Category: Personal Finance

Problems with Tax Reform

Problems with Tax Reform

Posted on by David Merkel

As I sit here, my taxes are done, all except for one K-1 that is very late, to put it mildly.? My taxes are complex, but my rule is that I do my own taxes.? If I can’t figure out the code, then I am probably doing something that I don’t understand the full economics behind it, and I should avoid it as a result.? Besides, it keeps me up with trends in the tax code that I might not truly grasp.? Surprises this year included the form for HSAs, and a credit? for promoting domestic production.? I also learned some of the intricacies in accounting for the sale of S corporation stock.? Not fun, but I learned something, and that is good.

It does motivate me to write a piece on tax reform, though.? I don’t fit neatly on the political spectrum: I’m a libertarian on economics, and a conservative on social policy (though conservative really isn’t the right word). Tax reform means different things to different people; let’s consider what it means to conservatives and liberals.

What does tax reform mean to conservatives?

  • Eliminate the estate tax
  • Eliminate the double taxation of dividends
  • Eliminate the marriage penalty (actually should be a goal of liberals, and not conservatives, but hey…)
  • Flatten the tax rate structure
  • Preferentially tax income classes that aid in capital formation
  • More taxation at the state level, less at the federal level
  • Carve out exceptions for political allies that support your broad agenda

What does tax reform mean to liberals?

  • Roll back the Bush tax cuts
  • Keep the estate tax
  • Increase the progressivity of tax rates
  • More taxation at the federal level, less at the state level
  • Preferentially tax wage income at lower rates
  • Carve out exceptions for political allies that support your broad agenda

To me, both of them miss a dimension of the problem.? The main problem is how we define income, not the rate at which we tax income.? Both liberals and conservatives support areas in the tax code that allow for deferral of taxation.? To me, that is a core problem in the tax code.? Taxation should be roughly proportionate to the good that a taxpayer is deriving from society.? As a proxy for that, it should be proportional to his increase in net worth, whether the increase in net worth is liquid or not.

I will use Warren Buffett as my example.? Because he rarely sells stock, his taxes are deferred both personally, and at Berkshire Hathaway.? His net worth keeps going up, and the Treasury doesn’t get a piece of it.? Then he has the nerve to show up on Capitol Hill in favor of the estate tax, a tax of which his estate will pay little, because he has given most of it away.

My view is that people should be taxed like traders, on the increase in their net worth, at the same rate, regardless of where the income comes from.? Taxes would be paid on a mark-to-market basis.? There would be no more tax deferral IRAs or 401(k)s, and even pension earnings would get taxed inside DB plans.? Life insurance and annuities would lose their tax breaks.? Even charitable endowments would be taxed.? Private equity would get taxed off of “phantom income” at a 15% compounded rate, i.e., a private equity fund with $100 million in equity would have to pay taxes on $15 million of phantom income, at the fund if 15% distributions are not made to shareholders.? Truing up would occur at the dissolution of the fund.

Another key component here would be that there would be no separate tax accounting basis — the IRS would use GAAP.? What you report, is what you get taxed on, with the exception that firms that are heavily indebted to avoid paying taxes would get taxed on phantom income, the same as private equity.? Also, all like-kind exchanges would be taxed.? Even real estate would follow the property assessor, and income taxation would occur on the increase.

Then eliminate all deductions, conservative and liberal ones, and you have a tax code that can operate at a low rate because the entire increase of wealth in the economy is being taxed, without exceptions.? Oh, and since the income has been taxed all of the way up, the estate tax is no longer needed.? It was needed when wealthy people could shelter their increasing net worth from taxation.

Objections to this Outlandish Proposal

  • Would you really allow investment losses to reduce someone’s income to zero, or below?? Yes, though there would have to be some safeguards against people who disguise their hobbies to be businesses.
  • This will kill investment; the economy won’t grow without tax deferral!? Nonsense.? Most tax deferral incentives don’t change the amount of investment, but just the forms that the investments go into.
  • Without tax deferral, people won’t buy life insurance, annuities, and corporations won’t provide pensions.? To some degree, yes, but after the shock wears off people will invest for maximum advantage again, and with an eye toward what is best, not what is tax-favored.? With my proposal, I don’t care if people have pensions or savings.? It’s all the same.? Life insurance and annuities will be bought for risk reduction reasons, not tax reasons.
  • This will kill private equity!? It won’t.? It may shrink it a little, but there are many advantage to private equity aside from deferral of taxation.
  • But phantom income will require illiquid investments to retain liquidity for taxes, or require equity holders to fund taxes.? Guilty as? charged.? It changes the business model to that degree.
  • This discriminates against the poor in favor of the rich.? No, it discriminates against the clever rich, who shield the increase in their net worth from taxation.? Taxes delayed often become taxes avoided in entire.? Poor people should pay some taxes.? They benefit from society a little, and taxes would give them greater interest in voting.
  • If there’s no deduction/credit for JKL, then JKL will disappear.? Good, or, maybe I should say, yes, there will be a decrease, but if it is valuable, it will find its own level.
  • This proposal is incomplete!? You haven’t considered a lot of other areas.? No doubt; there would be a lot to do here, should it ever see the light of day.? Let John McCain be a real straight-talking maverick, and adopt a proposal like this.? He could be a real conservative, while offending all of the “conservatives.”

I harbor no illusions here.? We have the tax code that we deserve.? Don’t blame the IRS.? Don’t blame the President or Congress.? Blame those who elected them, and those who failed to vote.? The politicians offer us favors from our own money, and we thank them for it, by re-electing them.? I know that my views of tax reform will never be enacted because it steps on too many feet.? Can you imagine how many accountants, attorneys and actuaries would be unemployed by this?? If they fought hard against TRA ’86, just imagine how they would fight against this.? The politicians like fostering the illusion that they create our prosperity, when in reality, they take a share of it.? A proposal like this, that makes taxation more immediate, and more transparent, would make people more concerned about where their taxes go, because they would feel it more acutely.

And then, after all of this, we should move election day to April 15th.? Let the voters feel acutely what the politicians have decided for raising revenue, and they will render a better verdict.

Broker Solvency as a Marketing Tool

Broker Solvency as a Marketing Tool

Posted on by David Merkel

I received this in the mail on Saturday:

ABC logo

March 31, 2008

Dear Investor,

I am writing to tell you that my firm is in very good financial condition. Normal market conditions would not require this correspondence. But I understand that many people are deeply concerned about the stability of their brokers at this time.

I have always tried to earn my clients? trust by running the firm conservatively, with clients? interests in mind. Today, 75% of the Company?s assets are in cash or cash equivalents and we have no debt. In addition, we have no investments in collateralized debt obligations or similar instruments. As a matter of policy, we do not carry positions or make markets.

Throughout the years, in making decisions about my business, I have always put the safety of my clients? assets first. This is one of the primary reasons my firm clears on a fully disclosed basis through DEF LLC (DEF), a GHI company. DEF clears our clients? trades and is in custody of their accounts. Their name appears with ours on monthly statements and confirmations. As of December 31, 2007, DEF had net capital in excess of $2.1 billion which exceeded its minimum net capital requirement by more than $1.9 billion.

In addition, when you do business at ABC, your account receives coverage from the Securities Investment Protection Corp. (SIPC) as primary protection for up to $500,000, including a limitation of $100,000 for cash. SIPC coverage is required of all registered broker-dealers. Since most ?cash equivalent? money market mutual funds are considered securities under SIPC, investments in money market mutual funds held in a brokerage account are protected by SIPC along with your other securities to a maximum of $500,000. Of course, there is no protection that will cover you for a decline in the market value of your securities. You may visit www.sipc.org to learn more about SIPC protection.

Furthermore, DEF has arranged for additional protection for cash and covered securities to supplement its SIPC coverage. This additional protection is provided under a surety bond issued by the Customer Asset Protection Company (CAPCO), a licensed Vermont insurer with an A+ financial strength rating from Standard and Poor?s. DEF?s excess-SIPC protection covers total account net equity for cash and securities in excess of the amounts covered by SIPC, for accounts of broker-dealers which clear through DEF. There is no specific dollar limit to the protection that CAPCO provides on customer accounts held at DEF. This provides ABC clients the highest level of account protection available in the brokerage industry to the total net equity with no limit for the amount of cash or securities. And, unlike many other brokers, there is no ?cap? on the aggregate amount of coverage for all of our customers? assets. You may access a CAPCO brochure about ?Total Net? Equity Protection? at ABC.com [deleted]?.

If you are concerned about the status of your assets at another brokerage firm, you might consider moving them to ABC. It is easy to transfer assets. If you have friends who are concerned about their brokers, you might consider referring them to us. We continue to offer free trades for asset transfer and referrals. If you have questions about anything in this letter, please feel free to call us at 800-xxx-xxxx from 7:30 a.m. –7:30 p.m. ET, Monday-Friday. Once again, thank you for your trust and your loyalty.

Sincerely,

President and Chief Executive Officer of ABC

I used to do business with ABC, and I presently do business with GHI. Both of them are good firms, doing business on a fair basis for their clients. To me, it is interesting to use financial strength as a marketing tool.

On another level, how many people actually check the solvency of their brokers before doing business with them? On a retail level very few, if any. On an institutional level, that’s a normal check for sophisticated investors.

That said, I would be surprised to see any major retail brokers go insolvent aside from those with significant investment banking exposure. Even there, accounts are segregated, and client cash typically has the option of being in a money market fund.

This is not something that I worry about in investing, but if I were worried about my broker, I would make sure that my liquid assets over $100,000 were in a non-commingled vehicle, most likely a money market fund.

What of Excess Insurance?

Now, I will add just one more note in closing. CAPCO is a nice idea, but I am always skeptical of small-ish insurers backing large liabilities with a remote possibility of incidence. There aren’t that many AAA reinsurers out there, and I am guessing that Berky is not one of them. Buffett does not like to reinsure financial risks, aside from municipal debt. That leaves the AAA financial guarantors — Ambac, MBIA, Assured Guaranty, and FSA (though I am open to a surprise here). I’m guessing it’s the first two, and not the last two. CAPCO is owned by many of the major brokers, but in a crisis, CAPCO has no recourse to its owners, but only to its reinsurers, should that coverage be triggered. The recent financial troubles have led S&P to place CAPCO on negative outlook, mainly because:

Standard & Poor’s assigns a negative outlook when we believe the probability of a downgrade within the next two years is at least 30%. The revised outlook reflects the challenging environment for broker/dealers and their parents. Deterioration in their credit quality and risk-management capabilities could affect CAPCO’s financial strength. In the past couple of months, Standard & Poor’s has revised the outlook on several of CAPCO’s members’ parents to negative. Also, the ratings on a couple of members are on CreditWatch with negative implications, which means there’s the potential for a more imminent downgrade. The capital of CAPCO’s members and–in some cases–their parents is an important resource for mitigating CAPCO’s potential payments for its excess SIPC (Securities Investors Protection Corp.) coverage.

It would be interesting to know for certain the underwriters and terms of CAPCO’s reinsurance. I’m not losing any sleep over it, though… there are bigger things to worry about, my personal broker is well-capitalized, and I have less than $100K at risk in cash, and that is in a money market fund. So long as accounts remain segregated, risks are small.

Eleven Notes on our Cantankerous Credit Markets

Eleven Notes on our Cantankerous Credit Markets

Posted on by David Merkel

1) Note to small investors seeking income: when someone friendly from Wall Street shows up with an income vehicle, keep your hand on your wallet.? One of the oldest tricks in the game is to offer a high current yield, where the yield can get curtailed through early prepayment (typically in low interest rate environments), or some negative event that forces the security to change its form, such as when a stock price falls with reverse convertibles.? Wall Street only gives you a high yield when they possess an option that you have sold them that enables them to give you the short end of the stick when the markets get ugly.

2) When times get tough, the tough resort to legal action.? Financial Guarantee Insurance contracts are complicated, and the guarantors will do anything they can to wriggle off the hook, particularly when the losses will be stiff.

3)? The loss of confidence in financial guarantors has not changed the operations of many muni bond funds much.? With less trustworthy AAA paper around, many muni managers have decided that holding AA and single-A rated muni bonds isn’t so bad after all.? Less business for the surviving guarantors, it would seem.

4) Jefferson County, Alabama.? Too smart for their own good.?? So long as auction rate securities continued to reprice at low rates, they maintained low “fixed” funding costs from their swapped auction rate securities.? But when the auctions failed, the whole thing blew up.? There will probably be a restructuring here, and not a bankruptcy, but this is just another argument for simplicity in investment matters.? Complexity can hide significant problems.

5) Spreads were wide one week ago, even among European government bonds, and last week, as these two posts from Accrued Interest point out,? we had a significant rally in spread terms last week.? Now, credit can be whippy during times of stress, and there are often many false V-like bottoms, before the real bottom arrives.? Be selective in where you lend, and if the sharp rally persists for another few weeks, I would lighten up.? That said, an investor buying and holding would see spreads as attractive here.? When spreads are so far above actuarial default rates, it is usually a good time to buy.? I would not commit my full credit allocation here, but half of full at present.

6)? I don’t fear ratings changes, if that is the only thing going on, and there is no incremental credit degradation, or increased capital requirements.? But many investors don’t think that way, and have investment guidelines that can force sales off of downgrades that are severe enough.? Personally, I think Fitch is best served being as accurate as possible here; they don’t have as large of a base to defend, as do S&P and Moody’s.? So, if downgrades are warranted, do them, and then make the other rating agencies justify their views.

7) I have not been a fan of the ABX indices, and I thought it was good that an ABX index for auto ABS did not come into existence.

8) So what is a auction rate security worth if it is failing?? Par?? I guess it depends on how high the coupon can rise, and the debtor’s ability to pay.? It was quite a statement when UBS began reducing the prices on some auction rate securities.? Personally, I think they did the right thing, but I understand why many were angry.? A complex pseudo-cash security is not the same thing as owning short-term high-quality debt.

9) Then again, there are difficulties for the issuers as well, particularly in student loans.? Not only are costs increased, but it is hard to get new deals done.

10)? GM just can’t seem to shake Delphi.? In an environment like this, where liquidity is scarce, marginal deals blow apart with ease, and even good deals have a difficult time getting done.

11)? Regular readers know that I am not a fan of most complex risk control models that rely on market prices as inputs. My view is that risk managers should examine the likely cash flows from an asset, together with the likelihood of the payoff happening.? With respect to bank risk models, they were too credulous about benefits of diversification, as well as what happens when everyone uses the same model.? Good businessmen of all stripes focus on not losing money on any transaction; every transaction should stand on its own, with diversification as an enhancer in the process.

Seven Notes on Equity Investing

Seven Notes on Equity Investing

Posted on by David Merkel

1) A lament for Bill Miller.? Owning Bear Stearns on top of it all is adding insult to injury.? Now, living in Baltimore, I get little bits of gossip, but I won’t go there this evening.? I think Bill Miller’s problems boil down to lack of focus on a margin of safety, which is the main key to being a good value manager.? During the boom periods, he could ignore that and get away with it, but when we are in a bust phase, particularly one that hurts financials.? When financials get hit, all forms of accounting laxity tend to get hit, making the margin of safety more precious.

2) Now perhaps one bright spot here is rising short interest. Short interest is a negative while it is going up, but a positive once it has risen to unsustainable levels.? What is unsustainable is difficult to define, but remember Ben Graham’s dictum, that the market is a voting machine in the short run, and a weighing machine in the long run.? The value of stocks in the long run will reflect the net present value of their free cash flows, not short interest or leverage.

3)? Now, if you want the opposite of Bill Miller in the value space, consider Bob Rodriguez of FPA Capital.? Along with a cadre of other misfit value managers that are willing to invest in unusual long-only portfolios aiming for absolute returns while not falling victim to the long/short hedge fund illusion, he happily soldiers on with a boatload of cash, waiting for attractive opportunities to deploy cash.

4) Retirement.? What a concept amid falling housing and equity prices.? Though we have difficulties at present from the housing overhang, and the unwind of financial leverage, there will be continuing difficulties over the next two decades as assets must be liquidated and taxes raised to support the promises of Medicare, and to a lesser extent, Social Security.? My guess: Medicare gets massively scaled back.

5) I get criticism from both bulls and bears.? I try to be unbiased in my observations, because amid the difficulties, which I have have been writing about for years, there is the possibility that it gets worked out.? When there are problems, major economic actors are not passive; they look for solutions.? That doesn’t mean that they always succeed, but they often do, so it rarely pays to be too bearish.? It also rarely pays to be too bullish, but given the Triumph of the Optimists, that is a harder case to make.

6) Bill Rempel took me to task about a post of mine, and I have a small defense there, and perhaps a larger point.? Almost none of my close friends invest in the market. It doesn’t matter whether we are in boom or bust periods, they just don’t.? These people are by nature highly conservative, and/or, they are not well enough off to be considering investments in equities.? They are not relevant to a post on investing contrarianism, because they are outside the scope of most equity investing.? They are relevant to a discussion of the real economy, and where your wage income might be impacted.

7) To close for the night, then, a note on contrarianism.? When I read journalists, they are typically (but not always) lagging indicators, because they aren’t focused on the topics at hand. They get to the problems late.? But when I think of contrarianism, I don’t look for opinions as much as financial reliance on an idea.? Many opinions are irrelevant, because they don’t reflect positions that have been taken in the markets, the success of which is now being relied upon.? Once there is money on the line, euphoria and regret can do their work in shaping the attitudes of investors, allowing for contrary opinions to be successful against fully invested conventional wisdom.? But without fully invested conventional wisdom, contrarianism has little to fight.

The Lost Decade

The Lost Decade

Posted on by David Merkel

I’ve written about “the lost decade” before at RealMoney.? A lost decade is where? the stock market goes nowhere, or loses money for ten years.? My purpose in doing so was to point out:

  • That it is normal for lost decades to occur.? Stock returns are weakly autocorrelated.? Good years tend to be followed by good years, and bad years by bad years.
  • Once a generation, you have to get a severe boom and a severe bust.? It is partly driven by monetary policy/financial regulation laxity, followed by tightness.? It is partly driven by the fear/greed cycle, because most people, even professional investors, chase performance.
  • This has a chilling effect on retirement planning.? Recall my recent article on longevity risk.? In that article, I tried to point out the similarities for retirement investment planning between Defined Benefit plans, and an individual with his own unique retirement circumstances, typically with defined contribution plans.

I’ll amplify the last point, because the WSJ doesn’t do much with it.? Nothing kills a DB plan’s funding level worse then a protracted flat/falling equity market, and low bond yields (showing not much alternative for reinvestment).? Same for an individual financial plan.? If a DB plan has an assumed earnings yield of 8%, and the stock market earns zero, and bonds earn 5%, with 60/40 stocks/bonds, than plan earns 2% when it needs 8%.? The funding deficits grow rapidly, and corporations finally bite the bullet, and begin making contributions to their DB plan, cutting earnings in the process.

As for individuals, they should start to save more for their retirements after such a long bad market, in order to get their retirement funding back on track.? Oops, wait.? This is America.? We don’t save personally (particularly Baby Boomers), and our governments run deficits (even more on an accrual basis when we look at Medicare, Social Security, and other long-term inadequately funded programs.? Only our corporations save on net.

So, what to do?

  • Save more.
  • ?Don’t materially increase or decrease allocations to stocks.? Things may be rough for a while longer, until excesses in the US financial system and in China are worked out, but positive returns will recur.
  • Avoid investing in companies with large pension funding deficits.
  • Avoid investments with high embedded leverage, whether individual companies, or ETFs.
  • Be wary of investing in esoteric asset classes this late in the performance cycle.? They may do well for a while longer, but their time is running out.? (It could be one year or another decade.)
  • Be ready for increasing inflation.? Even with the income giveup, it is probably wise to have bond durations shorter than the benchmark.
  • To the extent you can, push back retirement, or plan that you will do it in phases, where you slowly leave the formal labor force.

Of course, you could be a good stock picker, but that’s not a common gift.? The choices are hard when we have a “lost decade.”? There’s no silver bullet; only ways to mitigate the pain.

“Should I be worried about the economy?”

“Should I be worried about the economy?”

Posted on by David Merkel

Most of my friends don’t follow the economy or the markets that closely, so it has been interesting for a number of them to ask me recently, “Should I be worried about the economy?”? The answer isn’t a simple one.

Part of the answer depends on your line of work.? Stuff that’s economically necessary (utilities, staples, government, common services) will probably do okay, though there will be some slackening of demand at the edges.? For example, I visited? a hair salon recently, and asked how business was.? The answer was that customer numbers were unchanged, but that the average purchase level had dropped.? Even government positions, stable as they are will experience some pressure, because budgets have to balance, and tax revenues are starting to sag a bit.

Now if you work in an export-oriented sector, with the dollar down, you will probably do okay.? Demand for food, energy, raw materials, industrial goods, and some technologies will continue relatively strong.

But institutions that rely on credit risk, whether borrowing or lending, will have it tough.? During the boom phase, more and more bodies get added to service the cash flow.? At his point, bodies are coming out of banking, investment banking, real estate, homebuilding, etc.

You can also ask how well capitalized and profitable your current firm is.? This is not a time that rewards high degrees of leverage and short-term financing (unless you are very well capitalized). Volatility rewards firms that have excess capital; it is worth more when times are panicky.

Another part of the answer is how dependent you are on the need for continued external financing.? Can you meet all of your obligations, with some room for error over the next two years?? Do you have excess assets to aid you if you have a sudden crisis?

Finally, if you have investments, look them over.? Examine what investments are sensitive to worsening credit problems, and remove weakly financed companies from your portfolio.? You should have some investments that are inflation-sensitive, like stock in industries that have pricing power (precious few 🙁 ), cash, TIPS, and foreign-currency demoninated bonds.? Now, carefully selected muni, mortgage and corporate bonds have value here, though don’t put on a full position at present.

In summary, it depends on your personal financial position, the firm and industry that you serve, and how much you have prepared to weather bad times in investing.? It’s not a pretty time as the leverage unwinds, but if you planned in advance for the possibility of trouble, then you should do adequately.

Book Review: Easy Money

Book Review: Easy Money

Posted on by David Merkel

Easy MoneyFor most of my readers, this book may prove to be too basic, but we all have friends that are not “money people.” They don’t know how to take care of their finances, and they constantly get into money troubles. This book could be of help to them.

Now, as you can see from the picture, you can see that she refers to herself as, “The Internet’s #1 Personal Finance Expert.” I can’t vouch for that. I like to think that I am aware of a wide number of trends in investing and money management, and this was the first time I heard of her.

There were five main things that appealed to me about this book. First, it’s not a long book (173 pages in the main body of text), and it is simply written, so an average person not good with finances could make his way through it. Second, even though small, it is pretty comprehensive for the finances of an average person or family. Third, I think she gets most issues right for average people who have relatively simple financial problems. Fourth, it provides advice on where to get more data, without marketing herself directly. Fifth, it summarizes action points for each area of personal finance.

I do write about personal finance a little, but you will never get the detailed advice on cash management, budgeting, personal credit, hiring advisors, and shopping smart from me that you will get from this book. My contribution is a more savvy view of investing and insurance. On the latter topic, insurance, I thought she covered the bases well. (As an aside, she shares my bias against variable annuities.)


Now, was there anything that I wasn’t crazy about? I know she wrote a book on the topic, but I think it would have been worthwhile to briefly explain why keeping a high credit rating in this age is so important, because of the effect that it has on insurance premiums, and even employment, leaving aside how much you will pay in interest, and how onerous lenders and creditors will be with you if you ever make a mistake.

Now on investing topics, the book is good but not great. For the average person that doesn’t matter. For those wanting to take a step up, I would recommend The Dick Davis Dividend. She focuses on saving enough (most people don’t save enough), and asset allocation through passive investments. She is a little too bullish on real estate for my tastes. Someone following her advice in these areas will do better than most, if they have the discipline to avoid panic and greed.

But, leaving those quibbles aside, this is a solid book, and those following its advice will benefit.

Full disclosure: If you buy through Amazon.com on any of the books that I review through links on my site, I get a very modest commission.

Personal Finance, Part 15 — How I Buy Cars

Personal Finance, Part 15 — How I Buy Cars

Posted on by David Merkel

When I buy a car, I analyze what car I would like to buy.? I look at reliability, repair costs, overall costs, and style.? I use Consumer Reports to help me analyze this.? Then I go to the website(s) of the manufacturer in question, and copy the data on all of the used models on offer at the dealerships within 30 miles of me.? With price as the dependent variable, I then run a regression with model year as dummy independent variables, and total miles as an independent variable.? After I run my regression, I look at the cars with the biggest price deviations, the predicted price is a lot higher than actual.? I then look at the features of the underpriced cars, and choose one where there are good features with a discounted price.

I go to that dealer, review the car, test drive it, and if it passes my tests, I haggle over the price, and buy it. ? In my experience, this cuts thousands off the price of the car.? What a great reason to have studied econometrics.

One Dozen Notes on Our Crazy Credit Markets

One Dozen Notes on Our Crazy Credit Markets

Posted on by David Merkel

1) I typically don’t comment on whether we are in a recession or not, because I don’t think that it is relevant. I would rather look at industry performance separate from the performance of the US economy, because the world is more integrated than it used to be. Energy, Basic Materials, and Industrials are hot. Financials are in trouble, excluding life and P&C insurers. Retail and Consumer Discretionary are soft. What is levered to US demand is not doing so well, but what is demanded globally is doing well. Much of the developed world has over-leverage problems. Isn’t that a richer view than trying to analyze whether the US will have two consecutive quarters of negative real GDP growth?

2) So Moody’s is moving Munis to the same scale as corporates? Well, good, but don’t expect yields to change much. The muni market is dominated by buyers that knew that the muni ratings were overly tough, and they priced for it accordingly. The same is true of the structured product markets, where the ratings were too liberal… sophisticated investors knew about the liberality, which is why spreads were wider there than for corporates.

3) Back to the voting machine versus the weighing machine a la Ben Graham. It is much easier to short credit via CDS, than to borrow bonds and sell them. There is a cost, though. The CDS often trade at considerably wider spreads than the cash bonds. It’s not as if the cash bond owners are dumb; they are probably a better reflection of the true expectation of default losses, because they cannot be traded as easily. Once the notional amount of CDS trading versus cash bonds gets up to a certain multiple, the technicals of the CDS trading decouple from the underlying economics of the bond, whether the bond stays current or defaults. In a default, often the need to buy a bond to deliver pushes the price of a defaulted bond above its intrinsic value. Since so many purchased insurance versus the true need for insurance, this is no surprise.. it’s not much different than overcapacity in the insurance industry.

4) If you want a quick summary of the troubles in the residential mortgage market, look no further than the The Lehman Brothers Short Swaption Volatility Index. The panic level for short term options on swaps is above where it was for LTCM, and the credit troubles of 2002. What a take-off in seven months, huh?

LBSOX

5) Found a bunch of neat charts on the mortgage mess over at the WSJ website.

6) I have always disliked the concept of core inflation. Now that food and fuel are the main drivers of inflation, can we quietly bury the concept? As I have pointed out before, it doesn’t do well at predicting the unadjusted CPI. Oh, and here’s a fresh post from Naked Capitalism on the topic of understating inflation. Makes my article at RealMoney on understating inflation look positively tame.

7) The rating agencies play games, but so do the companies that are rated. MBIA doesn’t want to be downgraded by Fitch, so they ask that their rating be withdrawn. Well, tough. Fitch won’t give up that easily. Personally, I like it when the rating agencies fight back.

8 ) Jim Cramer asks if Bank of America will abandon Countrywide, and concludes that they will abandon the bid. Personally, I think it would be wise to abandon the bid, but large companies like Bank of America sometimes don’t move rapidly enough. At this point, it would be cheaper to buy another smaller mortgage company, and then grow it rapidly when the housing market bounces back in 2010.

9) Writing for RealMoney 2004-2006, I wasted a certain amount of space talking about home equity loans, and how they would be another big problem for the banking system. Well, we are there now. No surprise; shouldn’t we have expected second liens to have come under stress, when first liens are so stressed?

10) In crises, hedge funds and mortgage REITs financed by short-term repo financing are unstable. No surprise that we are seeing an uptick in failures.

11) As I have stated before, I am not surprised that there is more talk of abandoning currency pegs to the US dollar. That said, it is a getting dragged kicking and screaming type of phenomenon. Countries get used to pegs, because it makes life easy for policymakers. But when inflation or deflation gets to be odious, eventually they make the move. Much of the world pegged to the US dollar is importing our inflationary monetary policy.

12) Finally, something that leaves me a little sad, people using their 401(k)s to stay current on their mortgages. You can see that they love their homes, as they are giving up an asset that is protected in bankruptcy, to fund an asset that is not protected (in most states). Personally, I would give up the home, and go rent, and save my pension money, but to each his own here.

Personal Finance, Part 14 ? Low Investment Expenses

Personal Finance, Part 14 ? Low Investment Expenses

Posted on by David Merkel

Getting help in investing is a tough decision.? Who is worth the money that you will pay?? Precious few.? In equities, I could probably come up with a dozen “long only” managers that have real skill, and are worth their fees with decent probability.? With hedge funds and private equity, the questions are harder, and would have a harder tme judging who has a sustainable competitive advantage.

With bond funds, the answer is simple.? Go to Vanguard.? Almost all bond managers earn roughly the same amount before fees. Over a long period of time, fees make up most of the difference in performance.? In general, low fees work with equities, but with more noise.? With index funds, the lower the fees the better, they are generic.

Now there are a few places where additional money might help.?? Getting a good financial plan done can be worth the money.? For those that are wealthy, advice in limiting tax liabilities is usually worth it, though be careful when things get more complex than you can understand.? Also, insurance products can be useful, but don’t let someone sell you what is convenient for them.? Get advice from someone who won’t earn a commission, and then buy the products that you truly need.

Be careful, do your research, and buy what you want to buy.? Don’t buy what someone wants to sell you.

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