Investing: How to recognize a bubble - before it bursts

Asset bubbles, like artistic geniuses, have a reputation for going unrecognized in their lifetimes. That does not deter Ajay Kapur, Citigroup's chief global equity strategist, from trying to identify markets around the world that may be experiencing...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Insider: A hedge fund revolution? A prominent hedge fund manager is causing ripples within the industry for using a pay structure based on the idea of delayed gratification.

Among the certain unalienable rights of finance in 2006 is that of successful hedge fund managers to make a lot of money. That right is embedded in the compensation structure of the funds: Most managers receive 2 percent of the assets they manage as...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Hedge funds pose a risk, but less alarming, says Federal Reserve Bank of New York

The Federal Reserve Bank of New York said on Wednesday that the risk hedge funds pose to the global financial system has reached levels by some measures comparable to those just before the Long Term Capital Management fund imploded in 1998. But the...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Where the Next Big Bets Lie for Venture Capitalists

The venture capital sector is finally bouncing back from its post-bubble blues, although it's still a long way from the euphoria of the late 1990s. Blockbuster deals -- like YouTube's recent sale to Google for $1.65 billion and Skype's sale last...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

China expects trade surplus of $168 billion for 2006

The Chinese trade surplus will swell by 65 percent to a record $168 billion this year, the Chinese customs bureau said Thursday, less than a week before the U.S. Treasury secretary, Henry Paulson, travels to Beijing to discuss ways to reduce the...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

How To Beat The Stock Market: Buy Companies With High Customer Satisfaction Scores

A study in the Journal of Marketing concludes that you can beat the market consistently by buying stock in companies with high customer satisfaction ratings: Using a back-tested paper portfolio and an actual case, the authors of a study published in...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Bank of America/MBNA first the merger, now the song

Here's a clip of two Bank of America executives -- one on the guitar, the other doing his best Bono impression at the microphone -- celebrating the coming together of two great institutions into one great bank. It's quite shocking, particularly...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Tweets of the week

Tweets of the week (June 22, 2009)

Been on the road some with limited internet access, so this will be a bit unorganized and shorter...

PlanetMoney

1. Best NYT business article today in sports section: Golfers hurt themselves by playing it safe /lc http://snurl.com/k8azv
2. Looks like deflation might not be so scary a threat after all, at least according to the Fed /mk http://bit.ly/1ahpzZ
3. Brand new podcast: 5 takes on Obamas regulation reform. /jg http://snurl.com/kburp
4. AIG wins the prestigious Worst Company in America Award, the Golden Poo /mk http://bit.ly/PDnhO

WayneMarr

1. #SSRN East Meets West: A #Cross-Cultural Comparison of #Charismatic Leadership Among #Canadian and #Iranian #Executives http://bit.ly/P4oa9
2. #SSRN What Should #GAAP Look Like? http://bit.ly/LzLP4
3. Blog: "Return Factors" GOOD SUMMARY OF "CASE CLOSED" By Bob Haugen http://tinyurl.com/mbeq5s
4. #CFO: Will the New #FASB Code Change #Accounting? http://tinyurl.com/nsljgv
5. #SSRN - #Pricing #Model Performance and the Two-Pass Cross-Sectional #Regression #Methodology http://bit.ly/lWuJf
6. NBER: Do Multinationals or Domestic Firms Face Higher Effective Tax Rates? http://tinyurl.com/lohlmy

WestPan

1. RT @CatoInstitute: Paul Krugman's gets his history wrong. Very wrong. #FAIL http://bit.ly/JrKUx @nytimeskrugman @PaulKrugman
2. RT @leahita A Recent History of the US Economy! Truly enlightening! http://tinyurl.com/ln5o9o #tcot #liberty #C4L (via @codeezra)
3. Orwell's Time-Tested Warnings By Jeff Jacoby http://ff.im/-4iCnn (via @HighPlainsBlogr)
4. Protectionism, buying only from your immediate kin , i.e. Buy America, China, Canada, like incest, breeds weak-anemic offspring/economies.
5. Those who can make you believe absurdities can make you commit atrocities. - Voltaire, rationalist & satirist (1694 - 1778)

Others:

clusterstock Goldman Prepares To Pay Biggest Bonuses Ever http://bit.ly/478sk

clusterstock The Moneyball Movie Gets Scrapped http://bit.ly/MleYP

EverydayFinance Wealthy Nations Investing in Africa. TIME mag http://bit.ly/xuql3

EverydayFinance List of all bank failures to date in 2009 CNBC: http://www.cnbc.com/id/3104...

Eco_Feed: Stocks Cheap? Don't Be A Fool: Fund manager John Hussman looks at stock valuations a few different .. http://cli.gs/mbTB1X

SimoleonSenseDaily Behavioral Bias: The Issue Of Framing: Bias: Framing Quick Definition:(Via Wikipedia & Behavioral Fina.. http://tinyurl.com/mnh88s

diane1859: The fightback against 'Nudging' begins - just found fab new paper dissing fashion for behavioral economics, at http://snurl.com/knuqs

Convertbond Too big to fail? I say too big to succeed! 4 biggest US banks control 70% of all assets held by US banks Vs < 50% in 2000! #paulson #economy

Convertbond Lee Iacocca says the only way to get the US auto industry back to health is to take the keys away from the #government $F GMAC Rescap

mises The Deflating Bubble: The residential meltdown is nowhere close to being over. There is reportedly a million-hou.. http://tinyurl.com/nvzfv4

thecorplibrary New blog post about "The Future of Corporate Reform" conference: http://is.gd/14C1t #tclconference

publicoffering Eric Johnson comments on behavioral economics making an appearance in policy - regulation as intelligent, not intrusive http://bit.ly/6glDC

jimmahar Interesting interview: Geithner by @terrymoran (not T$). Discusses regulation, recovery, and the Fed. http://tinyurl.com/lu44hu

kevinlacroix The Boardroom Guide to Litigation -- analysis of legal climate in all 50 states http://bit.ly/Vi7HL


Some of little finance content, but:

allafrica Uganda: All Citizens to Get Free Mosquito Nets: http://allafrica.com/storie...

allafrica East Africa: Al-Qaeda Threatens Peace in Region: http://allafrica.com/storie...

KaztheProf If we want to reduce the cost of government then it starts with you...the more we do the less the government will think it has to do!!!

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[Source: FinanceProfessor.com]

Study: The controversial practice of backdating stock options went hand-in-hand with poor corporate governance practices and overbearing chief executives.

The research by three academics is the first to suggest a link between lax internal controls and stock options backdating. The scandal has so far engulfed more than 130 US companies in internal and regulatory probes but the study suggests that...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Courtroom intelligence: Hedge fund investment strategies

Hedge fund managers are always looking for an edge. Lately they've found one by sending patent litigators to court -- not to try a case, but as highly informed (and highly paid) observers. Their task: to pick up and quickly report back to the money...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Top 3 fund managers earn over $1bn

The combined earnings of the world's top 25 hedge fund managers of almost $15bn exceeded the national income of Jordan last year and three individuals took home more than $1bn, according to an industry survey.

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Citigroup to buy Bisys Group, for $1.45bn

Citigroup and hedge funds. The US uber-bank can't decide whether it wants to get into bed with the industry - or hide under it, for fear that it starts asking awkward questions about how the component parts of the world's biggest financial services...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

UBS Rolls Out Buy-Side Research

The New York arm of Swiss financial services firm UBS is introducing a curious animal into stock research: internally generated buy-side research that competes with the firm's own sell-side research. The brokerage firm is assembling a group of 10 to...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Wharton: Are Hedge Funds out of Control?

If you go to Amazon.com and search for books about venture capital, you get 14,114 responses, which include many text books. Andrew Metrick, a professor of finance at Wharton, has just written a new book on the subject titled, "Venture Capital and...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Judge postpones criminal trial of 16 former KPMG executives accused of selling illegal tax shelters.

One of the Department of Justice�s most high-profile white-collar crime cases has been dealt a blow after a New York federal judge postponed indefinitely the criminal trial of 16 former KPMG executives accused of selling illegal tax shelters. The...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

SEC chief gets blogging

Chairman of the SEC, Christopher Cox, has joined the blogging world. In a comment on Sun Microsystem's chief executive, Jonathan Schwartz's blog, the SEC chief showed interest in Mr Schwartz's recent request that blogs be used as a way to expand...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Failed Banks List: 2009 - Financials * US * News * Story - CNBC.com

Failed Banks List: 2009 - Financials * US * News * Story - CNBC.com:

"Below is a list of all the US banks that have closed this year, with the most recent ones first.

A total of 40 banks have failed so far in 2009, versus 25 for all of 2008. For more on failed banks, check out our slideshows of the ten largest bank failures this year and the two dozen of 2008."

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[Source: FinanceProfessor.com]

Big rise in suspicious trades

US stock and options exchanges are spotting more suspicious trading connected to high-profile deals, such as News Corp�s bid for Dow Jones, and are making more referrals to US regulators for investigation of possible insider trading. Between January...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Equities Swing With Harvard MBAs

Mr. Soifer tracks how many Harvard Business School graduates choose market-sensitive jobs each year. If 10% or less of that year's class take jobs in investment banking, investment management, sales & trading, venture capital, private equity, or...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Deloitte Touche: Holiday Spending Predictions

A quick glance at the windows of our nation�s retailers reveals that, once again, holiday season is upon us. While the holiday shopping frenzy is recurring and predictable, the nuances of consumer behavior during this time of year can have enormous...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Crestmont Research: The top hedge fund myths

The tone from Crestmont - which, according to its web blurb, says it �develops provocative insights on the financial markets and on the hedge fund industry� - is a tad tetchy. �Never has an industry so extensively studied by �experts� produced such...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Rising Exports Putting Dent in Trade Gap

Over half of the 9.1 million vehicles General Motors produced last year were sold in foreign countries... With the slumping housing market taking a toll on its business at home, Caterpillar is counting on sales of equipment and diesel engines in...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Drowning in zeros computing the OTC

Nowhere is it easier to be blase about big numbers than in the market for over-the-counter derivatives. Yet the numbers released by the Bank for International Settlements this morning, charting OTC derivative activity during the first half of this...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Dow Stocks: Best winning streak since '55...

The Dow Jones industrial average hit another record high Wednesday, capping its longest winning stretch in almost 52 years as investors welcomed strong earnings, lower oil prices, media merger news and a strong reading on manufacturing. The Dow (up...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

US economy on track for soft landing as consumer spending remained resilient

A slew of economic reports on Tuesday showed the US economy feeling the strain from the sharp slowdown in the housing sector, while offering very tentative hopes that inflation pressures could be easing. The news came as Japan announced a...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

US Fed Survey: Subprime Lenders Tightening Standards; Prime Lending Business As Usual

In its periodic Senior Loan Officer Opinion Survey on Bank Lending Practices released Monday, the Fed found that while bankers have become more stringent when dealing with subprime and nontraditional mortgages, policy toward standard loans remains...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Steve Forbes says the American economy is stable, but anxiety remains.

�There may be yet another villain at work: inflation. Many of us are familiar with John Maynard Keynes' quote, "There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Advantage of Youth: ignorance

Young people make better entrepreneurs because they're too inexperienced to know that their ideas are silly: The mistakes novices make come from a lack of experience. They overestimate mere fads, seeing revolution everywhere, and they make this kind...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Regulators probe trading in Dow Jones before Murdoch's bid

US authorities have reportedly launched investigations into suspicious trading in Dow Jones Co. before a bid for the company by Rupert Murdoch's News Corp. Dow Jones received a subpoena from the New York state attorney general's office and an...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Algorithmic trading to take majority share in 2010

More than half of all equities trading in the US will be done using algorithmic dealing systems by the end of 2010, according to Boston-based research consultancy Aite Group. Aite says algorithmic trading has hit the mainstream in the US equities...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Straight forward VC advice from Sequoia

In the crowded field of US venture capital, where arguably too much money is chasing the available quality investments and some firms bemoaning the industry's prospects , Sequoia Capital is on something of a run. Having reaped a reported $495m - or...

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[Source: TradeBlog (TM) .net / Personal Finance Blog]

Will there be any "green" in a Green Economy?

Not sure if this has much finance content. More of an editorial. Sorry, but I dislike when a major variable is left out of the analysis of things.


From Clusterstock: Green Economy Not Yet Ready For Primetime... But It Will Be Soon:

"The WSJ throws around some scary subsidy numbers, saying the government pays too much for renewable energy, and its still not cheap. The Journal says that if we try to hit Obama's mandate for 25% of our energy from renewables we will kill manufacturing. The high price of alternative energy means factories will go under as they struggle to pay the outsized electricity bills....The flaw in this argument is the time frame: Obama only wants to raise our current level of alternative energy consumption from 1% to 10% over the next four years. And then hit the 25% mark by 2025....Also, as long as we keep investing in green technology, technology improvements should rapidly reduce the cost of green power. In the next two years, for example, solar power could reach grid parity"

Let me state up front that I am biased. Not because of any stock holdings. Not because I have forgotten all of my economics (at least I hope not!) But because as a runner/cyclist/outdoors aficionado/citizen worried about the future, I really hope "The Green Economy" takes does well. Why? For a reason that both the WSJ and Clusterstock seemingly ignore: the externalities of traditional energy sources.

Externalities are those costs that the user of the product do not bear. For instance, I can drive around all day in a car that pollutes the atmsophere and yet most of that cost of pollution falls on others. Externalities are notoriously difficult to measure so often we assume them away. But they are real and in any economically correct discussion must be included.

All energy comes with costs. And it is definitely true that "Green" sources have externalities as well (locally there is a major controversey about wind power right now). But I believe (and this is something that can not be proven since we each may have different probabilities on future events) that the expected present value of the externalities from "Green" energy appear to be lower than those of other sources of energy.

Of course this is just my opinion and your mileage may vary.

To compare differing power sources, we really want to be comparing apples to apples and this is not being done.

The question that needs to be answered convincingly is whether government subsidies (which are easily measurable) greater or less than the the externalities (largely not measurable) that accompany more traditional energy sources?

What are these "difficult to measure" externalities? To name a few: pollution (carbon and other), reliance on oil from politically sensitive areas, drilling in pristine wilderness areas, risk of spills, poor diversification of supplies (if I could steal from Taleb "over optimized") which leads to excessive volatility etc.). These externalities are generally not priced in oil (and hence oil is priced "artifically" low), so oil is used more than is strictly optimal in an economic sense.

But "what about nuclear?" some may say. "Look at France. They use much nuclear and have had very few problems" And at some point these nuclear activists have a point. But while the unpriced costs are different, they still exist. The easiest is to understand is the risk of a catastopic event (meltdown etc.). Oh sure the odds are low, but remember Black Swans do happen. And the true cost of that has to be borne in advance.

Why should it be borne in the present you ask? Doesn't this appear to be very similar to the idea of paying large bonuses for good earnings when looming off in the distance was a financial meltdown? Only if the costs are considered a priori will be make the correct decisions. Or in simpler terms, just because something has not happened, does not mean it won't. And if it can, we have to include that in our decisions today.

[Here the reader can flash back a few years to an imaginary conversation at a large investment bank: "Look at Bear Stearns. They take big risks and are heavily levered and they have had very few problems. The cost of debt is lower than the cost of equity. Why don't we do the same? "]

So what should be do? I do not know. I do not think anyone knows for sure, but I will argue long and hard that externalities (both current and future) are as much a cost as the billions of dollars of subsidies for green energy and should be factored into any analysis. Otherwise we are comparing apples and kiwi fruit.

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[Source: FinanceProfessor.com]

Wall Street Journal to Convene Financial Leaders for Its Future of Finance Initiative - MSNBC Wire Services - msnbc.com

Wall Street Journal to Convene Financial Leaders for Its Future of Finance Initiative - MSNBC Wire Services - msnbc.com:

"The Wall Street Journal today announced it will host the 'Future of Finance Initiative,' a working session that brings together top leaders and thinkers in global finance to identify the basic principles on which a new financial system must be reconstructed. The Journal's financial editors and reporters will moderate the discussions, which will be held March 23-24 in Washington, D.C."

The Future of Finance Initiative will feature the following financial leaders:

(Long list including:
* Robert E. Rubin, former U.S. secretary of the Treasury, director
 and former senior counselor, Citigroup Inc.
* Myron S. Scholes, Frank E. Buck professor of finance, emeritus,
 Stanford Graduate School of Business
* Robert J. Shiller, Arthur M. Okun professor of economics, Yale
 University"

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[Source: FinanceProfessor.com]

Behavioral Personal Finance: Customers' Fixation On Minimum Payments

Anchoring is a term often discussed within the realm of Behavioral Finance. Like its closely related sibling heuristics (or using rules of thumb), Anchoring may lead us to expect that a stock price will go back to a previous high just because we remember it being there. It also can give high priced stocks the appearance of being better than low priced stock. Here is an interesting look at what I guess I would call Behavioral Personal Finance.

Customers' Fixation On Minimum Payments Drives Up Credit Card Bills:

"The research, by University of Warwick Psychology researcher Dr Neil Stewart, is to be published in Psychological Science, in a paper entitled �The Cost of Anchoring on Credit Card Minimum Payments�. It focuses on the psychological phenomenon of �anchoring� in which arbitrary and irrelevant numbers bias people's judgments. The research reveals that anchoring affects the way people repay their credit card bills. For those people who make only partial repayments of the outstanding balance (about 35% of card holders), the suggested minimum payment on the credit card statement acts as an anchor and lowers the actual repayments people choose to make."

BTW here are some more behavioral finance posts if you are interested. If you are interested in the field (and I have no idea how you would not be!), Wikipedia has a pretty good intro, but if you have just a bit more time both Jay Ritter and Behavourial Finance.net (Martin Sewell) have excellent "primers" on the field. (HT to Simoleonsense.com)

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[Source: FinanceProfessor.com]

Financial quote of the day

Today is Lincoln's Birthday:

"The government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the government and the buying power of consumers. By adoption of these principles, the taxpayers will be saved immense sums of interest. Money will cease to be master and become the servant of humanity."

As quoted at from Liberty-Tree.ca

Is he calling for monetizing the debt? Might not want him as out next Fed Chair.

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[Source: FinanceProfessor.com]

Muslim investors profit by adhering to faith

This past week in my Problems in Finance class we did a fast review of international finance (I miss teaching that class BTW). In it we did not get to speak about many of the differences based on religion, so I was pretty excited to see this article from the San Francisco Chronicle that will provide me an excuse to mention that strict adherence to the Quaran does not allow lending and borrowing.

Muslim investors profit by adhering to faith:

"Their renunciation of the interest-based economy kept them away from investments in financial services companies, whose stocks have collapsed, and out of traditional mortgages.....Dow Jones Islamic Market Indexes, which represent benchmarks for Islamically correct investment categories, have been outperforming their non-Islamically compliant counterparts by 3 to 4 percent in key indexes.

Of course one year does not mean that much, but it does show that at least last year forgoing debt, for whatever reason, was a good thing!

BTW If you are interested in this, here is a page of notes on Islamic Finance that I used back when I did teach International Finance. I have not touched it in a long time.

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[Source: FinanceProfessor.com]

Cramer's Star Outshines His Stock Picks - Barrons.com

I get more questions every year from students is on Jim Cramer than any other topic (well except "will this be on the test"). Most such questions come in two main flavors: "what do you think of Cramer" or "did you see Cramer talking about ....".

My stock answer is that while I think he is a really smart and hard working person, I have my reservations that anyone can consistently outperform the market and further most of the evidence suggests he can not.

My points were strengthened by Barrons this week:

Cramer's Star Outshines His Stock Picks - Barrons.com:

"The guy is a hardworking genius with a word of advice for everyone...many words of advice, actually. He dispenses thousands of Buy/Sell recommendations a year.....From May to December of last year....Cramer's Sells "made money" by outperforming the market on the downside by as much as five percentage points (depending on the holding period and benchmark). His Buys, however, lost up to 10 percentage points more than the market."

But the article went on to discuss much more. For example Cramer's "prepared buys and sell recommendations" did (SLIGHTLY) better than the lightning round picks. Which might be because of more rigorous analysis but the differences (especially on buys) makes any theory speculative.

Further, recent price movements appear to be a factor in what stocks get discussed and their recommendations. While I am usually not a fan of charts, this one may show why he does not do very well; his buy recommendations are usually for stocks that have gone recently (while his sells are for those that have gone down).

All in all a good article and definitely worth reading.

Two past FinanceProfessor blog articles on Cramer that are of interest:

1. A Barron's article showing his stock picking was not not much better back in 2007.
2. A tirade (which turned out quite prophetic) from 2007 saying that rising rates and falling real estate markets were going to cause a major problem with liquidity.

Unrelated to Cramer but one tidbit in the article that I am looking forward to using in class: EventVestor.com. Seems like an easy way to do event studies that could be used in several classes. Stay tuned on that!

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[Source: FinanceProfessor.com]

SSRN-Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis by Ran Duchin, Oguzhan Ozbas, Berk Sensoy

Durchin, Ozbas, and Sensoy look at Corporate Investment after the Subprime Mortgage Crisis and find much proof that the liquidity crisis is reducing capital spending.

SSRN-Costly External Finance, Corporate Investment, and the Subprime Mortgage Credit Crisis by Ran Duchin, Oguzhan Ozbas, Berk Sensoy:

"We study corporate investment in the wake of the sub prime mortgage credit crisis that began in summer 2007. The crisis represents an unexplored negative shock to the supply of credit for non-financial firms. We find that corporate investment declines significantly following the onset of the crisis. The decline is greatest for firms that have low cash reserves (or high net debt) or are financially constrained, i.e. more likely to face difficulties raising external capital. These results are robust to controls for industry- and firm-specific investment opportunities. We also find that 'excess' cash, as defined by previous work, is positively related to post-crisis investment, suggesting an important precautionary savings role for seemingly excess cash that has not been emphasized in the literature. Overall, our results suggest that an important channel for the effects of the sub prime crisis on the real economy is a tightened supply of credit for non-financial firms."

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[Source: FinanceProfessor.com]

An imperfect hedge: the case of Metallgesellschaft

If you have had me for MBA 610 you know in the "what can go wrong" with derivatives part of the class we usually discuss Metallgesellschaft. It is a classic case of when an imperfect hedge can really hurt you. I just stumbled upon this six minute explanation of what caused their problems that is very good.



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[Source: FinanceProfessor.com]

New feature: Financial Quote of the Day

I am sure I won't do one every day, but seems like something fun to do for a while, so here goes:

"It is wonderful how preposterously the affairs of the world are managed. We assemble parliaments and councils to have the benefit of collected wisdom, but we necessarily have, at the same time, the inconvenience of their collected passions, prejudices, and private interests: for regulating commerce as assembly of great men is the greatest fool on earth."

* Benjamin Franklin as quoted in Dean LeBaron's Book of Investment Quotations, page 119.

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[Source: FinanceProfessor.com]

Financial Quote of the day

This one, which was right on, is by Susan Schmidt Bies (Fed Governor) speaking at a risk Management Conference in December of 2004. Seemingly many financial institutions did not get the message.

FRB: Speech, Olson�Qualitative aspects of risk management�December 7, 2004:

"Although the importance of the quantitative aspects of risk measurement may be quite apparent...the importance of the qualitative aspects may be less so. In practice, though, these qualitative aspects are no less important to the successful operation of a business.... Some qualitative factors--such as experience and judgment--affect what one does with model results. It is important that we not let models make the decisions, that we keep in mind that they are just tools, because in many cases it is management experience--aided by models to be sure--that helps to limit losses."

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[Source: FinanceProfessor.com]

More evidence that correlations increase in bad times

In the typical "wow what great timing" yesterday as we were talking about correlations and diversification in class, SeekingAlpha ran the following article:

Opportunities in a High Correlation World -- Seeking Alpha:

"One of the most striking features of 2008 was the fact that correlations between most asset classes went up substantially: everything declined at the same time. One of the principal motivations behind diversifying is that all of your holdings will not decline at the same time. Declines in one class will be buffered by gains in another�or at least lesser losses in others. This effect has not provided much buffer in 2008."

The article provides some very interesting correlation matrices (uh, that sentence may never have been written before!) showing how correlations went way up as market prices went way down.

This is not the first time that has happened. In fact, it seems to be the norm. Butler and Joaquin (2001) showed the same thing. From their paper Are the Gains from International Portfolio Diversification Exaggerated? The Influence of Downside Risk in Bear Markets:

"The fundamental rationale for international portfolio diversification is that it expands the opportunities for gains from portfolio diversification beyond those that are available through domestic securities. However, if international stock market correlations are higher than normal in bear markets, then international diversification will fail to yie ld the promised gains just when they are needed most...."

This does not mean to not diversify, but rather to realize that diversification may not be enough and that in bad times, you have to expect all assets to more together more. This can help explain why puts (that move in opposite directions) and cash are in such demand during bear markets.

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[Source: FinanceProfessor.com]

SSRN-The Equity Premium in 100 Textbooks by Pablo Fernandez

So which is it? In class this week we have been discussing CAPM and the question has some up a few times as to what is the market risk premium. I guess we are not the only ones who have some uncertainty on this issue. Pablo Fernandez shares with us his working paper on the issue.

SSRN-The Equity Premium in 100 Textbooks by Pablo Fernandez: "[I review] 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and find that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages.

Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premium and Implied equity premium."

A look in:

"... The average is 6.6%. Figure 1 is in line with an update of Welch (2000), who reports
that in December 2007, 90% of the professors used in their classrooms equity premiums between 4% and 8.5%, and with Fernandez (2008) who reports that in June 2008 finance professors in Spain used equity premiums between 3.5% and 10% (average 5.5%).

Figure 1 of the paper is very interesting:

After this he goes on to show what each author has used for the Risk Premium in different editions of the book.

So if you are not sure which premium you should use, I guess you are not alone. What do I use in class? Usually 6% but this follows a discussion of why risk premiums may change (transaction costs, increased/decreased risk aversion, more/less volatile economy).

Interesting work. Must have taken a while to go through 100 text books.

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[Source: FinanceProfessor.com]

Commentary: How to rescue the bank bailout - CNN.com

Joseph Stiglitz has a thoughtful piece on CNN.com. While I disagree with what appears to be a call for the nationalization of more banks, I do agree that rewarding upside without some real downside risk will only yield more risky behavior which will hurt the economy and lead to future blow-ups. My solution I guess would be to both allow temporary nationalizations (but with a hard fast exit date of no more than five years where the bank is either sold or closed) but also bite the bullet and let some banks fail now. Sure it is painful. Sure some will lose jobs, but what is the alternative?

Some look-ins that might help explain why there is no simple quick fix:

Commentary: How to rescue the bank bailout - CNN.com:

"For a while, there was hope that simply lowering interest rates enough, flooding the economy with money, would suffice; but three quarters of a century ago, Keynes explained why, in a downturn such as this, monetary policy is likely to be ineffective. It is like pushing on a string."

Then:

"...came the idea of equity injection, without strings, so that as we poured money into the banks, they poured out money, to their executives in the form of bonuses, to their shareholders in the form of dividends.

Some of what they had left over they used to buy other banks -- to pursue strategic goals for which they could not have found private finance. The last thing in their mind was to restart lending."

And his version of "Debt makes good times great, bad times horrible" and realization the problem is REALLY big:

"Leverage, or borrowing, gives big returns when things are going well, but when things turn sour, it is a recipe for disaster. It was not unusual for investment banks to 'leverage' themselves by borrowing amounts equal to 25 or 30 times their equity.

At 'just' 25 to 1 leverage, a 4 percent fall in the price of assets wipes out a bank's net worth -- and we have seen far more precipitous falls in asset prices. Putting another $20 billion in a bank with $2 trillion of assets will be wiped out with just a 1 percent fall in asset prices.... So they have come up with another strategy: We'll 'insure' the banks, i.e., take the downside risk off of them.

The problem is similar to that confronting the original 'cash for trash' initiative: How do we determine the right price for the insurance?"

Why aren't banks lending?

"But even were we to do all this -- with uncertain risks to our future national debt -- there is still no assurance of a resumption of lending....risks are high in a recession. Having been burned once, many bankers are staying away from the fire...Many a bank may decide that the better strategy is a conservative one: Hoard one's cash, wait until things settle down, hope that you are among the few surviving banks and then start lending. Of course, if all the banks reason so, the recession will be longer and deeper than it otherwise would be."

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[Source: FinanceProfessor.com]

Google Trends: unemployment

With thousands of jobs being lost daily, thought it might be interesting to look at the number of searches for unemployment being done on Google. Not surprisingly the searches are way up (about 3 times as high as a few years ago).

Google Trends: unemployment: "Scale is based on the average traffic of unemployment from United States"

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[Source: FinanceProfessor.com]

DAVOS 2009 - DealBook Blog - NYTimes.com

Davos always creates good news items, interviews, and even class discussions. Keep on eye on the NY Times blog from the festivities.

DAVOS 2009 - DealBook Blog - NYTimes.com:

"A team of reporters and editors from The New York Times and The International Herald Tribune will be in Davos, Switzerland, reporting on World Economic Forum Annual Meeting 2009 from Jan. 28 to Feb. 1. The conference brings together world leaders from politics, business, religion, media and philanthropy. We will be providing updates throughout the day with news and analysis."

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[Source: FinanceProfessor.com]

SSRN-Moral Hazard in Leasing Contracts: Evidence from the New York City Taxi Industry by Henry Schneider

Great for class! Interesting, memorable, and on a topic which students often find boring and forgetful.

Leasing is an important, but understudied method of financing a wide range of assets. Unlike owning an asset where the owner of the asset is also the user of the asset, in a lease (and also in a rental agreement), the asset is used by one party (lessee) and only reverts to the lessor after the contract expires. Thus, it can lead to behaviors that are different than if the owner was also using the asset.

These differing behaviors are generally called a moral hazard problem and can help explain why many treat a rental car differently than their own vehicle.

Henry Schneider takes this idea one step (uh, one mile may be more appropriate) and examines the differences between taxi cab driver behavior when the taxi is leased vs when it is not.

the main finding: Even after controlling for endogeniety problems (that is self selection where safer drivers might be more apt to own), leasing does seem to lessen the maintenance and care of the vehicles and lead to more accidents.

The paper: SSRN-Moral Hazard in Leasing Contracts: Evidence from the New York City Taxi Industry by Henry Schneider:

"...evidence about the leasing moral hazard by examining the New York City taxi industry, which is split between taxis operated exclusively by lessees and taxis with owner-drivers. Lessees have significantly worse driving outcomes than owner drivers:

In 2005, long-term lessees experienced 62 per cent more accidents and 64 percent
more driving violations per mile than owner-drivers, and operated taxis that failed vehicle
emissions and safety inspections at a 67 percent higher rate. Moral hazard is an obvious candidate to explain these differences...contracting over driving outcomes instead of actions also faces obstacles since taxis are typically operated by multiple drivers, which prevents some driving outcomes (e.g., vehicle mechanical failures) from being matched to individual drivers....",

On the endogeneity issue:

"...controlling for driver and vehicle characteristics is not straightforward: As
with most empirical work in contract theory...address this challenge in three ways. First, I
estimate the difference in outcomes between lessees and owner-drivers conditioning on a
rich set of observed driver characteristics. Second, I conduct an instrumental variables
analysis to address the possibility of unobserved driving risk that is correlated with leasing
choice, instrumenting for leasing choice with community norms for taxi-ownership. Third,
I compare the before and after outcomes of the 1,130 drivers who switched from leasing
to owning during the sample period....All of these approaches yield qualitatively similar results..."

and finally:

"After controlling for vehicle usage and driver characteristics, I estimate that moral
hazard explains 34 percent of lessees� violations, 18 percent of their accidents, and 30
percent of leased taxis� vehicle inspection failures."

Cite: Schneider, Henry S.,Moral Hazard in Leasing Contracts: Evidence from the New York City Taxi Industry(November 2008). Johnson School Research Paper Series No. #03-09. Available at SSRN: http://ssrn.com/abstract=1146648

good stuff!!

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[Source: FinanceProfessor.com]

The role of Speculation on oil prices

60 Minutes recently did a piece on the impact of speculators on oil prices that is worth some attention.

Did Speculation Fuel Oil Price Swings?, 60 Minutes: Speculation Affected Oil Price Swings More Than Supply And Demand - CBS News: "'Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that...don't actually take delivery of the oil."

Much later:

"Gilligan said. "I tease people sometimes that, you know, people say, 'Well, who's the largest oil company in America?' And they'll always say, 'Well, Exxon Mobil or Chevron, or BP.' But I'll say, 'No. Morgan Stanley.'"

Morgan Stanley isn't an oil company in the traditional sense of the word - it doesn't own or control oil wells or refineries, or gas stations. But according to documents filed with the Securities and Exchange Commission, Morgan Stanley is a significant player in the wholesale market through various entities controlled by the corporation.

It not only buys and sells the physical product through subsidiaries and companies that it controls, Morgan Stanley has the capacity to store and hold 20 million barrels. For example, some storage tanks in New Haven, Conn. hold Morgan Stanley heating oil bound for homes in New England, where it controls nearly 15 percent of the market. "

Interesting. I should warn you that the video is not ground breaking (for as anyone knows speculation obviously played a role in price swings), but worth including as it shows how far investment banking has gone from traditional investment banking and it has some good insights in the market for oil.

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[Source: FinanceProfessor.com]

Holy Agency Costs Bat Man

Wow. Talk about your agency cost problems.

$1.2 Million Spent On John Thain's Office:

"Amidst everything else going on at Bank of America (BAC) and its boneheaded decision to buy dying Merrill Lynch, Gasparino reports, for the Daily Beast, that John Thain had a ridiculous amount spent on his own perks, including a redecorating of his office.

According to documents reviewed by The Daily Beast, Thain spent $1.22 million of company money to refurbish his office at Merrill Lynch headquarters in lower Manhattan. The biggest piece of the spending spree: $800,000 to hire famed celebrity designer Michael Smith, who is currently redesigning the White House for the Obama family for just $100,000.

The other big ticket items Thain purchased include: $87,000 for an area rug in Thain's conference room and another area rug for $44,000;"

The list goes on, but enough is enough....

Which surely reminds others of the problems at Tyco about 6 years ago. Don't remember? Here are some of what I wrote about it at the time in the old FinanceProfessor Newsletter in August 2002:

"...the ex-CEO of Tyco has pulled the wool over investors� eyes more than anyone knew. It is reported that he received approximately $135 million from the firm that was above and beyond any reported pay. How? $18 million for a plush NYC apartment plus over 2 million to furnish it (where would one find a $6000 shower curtain?!?),
forgiven loans, the payment of the taxes on the forgiven loans, foreign
trips, and even birthday party for his wife that featured a concert by
Jimmy �don�t call me Warren� Buffett. (It seems he was a real world
version of Brewster from Brewster�s Millions!)

and then again in September 2002.

"Tyco: It seems Tyco had more problems than originally thought. Not only did Dennis Kozlowski get many unreported perks from the firm, now reports indicate that others at the firm also partook in the excess. Some had loans forgiven and some rather extravagant (and unreported at the time) perks including $15,000 for dog umbrellas and $2900 for hangers! (Can you imagine the size of the closet?!) One theory behind this lavish spending is that Kozlowski was trying to �buy off� those who knew what he was doing. All told over $170 million may have been taken from the firm. "

In case you were wondering, Kozlowski did end up in jail.

See his 60 Minutes inteview from 2007. It is definitely worth watching and very good. I had never seen it until now. (sorry I can not embed it. Click here.)

A much shorter (and not as good IMO) version with Katie Curic is here:



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[Source: FinanceProfessor.com]

RGE - Everything You Wanted to Know about Credit Default Swaps--but Were Never Told

Ok, this is a clear case of substance over form. Great material, but challenging to compress in the few minutes (ok, so negative minutes-but I am always late, so?? ) I have before I have to go to a meeting. BUT it is very good and I definitely recommend looking over it. I will try to summarize later. Two look-ins now


RGE - Everything You Wanted to Know about Credit Default Swaps--but Were Never Told:

"...if CDSs are not responsible for the financial crisis or the need to rescue financial companies, why are they so distrusted? Some observers may simply be drawing a causal connection between the current financial crisis and something new in the financial firmament that they do not fully understand. Misleading references to the large "notional amount" of CDSs outstanding have not helped. This Outlook will outline how CDSs work and explain their value both as risk management devices and market-based sources of credit assessments. It will then review the main complaints about CDSs and explain that most of them are grossly overblown or simply wrong. Improvements can certainly be made in the CDS market, but the current war on this valuable financial innovation makes no sense."

and later

"In light of the consistent failure of traditional regulation, a sophisticated and intelligent regulatory process should now foster risk-management innovations that have been developed by the private sector, especially the derivative instruments that have greater potential to control risk than government oversight. CDSs are one of these instruments, but not the only one."

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[Source: FinanceProfessor.com]

Why Economics Is Important! (Mises & Keynes, Think So!) | Simoleon Sense

SimoleonSense has the following great piece.

Why Economics Is Important! (Mises & Keynes, Think So!) | Simoleon Sense:

"Economics must not be relegated to classrooms and statistical offices and must not be left to esoteric circles. It is the philosophy of human life and action and concerns everybody and everything. It is the pith of civilization and of man�s human existence��

�In such vital matters blind reliance upon �experts� and uncritical acceptance of popular catchwords and prejudices is tantamount to the abandonment of self-determination and to yielding to other people�s domination.�

�Economics deals with society�s fundamental problems; it concerns everyone and belongs to all. It is the main and proper study of every citizen.�"

I can not tell you at how many family dinners and group runs that the idea that economics should be a required class for all students has come up, but it is in the hundreds. Well said!

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[Source: FinanceProfessor.com]

FinanceProfessor.com Podcast

FinanceProfessor.com Podcast-

Let's see if this goes better this time around. I tried it a few years ago and very few students used it, but it seems like it should at least help those who miss class. So I will begin posting MBA 610 lectures again this semester. The notes (always a work in progress) for the class are largely here.

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[Source: FinanceProfessor.com]

Peter Schiff's Clients Down In 2008

Remember Peter Schiff? How he called the market collapse? If you don't, here is the link to his video that was spotlighted last fall.

Well, it appears that while he seemingly called that correctly, he has not been as good at making money on the call.

From Clusterstock: Peter Schiff's Clients Down In 2008:

".... several clients who claim losses of 40%-70% after investing with EuroPacificCapital. How could this be? Hasn't Schiff been bearish during a horrible year for US equities? Yes, but that negative on US equaties was just a part of his overall strategy"

Which yet again shows how difficult it is to beat the market on a risk adjusted basis.

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[Source: FinanceProfessor.com]

SFA 2009 Annual Meetings

What are you doing this coming November? How about going to the Southern Finance Association Annual meetings? The deadline for paper submission is coming up.

SFA 2009 Annual Meetings: "Southern Finance Association Annual Meetings November 18 - 21, 2009"

"Interested in presenting a research manuscript, or organizing a special session, a panel discussion or a tutorial?
Please complete and submit the Paper Submission or Special Session proposal form at the Southern Finance Association website. The deadline for manuscript submissions, as well as topics for special sessions, panel discussion, and tutorials, is Monday, March 2nd, 2009. Only electronic submissions of papers (in Adobe Acrobat form) will be considered.

Interested in serving as a discussant or session chairperson?
Please complete the Participation as Chair or Discussant form available on the Southern Finance Association website. The deadline for submitting the meeting participation information is Monday, March 2nd, 2009."

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[Source: FinanceProfessor.com]

Lesson One: What Really Lies Behind the Financial Crisis? - Knowledge@Wharton

It is a simple rule, but like many other rules, there is a great temptation to break it. If you are a financial intermediary you should not take positions (i.e. buy and hold), but merely work as a conduit. You make your profits on transactions not market moves. A mental literature review of this idea goes back at least to Hasbrouck and Sofianos (1993) and Madhaven and Sofianos (1998). (True they were writing about specialist firms but the point is the same.

Why is it worth noting today? Because as Jeremy Siegel noted recently not abiding by the "rule" got many financial giants into a whole heap of trouble.

From Knowledge@Wharton:

Lesson One: What Really Lies Behind the Financial Crisis? - Knowledge@Wharton:

"According to Siegel: Financial firms bought, held and insured large quantities of risky, mortgage-related assets on borrowed money. The irony is that these financial giants had little need to hold these securities; they were already making enormous profits simply from creating, bundling and selling them. 'During dot-com IPOs of the early 1990s, the firms that underwrote the stock offerings did not hold on to those stocks,' Siegel says. 'They flipped them. But in the case of mortgage-backed securities, the financial firms decided these were good assets to hold. That was their fatal flaw.'"

The article, based on a presentation Siegel made as part of Wharton's series on the finacial crisis, went on to include these points:

CEOs needed to understand the risks their firms were taking:

"Siegel pointed to two interlocking issues: One is a massive failure, not only by traders, but by CEOs of financial firms, their risk management specialists and the major rating agencies to recognize that an unprecedented housing-price bubble began building after 2000....They believed that as long as home prices kept rising, the underlying value of the real estate would provide a hedge against the risk of such defaults. They failed to realize that this reasoning was based on the assumption that home prices would go in just one direction -- up. In fact, these assets became enormously risky once the housing bubble burst and home prices began their inevitable decline. Siegel also argued that ultimately, the buck stops with corporate CEOs who didn't ask hard enough questions about the risks posed by mortgage-backed assets."

He also had criticism for The Fed (and particularly Greenspan)

""[Greenspan was] the greatest central banker in history -- he had access to every piece of data," Siegel said. "He could have looked at the balance sheets of Morgan Stanley or Citigroup and said, 'Oh my God -- they didn't neutralize their risk.'"'

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[Source: FinanceProfessor.com]

Back to class and back to blogging

Well it is time to restart our engines.

It has been a while. Texas went great. Really got a great deal done. I would encourage others to go volunteer in the area. It may set your pocket book back a bit, but well worth the price. You will help others.

Ok, so fast recap. When classes ended the Dow was at about 8500 it rose to a bit over 9,000 at the start of the year and is now down to about 8200 (down a bit more than 3% since our last class).

In other news, while the speed and surprise of financial difficulties may have abated, financial firms are not out of the woods yet. Recently the Royal Bank of Scotland announced major losses and the need for a cash infusion from the Bank of England. (interestingly RBS was a frequently studied case study in my finance classes in past years for the agressive takeovers.).

As soon as I get my last syllabus in, we can get back to regular blogging. See you soon!

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[Source: FinanceProfessor.com]

Where in the world are you?

hey folks, I am fine. Thanks for the concern.

It is just that I am working with BonaResponds in Bridge City for about 2 weeks. You can read what we are doing on our BonaResponds blog.

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[Source: FinanceProfessor.com]

One Fund, 10 Years, No Annual Losses | Mutual Funds Update | Financial Articles & Investing News | TheStreet.com

Interesting trivia:

One Fund, 10 Years, No Annual Losses | Mutual Funds Update | Financial Articles & Investing News | TheStreet.com:

"....TheStreet.com Ratings team combed its database of open-end equity and hybrid mutual funds to search for such a performer. Astoundingly, we uncovered a single fund that has not suffered an annual loss over the most recent 10 years.

The GMO Alpha Only Fund III (GGHEX Quote - Cramer on GGHEX - Stock Picks) fulfilled its purpose of hedging against losses while successfully investing on the 'long' side of the market to become the only equity or hybrid fund to pass the 10-calendar-years-with-no-annual-losses test for the decade ended Dec. 31, 2008."

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[Source: FinanceProfessor.com]

Why We Take Risks � It's the Dopamine - TIME

We know that most investors are risk averse, but in spite of that, many of us take risks that rationally may not make sense. In class we have generally explained this via a catch-all "Its fun" and people maximize utility not a risk adjusted return.

From science we now have a better grasp on the "it's fun".

From Time: Why We Take Risks � It's the Dopamine - TIME:

"A new study by researchers at Vanderbilt University in Nashville and Albert Einstein College of Medicine in New York City suggests a biological explanation for why certain people tend to live life on the edge � it involves the neurotransmitter dopamine, the brain's feel-good chemical. (See the Year in Health, from A to Z.)

Dopamine is responsible for making us feel satisfied after a filling meal, happy when our favorite football team wins ....It's also responsible for the high we feel when we do something daring,...skydiving out of a plane. In the risk taker's brain, researchers report in the Journal of Neuroscience, there appear to be fewer dopamine-inhibiting receptors � meaning that daredevils' brains are more saturated with the chemical, predisposing them to keep taking risks and chasing the next high.....

The findings support Zald's theory that people who take risks get an unusually big hit of dopamine each time they have a novel experience, because their brains are not able to inhibit the neurotransmitter adequately. That blast makes them feel good, so they keep returning for the rush from similarly risky or new behaviors, just like the addict seeking the next high...."It's a piece of the puzzle to understanding why we like novelty, and why we get addicted to substances ... Dopamine is an important piece of reward."

So, there are risk lovers out there.

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[Source: FinanceProfessor.com]

Putting Bernie Madoff On The Couch - TIME

While it is not a finance article per se, it is interesting and relevant for any class discussion on the Madoff case specifically and many frauds more generally. Especially since it does not fit normal (i.e. rational) economic models.

Putting Bernie Madoff On The Couch - TIME:

"No matter how grand your ill-gotten Bentley or your cooked-books villa, they have to be hard to enjoy when you know that at any moment the jig could be up....

A Ponzi scheme � as anyone smart enough to engineer one knows � is a plan that is uniquely without an exit strategy. It requires a constant infusion of new investors to pay off a growing body of existing ones, and ultimately it becomes impossible to find enough suckers. When that happens, the scam collapses. Sure, you could always flee the country before the roof caves in, but many scammers don't and Madoff famously didn't. The reason lies in the personality � or, more accurately, the personality disorder � that drives them to such frauds in the first place.

Forensic psychologists studying Madoff-type minds start with the usual menu of personality disorders, particularly narcissism. "These people get real enjoyment from doing what they do," says forensic psychologist Michele Galietta of John Jay College of Criminal Justice in New York City. "They feel good pulling the wool over other people's eyes."

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[Source: FinanceProfessor.com]