laughable. If you were in this position, you would have gone bankrupt long-ago.

Fannie Mae, Freddie's big sister, is in a similar position, albeit to a lesser extent, with $9.3 billion in such losses. Of course, both these companies are betting on a market turnaround, which would see the underlying assets appreciate and eliminate the losses that they refuse to realize. That said, anyone who's owned a home knows that this appreciation can take many years and neither Freddie or Fannie have included anything in the notes to their financial statements indicating what their own expectations are for these reversals.

It's just a loop-hole and it will be closed sooner or later - forcing these firms to face the music. The reality, however, is that facing the music earlier in the process could have prevented much of what they're now trying to hide. Marking-to-market would have forced the firms to acknowledge the losses as soon as they started to appear and would have likewise forced them to make adjustments to their practices and strategies to compensate for those losses. The capital markets are a great motivator for management to do their jobs well; if they don't, they get fired by their boards who in-turn represent the shareholders.

It Wasn't Us; It Was The Computers!

2008-05-22T06:40:00.002-04:00

That's what Moody's appears to be saying, or at least laying the groundwork to say, in light of the many law suits that are waiting in the wings spurred by the collapse of so-called Aaa-rated securities. One of the biggest head-scratchers with the financial crisis has been how such high credit ratings could have been issued on securities that were so susceptible to default; with news that Moody's is now investigating a possible computer bug that caused the mismatched ratings, it certainly does look as though it's covering its proverbial ass.

Both Moody's and S&P only began to strip-away their previously issued triple-A ratings after some of the constant proportion debt obligations (CPDOs) defaulted. Are we to think, then, that S&P's rating system was inflicted by the same virus?

CPDOs are portfolios of index-based credit default swaps (CDSs) that include both risky and safer trenches that have, somehow, made them candidates for the highest investment grade ratings. These CPDOs represent the latest innovation in one of the largest markets - credit default swaps - allowing investors to collect even higher returns as a result of even higher leverage. From this short description alone, does it sound to you as though this would qualify as deserving a Aaa rating? When will investors learn that there's no free lunch; higher rates of return do necessarily mean higher assumed risk. Period.

Banks created at least $4 billion of CPDOs, promising annual interest of as much as 2 percentage points above money-market rates combined with the highest credit ratings -- described a ``holy grail'' for investors by Bear Stearns Cos. strategist Victor Consoli in a November conference call.

There's no holy grail; if there were, every investor, their brother, their sister and their cousin's nephew would be buying and the price of such assets would rise and thereby reduce its yield. It's a classic arbitrage opportunity that just can't exist for any extended period of time. If a broker or advisor is telling you differently, then they themselves probably don't understand the securities.

Here's a bit of a primer on CPDO's and credit default swaps from this bloomberg article:

CPDOs sell contracts on credit-default swap indexes and use the premiums to pay investors. If the perception of credit quality deteriorates, the cost of insuring the debt increases and CPDOs lose money. To make up for losses, the funds would typically increase their borrowing.

Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

Rating a CPDO involves making assumptions about the way the indexes of credit-default swaps will move, based on a limited history of the benchmarks. The U.S. index referenced by CPDOs was created in 2003; its European counterpart started in 2004.

CDSs and the web we weave

2008-05-21T11:48:00.003-04:00

Covering more that $62 trillion in debt, credit default swaps are a market larger than the value traded on the New York Stock Exchange, but little is known about them - even among those who invest, and worse yet, those who issue the derivative securities.

CDSs are derivatives; they are assets that are synthetically created and how's value is derived from underlying assets - the debt obligations their holders are attempting to protect against default. Unlike your home, which you do not expect to actually burn down and buy insurance against such a rare eventuality just in-case, CDSs are purchased on the worst debt securities - those rated below investment grade. Of course, these too are the very securities are most likely to default when times are bad and, if you hadn't yet noticed, times they are bad ...and getting worse.

It gets worse. The firms selling these insurance policies are not only unmonitored, but are not officially considered banks - including the likes of JPMorgan, Goldman Sachs and many hedge funds. With losses expected to be as high as $150 billion dollars on the first round of defaults, will these firms be able to survive? Moreover, as we saw with Bear Stearns, can the economy afford the collapse of even one such firm or would it spell disaster for the capital markets as a whole? Unlike Bear Stearns, however, the Fed is unlikely to bail-out a hedge fund.

It gets more complicated. To get a handle on the situation, the first step would need to be to properly value the risk that is actually assumed by these various counterparties, but even this first step is not easily accomplished. Firms resell these securities as they would others - if you're having a moment of CDO-inspired Deja Vu, you ain't alone.

Most fundamentally, the CDSs were created with a very useful purpose in mind: to distribute the risk of a default across many firms that could bear that risk. However, with so few firms actually acting as the counterparty in many of these transactions, the very opposite has happened - with much of the risk concentrated. Go figure!

CDSs & Counterparty Risk; What Every Investor Should Know

2008-05-21T07:51:00.002-04:00

Credit Default Swaps (CDSs) are making headlines these days, and not for good reasons. CDSs are essentially insurance contracts on debts - investors buy them to protect their income streams and principal investments in debentures should the issuing party default on their obligations. Most notable of these almost-defaults, of course, has been Bear Stearns and CDSs have been in the headlines ever since.

Why do you care? Well, would you believet that CDSs are unregulated and that there's no public record of the sellers solvency should they actually have to deliver on the contracts they sell. As an investor, this should scare you to death. Think about it this way: imagine you paid into your insurance policy, for your car, your home or even your life, and when the worst actually happened, the insurance company just disappeared; this is the situation that may very well still happen. Yes, still; we're not out of the woods by any extent.

George Soros has been one of the most outspoken investors on the subject of how "unacceptable" it is to have a market such as this develop in an unregulated fashion. Now representing as much as $62 trillion in contracts, the collapse of such a market could mean worldwide financial fallout. This is no joke folks.

How's this for a revelation. JPMorgan is not only the investor of these types of contracts, but is also one of its biggest issuing firms (i.e. counterparties). Unlike traditional insurance companies, there is no agency that monitors the sellers of swap contracts. What makes things even more interesting, you don't even have to own the asset that you want to protect when you buy the swaps. Yes, that's like buying a life insurance policy on someone else - could you imagine if that were possible and what sort of practices that would condone?

Europe Feeling the Economic Pinch

2008-05-20T06:44:00.003-04:00

The headlines today scared me a little bit. First, I read that Germany's consumer confidence index has fallen, again, as a result of the relatively stronger dollar and fallout from the slowing the US economy. Similarly, Marks & Spencer, the premium UK retailer, has reported slowing growth and staff cuts in response to the same growth concerns. Likewise, Morgan Stanley is reporting that it's planning job cuts for its Japanese offices. If there's any doubt that the world economy is only beginning to slow down, then reports such as these should give you second thought. That, however, is not what scared me this morning.

What continues to worry me is the American investors' apparent refusal to see or believe any of it. Whether it's the report of inflationary pressures right in their own backyard or the many companies reporting lower earnings, investors are ignoring the bad news and looking only for the good stuff that confirms what they already hold to be true. Yesterday's rally and today's headline stating lower volatility is representative of growing buy-pressure only further America's case of the blind following the blind.

Lower volatility, over the period of one day, does not mean that there is less uncertainty. Any statistical change over a period that short cannot be interpreted to mean anything - it's just not relevant. It's really time for Americans to wake-up and smell the coffee; Europe is only now beginning to feel the pinch from what's been developing on this side of the bond for the better part of this year and that too will take time. This is only the beginning folks and the sooner that we realize this as a country, the sooner we can 1) save to give ourselves some recovery insurance, and 2) truly plan and prepare for a recovery.

The Cost of Trust :: The Value of Due Diligence

2008-05-19T16:52:00.002-04:00

It's been as many as eight years, but the top execs at AOL have settled with the SEC for their part in the company's stock-inflationary financial reports for the period 2000 through 2002. It'll cost them $8 million collectively, but I have no doubt that that represents a drop in the bucket in comparison to what investors lost as a result of their fibbing.

Eight execs, including CFO Michael Kelly, conspired to overstate online advertising revenue expectations by more than $1 billion. With online ads representing a key part of AOL business at the time, this exaggeration represented a significant factor in the company's valuation at the time. With higher valuations, the stock and option-holding executives were able to collect millions of dollars at the expense of lowly investors who got stuck holding the bag when reality fell far short of the lofty expectations.

Analysts hold an incredibly powerful position in the capital markets; they hold a fiduciary responsibility to the firms they represent and, ultimately, the investors who use their advice as an input to their investment decisions. While it's hard to place blame exclusively on the analysts in a case such as this, where their sources were apparently lying, $1 billion is not a small sum. An amount as large as this must be relatively easy for a dedicated analyst to substantiate. They have access to the company's executives, who they interview regularly, and have superior access to information otherwise.

As an investor, it's important to learn from this experience. Analysts are a wonderful source of information, but they're likely more valuable in the negative direction than they are in the positive direction. Analysts, in one form or another, are rewarded for spotting winners more than they are for spotting losers. Consequently, we lowly investors must be sceptical of any positive news and seek to perform our own due diligence to whatever extent possible. Think of analysts, like your broker, as a salesperson; you wouldn't buy a $10,000 toy solely on the advice of a kid at BestBuy - you would likely do some research first. Don't treat your investment decisions any different.

Microsoft Blocking Google with Yahoo! Deal

2008-05-19T07:43:00.002-04:00

Yahoo!'s stock is up in pre-market-trading on news that Microsoft has approached them once again with a proposal that may satisfy the needs of both firms - at the expense of Google, of course.

Following the collapse of Microsoft's buyout of Yahoo! earlier this month, analysts and media alike have been talking about the possibility of a partnership with Google wherein Yahoo would outsource it's primary business: online advertising. In today's early morning news, it now appears that Microsoft is working to keep its options open by pass-blocking such a deal by offering Yahoo!'s management an olive branch in the form of a very similar advertising partnership deal.

The deal, although no details have been disclosed, would likely see Microsoft's advertisements appear throughout the Yahoo!'s portal website - offering Yahoo! the opportunity to hang-on to some of their independence as well as forging a new cooperative relationship between the two firms. Of course, no one is fooled; the real goal here is to keep Google away and make sure that Microsoft's buyout option is not killed-off completely.

In continuing analyst talk today, there seems to be consensus that Yahoo! will be bought - the only question is by whom. This continuing saga between some of the biggest names in online advertising today is certainly a sumo match to watch closely.

Paulson: Deny, deny, deny. Ok, but it's over!

2008-05-19T07:26:00.002-04:00

Treasury secretary, Henry Paulson, is being lambasted for his glass-is-half-full approach to reporting on the state of the economy and the role of the financial markets going forward. While Mr. Paulson has been denying any serious problems in the capital markets, he's finally admitted that there was a problem, but that it's now over ...how convenient.

I'm very much aware that politicians need to put a positive spin on even the worst scenarios in order to keep people from panicking, but Mr. Paulson's approach has worked to to make him less than credible. I've been equally critical of Fed Chairman Ben Bernanke, but at least he both acknowledged and acted to quell credit crunch. Mr. Paulson has been adamant about denying the realities faced by both business and consumer until we reached a point in this down-cycle that appears, to Mr. Paulson, to be a turning-point. The reality, of course, is likely not all that rosy, which will only work to further discredit Mr. Paulson as reliable source for information on the state of the economy.

To be fair, Mr. Paulson is not saying that the economy is rebounding, but that the capital markets will play less of a role - replaced by the forces at-play in the housing and commodities markets.

"We are seeing signs of progress as capital and credit markets stabilize,'' Paulson said. "The markets are considerably calmer now than they were in March.''

He goes on to say...

"We will continue to look for additional tools to reach and help homeowners and to make existing programs work more smoothly,'' he said, cautioning that more declines may occur in months ahead. ``We know the correction has further to go, and so we should not be surprised at headlines that note rising foreclosures and falling home prices.''

So, at least he doesn't have a problem admitting that we do, in fact, have some problems in the housing market. As per my earlier posts, the Democrats are working to introduce legislation to help homeowners in much the same way as the Fed has helped financial institutions. The question will be wether it's too little too late.

Auction-rate bonds & Sub-prime loans; Deja-Vu anyone?

2008-05-16T14:46:00.003-04:00

I have to admit that I wasn't familiar with auction-rate securities shortly before writing this post. From the news reports now filling the pages of many online financial news sites, it would seem that I wasn't alone. Of course, as with the sub-prime loans, the lack of understanding didn't seem to stop many from buying into these products.

One can't help but recite Mr. Warren Buffett's mantra: invest in what you know.

Auction-rate securities offer borrowers seeking long-term capital the opportunity to pay only short-term rates. Sounds ideal, right? You get money for as long as 40-years, but don't have to pay the premiums that would generally go along with such a maturity. This is possible because of the 'auction' in auction-rate. Specifically, as often as every 7-days, the interest rate cost on these securities are reset in a dutch auction. So, for those buying the securities, it's very much like buying short-term debt. Of course, as you might have guessed, there is a catch.

Unlike Treasury bills or investing in short-term money market funds, investors who purchase these auction-rate securities are essentially buying long-term debt (yes, like 40-years), but with the expectation that they'll be able to hand-them-off at the next auction. You have to ask yourself, then, what happens no other buyers show-up at the next auction? You guessed it, you get to keep those bonds. For individuals and institutions that purchased these securities because they were short-term, this could spell disaster if the funds were expected to be liquid to satisfy some other obligations.

It's not all bad news, if you have some other flexibility in your portfolio. There are penalties when the auctions fail; if you happen to be one of the owners of these little-understood securities and can manage to make-do when the auction fails, your return can shoot-up to as much as 20% on an annualized basis. That ain't bad when the banks are offering you less than 1% for short-term, liquid, savings accounts.

Of course, it's hard to think about the other side of the table - the institutions that sold these securities and are now forced to pay those double-digit rates.

At the end of the day, Mr. Buffett's wisdom certainly does shine-through. It's so simple. Invest in what you know and in what you understand. As an investor you have to appreciate that your broker is a salesman; he or she makes their money by selling securities to you. When they offer you a product that is unknown to you, then take the time to quiz them on the details. If they aren't able to answer your questions, then that should tell you something. If they aren't willing to explain them, then just get a new broker.

The Media & Lying with Statistics

2008-05-16T14:08:00.002-04:00

I'm continually amazed at how the media manipulates economic data to present whatever picture it feels will best attract viewers, listeners or readers. Today's housings statistics are a perfect example of just such manipulation.

All morning, the news has been a buzz with the jump in housing starts - everyone clamoring to talk about how this may represent the rebound for which we've all been waiting. With no more than a glance at one article on Bloomberg, however, it's easy to learn of the whole picture. This is an example of the statement to which everyone has been referring:

Total housing starts jumped 8.2 percent to a 1.032 million rate as construction of multifamily units rose 36 percent following a 35 percent drop in March.

Here's the paragraph that immediately precedes it:

... a Commerce Department report showed construction of single-family houses in April dropped to the lowest level in 17 years, even as building of condominiums and townhouses rebounded. Builders broke ground on 692,000 single units at an annual rate, the fewest since January 1991.

I know; I shouldn't be surprised. In some ways it is a positive thing that those with a voice work to rally the rest of us into a [hopefully self-fulfilling] belief that the economy is indeed OK. However, when we folks like Mr. Alan Greenspan, the former Fed Chairman, and Mr. Myron Scholes, the winner of the Nobel prize in economics for his work on option valuation, both referring to the current state of the economy as the worst since the great depression, it's time to face reality.

When news reports focus only one the one part of the housing segment that is doing well and neglect to mention that the industry as a whole is declining to almost two-decade lows, then something is amiss. With the average American saving less than ever before and average American debt at record highs, the rising unemployment figures spell doom for those who fall only hear the headlines and continue to spend themselves into future financial ruin. It's time for those with a true understanding of what is going on in the economy to help those who do not.

Forget the Soft Skills; it's All About the Numbers

2008-05-15T19:53:00.002-04:00

An interesting study was released this week that showed, at least in the UK, that the top spot at the big companies is reserved for those of us with the number skills. Sales and marketing skills may be good for something, but if your goal is to get a capital 'c' in front of your name, it's time to master that calculator.

Out of 200 CEOs surveyed by the recruitment firm Robert Half, 32 possess a background in finance whereas only 9 have a background in marketing communications - the second most common background. Although I'm certainly biased, being a numbers guy myself, I have to agree that the findings are consistent with my own feelings about what companies need. With Sarbanes Oxley and other new demands on the executive management of our publicly traded companies, it only makes sense that the individuals responsible for singing-off on the reports their companies release to the public actually understand what it is that they're signing.

CBS to buy CNet, but why did it take so long?

2008-05-15T14:00:00.002-04:00

CNet is one of the biggest names on the Internet you never hear about. It's one of those brands who's logo you noticed when you stumble upon one of its websites (it has many) in search of the latest technology gear or review, but otherwise forget that it even exists. The reason, quite simply, is that it's not exciting.

Like the many brick and mortar businesses we never hear about, CNet is profitable and growing. The only difference when compared to the likes of Google and MSN is that it's growing slowly and doesn't really make a lot of fan fair about the addition of a new feature or technology to its arsenal. With a price tag that had floated between $1 and $2 billion dollars, the sheer cost to acquire the giant didn't do much to attract buyers either. So, why is CBS different?

How about TV.com and News.com to start. That's right, CNet is the guy behind the domains we would all love to own. TV.com may represent an incredible opportunity for CBS to take a position in online entertainment and News.com, similarly, could represent an opportunity to revive its once-great news programming. At the end of the day, however, it's just smart business. Whereas Facebook and Digg may be a lot more sexy these days, they are smaller in the size of their actually businesses and significantly more risky. With an internal rate of return (IRR) of about 13% projected by CBS for the deal, the purchase may not mean a sky-rocketing stock price, but it's certainly not the gamble that the likes of Microsoft are making in their on-again-off-again bid for Yahoo!

Team Icahn & The Continuing MS-Yahoo! Saga

2008-05-15T13:40:00.002-04:00

Following the collapse of the Microsoft buyout of Yahoo! there were a lot of puzzled faces walking the streets of Wall. Likely no more puzzled than the faces of the investors in Yahoo! who stood to make a pretty premium over the now deflated stock price. Some notable investors, however, aren't taking this sitting down, standing-up or any other way.

Carl Icahn, the activist investor, has brought together a powerhouse team that he's threatening to run for Yahoo! board if Jerry Yang doesn't get his act, and team, together and resume talks with the big-M. The latest name added to Mr. Icahn's roster is none other than Mark Cuban who previously sold his video start-up company to Yahoo for a cool $5.7 billion in stock - yes, stock - making him a considerable addition.

With prices, as at the writing of this post, sitting at $27.5 per share, shareholders have see more than 15% of their possible take slip through their hands when Mr. Yang walked away form Microsoft's offer of more than $31.

Mark Cuban, irrespective of his financial might as an investor, is a powerful force in bringing further attention on the apparent missed opportunity at Yahoo! With consensus now that Microsoft and Mr. Ballmer have moved-on to bigger an better things, more attention may be too late. That said, there is equally strong consensus that the deal makes as much sense today as it did weeks ago and that Microsoft could be arm-twisted to returning to the table should it be greeted by a board that is more welcoming. With any deal this large, there is little doubt that Microsoft spent months planning its strategy and ultimate attack. While certainly not weeping at the loss of that investment, I for one would feel confident in saying that its management would welcome the opportunity to feel vindicated.

Earnings & Credit Ratings

2008-05-14T15:08:00.003-04:00

In reading this article about GE on Bloomberg, I felt the need to write about the distinction between earnings reports and concerns over credit ratings. The two are separate and one does not directly depend on the other.

Credit ratings are simply that: relative evaluations of a company's creditworthiness or its ability to repay its loans. The difficulty arises from the fact that we tend to try and relate the stories we read to our own experiences. We know, for example, that the loss of a job will directly impact our credit rating and consequently the cost of borrowing to buy a home or car - as it should. Although this is accurate, it's not wholly relevant when discussing a company such as GE.

A lower earnings report is not the same as the loss of a job; it's more akin to rising expenses. Your personal credit rating may rise if you suddenly have mounting medical bills to pay, but it's probably not going to change as a result of the higher cost of oil. The important thing to note is the magnitude of the change relative to our overall wealth. In the case of GE, that wealth is significant. When GE reports lower earnings for the quarter, its rating is certainly not going to change. The reason is that this is likely both insignificant in light of its overall market capitalization as well as likely to be a temporary glitch in its continued profitability. Should GE show similarly weak earnings on an ongoing basis, however, then there may be cause for concern as this would tend to indicate signs of trouble within the company and not necessarily as a result of general market or economic conditions.

To make a long story short, it's easy to be swayed by an article that presents the facts in a way that is designed to stir discussion and either increase page views or newspaper sales. As with any information, consider the facts in light of the other information available to you.

Housing Market Outlook

2008-05-14T14:54:00.002-04:00

I'm still sitting on the fence, waiting for the right opportunity to buy my first home-sweet-home. With all the trouble in the housing market, I'm sure that my opportunity is not far away, but the question now becomes how low can the prices really go. As with any declining market, an investor wants the most bang for their buck and seeks to time their purchase for the absolute lowest low. With foreclosures being reported up by 65% this month compared with the same month last year, however, the supply of homes on the market is still very much on the rise. Consequently, prices are still very much on the decline.

Watching Jim Cramer's Mad Money on CNBC last night I heard the mention that the first real estate markets hit by the slow down in Florida are beginning to show signs of life. As with the recent bull runs in the stock markets, it's likely just a head-fake. The underlying problems in the economy haven't gone away. Business bankruptcies are still mounting. Unemployment is still rising. Foreclosures are, well, you get the picture. Before these underlying factors are addressed, there isn't going to be any rush to buy any homes. People certainly aren't going to be bidding against each other in this market and that's a necessary condition for prices to rise.

We will continue to hear about some homes being sold and some real estate markets around the country rebounding. I would tend to suggest that this represents localized feelings of a trough; this is unlikely to be representative of a more broad-based recovery. Too many things are just ugly right now and people are stuffing those bills into the mattresses to insure against more rainy days. I, for one, am still waiting for when I can un-tuck some of those bills.

Is the CPI a scam?

2008-05-14T14:35:00.002-04:00

The latest consumer price index figures were released yesterday and they showed a less-than-expected rise in the prices the average consumer pays for goods ranging from food to medical expenses. Of course, with the news dominated by the high cost of fuel and food prices continuing to rise, it's difficult to believe that inflation is not still higher than what is being reported. Consequently, I'm not surprised when asked how the CPI could possibly be an accurate reflection of the changes in the prices we really pay.

The reality is that it's probably not too far off from the truth. Sure, there are likely to be some estimation errors that come from the fact that not every single product can be monitored, but - on the whole - the Department of Labour is most likely reporting the figures it actually does record from in the marketplace. So, then, what is the discrepancy? Why is it that it seems as though our prices are rising faster than what our government is telling us?

The answer, unfortunately, is unlikely to satisfy many who are pondering the question. For one, the media isn't helping matters. The fact that we hear so much about commodity prices and the cost of oil on the rise and hitting record levels tends to overwhelm the public consciousness as it relates to prices.

Furthermore, it's important to remember what the CPI actually represents: the average price paid for a specified bundle of goods by the average consumer in America. Now, ask yourself: are you average? To answer the question, consider the goods that you buy; are they representative of what the average person buys on a regular basis?

Although unsatisfying, the reality is that the CPI does probably represent a relatively accurate estimate of how prices change for the average consumer. Maybe what we should all be complaining about is the fact that there is no price index for the middle class, middle-upper class and so-on. All our concerns over gasoline prices are warranted, but does the average consumer drive an SUV or take the bus? While the 100% rise in the price of rice is undoubtedly troubling for developing nations, the extra $5 a month for the American household is, in all likelihood, going to go unnoticed as a change in the bank account balance.

Does a AAA rating still mean what it used to?

2008-05-14T14:16:00.003-04:00

I've written before about the growing concerns over the reliability of analyst reports on the companies in which we all invest, but there is something to be said for the information available to the analysts as well. Mood's and Standard & Poor's, the two largest ratings agencies, hold an incredibly influential place in the market; it is based on their evaluation of a company's ability to repay its loans that it assigns its ratings with a triple 'A' rating representing the least risky investment. Of course, when the companies bearing this esteemed rating begin to show signs of diminishing creditworthiness, shouldn't the ratings move in tandem?

The answer appears to be no. When the two largest bond insurers, MBIA and AMBAC - insuring more than $1 trillion dollars in debt between them, began writing down hundreds of millions of dollars in losses resulting from collateralized debt obligations and other mortgage-backed securities, neither ratings agency showed any sign of concern. Fortunately for both these insurers, that meant that they could each turn to the capital markets to raise new funds at the lowest possible rates. But what about the lowly investor relying on these same ratings to judge the risk of purchasing a bond?

Unfortunately, there is no simple answer. The un-simple answer is that investors should never rely too heavily on a single source of information. Yes, I'm afraid that needs to include even the most respected ratings agencies in the business. So far, there is nothing to indicate that they haven't acted responsibly. After all, neither MBIA or AMBAC has defaulted on its own obligations and that, ultimately, is what a lower rating would tend to indicate is more likely to occur. Then again, as the saying goes, it's better to be safe than sorry.

Democratic foreclosure-prevention package - OK'd

2008-05-13T12:45:00.004-04:00

With all the talk about the hundreds, yes hundreds, of billions of dollars made available each month by the Federal Reserve to help financial institutions survive the worst of the continuing credit crunch, it seems that the little guy may finally get something too. The U.S. House of Representatives approved a Democrat-sponsored foreclosure-prevention package that will essentially guarantee mortgages if banks cut principals so as to lower the payments on those loans. With foreclosures consider to be one of the key catalysts for the slowing economy and financial woes on Wall Street, this should certainly help everyone involved.

No one benefits in a foreclosure.

For the little guy, that's you and me, this means that banks should be just a little more willing to work with us to avoid foreclosure. The banks don't want to foreclose; besides all the transaction costs involved, it's just a hassle. They need to come-up with the paper work (both financial and legal) and ultimately boot some family out of their home. With their expectation to see only part of their loan returned to them given the current state of the real estate market, it's a lose-lose proposition for everyone involved. This new program gives them an out.

Assuming that banks are willing to do their part and cut the principal amounts on the loans, then those loans will be guaranteed - essentially eliminating their risk of holding-on to the mortgage and giving the borrowers (i.e. homeowners) a little more slack with which to retain ownership and make their monthly payments. The key here is that everyone needs to still do their part. The banks aren't getting something for nothing; they'll first need to make their own judgements as to who's mortgages should be cut and kept vs. those that they'll foreclose regardless.

Similarly, homeowners can't run away from their responsibilities. With news of people choosing to burn their homes or drive their cars into lakes and rivers so as to collect on insurance policies and avoid further payments, there doesn't seem to be a better time than the present to offer something to us little guys. The economic slowdown will continue for some time. More businesses will close and more people will lose their jobs. At least its nice to know that it's not only Wall Street that has the attention of our government.

LIBOR - The London Interbank Offered Rate

2008-05-13T12:23:00.002-04:00

The London Interbank Offered Rate, also known as the LIBOR for short, is a daily reference rate at which banks offer to lend unsecured funds to other banks - specifically on London's money market. The LIBOR, however, is used all over the world as the basis for many securities that return a variable rate of return. Why is all this important or interesting? Well, the way it is calculated has come under attack in recent years and that model may very well be changing as a result.

The non-governmental British Bankers Association (BBA) that sets the LIBOR does so by first collecting reports from its member banks. These banks report what their costs of borrowing are to the association which are then figured into an average for use by all banks as their reference rate - the basis on which they offer funds to business and individuals for anything from mortgages to company lines of credit. In recent years, however, there has been mounting speculation that the member banks reporting their borrowing costs have been fibbing - under-reporting so as to keep their own borrowing costs lower.

With the slowing world economy and continued concerns over credit availability for many financial institutions - not exclusively those in the United States - interest rates are expected to begin to rise. Just as this means our own cost of borrowing on car and school loans will begin to tick upward, the big banks are concerned that their own costs will rise. Having issued much of their recent loans at the presiding low rates and many still saddled with quickly depreciating assets, this does not paint a rosy picture for banks as an industry. Of course, it's hard to see how this is any justification for manipulating the system for their own benefit.

As with CDOs, default swaps and mortgage-back securities, it's important for any investor to understand exactly what it is that they're buying when they invest their savings. The LIBOR is one of those elements that many of us likely take for granted, but this too should be a factor in our investment decisions. Understanding that the LIBOR is a manufactured entity should spur our own questioning of its validity and interest in alternatives - and there are many. The Fed Funds Rate, the Treasury Bills rate (for the relevant maturity, of course) or even your own banks prime rate. Consider the alternatives; talk with your bank managers and choose a reference rate with which you feel comfortable will provide you with an accurate representation of the cost paid by banks - the cost that they will the pass along to you.

The Real Price of Oil - Forbes.com Interactive Chart

2008-05-13T12:11:00.005-04:00

There is, no doubt, a lot of talk about oil prices these days. Maybe more surprisingly, however, is the sometimes devil's advocate-like position that some take when discussing today's real price of oil relative to that of a decade or more ago. Similarly, in comparing the oil prices faced by American today with those faced by citizens of most European countries, some critics argue that we shouldn't by arguing at all. Well, for those of you still reading, you should check-out this link to a chart prepared by Forbes.com

The fight over the difference between nominal and real prices will continue to undercut some arguments when it comes to the CPI, but given the chart prepared by Forbes, it's difficult to see anything but a staggering rise in the real (i.e true) cost we face at the pump. In the last ten years alone we have seen almost a 10-fold increase in the price of oil and a similar rise in the prices of gasoline. That's a ten-times increase; put differently, 1,000 percent. 'nough said.

REVIEW: The Audacity of Hope - Barack Obama

2008-05-12T19:59:00.003-04:00

As many of you know, I'm an avid West Wing watcher. I've probably seen every episode a few times. The reasons are many. For one, the acting is wonderful. The writing is exceptional and plots are both realistic and fantastic. Most of all, however, I find myself continuously intrigued by the many forces that pull on politicians at the highest ranks in their effort to serve both their constituents as well as their own ambitions. Mr. Barack Obama's book, The Audacity of Hope, provides a similar view on such forces and, similarly to the fictional President Bartlet, makes one yearn for a political candidate that seems to truly represent the many feelings most of us share about politics.

The Audacity of Hope is not what I expected. When I cracked open the book I looked to find one politician's manifesto - written to advance his bid for the next office. Instead, I found a cross between a biography and window on political life ...interspersed, of course, with tidbits of political speak that refer back to Mr. Obama's platform. On the whole, however, the book is both well written and interesting; one that you will want to finish once you start.

Just like the reasons for which many believe The West Wing was so popular, it provides the reader with hope for what our leadership could be. It provides us with hope for what government can be. I don't agree with everything for which Mr. Obama argues in his book, but I did find myself marveling at his ability to empathise and play devil's advocate on many of the issues he does address. It is this simple act that attracts me to him as a candidate for the American Presidency.

I am naive, or so I've been told. It's likely true. I always like to believe that people are good and that what they say are either true or are believed to be true when said. Mr. Obama never made me feel otherwise. Politicians, of course, are known for speaking the words and ideas that their constituents want to hear - I am not so naive to not acknowledge this. I will say, however, that I have found that Mr. Obama convincing.

When speaking on subjects in which we don't truly believe or understand, there is a tendency for anyone to speak in broad generalities and use metaphors to relate the listener or reader to the ideas presented. When we speak on subjects about which we truly believe, however, we have a tendency to use our own experiences from which we learned the lessons we hope to share with others. Mr. Obama's The Audacity of Hope comes across as the latter and if his words are only partly representative of the President he may become, then it is no wonder that he has been so successful in organizing such broad support for his campaign cost to coast.

CNBC's Million Dollar Portfolio Game - One Caveat

2008-05-12T13:34:00.003-04:00

Ever wanted to play the stock market, but were too afraid to risk your own money? Virtual stock market games are a great way to learn the fundamentals with real data, real stocks and real news. You don't risk any money - it's like investing with monopoly money. With many of these games you can start as may portfolios as you like to try-out all your different portfolio strategies to see what works best for you. Within week (sometimes days or even hours) you'll know if this is something that interests you or not and, more importantly, you will not have risked your savings to find out.

Well, if you'd like to give this a shot, then there's no better time than the present. CNBC has started its annual Million Dollar Portfolio Challenge today. It's open to all American residents (yes, I know; that doesn't include me) and as long as you're of legal age, then you probably meet the rest of their eligibility requirements. They're giving away some great prizes to the top portfolios each week with the grand prize of $1 million dollars shared among the top portfolios as the conclusion of the challenge. Like I said, if you want to give this sort of thing a shot, then this is a great way to learn and profit.

There's an important caveat to keep in mind: you will not learn sound investment practices by playing such games. Why? Because these are short-term games ...akin to sprints, not marathons. To win this sort of game you'll need to invest in high-volatility (i.e. risky) stocks to get the greatest potential return within the few weeks of the competition. This is obviously not a strategy that anyone would advocate if you were investing with your own money. That said, you're not investing your own money; so, as long you as you keep this caveat in mind, then go for it. Play. Learn. Profit!

Hillary Clinton $11 million in the Red - Personally!

2008-05-12T10:33:00.002-04:00

From my years of watching The West Wing I knew about the campaign finance provision that allows candidates to loan personal funds to their campaigns. What I didn't know, however, was that there was a time limit for by when the candidate can recoup those loans by raising money as a candidate. That time limit is their party's nomination. With the August democratic convention nearing, Clinton has only a few months reaming to come-up with a whopping $11 million that she has loaned to her campaign!

Why is this interesting? Well, on the surface it's interesting to hear the kinds of sums of money that are involved - even as a personal loan from a candidate. The real news, however, is what this may mean for the democratic race for the nomination. Depending on how significant $11 million is to the Clintons, Mrs. Clinton may be tempted to back-out of the race and back Mr. Obama in exchange for some financial support. This, of course, would end the inter-party bickering and allow Mr. Obama to finally set his sights on the White House. Of course, having earned over $100 million since the start of this decade, the Clinton's aren't exactly struggling - even if they do need to walk away from their loan.

The law states that Mr. Obama would not be able to help Mrs. Clinton directly, but there is nothing that prevents him from looking to his record-breaking fundraising base to do so. Of course, with his own need to raise further funds in preparation for the national campaign following the convention, he may hold his own interests in priority to those of his rival.

Money makes the world go around. The same is true for politics. The fact that Mrs. Clinton is having difficulty raising funds and has had to resort to personal loans means that she has lost support among her backers. This, of course, is an indicator of where that support may have gone. With Mr. Obama now leading in both the super delegate race as well as the popular vote, it's not difficult to put one-and-one together.

Research In Motion's Bold Tactics

2008-05-12T09:58:00.003-04:00

Research in Motion, the company behind the Crackberry (aka Blackberry) finally announced its long-anticpated 9000-series phone, dubbed the 'Bold'. The phone, already been teased as a potential iPhone-killer, sports a touch-screen and new technology that speeds dowloading so as to even allow live tv-like streaming over wireless networks. With Apple's next-gen iPhone expected to be announced in a matter of weeks, the segment that is expected to quadruple to 400 million users worldwide in the next three years is definitely heating-up.

RIM has not been sitting idly-by as Apple's iPhone began to dominate the smartphone market. With the release of its popular Pearl and Curve phones, it went head-to-head with Apple offering business users multimedia features and simultaneously enticing non-business users to give their products a try for the first time. It worked. RIM has seen tremendous growth ever since and that growth is expected to continue with today's latest launch.

From a pure business perspective, it's an interesting company to watch; they've got some smart, entrepreneurial, minds behind those sleek devices. To help bolster their consumer appeal as well as solidify their hold on the enterprise sector, RIM introduced a $150 million venture fund to help finance businesses building applications for their phones and therein insuring that growth of the developer community that ensures their continued success. Not surprisingly, Apple's soon-to-be launched iPhone Application Store (part of the iTunes Store) is using the same logic tap into the already thriving 'blackmarket' for 3rd party applications already numbering in the thousands.

I remember my first PDA; it wasn't a Palm Pilot and it really should have been. The one that I did buy was from Texas Instruments and by all counts it was a superior device to anything that Palm had released. Its downfall, however, was that it was marginally more expensive and consequently attracted significantly fewer buyers. Fewer users, in turn, mean that there was a smaller market for applications developed by 3rd parties and those developers flocked to the Palm computing community who's application collection surged. Ultimately, of course, Palm became the de-facto PDA not because it had the best product, but because it had the best supporting community. To see both RIM and Apple working to ensure that same thriving community makes both these companies ones to watch.

Citigroup to shed $500 Billion; that 'B' for Billion!

2008-05-10T10:44:00.002-04:00

In today's financial climate it's not particularly news to hear that a bank is writing down some assets. When its this scale, however, it tends to grab your attention.

Don't mistake my comments for criticism. I agree with other opinions on the matter that this is the right move for Citi's new chief, Vikram Pandit. A good rule of thumb for any investor is to limit their focus to only a handful of securities; you really can't properly monitor more than that and adequate portfolio management is key to long-term success. I see Mr. Pandit's actions as no different. He's consolidating. Here's a good summary of their reasoning for the move form this article:

...Citigroup executives did point out several shortcomings at the bank that need to be fixed, including organizational redundancies, a fractured corporate culture and waning market share in U.S. retail banking. And the company introduced a new slogan as part of its revamping efforts: "Citi never sleeps."

It's funny that people are actually concerned about Citi's resulting loss of its top-spot as the nation's bank; who cares! I'm not a shareholder, but if I was I wouldn't care about its ranking nationally or otherwise; I care about the bottom line. I care about what management's decisions mean for its earnings and how that will affect equity value. Period.

Unemployment Trending Upward

2008-05-10T08:43:00.004-04:00

It's an election year and no one wants to admit it, let alone talk about it, but the reality is that the employment outlook is not pretty. Since early last year unemployment has been steadily rising and shows no signs of slowing down - regardless of what the politicians want us to believe. Oh, and if you think that unemployment can't go much higher than it is already, then look at the included graph as a comparison against what it used to be during this decade's first recession.

Unemployment, for the sake of unemployment, sucks. What makes this picture that much worse, however, are all the other factors that are still mounting an attack on the lowly consumer. Rising fuel costs; rising food costs; falling home prices... maybe worst of all, rising consumer debt. You can't really blame people for drawing on their lines of credit to make it through the tough times, but I'm sure that you too can guess what will happen when the cost of credit begins to rise as it is expected to do in the coming year. All that debt will suddenly become increasingly expensive leaving everyone scrambling with even fewer options to cover their living expenses.

The picture is gloomy, I know. It doesn't need to be as bad as it is though. The most important thing that people can do is to recognize the true state of the economy and act accordingly. Yes, it's time to cut-back on spending and increase savings for those sure-to-come rainy days. Every business owner knows that to survive the troughs you need to lower expenses along with falling revenues; it's just too bad that not every person has the same business know-how to make similar adjustments in their personal finances.

Fooling Some of the People All of the Time

2008-05-09T08:11:00.003-04:00

CNBC just had a great little interview with David Einhorn, the president of Greenlight Capital and author of a new book: Fooling Some of the People All of the Time: A Long Short Story. I haven't read it yet (just learned of it), but I think that it's going on my reading list. Why? In the interview, Mr. Einhorn suggested a fairly simple idea to help avoid the sorts of financial problems that he saw at Allied and that we're seeing today with CDOs and mortgage-backed securities: why not mark-to-market all securities?

Marking-to-Market is simply the idea that your portfolio should accurately reflect the value of your investments even if they are not yet realized. For example, if you sold a call option (sold the option to buy a stock/security to someone else), then you have the obligation to deliver that stock or security if that call option is ever exercised. Now, let's further assume that you sold that put right at the money and it has since declined by $10. Since options are marked-to-market, your broker may require you to place the $10 in your cash account as a security against the $10 that you will be obligated to pay upon the exercise date. Sure, the exercise date may be months away and the price may very well reverse in the meantime, but the concept of marking-to-market ensures that those investors issuing those securities have the assets to finance them. From the perspective of the big banks doing the same thing, the marking-to-market would clarify the value of their balance sheets and make retail investment in those banks that much safer.

So why isn't Marking-to-Market not done all of the time? Well, the principle reason is cost. Marking-to-Market on some securities can require a great deal of monitoring expense that would undercut the earnings investors were collecting from those investments. This is a valid point, but like most things in life, there should be some compromise. Moreover, as the digital age advances, our financial transactions are increasingly computerized. As some of you know, however, at least part of the problem with the CDOs and mortgage-backed securities is the documentation: it's a mess. Marking-to-Market of such securities would undoubtedly increase the cost of these assets, but it would also require the financial institutions both issuing and purchasing them to keep very accurate records of their value.

What I like most about this idea, as Mr. Einhorn explains, is that it doesn't require more legislation or regulation besides requiring companies to do what they already must do on other (similar) securities. Even monitoring by the government and its agencies would be simple. I'm going to have to think this idea through further, but for now... it's a very interesting idea for both its simplicity and effectiveness.

12 times $625 million equals $7.5 billion

2008-05-08T12:19:00.002-04:00

That's the total, potential, exposure that State Street faces in light of a law suits already filed against it by several insurance companies for whom they managed retirement funds. No one believes that the verdict will be that high, of course, but that's the maximum as calculated based on the losses suffered by the funds under management as a result of the sub-prime mortgage investments. $625 million, on the other hand, is what State Street set aside late last year in anticipation of these lawsuits. See a discrepancy? Me too.

The lawsuits, under review for class action status, appear to have more than one leg to stand on. The reason is that the suits are filed under the Employee Retirement Income Securities Act (ERISA); why is that important? Well, funds registered under ERISA are designed to be relatively low-risk so as to appeal to individuals looking for retirement-oriented investments. As it turns-out, of course, sub-prime lending isn't all that safe and a lot of people are now faced with the loss of as much as half of their retirement savings. How would you feel or react if that were you? Yea, me too.

State Street, of course, isn't the only one in this position and there will be others hitting the headlines in the coming months. The issue is really the extent to which these fund managers owe a fiduciary responsibility to the individual investors whose money they are ultimately investing. Were these investors properly informed of the risks being taken? Did the fund managers even appreciate the risks themselves? If you're interested in corporate finance, then the next year will certainly be an interesting one to observe.

Just as in we had Sorbanes Oxley come-about as a result of the scandals earlier this decade, I'm sure that we'll have new legislation and regulation written to avoid such events in the future. It's easy to view this as just a cycle - one that will repeat again, just in a different form with a different name and with different acronyms. What makes this a little more real is the thought of the millions of people whose life savings have been so detrimentally affected by the decisions of so few.

Vallejo, California's Bankruptcy 'Unrelated' to Sub-Prime Lending?

2008-05-08T10:03:00.002-04:00

Yesterday's big economic news, as far as I'm concerned, was that a town in California would be filing for bankruptcy. As the announcers were saying it, they adamantly followed-up each and every statement clarifying that this was not the result of the wide-spread sub-prime lending problems plaguing the rest of the country. ...how is this not related? Who are they kidding?

I'm the first to support the notion that the government, via the media, should do what it can to keep confidence levels up and maintain positive future prospects among the citizenry. That said, there's a point at which doing so can be more harmful than good. This is one of those moments.

People are funny. They watch the news in segments - disconnected segments. In one segment, an economist will be warning people of rising unemployment, growing concerns over inflation and work diligently to avoid saying the R-word (recession). In the very next segment, albeit after a regularly scheduled commercial break, the well-dressed financiers will excite everyone while quoting statistics from the latest rally sparked by news of higher sales volumes. How is it that no one connects the two segments to provide people with a more complete picture of what's going on in America?

Rising sales - sure, it's possible. Of course, the question is how are those sales being financed? With interest rates at 2%, I bet that you could guess! With the decline of home values to record lows, the average person's wealth has diminished dramatically. All the while, these same people are taking-on more and more debt, forgetting that unemployment is rising and their job security may not be there a month or week later. Then, ask yourself what happens when those individuals and families with all that debt lose their jobs and have zero (or negative) home equity. What happens to those individuals and families when interest rates begin to rise again and the cost of all that debt increases on them? I bet you could guess that too...

Credit lines in the sand

2008-05-07T20:01:00.003-04:00

It's tempting to believe that the credit crisis is nearing an end. I hear it too; many of you know that I'm an avid CNBC watcher and their stance, more often then not, is that the worst is behind us. I'm afraid that I disagree. The worst is yet to come. The reason? The tighter belts at the banks and slowing credit hasn't had enough time to really impact businesses ...yet.

I wrote a post a few days ago quoting an article wherein they stated that bankruptcies were up 49% year-over-year. I'm afraid that even that is only the beginning, but it is an indication of what is yet to come. Businesses, especially growing businesses, rely on their credit lines to get them through the tough times. We're in one of those times now, but the credit lines won't be there to provide the businesses with the cushions that they need.

In stead, businesses will begin to see their cash reserves dwindle as their sales and revenues decline. Of course, no business, especially new businesses, can react instantly to changing market conditions. As a result, fixed costs will remain at their original levels for some time and those fixed costs will need to be covered - if not by revenues, then by what? The credit lines won't be there... Put one and one together and you begin to see the picture that's developing nationwide.

The credit crises, or at least what started it initially, may be nearing an end. Unfortunately, the effects of that crisis are only now beginning to be felt and it will take time for their full impact to reach the bottom line.

Everyone believes that they're underpaid...

2008-05-07T17:25:00.002-04:00

I'm sure that no one is surprised by the title of this post; we all believe that we're underpaid. More precisely, we believe that others are paid better than we are. The reality, however, is likely far from the truth. This differential between what people earn and what we believe that they earn comes from the fact that no one speaks about their earnings - we infer their earnings from their spending behaviour. With personal debt levels at all-time highs, this is undoubtedly a poor indicator.

For those of you unaware, I'm a Canuck. Up here north of the border, the average salary is about $27,500 for an individual living alone (this excludes students working part time or summer jobs that would otherwise drag-down the average). Shocking, isn't it? With all the talk about six-figure salaries, the reality is that a six figure salary more than four-times the average salary.

Most people spend beyond their means. They spend more than what they earn and incur massive debts in order to live like they believe their neighbors can in-fact afford to live. In trying to keep-up with the Jones', it seems that we're all chasing a lifestyle that very, very few of us can actually afford.

What does this all mean for those currently on the job hunt? Well, for starters, it should give pause in consideration of what sort of salary is actually deserved based on your experience and abilities. Of course, we all believe that we're above average - which, of course, can't be true - so we all demand salaries that are above average. There's no harm in believing in ourselves; it's a positive thing. I suppose that I'm writing this not to suggest that anyone suppress their earnings expectations, but rather than we think twice about what it is that we're actually worth. Think about it from the perspective of your employer or potential employer. What sort of value are you going to generate for them? If you're worth six-figures, then that would imply that you can generate at least that much profit (not revenue) for the company; can you?

Money Market Funds ...Almost Risk-Free

2008-05-07T14:26:00.002-04:00

If you've ever studied finance, then you know that the notion of the risk-free rate is critical to the valuation of many other financial instruments. U.S. Treasury Bills (T-Bills) are most often used as the de-facto risk-free rate, but what about money market funds. Since they were introduced almost four decades ago, not a single retail investor has ever lost a cent. Does that mean that they're risk-free?

No. Fortunately, that shouldn't dissuade anyone from including them as part of their well diversified portfolio. Money market funds tend to offer rates of return slightly better than T-Bills and certainly better than what your bank will offer on your savings or checking accounts. What should be considered as part of the decision, however, is that they are not guaranteed by the government in the same way as your savings and checking accounts are. There is a risk of default and there is a risk that you could lose all or part of your investment.

Money market funds, like other funds, group various types of investment assets together to offer retail investors (that you and me) the opportunity to buy an already-diversified (and presumably less-risky) asset in one go. In the case of money market funds, these include T-Bills, short-term corporate bonds and other, generally high-quality, short-term debt. The fact that they're short-term is important. The fact that they're high-quality is also important. These two facts together mean that it is highly unlikely that a debt instrument that is deemed to be high-quality is to default within one-year or less (the generally accepted short-term duration). As investors, however, we should be aware that there is a risk and like any risk, should not be ignored.

So what does this mean for your investment decisions? Probably, not much. If you're a savvy investor, then you already know that diversification is your best safety net. As long as you don't invest too much (proportionally) in any one type of asset, then you're unlikely to suffer a significant loss in even the worst of circumstances. Money market funds are a great safe bet. Just remember that safe doesn't equate with risk-free.

Bankruptcies up 49%! Yes, 49%!

2008-05-06T20:24:00.002-04:00

Some days, when you listen to the latest equity market numbers, you wonder can't help but wonder where all the fuss about recession comes from. Sure, the markets decline some days, but for the most part we only hear about the rallies and bulls. The bears are sparse and far between. Then you come upon an article that shocks you with some numbers that bring your feet back on the ground... bankruptcies up 49% years-over-year.

We already heard about the foreclosures, but that's because of the sub-prime hoopla, right? If there was any doubt as to whether the economy was slowing, the rising number of businesses forced to closedown should shed some light on the matter.

1.1 million bankruptcy filings! Yes, that's 'm' for million. As in... if you had one dollar for each business that failed, you would be a millionaire with some change to spare. Sobering, isn't it?

Indexes as Market Indicators

2008-05-06T09:36:00.003-04:00

An index is just a collection, usually weighted by some variable, of assets so as to provide an average that observers of that index can use to evaluate general trends in the underlying market for those assets. This implies a very important concept: an trending indicator is not an indicator of underlying value.

For some reason, people (including sophisticated investors) are tempted to view indexes as representative of the value of the assets that they represent. The credit default swaps market and indexes like ABX, CMBX (any kind of X, really) is an ideal example. According to accounting principles, companies must use such indexes to value securities, like swaps, that are traded irregularly or for which there is limited liquidity. Why is this important? Simple. Like any other market index, it is susceptible to volatility resulting from investor speculation; as investor excitement grows for the underlying assets, the value of the index can climb completely unrelated to the underlying growth of the assets that they represent. Of course, the opposite is true as well and this has proven to be a big problem in the face of the persisting troubles resulting from the sub-prime mortgages.

It became a self-fulfilling prophecy. As concerns over mortgage back securities, collateral debt obligations and other new acronyms abounded, investors began speculating the market (and its index) downward. As the index crashed, companies around the globe relying on them as representations of underlying value were forced to write-down the value of their holdings in those assets. A vicious circle emerged with more and more news of write-downs spurring greater and greater downward pressure on the market indexes and even further declines in the representative value of the assets held by financial institutions.

Suddenly, banks were losing tremendous amounts of money and reporting lower performance in their reports. To protect themselves, they started selling-off the assets that caused them problems and, more importantly on an individual basis, began to tighten their lending making it more difficult to obtain loans. As credit shrank, the economy began to slow further when companies could not borrow the funds they needed to finance their growth plans. As banks looked to cover their butts, foreclosures ramped-up driving even greater pressure on homeowners already facing higher prices and growing unemployment.

Fortunately, nothing lasts forever. The price of anything can only fall to zero and no lower; there is a lower limit. Yes, many of these sub-prime mortgages will default, but not all. Eventually the market will stabilize and banks will resume business-as-usual. As this happens, new legislation will be passed and new accounting principles written to help avoid a similarly vicious circle in the years ahead. It's all a learning process for everyone involved. The politicians and policy makers that write the laws and regulations we all follow are only human and they too learn from their mistakes... sometimes.

Reserve Status and Long-Term Currency Concerns

2008-05-06T09:09:00.003-04:00

The US dollar has been tumbling for the past six-years; down about 40%. For ten-times as long, six-decades, the US dollar has been the reserve currency for the world. While this may not change dramatically any time soon, the change is already underway and the consequences spell dire forecasts for the US economy.

The short-term pains already felt by Americans as a result of the low dollar have topped headlines for some time already. Exporters are suffering. Interest rates have fallen quickly to help avoid an inevitable recession causing further devaluation. This pales in comparison to what would happen if the US dollar is no longer seen as a store of wealth by our trading partners.

Here's a great quote from this bloomberg article I just read:

Official reserves equal 33 percent of global imports, according to UBS AG. If a company in country A trades with a company in country B and the transaction is invoiced and settled in the currency of country C, that third currency will have reserve status. That's because both companies are likely to keep cash balances in that currency.

The US has had the privilege of being country C for the better part of the last century and has, as a result, enjoyed what amounts to an interest-free loan from the countries that trusted the greenback as their safety net. As countries begin to trade (i.e. sell) their US dollars for better stores of wealth, there will be even greater downward pressure on the currency - just like any other commodity demand and supply market. This spells greater future pain for the American economy.

As other currencies take the place of the US dollar as the most desired reserve currency, Americans will be asked to pay for foreign goods in those other currencies more often. This means greater transaction costs and higher prices. Similarly, as fewer investors want to hold the greenback, interest rates will need to rise to make the dollar more attractive; this results in higher borrowing costs and further slowing of economic growth. So what do we do about it?

It's quite simple actually. Americans need to start living within their means. Americans need to borrow less and save more. When this new thinking begins to sink-in among the populous, then fewer dollars will need to flow across the nation's borders. As this occurs, Americans will be less dependent on foreign financing of their spending and the currency will begin to regain some of the value its already lost. I said it was simple, not easy...

What's driving the price of Oil?

2008-05-05T18:58:00.002-04:00

We've all cringed at the sight of the prices at the pumps, but what's driving the staggering and persistent climb? Demand? Unlikely. If it were demand, then how could it have changed so dramatically in such a short period of time? Sure, China is certainly demanding more than before; China, as big as it is, however, is still not big enough to sway world demand to the extent that we've seen in the past year. So what is it?

Yes, I know, everyone's got politics on the tip of their tongue. The truth is, that that's probably a big factor. The even greater truth, however, is that this is really the underlying factor - the real cause of the rise in price is speculation. That's right; folks like you and I, investors, buying-up contracts in the belief that prices will continue to rise. The funny thing is that it becomes a circular and self-fulfilling prophecy. Although we all complain about the rising price, we too might be responsible for those very prices.

There is a silver lining, at least for those of us who are speculating. For said investors [speculators], they're hedging their increased pumping fees by profiting for those same rising prices in the capital markets. If you've ever studied economics, then you'll quickly be reminded of the Prisoner's Dilemma. Although its in our interest, collectively, to quit the speculation, we are best served individually by joining-in on the free-for-all in the futures market. Like the saying goes: if you can't beat 'em, join 'em.

Buffett Chastises Wall Street for Financial Mess

2008-05-05T18:48:00.002-04:00

Yes, I know, it's another Buffett post, but can you really blame me?

Did you know that Berkshire Hathaway Inc. and Mr. Buffett were approached as a possible white knight for Bear Stearns? Neither did I. Apparently Berkshire turned-down the offer because they didn't have enough capital or enough time to properly evaluate the situation. When you consider that Mr. Buffett is just about to leave on a European buying with about $35 billion in spare change.

In what has now become known as Woodstock for Capitalists, Mr. Buffett and his Berkshire investing partner, Charlie Munger, chastised Wall Street and financial institutions in general for letting the financial system slip into this kind of disarray. Mr. Buffett has said before that he doesn't trust the financial statements of most financial institutions and he said it again: banks can get away with too many big secrets for too long.

I, for one, will certainly be keeping an ear open to hear about what comes from Mr. Buffett's Eurotrip. I'll be sure to keep you all in the loop.

The Fine Line Between Admiration & Jealousy

2008-05-05T07:14:00.003-04:00

Just like the title says, there seems to be a fine line between admiration and jealousy. Why is it that we are jealous of some very successful people and simply admire others? Warren Buffett is a great example. With all his success, most recently regaining his title as the world's richest man, this is a man that is admired. You just never hear of anything negative said about this man.

I was watching CNBC again this morning and found it interesting how they made this distinction and why Mr. Buffett has been able to find the sweet spot in being recognized as a leader. In their opinion, it had a lot to do with his modesty and a general awe-shucks approach to his success and that of his company. It's simply difficult to dislike someone who takes such a modest approach to his incredible achievements. Personally, I think that there's more to it.

Mr. Buffett is a prolific writer and speaker. He's always been willing to share his opinion and thinking on topics relevant to his business. Because us regular-folk have consequently been able to better understand why he does what he does, there's been less mystery and mystique in his actions. As a result, individuals such as myself have been able to reason through the logic and come to similar conclusions reached by Mr. Buffett; when we do so, it's difficult not to acknowledge Mr. Buffett's wisdom and, maybe more importantly, his willingness to share it with anyone who will listen.

D-Day + 1 Week :: Lose-Lose

2008-05-04T20:09:00.004-04:00

Well, I must admit that I'm surprised by the outcome, but Microsoft has decided to withdraw its buyout offer for Yahoo! after a fight over, you guessed it, price. Here's a short excerpt:

Microsoft said it offered to raise its $44.6 billion bid by about $5 billion, to $33 a share. Yahoo demanded $37, Microsoft said yesterday in a statement.

After careful consideration, we believe the economics demanded by Yahoo do not make sense for us, and it is in the best interests of Microsoft stockholders, employees and other stakeholders to withdraw our proposal,'' Ballmer said in the statement.

I think that this is a copout - at least to some extent - on the part of Ballmer. He went out on a limb and got burned. He made bold statements that left him with few alternatives and made Microsoft's decision just that much more difficult.

It's probably one of the first things you learn in any strategy or negotiations class: Don't state your position until you clearly understand your counterpart's position. Sure, it's not always easy, but the underlying principle is simple; you can ensure that your position, once stated, accommodates the goals of the other party such that accepting your proposal can be seen as both a fair and equitable compromise. What Ballmer did was foolish - he drew a line in the sand and left himself very little room to negotiate further.

Yahoo!'s management, on the other side of the table, certainly appear to have made a selfish decision - choosing to protect their own job security rather than serving to the needs of their shareholders and stakeholders. The stock will drop between 20 and 30% tomorrow morning when the markets reopen - that's gotta hurt!

UPDATE (The following morning): Yahoo! down 21% before the market open... Microsoft, actually up a few cents...

Banks need to shed the fat before the next lending feast can begin

2008-05-01T17:30:00.003-04:00

Banks have been working diligently to rid themselves of the lending commitments that helped to take down Bear Stearns. It's not only the mortgage-backed securities and CDOs that everyone's been talking about. Low-rated, high-risk, debt sitting on the balance sheets of many of the top banks is holding back any new motivation for new lending. It's gotten so bad that banks are willingly taking a loss on these loans just to get themselves clear of the whole mess.

From Citibank to Goldman to Deutsche Bank, no one is exempt. Banks are not only selling off loans with junk ratings at almost half-price, but are offering below-cost financing terms to anyone who will buy them. To put that into perspective, that's like someone selling you their home for less than what it's worth (on paper) and lending you the money to buy it at interest rates lower than what you could get elsewhere. Sure, if someone wants to get rid of something that badly, then it can't be all-good, but rest assured that some of these risk-loving buyers are going to win big when things finally do settle.

Cut your losses. It's a saying that every investor knows (or should know). Banks are well known for their ability to make money in any market and their ability to weather almost anything (obviously with some exceptional exceptions). They do so by knowing when to get out of a bad situation. There's a lesson in there, I'm sure...

Obama's Mailing List - It's not what you know...

2008-05-01T17:08:00.003-04:00

I read an interesting article on Bloombert (here's the link) that spoke about Barack Obama's most valuable asset developed over the course of his Presidential campaign: his mailing list. Two million people have not only sent Mr. Obama their hard earned money, but they have given him, and his campaign, their personal contact information - information that may prove to be Mr. Obama's ace-in-the-hole regardless of the outcome of the Democratic convention.

Via his own website as well as via social networking websites like Facebook and MySpace, Barack Obama has a marketing database that has allowed him to fill stadiums with supporters from coast-to-coast. Whether as a gold mine for future candidates looking to raise funds or as a powerful communication tool, the article goes on to explain how this mailing list will make him a power broker in the Democratic party for years to come. The only real thing that's surprising about this, however, is that it took the politicians this long to figure out what every teenager new already for years.

It's who you know and Mr. Obama knows a lot of people willing to part with their money in support of a candidate that they favor. He also happens to know a few techies. Chris Hughes, a 24-year-old Facebook co-founder is a full-time campaign staffer and helped create Mr. Obama's own website. Via the site, they've put every new member to work as a member of the campaign creating a quasi-pyramid scheme working to build on the campaign's success.

You really have to commend the Obama campaign for taking advantage of the tools out there. There's no way to know how much of a role this has played in the differential between the Obama and Clinton campaigns, but the fact that the Barack Obama Facebook site has about 5-times the number of friends is hard to overlook.

Now, from the perspective of a business guy, how can this approach to building a brand help other businesses and business people?

The wait continues for future home buyers

2008-05-01T16:55:00.003-04:00

It's been about two years since I first thought about buying my first home and subsequently decided to wait ...wait for the market to fall-apart. Well, it finally has (in the U.S. at least - we're still waiting here in Canada). In reading about all the foreclosures and other empty houses sitting on the market, I can't help but think how many other people there are out there like me - waiting for the market to bottom-out to get the best possible deal.

Yes, market timing is difficult, if not impossible, but everyone believes that what they're strategy can outsmart the market and I'm no different. I don't know when the bottom will come, but I'm pretty sure that we're not there yet. The fact that the Fed cut another quarter-point yesterday points to the fact that a lot of people (smarter than me) tend to agree.

A cut in the interest rate, although there's no doubt that the cut was primarily motivated by the credit crunch, it's also clear that the Fed and all those economists aren't convinced that the current recessionary trends are significant enough to halt (or even hike) the rates. The time will come, however, when those rates will have to rise. Inflation, by all reasonable accounts is nearing double-digit levels ...regardless of what you hear in the news. To bring that sort of inflation under control and help boost the dollar, the rates will have to soar. When they do, so too will mortgage rates and that will most certainly take its toll on the housing market.

...that's when the market will bottom and when a lot of people sitting on their down payments will finally be able to buy their home-sweet-home.

Buffett: "I invest in what I know and in what I understand"

2008-04-28T13:50:00.002-04:00

Warren Buffett, the world's richest man, is someone to whom all investors should listen and from whom they should at least attempt to learn. In an interview on CNBC this morning, Mr. Buffett spoke about his latest deal to partner with Mars in a purchase of Wrigley at $80 per share (I wrote a blog about that here). When asked about why he was interested in the company, his comment was quite refreshing. Well, he said, when compared to the balance sheets of Wall Street's banks, this is a company whose value I understand.

Coming from one of the world's most respected, and successful, investors, this should cause many investors to truly question what is going-on in today's marketplace. When a savvy investor like Mr. Buffett can't make heads-or-tails of what financial institutions are reporting in their reports, how can a retail investor hope to do so? Instead, invest in what you understand.

Mr. Buffett's joke about doing a 70-year taste test of Wrigley's products speaks volumes about how investors should make their own investment decisions. Just like you shouldn't buy foods whose ingredients you can't pronounce, don't buy stocks who's underlying business you can't describe in a single sentence (or paragraph). Simple.

Never mind a cut to 2%, how about a hike to 2.50%

2008-04-28T13:33:00.003-04:00

On Wednesday this week, the Federal Reserve, headed by Ben Bernanke, will meet to decide the fate of interest rates for the next six weeks. The rate currently sits at 2.25% - 3% lower than it was just nine-months ago. Mr. Bernanke and the Fed have been very aggressive with their cuts to help keep the economy out of a recession. Today, however, with most people agreeing that the economy is already in a recession, what should the Fed do next? More importantly, with inflation concerns higher than ever, a further attempt by the Fed to keep this recession as mild as possible could come at an incredible cost a year from now.

The rising cost of fuel and, more recently, commodity prices have made living expenses rise for the average consumer. The Fed hasn't helped either. The lower interest rates have caused the American dollar to sink against the Euro and other currencies - as much as 7%! This too has caused import prices more expensive and driven-up costs for consumers. All these rising prices mean one thing: inflationary pressures.

Today's economy is being compared to that of the late 70s and early 80s more than ever. A lot of people are beginning to foresee high inflation. The only thing that has helped the Fed, and the economy, is the general believe by the American people that the Fed is doing (and will continue to do) all that it can to keep inflation under control. This belief may quickly vanish, however, if the Fed doesn't begin to deliver on those expectations. Why care?

If inflation does start to creep-up like a lot of people believe that it will, then it will need to eventually be brought under control by the Federal Reserve. In the 80s, Paul Volcker, then Fed Chairman, pushed interest rates up to the high-teens in order to bring inflation back from its double-digit levels. This, of course, sent the economy into a VERY deep recession. If Mr. Bernanke isn't careful, his successor will need to do the same thing because he'll certainly be out of a job.

As speculation mounts over whether the Fed's meeting will result in a quarter percentage point cut to 2% or stay-the-course at 2.25%, maybe the Fed should rather be considering a quarter-point hike!

Sky-High Commodity Futures Prices Not Good for Farmer?

2008-04-28T13:11:00.002-04:00

It's counter-intuitive, I know. But the sky-rocketing prices of commodity prices have made things difficult for farmers. Logically, you would think that higher prices for their produce would make farmers ecstatic, and they are. Getting more for their output is always a good thing. The problem arises from what has been happening in the financial markets and understanding how farmers use those markets to protect their income.

Farmers are investors! It's true; although farmers have an unwarranted stereotype of being uneducated 'rednecks', reality is far from that.

First you have to understand that farmers plant their crops months before they'll be able to harvest and even longer before they'll be able to sell. This leaves farmers with a lot of uncertainty as to what they'll actually get for their harvest when they're sowing those seeds. To help hedge against that risk, farmers participate in the futures market - selling contracts on exchanges like the Chicago Board of Trade (CBOT). They do so in order to ensure that they'll be able to sell their crops at the price guaranteed by their contract - regardless of what the market condition is at the time of harvest. The problem is volatility.

So many new investors have entered the hot commodities markets that volatility in these markets has almost doubled over the past year. That doubling means a lot more uncertainly for those selling the contracts - farmers. What used to be a great way to hedge against uncertainty now has more uncertainty that the market for the crops itself. The market for crops such as grain and corn have been rising steadily for most of the past decade. This is the saving grace for farmers; while they may not be able to use the future contracts to protect future revenues, those revenues are more likely than not, to rise.

...Of course, then there's the whole problem that farmers face with the rising cost of fuel, but that's a story for another time.

Buffett, Mars & the 70-year Wrigley Taste Test

2008-04-28T08:40:00.004-04:00

CNBC had a great interview this morning with Warren Buffett following the announcement that his firm, Birkshire Hathaway and Mars are teaming-up to buy Wrigley (yes, the chewing-gum company) for $$80 per share. It continues to amaze me how easy-spoken Mr. Buffett is given his success. No pretentiousness; no stuffiness; just a regular businessman doing his thing.

They started the interview by asking Mr. Buffett why he wanted to buy $6 Billion (his firm's share) worth of Wrigley. His answer was fabulous: well, I've been doing a 70-year taste test of Wrigley's products and like their products. He goes on to make a very powerful statement: when you have the opportunity to buy a great company, take it. He couldn't help buy quoting Yogi Bear: "when you come to a fork in the road, take it!"

Mr. Buffett compared this deal with Lays' (the potato chip company) offer to sell to Coca Cola year ago. Coke passed on the deal and Lays ultimately sold to Pepsi Co., largely considered their best acquisition. Coke, Mr. Buffett says, made a big mistake. Wrigley is a geat company according to Mr. Buffett and the best time to buy it is when you can afford to do so. Period.

One more thing...

Mr. Buffett also made the following statement regarding the state of the economy: I think that we are in a recession and that it will be deeper and longer than people think. I don't think that he could have been more blunt, do you?

D-Day + 2 ...at least they're talking about the deal now.

2008-04-28T07:06:00.004-04:00

I woke-up this morning to find that the Microsoft and Yahoo! deal was in the news once again. Nothing new, really, to report, but at least they're talking about it. I found it simply strange that nothing was said on Sunday when so much was discussed coming-up on the Saturday deadline for Microsoft's offer to buyout Yahoo!

Today, I heard an interesting opinion on the deal. Could it be another AOL-Time Warner? Could it be another dot-com deal orchestrated by Wall Street with no real business sense? I said it was an interesting opinion, but not that I agree with it.

AOL was doomed to begin with. When Time Warner bought it, it was buying a dying entity. AOL's success was on making the Internet accessible. Could anyone possibly argue that the Internet still needs to be simplified today? Furthermore, could anyone argue that there are not a multitude of alternative service providers offering equally (or better) solutions to get Internet-newbies signing-on to the web? AOL was slow to adjust its business and Time Warner paid the price. I don't believe that this is the case when it comes to Yahoo!

Yahoo!'s business is display advertising. The only problem that it's having is converting its traffic into great revenues. Microsoft is already in the same business, but offers a broader reach and richer-content that helps to keep users clicking on its sites. I believe that there exist true synergies between these two companies. Put differently, Microsoft + Yahoo! is worth more than each is worth separately.

UPDATE: Microsoft, according to those 'close' to the ground, is now saying that it's likely to be a proxy fight that they'll announce later this week.

1st Half-Marathon!

2008-04-27T15:11:00.005-04:00

Today was the day. I ran my first, official, half-marathon. I've run 20km many times before, but never in an actual race. Let me tell you, 20km along the lakeshore in Toronto is not the same as 20km over rolling hills an hour north of the city.

With just 2km to go, my knee finally gave-out on me and I was forced to all-but walk the last couple of clicks. As a result, I fell short of my goal time of 1:45 and ended-up a whole 10-minutes slower. Disappointing, yes, but what really hurt was getting passed by men twice my age - no, I'm not exaggerating. If you run, you'll appreciate that my goal time (even my slower time) is not all that bad, but when someone 20 or 30-years your senior passes you on the last leg, it hurts!

It was a great event though. It was in support of a local hospital north of Toronto in Uxbridge and the volunteers and sponsors put-on a really nice show. The people were friendly, the medals were shinny and the post-race refreshments were, well, there. To those who made it happen, thanks from those of us who participated.

D-Day + 1 ...and no news on MS / Yahoo! deal?

2008-04-27T15:08:00.000-04:00

Is it jsut me or does anyone else find the lack of any news on the Microsoft Yahoo! deal a little bizzare? Yesterday, the day of the deadline on Microsoft's buyout offer for Yahoo!, it's all we heard about. Today, I've listening to the radio for a couple of hours and ...nothing?

My best guess? Something is brewing behind the scenes. But what?

D-Day :: Decision day on MS & Yahoo! Buyout

2008-04-26T12:59:00.003-04:00

Today is the day. Yahoo! is to make a final decision today on the buyout offer from Microsoft or face two possibilities:

A retraction of the bid by Microsoft, or
A hostile bid for Yahoo!

Personally, I don't think that either will happen, but I do believe that Microsoft cannot walk away from this deal. So, how do you reconcile this: an all-cash-offer. Microsoft's bid for Yahoo! is in stock; Yahoo! has been adamant that its offer is too low and Microsoft has been equally stubborn on its stance not to increase its offer. By offering an all-cash bid in lieu of its stock-bid, Microsoft could make its offer a little more enticing as well as offer Yahoo! an 'out' without forcing a hostile action by its soon-to-be owner.

Microsoft needs Yahoo! Google has already made its quasi-white knight intentions clear and Microsoft certainly cannot afford to let Yahoo! slip into the hands of its arch rival. It will be interesting to see what happens next from both a business perspective as well as from the perspective of a consumer.

I'm both a Yahoo! user and Google user. I don't really use MSN's search offer, but do enjoy its homepage as a news aggregator. A merging of some search and rich-content could very well help Microsoft take a dominant position in the market. In terms of display ads, the mere purchase of Yahoo! by Microsoft will make it bigger than Google in this arena, but I think that its true success will come from leveraging the synergies that these two future siblings can offer together in providing us lowly surfers with an even better way to spend our time online.

A market disconnect indeed!

2008-04-26T11:52:00.004-04:00

I just got through reading an interesting article in the Toronto Start (read it here). To put things in context, here's a little excerpt:

The headlines continue to paint a dire economic picture. The credit crunch has forced global financial institutions to take major losses and slash jobs. Meanwhile, the U.S. housing downturn and crushing oil and gasoline prices have clobbered U.S. consumers, which promises to dampen Canada's already struggling manufacturing sector.

That pretty much says it all. I personally believe that rumours that the current recession is nearing an end (yes, we're in a recession) are largely overstated. In Canada, especially, the worst is yet to come. The impacts of the economic slow-down in the U.S. have yet to really hit us north of the border and when they do (they will) things will tumble hard.

I recently read some stuff on technical analysts' approach to investing and found it quite enlightening. The reason: they seem to see opportunity in almost every market situation, and for good reason. Many people (myself excluded) have made a bundle while others stayed on the side-lines (myself included) waiting for this bubble to burst. I'm sure that I'll take some satisfaction in being proven right, eventually, but it's still a little frustrating to see potential profits fall into the pockets of others.

Inflation and the Interest Rate, what's the deal?

2008-04-26T11:35:00.003-04:00

So some of you have asked about the connection between interest rates and the rate of inflation. Why do the two always appear in the same sentence? Why do we care; what does it mean?

First, you have to understand that there are many definitions of the interest rate. What most people really mean whey the talk about the interest rate is the nominal rate. The nominal rate is actually the combination, itself, of a few things. Without getting too complicated, it's comprised of:

The real interest rate, and
The inflation rate

Ignoring other stuff, the nominal rate = the real rate + the inflation rate. Beginning to see the picture? No? That because you need to understand why you really care about the real interest rate, not the nominal rate.

The real interest rate is the return on your investment (or savings) that you expect to receive as compensation for letting others (banks, and borrowers from banks) use that money. Unfortunately, no one pays you real interest - they pay you nominal interest. The reason is that no one actually know the rate of inflation at a give point in time - only in hindsight and even then not all that accurately.

Let's say that the bank pays you 5% on your savings or investment(s) for one-year. Ignoring compounding for the time being, you expect to get $105 back a year later for an investment of $100. What if you find out a year later, however, that inflation over that period was 4% (like it is today!). An inflation rate of 4% means that it roughly costs you 4% more to buy the things you normally buy (your mortgage or rent, food, gasoline, etc.). So a year later you're only better off by 1%, right? ...actually, wrong!

We forgot about taxes. Yup, taxes.

It would be great if we got taxed on only the 1% that we're really getting a year later, but the government taxes us on the whole 5% (the nominal rate). To keep things simple, let's say that we get taxed at a marginal rate of 50%. Well, that would mean that our 5% has been reduced to 2.5%. So, now if we subtract the inflation rate (the rise in the cost of living), then we're really left with -1.5%. Yes, that's a negative sign ...sorry, it's not a typo.

So, now that we're clearer on what all the fuss is about, I hope that those boring discussions about interest rates and inflation will mean more to you... it should. Really.