• Irene's Financial Aftermath

    (Watch this Weather Channel video here)

    Hurricane Irene may end up being one of the top 10 most costly hurricanes after all.  Insurance companies, however, may have dodged a bullet.  Much of the damage did not come from the wind as in most hurricanes, but rather came from flooding which is not always covered under the insurance policies. 

    The cost of this hurricane comes at a bad time for our economy.  If insurance policies don’t pay for the damage, then rebuilding will be thwarted and the housing industry may slow down further.

    This once again makes a case for weather derivatives.  Here is an example where the holder of a hurricane derivative would receive a payout while the holder of an insurance policy might not.  The hurricane futures contract described in this recent blog post pay the buyer if a named hurricane makes landfall.  She did.  Her name is Irene.

     Discussion Questions:

    1.     According to this NY Times article, how much of the cost of prior hurricane damage has been covered by insurance companies? How much of Irene’s damage is expected to be covered by insurance companies?

     

    2.     What are some specific ways that the economy might be affected if insurance policies fail to cover the damages?

     

  • Can I Get a Do-Over?

    What keeps you up at night? Apparently, the U.S. Treasury market has caused Bill Gross, the widely followed manager of PIMCO’s Total Return Bond Fund, to lose sleep.  According to the L.A. Times,

     

    Bond market guru Bill Gross is telling his investors what many of them already know: He made the wrong call on U.S. Treasury bond interest rates this year, and that has cost him dearly in his renowned Pimco Total Return bond fund.

     

    Gross told the Financial Times on Monday that the U.S. economy has grown more slowly in 2011 than he had expected, which has pushed Treasury bond yields lower as investors have rushed for relative safety.

     

    Because he kept the $245-billion Pimco fund largely out of Treasuries until recently, Gross missed out on the rising market value of older fixed-rate Treasuries as rates on new bonds fell.

     

    One of my recent posts talked about bonds being in a “speculative bubble.” Bonds may still be in a bubble, but that is little consolation for fund managers like Bill Gross.

     

    “Do I wish I had more Treasuries? Yeah, that’s pretty obvious,” Mr. Gross told the Financial Times last week, adding: “I get that it was my/our mistake in thinking that the US economy can chug along at 2 percent real growth rates. It doesn’t look like it can.”

                (“Pimco’s Gross Regrets ‘Mistake’ on US Debt Call, Dan McCrum, Financial Times 30 Aug 2011)

     

     

    Discussion Questions:

     

    1.     How has the PIMCO Total Return Bond Fund performed compared to its peers?

     

    2.     What happens to bond prices and yields during a recession?

  • Baby Boomer, Market Buster

    Research published by the San Francisco Fed suggests that our aging U.S. population may put downward pressure on U.S. stock markets in the coming years.

    The authors of the recent FRBSF Economic Letter, Liu and Speigel, compare the ratio of the average price of the S&P 500 to the average earnings per share (i.e. the P/E ratio) with the ratio of people age 40-49 to people age 60-69 (which they call the M/O ratio).  They find that these two ratios are highly correlated over time (see Figure 1).  They suggest that the stock market may decline as baby boomers retire and decline in number (see Figure 2).

     

     

     

    Read the full article here.

    In theory, this type of knowledge should already be reflected in stock prices because it is freely available to investors. In other words, there should be no way for the average investor to take advantage of the coming trend.  In practice, the model suggests otherwise.

     

    Discussion Questions:

     

    1.     How could an investor try to make money in the financial markets based on demographic trends? What is the Efficient Market Hypothesis and what would that mean for investors who try to make money based on demographic trends?

     

    2.     According to the article, how might baby boomers affect the stock market in the coming years?

     

    3.     What are some of the reasons why the stock market may not behave according to the model presented by the authors?

  • Hurricane Season 2011

    Hurricanes are costly.  Though we saw a number of storms in 2010, few brought the kind of damage that earlier storms had caused.  CNBC reports that the top 10 most expensive hurricanes (adjusted to 2009 dollars) have been:

     

                10.    Jeanne (2004)  $4.146 billion

                  9.    Frances (2004)  $5.212 billion

                  8.    Rita (2005)  $6.177 billion

                  7.    Hugo (1989)  $6.624 billion

                  6.    Ivan (2005)  $8.065 billion

                  5.    Charley (2004)  $6.479 billion

                  4.    Wilma (2005)  $11.306 billion

                  3.    Ike (2008)  $12.648 billion

                  2.    Andrew (1992)  $22.231 billion

                  1.    Katrina (2005)  $45.115 billion

     

    No one can put a value on the loss of human life.  But when it comes to property damage, insurance companies can estimate the loss of wealth.  We all understand that insurance can be used to protect the value of assets from wind and rain.  Insurance removes risk from one party (the homeowner) and sells that risk to the insurance company. 

     

    Weather derivatives sold on the Chicago Mercantile Exchange (www.cme.com) serve a similar function. 

     

    Derivatives are contracts whose values are derived from an underlying asset.  In this case, the “underlying” is the weather.  You can buy a contract on the number of heating days or the number of cooling days in a month. You can bet on the level of rainfall or snowfall in a particular city. And you can buy or sell a hurricane. 

     

    The CME hurricane contract allows the buyer to pay a price and then earn a payoff if a named hurricane makes landfall between Brownsville, Texas and Eastport, Maine.  Though it sounds like gambling, this contract can protect an investor whose business will be disrupted should a hurricane make landfall in the community.

     

    Hurricane Irene is expected to make landfall in my community of Wilmington, North Carolina shortly. Our university has called for a voluntary evacuation and public grade schools are cancelled for Friday.   The simple disruption of business over the next few days will come at a cost.  We’re all hoping, though, that this storm does not make the list of the top 10 most expensive hurricanes.

     

    Discussion Questions:

     

    1.     Go to www.cme.com and describe the details of the hurricane contracts that are available for trading. What do you get if you buy (long) a hurricane contract? What if you sell (short) the contract?

    2.     What is the benefit of a weather derivative contract over a traditional insurance policy with a traditional insurance provider?

     

     

  • Winning the Olympics

    Is hosting the Olympic games a wise investment for a city?  Beijing is coming to grips with that question as the huge price tag for the 2008 Olympics is now coming due. According to Bloomberg, a Chinese National Audit Office report showed that “the Beijing Olympic Games were profitable, with revenue exceeding what it said was a total cost of 19.3 billion yuan.”

    The question remains whether the revenue generated during the 2008 games is enough. Bloomberg News reports:

    Beijing’s state-owned infrastructure companies face a record amount of bonds maturing next year as China’s capital city pays the bills for the $70 billion 2008 Olympic Games.

    Fifteen local government financing units based in Beijing must pay 16.2 billion yuan ($2.5 billion) next year plus interest to investors, breaking last year’s record 12 billion yuan, according to data compiled by Bloomberg. A further 11.6 billion yuan matures in 2013 and 37.6 billion yuan in 2014.

    The debt is coming due as government efforts to control inflation cause corporate borrowing costs in China to rise to a three-year high of 5.92 percent this month, double the rate in the U.S. How Beijing deals with the bill, which dwarfs the estimated $15.3 billion budget for next year’s London Games, may set a pattern for more than 10,000 local-government financing vehicles across China with about 10 trillion yuan of debt.

    Bloomberg reports that the last two summer Olympics have “left the host cities with underutilized facilities.”  In China, the Bird’s Nest stadium is used “occasionally” while Athens has leased out only a fraction of its 2004 venues. 

    In finance, the first step in capital budgeting involves forecasting the cash flows to be generated by a potential project.  We then use these forecasts in decision tools such as the internal rate of return, net present value, and payback period to make capital budgeting decisions.  I wonder which data forecasts and decision tools were used by the city planners when they bid on the Olympics.  Look out London 2012.  Let’s hope you paid more attention in class.

     

    Discussion Questions:

    1.     What is happening to the yields on Chinese sovereign debt?

    2.     The Bloomberg article mentions credit default swaps or CDS rates. Why would CDS rates rise for Chinese sovereign debt?

  • Up Up and Away

    Photo from 4freephotos.com

    Bonds may be in a bubble, but who knows if, or when, that bubble will burst.  Speculative bubbles are cases when asset values rise beyond their intrinsic of “fundamental” levels.  In such markets, investors expect that values will eventually—suddenly—return to reasonable levels.  But the timing of this return to commonsense is hard to predict.

    Some investors have been warning for some time now that U.S. Treasury bonds are in a bubble.  Bill Gross, the well-respected manager of the $245 billion Pacific Investment Management Company (PIMCO) Total Return Fund dumped U.S. Treasury bonds back in February and others have followed suit.  

    But bonds haven’t dropped in value.  On the contrary, they’ve continued to rise.  Faced with volatile stock markets and near-zero yields on money market instruments, investors continue to invest in longer-term bonds, including U.S. Treasury bonds.  According to the Wall Street Journal’s Smart Money:

    The latest Treasury rally has done little to quiet year-long concerns that bonds are in a bubble. Last week, investors flocked to government bonds, pushing yields on the 10-year Treasury below 2% for the first time in at least 50 years. That's also down from the 2.6% yield pre-downgrade, and below the 2.8% threshold first hit last October, when many took the view that the bond market was headed for a pop. Now bond bears say the latest rally is setting up the bond market for an even bigger crash once interest rates start to rise again.

     Seems like investors are reaching for yield by buying longer-term bonds. Though that may fuel the bubble, what else can they do?

     Discussion Questions

    1.     What will happen to the values of corporate bonds if the prices of Treasury bonds begin to fall?

    2.     Why do many believe that U.S. Treasury bond prices will not fall in the near future?  Why do others believe that they will fall?

  • Big Brother Banking

     photo by lydiashiningbrightly licensed under Creative Commons

     

    If the government is having trouble collecting taxes, why not outsource that responsibility? Delegate the job to banks.

     

    In an effort to stem tax evasion, the Foreign Account Tax Compliance Act, or FATCA, forces global financial institutions to collect and report data about their wealthy U.S. clients or withhold 30 percent of investment earnings from those clients. If the financial institutions fail to comply, they face a stiff penalty of 40 percent of the amount and “heightened security by the IRS.”

     

    Being called “A U.S.-centric law for the world,” FATCA is facing opposition by bankers and other trade groups. In this CNBC article, criticisms center on FATCA’s reach and the cost of its implementation.

     

    In a barrage of letters to the Treasury, IRS and Congress, opponents from Australia to Switzerland to Hong Kong assail FATCA's application to a broad swath of institutions and entities. Those affected include commercial, private and investment banks and shells and trusts; broker-dealers; insurers; mutual, hedge and private-equity funds; domiciliary companies; limited liability companies, partnerships; and other intermediaries and withholding agents.

     

    Many questions remain unresolved. Among them is how the U.S. government will handle the flood of information that will be reported. Another question is how banks will react. Some have already indicated that they’ll take their business and go home.  According to CNBC, “the private banking arm of HSBC said it will stop offering services to U.S. residents outside the United States because of the cost of complying with the rule.” Yet another question is what this will do to international bank relationships. Swiss bankers are feeling especially picked on as the U.S. government tries to nab those pesky tax evaders who hide money in their numbered accounts.

     

    Discussion Questions:

    1. How much revenue is this new law expected to generate for the U.S. government?

    2. What are some unintended negative consequences of such a law?

     

  • Jobs in Finance

    In an effort to right the ship, Bank of America has announced that it is laying off 3,500 workers and that more job cuts may be on the horizon, perhaps as many as 10,000. This isn’t sounding like good news for business students in general or for finance students in particular. So what’s a college student to do? Give up? Change majors?

    Not just yet.  According to Vault.com, jobs in finance can still be had.

    Even in these days of downturn, companies make money, and as long as getting the green is the bottom line, companies are going to need finance and accounting professionals to manage their money. This simple truth should make corporate finance an attractive option if you’re the type of person who has great math skills and enjoys being part of real solutions with bottom line impact. You’ll be asked not just to manage a business’ finances, but forecast where the money will come from and help decide how to spend it in ways that will ensure the greatest return. This means it’s your job to free up capital while raising profits and decreasing expenses. Oh, and you’d better be a fan of spreadsheets, because you’ll be looking over many of them as you detail all of this.

    Corporate finance might not be as high-profile as investment banking, but keep in mind, every company makes financial decisions, whether the company sells lumber or stocks and bonds.  Firms must choose which assets to place on their balance sheets, and they must find ways to finance those assets. Finance goes beyond the high-flying world of M&A, hedge funds, and IPOs. Finance includes the most fundamental business decisions: where can we get funds and how should we invest them. Understanding capital budgeting and capital structure—those topics covered in every Fundamentals of Corporate Finance course—will serve you well.   

    (photo N. Richie, all rights reserved)

    Discussion Questions:

    1.     According to www.vault.com, what are some other careers in finance? What is the outlook for these careers?

    2.     What kinds of skills will help a graduate succeed in these fields?

    3.     How can a college degree help you in these careers?

  • Fear of Volatility

    (photo by Stevage and licensed under Creative Commons)

    This recent roller coaster ride (a.k.a. the stock market) has investors heading for the hills. Though investors would like to pull their money out of the stock market altogether, there aren’t many alternatives.  Those heading into their retirement years have shifted their money into bonds and passive mutual funds. The young ones with many years to retirement don’t seem to be much braver.  According to Bloomberg,  

    Younger investors aren’t replacing their retiring counterparts. Cash holdings are at the highest levels since the record in March 2009, according to an Aug. 16 survey by Bank of America Merrill Lynch. Investors from 18 to 30 years old have the highest cash position of any age group at 30 percent of their portfolio, MFS Investment Management said in an Aug. 8 report. Almost three in five investors cite fear about volatility or needing money someday as a reason they hold high or increasing levels of cash.

    (read the full article here)

    The roller coaster ride isn’t quite over yet. The S&P 500 ended down 4.46% today. The Dow was down 3.68%. Though it may feel like time to head for the hills, perhaps there’s a silver lining. Perhaps it’s time to buy.

    Discussion Questions:

    1. How do investors measure volatility in financial markets?
    2. According to the related article, how did investors react to volatility in the past?
  • The Downside to Low Interest Rates

     

    Are low interest rates a good thing or a bad thing? Depends on who you ask. 

    Borrowers like low interest rates because of the low interest expense. Savers, on the other hand, find themselves in a bind.  With rates near zero and the promise from the Fed that rates will stay there through 2013, retirees are having trouble living off their investments.

    $100,000 invested in a 1-year bank CD earning 1% delivers $1,000 per year.  For a 6-month CD, you’re looking at half of that amount. That’s not much to retire on, but many Americans are finding themselves in that boat. 

    According to this Times Magazine article, financial advisers are suggesting investing in a diversified portfolio of high-quality stocks as an alternative. Though investing in stocks is riskier than putting your money in a bank CD, at least stocks offer the possibility of higher returns. 

    So when Chairman Ben Bernanke announced that rates would remain low for the foreseeable future, not everyone was jumping for joy.  Some investors recognized that they’ll need to hunt for yield elsewhere because that future doesn’t look too bright for their “safe” investment options.

    Discussion Questions:

    1. What reasons did Chairman Bernanke give for the continued low interest rates?
    2. What risks do investors face if they choose to invest in stocks instead of CDs or bonds?
    3. To be able to retire with $1 million in 40 years, how much would an investor need to invest each year if interest rates are 6% per year? What if interest rates are 2% per year?
  • The Contrarian Play

    A discontinued 10 Deutsche mark banknote showing a graph of the normal distribution and a portrait of the mathematician, Carl Freidrich Gauss.

    (Photo: public domain)

    Some of the big names in hedge funds lost money this week. Lots of money. Meanwhile others are simply raking in the profits.   

    Calamity funds—hedge funds designed to profit during market downturns—are turning up as the big winners. A hedge fund is an investment company that invests in financial assets. Like a mutual fund, a hedge fund pools the investments of its owners, and uses the funds to invest in stocks and bonds. Unlike mutual funds, however, hedge funds are organized as private partnerships and are often secretive about their investment strategies. These strategies include “long-short” equities, which means that the fund managers can go long to profit from market upturns and go short to profit from market downturns. Those who have chosen to go long, hope to be successful in picking the winning stocks.

    However, according to the NY Times article by Azam Ahmed (Aug 10, 2011):

    Industry watchers say it has been a tough month for such traders because when markets collapse, it doesn’t matter how well you pick stocks. While many of these managers pride themselves on knowing which companies are undervalued and which are overpriced, everything tends to decline during a big market sell-off.

    Enter the double-secret calamity funds.

    These funds win by taking the very unlikely bet that the market will collapse. Sometimes the probability of such a collapse is less than half a percent, which is why the risk of calamity can be called “tail risk.” Calamity funds bet on tail risk, and right now, their bets are coming up heads.

    “Our philosophy is more like a trapper: we set volatility traps and the market falls into them,” said Jerry Haworth, the head of 36South, which returned more than 200 percent in 2008. “We seem to have a windfall every time there is a systemic crisis. All the traps seem to get sprung.”

    Discussion Questions:

    1. What are the characteristics of a hedge fund?

    2. According to this second NY Times article, what are “fat tails” and how do they affect investors?

     

  • Just Another Manic Monday

    Monday was a bad day for Bank of America. It was a bad day for all financial stocks in general, but for B of A, it was particularly unpleasant.

    According to this NY Times video, banks are the “plumbing of the economy” so when something is bad news for the economy, it is bad news for banks. And bad news was in abundance yesterday. With the decision by S&P to downgrade the U.S., global fears of recession led to selling in Asian markets followed by European markets declining. The S&P 500 index fell 6.6%, possibly due to overreaction by investors to the news.

    If all that wasn’t enough, Bank of America (along with Merrill Lynch and Countrywide, which were purchased by B of A during the credit crisis) was slapped with a lawsuit for $10 billion in damages by the American International Group on Monday.  A.I.G. asserted the Bank of America engaged in fraudulent practices when it sold mortgages and mortgage-backed securities to investors. Apparently A.I.G.’s forensic team uncovered what they consider to be deceptive information and poor underwriting practices.  According to the lawsuit filed by A.I.G. with the Supreme Court of N.Y.,

    Between 2005 and 2007, Defendants fraudulently induced AIG to invest in nearly350 residential mortgage-backed securities (RMBS) at a price of over $28 billion. Driven by a single-minded desire to increase their share of the lucrative RMBS market and the considerable fees generated by it, Defendants created and marketed RMBS backed by hundreds of thousands of defective mortgages.

    The Offering Materials used to sell the RMBS fraudulently misrepresented and concealed the actual credit quality of the mortgages by providing false quantitative data about the loans, thus masking the true credit risk of AIG’s investments. The Offering Materials also falsely claimed that the mortgages had been issued pursuant to objective underwriting guidelines. In fact, the loan originators, including Defendants, encouraged borrowers to falsify loan applications, pressured property appraisers to inflate home values, and ignored obvious red flags in the underwriting process.

     The CEO of Bank of America, Brian Moynihan, will be answering questions on a conference call on Wednesday. In the meantime, Bank of America’s response, according to the N.Y. Times is:

    In a statement, Bank of America rejected A.I.G.’s assertions. “A.I.G. is the very definition of an informed, seasoned investor, with losses solely attributable to its own excesses and errors,” Bank of America said.

     The NY Times called this a no good, very bad day for Bank of America.  They’re right.

    Discussion Questions:

    1. What is a mortgage-backed security?

    2. Who is responsible for the due diligence on the securities purchased by A.I.G--Bank of America or A.I.G. itself?

  • Breaking News: S&P Downgrades the U.S.

     (see the full report here)

    One of the CEO’s responsibilities is convincing financial markets that all is well at the shop. In fact, the entire executive team of a firm sets the tone for how well the company’s stocks and bonds will be received by investors. If investors are not convinced, then P/E ratios languish and stock prices do not climb. 

    Standard and Poor’s announced on Friday that it is unconvinced. The “firm” in question is the United States of America, and the executive team is led by our nation’s chief executive. 

    According to the S&P announcement that was sent to the U.S. Treasury after markets closed on Friday, August 5:

    The political brinksmanship of recent months highlights what we see as America's governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed….

    Our opinion is that elected officials remain wary of tackling the structural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a 'AAA' rating and with 'AAA' rated sovereign peers. In our view, the difficulty in framing a consensus on fiscal policy weakens the government's ability to manage public finances and diverts attention from the debate over how to achieve more balanced and dynamic economic growth in an era of fiscal stringency and private-sector deleveraging….

    As expected, the government was not thrilled with the news.

    The Obama administration reacted with indignation, noting that the company had made a significant mathematical mistake in a document that it provided to the Treasury Department on Friday afternoon, overstating the federal debt by about $2 trillion. (Read the full NY Times article here)

    The question now is just how much the downgrade will affect the cost of debt in the U.S., both the cost of government borrowing and the cost of household borrowing. According to the NY Times article, the effect might be “modest,” particularly since the other rating agencies have decided not to downgrade for the time being.

    Time will tell.

    Discussion Questions:

    1. According to the S&P announcement, what are the reasons for the downgrade?

    2. According to the government, why is S&P wrong?

    3. What are the likely effects of this decision by S&P?

  • Three Years After Lehman

    Lehman Brothers Times Square Aug 2007, photo by David Shankbone

    Who’s in charge of the over-the-counter market? When no exchange acts as a middleman or serves as a counterparty, what happens when one party fails to make good on its end of the bargain?

    Investors are learning the answer to questions like these as the fallout continues in the case of the Lehman Brothers bankruptcy that hit Wall Street in 2008. Many financial institutions had purchased or sold financial assets from or to Lehman Brothers before Lehman announced its bankruptcy on September 15, 2008—a textbook example of counterparty risk.

    Now three years later, on Friday, August 5 2011, State Street Bank announced that it has reached an agreement with some of the Lehman Brothers bankruptcy estates over the value of some of the contracts that failed.

    According to Reuters on Friday:

    With some $23 trillion of assets under administration and thousands of investment clients around the globe, State Street was embroiled on both sides of the 2008 Lehman bankruptcy. The bank said it is both seeking the return of some funds and may be liable for some claims.

     "We are in discussions with other Lehman bankruptcy administrators and would expect over time to resolve or obtain greater clarity on the other outstanding claims," the filing stated. "We continue to believe that our realizable claims against Lehman exceed our potential return obligations, but the ultimate outcomes of these matters cannot be predicted with certainty."

     Discussion Questions:

    1. What is a “repurchase agreement” and why would State Street have been affected by the failure of Lehman in the case of these contracts?

    2. What is the over the counter market and how does it compare with an exchange-traded market?

  • ...Where the Deer and the Antelope Play...

    photo by Clydehurst under Creative Commons

    If you’re looking for an alternative investment, you might want to consider investing in a ranch.  Investments in farmland and timber have long been popular among many asset managers. Offering slow and steady returns in a world of rising food prices, these investments have gained in popularity.

    According to Paul Sullivan of the NY Times: 

    Ranch life taps into the American desire for space, freedom and a connection with the land. Lately, owning a ranch, and selling the products raised on it, has emerged as an alternative investment class for those with deep pockets and a time horizon that stretches as far as the eye can see.

    But owning a ranch is not all campfire songs and cloudless skies. There are maintenance costs to keep it running and a lack of liquidity should you want to sell. Agricultural land is perhaps less “fun,” but may offer better returns. In any case, owning a piece of America (especially a piece of the wild, wild west) may bring a certain satisfaction that can’t be valued in dollars and cents.

    Discussion Questions:

    1. How would a potential investor determine the right value for a ranch?
    2. What are some of the problems an investor might face if he/she invested money in this alternative investment?
    3. What are some of the benefits of investing in agricultural land, timber land, or ranch land?

     

    (photo by Clydehurst under Creative Commons licence at www.flickr.com)