Last year The Lamb began writing this blog.  The experience has been illuminating and more than just a little fun — hopefully, for you as well.  We’ve discussed topics from taxes to trading and from currencies to commodities.  We even had guest posting.

At this time, however, The Lamb will be taking a new job which will prohibit him from dedicating the requisite effort to keep this blog going.  Regrettfully, today’s post will be the last.

The Lamb would like to gratefully acknowledge his loyal readers for their comments and confidence.  He would also like to thank his friends and family for their encouragement and support. 

But The Lamb is most grateful for his beautiful and brilliant wife.  She was the inspiration for this blog as well as its designer, programmer, and chief editor.  Without her efforts, none of the posts over the past several months would ever have made it to your computer screen.

I am, as always, awed by her.

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Well, Maybe Not Taxes


Benjamin Franklin once remarked, “Nothing is certain but death and taxes.”  (The Lamb would add one more certainty — Michigan football will have a weak secondary every season).  We all hate paying taxes, though we realize that it’s a necessary part of life — sort of like having to spit out the seeds when you eat watermelon.

Now along comes Associated Tax Relief.  You may have seen their ads blaring at you on TV.  The company claims to “end your IRS headaches if you qualify.”  On their website, the company boasts of the huge savings provided to some of its clients.  For example, “‘Robert R’ owed $114,625, but settled for $20,688.  Wow!  Great for “Robert R.”  But how about for you?

You get to pay all the taxes that you owe, and your neighbor gets to take the money he owes the government and buy a big-screen television or maybe a speedboat.  The nearly $100,000 that Robert didn’t pay has to come from somewhere.  And that place is your wallet. 

According to Associated’s website, the Robert R situation and others like his are “not necessarily representative of all those who have used our services.”  Thank goodness for that.  Why should other taxpayers subsidize those that don’t pay their bills?  People like “Paula A.”  Paula owed $36,970.20 but, according to Associated Tax Relief, settled for $1,520, barely 4 cents on the dollar.

These are very different situations from those of people who negotiate with credit card companies for lower balances or installment payment plans.  Those are agreements made between two private parties.  And, except for shareholders and bondholders of these credit card companies who may be impacted by these arrangements, Ma and Pa Taxpayer are not forced to subsidize the arrangement.

You may or may not agree with our current tax structure in which, according to an op-ed piece in Monday’s Wall Street Journal:

According to the CBO, those who made less than $44,300 in 2001 — 60% of the country — paid a paltry 3.3% of all income taxes. By 2005, almost all of them were excused from paying any income tax. They paid less than 1% of the income tax burden. Their share shrank even when taking into account the payroll tax. In 2001, the bottom 60% paid 16.3% of all taxes; by 2005 their share was down to 14.3%. All the while, this large group of voters made 25.8% of the nation’s income.

When you make almost 26% of the income and you pay only 0.6% of the income tax, that’s a good deal, courtesy of those who do pay income taxes. For the bottom 40%, the redistribution deal is even better. In 2001, these 43 million Americans, who earn less than $30,500, made 13.5% of the nation’s income but paid no income tax. Instead, they received checks from their taxpaying neighbors worth $16.3 billion. By 2005, those checks totaled $33.3 billion.

However skewed the current tax system may be, each citizen is expected to pay his legally legislated share — no more and no less.  When citizens try to escape this obligation, with the help of outfits like Associated Tax Relief, they are not simply cheating some amorphous entity (the IRS), they are effectively taking money from those that have paid their share.

You likely just went through the joy of filing your tax returns and maybe wrote out a sociable-sized check to Uncle Sam.  If so, just try to watch the following video without getting angry:
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Rule #7 — A Case Study

Commodities, Currencies, Investing, Rule #7, Trading

Inflation — the arch nemesis not just of the fixed-income market, but potentially of a nation’s entire economy (see Zimbabwe).  There has been increased talk of potential inflation in the U.S. as the federal government debt zooms past $11 trillion with ubiquitous predictions of multi-trillion dollar deficits exacerbating the problem.

Obviously, a rising federal government debt has negative implications for future inflation.  However, this is far from the only debt threatening to storm the gates.  State and local governments are facing some of their most trying times ever in balancing their budgets — taxes are being raised and services are being cut — yet bankruptcy is a looming possibility for more and more municipalities.  Add to this the frightening situation over unfunded pension liabilities and you have a recipe for disaster.

Already, fears of governments not being able to fund their growing liabilities are spooking investors.  Just last week, Great Britain was unable to sell 1.75 billion pounds of 40-year gilts (British Treasury bonds).  The hegemony of the U.S. dollar has made it highly doubtful that the U.S. would default on its debt, though by running the printing presses overtime, the government may simply “monetize” its debt, rendering the value of the currency in which the debt is paid all but useless.

Recently, both Russia and China have made noises regarding the risks (to all countries without the initials USA) of maintaining the U.S. dollar’s place at the top of the global currency pecking order.  Last Thursday, China’s mere suggestion of introducing a global reserve currency caused a vicious selloff in the dollar on world currency markets.  Later, a United Nations panel ran with the same idea.  Clearly, a pattern of nervousness is growing in the guts of some of our country’s biggest debtholders (China currently holds a $700 billion-plus IOU with Uncle Sam’s autograph at the bottom of it).

Inflation hasn’t been a huge problem in the U.S. in a generation.  But the days of 18% mortgage rates and WIN (Whip Inflation Now) buttons could be just around the corner.  When inflation strikes, the cost of protection will be prohibitive.  What follows can be thought of as the personification of The Lamb‘s Rule #7 — “If you’re gonna panic, make sure you’re the first.”

There are several ways to protect oneself from the dangers of inflation.  While some are simpler than others, each carries varying degrees of difficulty and liquidity built into it.

*TIPS — An acronym for Treasury Inflation-Protected Securities, these are U.S. Treasury notes that pay a fixed coupon plus the rate of inflation.  For example, the current 10YR TIP carries a real yield of approximately 1.25%.  That means that, if bought and held to maturity, an investor would earn 1.25% plus the rate of inflation as measured by the U.S. Consumer Price Index (CPI).  TIPS can be bought from myriad securities dealers and from Treasury Direct

However, while the coupon on TIPS moves in step with inflation (via adjustments to the bond’s principal), TIPS do not protect investors from increases in market interest rates.  In other words, as real yields rise, the value of TIPS will fall, often precipitously given their very high durations.  Only by concurrently shorting nominal Treasury securities against a long position in TIPS (somewhat difficult from a practical standpoint) can an investor protect himself against an increase in real rates.  As a final caveat, the CPI figure’s components are determined and calculated by the very entity paying the coupon (the U.S. government), creating somewhat of a conflict of interest.

*Rate ETFsExchange-traded funds (ETFs) have been around for several years.  They are relatively liquid and trade very much like stocks.  They were created to enable investors to participate in strategies or to purchase combinations of stocks (similar to mutual funds) in which they would otherwise be unable to.  The PST and TBT ETFs offer a leveraged view on Treasury Note performance.  Their performance is intended to correlate closely with double the inverse total return of different segments of the Treasury curve.

One downside to these ETFs is that rates must increase by enough to cover the coupons earned by the underlying securities.  In other words, unless rates rise by a large amount, an investor would still see her investment decline in value should the rate move be less than the coupon payments.

*Foreign Exchange ETFs —  These ETFs offer investors the opportunity to profit from a decline in the value of the U.S. dollar in relation to other currencies, without the difficulty of trading foreign exchange directly with a currency dealer.  If/when inflation becomes more pronounced as both capital account and current account deficits overwhelm the U.S. economy, the value of the dollar could fall.  These ETFs offer some measure of protection.  The CYB and UDN ETFs offer a short position in the U.S. dollar versus the Chinese Yuan and a basket of currencies (British Pound, Canadian Dollar, Euro, Japanese Yen, Swedish Korona, and Swiss Franc), respectively.

Of course, as inflation rises and the Federal Reserve attempts to fight it, the Fed could raise short-term interest rates (as Chairman Paul Volcker did in the late 1970s).  This could squeeze U.S. dollar shorts as the cost of financing those positions increases.

*Commodity ETFs — Like other ETFs, these funds make it easier for investors to gain exposure to a given asset class, in this case — commodities.  Precious metals such as gold are often considered the “classic” inflation hedge.  However, any commodity denominated in U.S. dollars can serve as an effective inflation hedge.  There are a variety of commodity ETFs available, including ones for gold (GLD), oil (USO), and grains (DBA).  There are also more generic commodity ETFs that cover a more diverse set products, such as the GSG ETF.  Essentially, in purchasing these ETFs, an investor is wagering on the relative value of these products against the U.S. dollar.  In a sense, buying equities accomplishes much the same thing.

*”Hard” Assets — Vacant land, a farm, even the house in which you live (if you own rather than rent) can serve as an effective inflation hedge.  This is perhaps the simplest and easiest way to hedge against inflation.  Simply by owning a home, one can protect against the ravages of inflation.  Owning a home can have a dual benefit, depending on how it is financed.  This leads to the next inflation hedge…

*Financing — As long as payments are affordable, financing a large (80%?) portion of any purchase on a fixed-rate basis, particularly one as large as a home, has several (inflation fighting) advantages.  For example, take a homebuyer who borrows money at, say, 6%.  If inflation and interest rates skyrocket, as occurred some thirty years ago (remember those 18% mortgage rates), not only has the borrower saved himself a huge opportunity cost, but he can essentially monetize his debt to the bank by investing any current savings/income in higher interest bearing instruments, effectively arbitraging the remainder of his loan.  Fixed-rate financing brings with it another built-in advantage — if mortgage rates drop, the homeowner can refinance (assuming adequate equity) at a lower rate, decreasing his monthly payments.  This exemplifies positive convexity, a key benefit of a mortgage’s refinancing option.

*Payer Swaption — This is The Lamb‘s preferred means of inflation protection.  As a background note, The Lamb is a HUGE fan of insurance.  You name the insurance, The Lamb owns it —  health, property, life, long-term care — The Lamb’s got it all.  He likes the safety, the protection, and most of all, the peace of mind.  So, it should come as no surprise that The Lamb likes “payers” as inflation protection.  Like other insurance, a payer swaption can be thought of as an “option premium”, or the cost of buying insurance.  Your “downside” is that nothing happens, and all you’ve lost is the premium you paid for the insurance. 

While most insurance doesn’t pay off, and is viewed by some as a waste of money, try buying hurricane insurance in Miami when a Category 5 monster is in the Florida Straits — you may find it a tad expensive.  It’s the same with inflation.  Buying protection is cheapest before you see the whites of its eyes.

So, back to payer swaptions.  Essentially, payer swaptions give the buyer, in exchange for an upfront premium (just like insurance), the right (but not the obligation) to pay a pre-determined fixed interest rate for a certain period of time beginning at a certain time in the future.  Think of them as puts on interest rates.  For example, if you own a payer swaption struck at 6% and rates are at 8% when the put expires, you would exercise the option and pay a 6% interest rate when market rates are at 8% (as a practical matter, you would “cash settle” the trade, pocketing the present value of the difference between the two rates).

Payer swaptions can be utilized to garner inflation protection while only risking a small cash outlay.  As an example, a payer swaption giving the buyer the right to pay a 5.50% fixed rate (versus a series of floating three-month rates equal to LIBOR) for ten years, beginning in ten years, can be purchased for roughly 3% of the notional amount (e.g. — $30,000 for a $1,000,000 swaption).  A relatively small premium, an investor can lose 3% in just one day of stock market moves. 

If, in ten years, inflation and interest rates are higher, say even at just 7% (just above the average over the past 20 years, and far below the 10% in 1989, and the mid-teens reached a decade before that), the swaption would be worth approximately $100,000 — more than triple the initial premium.  What’s more, unlike other types of insurance, this insurance provides ten years worth of protection.

Via The Bloomberg (click on image for better view):

Historic 10YR Swap Rates

Historic 10YR Swap Rates

Purchasing a payer swaption will help alleviate inflation fears and eliminate the need to walk around wearing a WIN Button on your 1970s sports jacket.  Just remember, buy your inflation insurance before the hurricane warnings sound.

Disclosure:  The Lamb owns CYB, UDN, DBA, GLD, USO, and an apartment financed with a fixed-rate mortgage.  He is currently in the market for a payer swaption.
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Charlie Rangel As Woody Hayes

Regulation, Taxes

The House of Representatives is set to vote today on a measure that would effectively tax MORE than 100% of some Americans’ income.  In an attempt to placate the public’s wrath over bonuses paid to employees at AIG and other TARP recipients, Congress will seek to cut off bankers’ noses to spite America’s face.

As we examine this issue, let’s keep in mind that at many companies, particularly on Wall Street, the term “bonus” is nearly interchangeable with the term “compensation.”  The difference is just semantics.  The rationale for paying the bonus is to have a carrot for employees to strive for during the year (over which time these employees receive comparably less in the form of a salary, or draw).  No performance, no carrot.  While it’s certainly true that some bonuses have been paid for subpar performance, the overwhelming majority are paid as the result of success.

Paying a higher salary and lower (or zero) bonus removes the incentive to perform and increases risk to shareholders, including (now) the government.  The less profitable a given company, the less likely the government is to continue receiving its preferred stock dividend, via the TARP program, and ultimately the return of its original investment.  (Recall that many of these firms were forced, essentially at gun point, to take these government funds whether they wanted them or not — the strings were attached later).

While it is clearly Congress’s intent to strip TARP firm employees of any “excessive” compensation, the effort is misguided.  The vast majority of these “bonus” recipients have generated profits for their respective firms, often far outweighing the losses of their colleagues that Congress is endeavoring to punish.  To paint them all with the same broad brush does a great disservice to the good performing employees as well as to the Treasury’s collective wallet.

Let’s look at this from another angle.  Take General Motors.  Here is a company that has lost tens of billions of dollars, not for one quarter or one year, but year after year after year.  This company has also received billions of dollars of taxpayer money — money that GM was NOT forced to take, unlike the situation at many banks.

Would it be just as fair for Congress to enact legislation confiscating taxing 90-100% of the wages of UAW workers because the company for which they work was (is) a financial disaster?  Similarly, how about the workers at GM subsidiaries such as OnStar?  Many of these employees (one of which is a close friend of The Lamb) received bonuses for contributing to OnStar’s success despite the fact that GM was hemorrhaging money like a broken Vegas slot machine.  If these employees can escape the Congressional tax assessor, why should bank employees whose units were profitable labor under an exorbitant tax regime?

The illustrious Charlie Rangel, Chairman of the House Ways and Means Committee that is shepherding the bill, in explaining how he arrived at the 90% federal tax rate for TARP bonuses, explained, “we figure the local and state governments will take care of the other 10 percent.”

This reminds The Lamb of (in)famous Ohio State football coach Woody Hayes.  Leading archrival Michigan (Go Blue!) 42-14 late in their annual football death match in 1968, the Buckeyes scored a meaningless touchdown to go up 48-14.  Rather than kick the extra point, Hayes elected to attempt a two-point conversion in order to hang half a hundred on The Lamb’s alma mater.  The attempt was good and tOSU won 50-14.

After the game, a reporter asked Hayes why he had decided to go for two.  The old coach growled, “Because they wouldn’t let me go for three.”

In their vindictive attempt to punish successful employees for the failures of a minor few, Congressman Rangel and his legislative cohorts are demonstrating a poorer sense of fair play than Coach Hayes did over 40 years ago.  If they succeed, The Lamb is one alumnus who won’t be singing Hail to the Victors.


In Praise Of The Mesquakie Indians


More than 200 years ago, a French Canadian named Julien Dubuque became the first white man to settle in what would later become the state of Iowa.  At that time, the area was inhabited by the Mesquakie Indian tribe and the main industry was the mining of lead.  Though not the first miner in the area, and certainly not one of the indiginous people, Dubuque was nevertheless one of the more productive miners in the area.

Fortunately for Messier Dubuque, national origin was not a qualification for working with the Mesquakie.  Fast forward a few hundred years.  Enter Senator Chuck Grassley.  The honorable gentleman from Iowa has introduced legislation that prohibits American companies from “replacing laid off American workers with foreign workers.”

Of what long-term remunerative benefit is this to the American or global economy?  Shouldn’t job openings go to the most qualified applicant (acknowledging, of course, that “qualified” includes valid H-1B visas, etc.)?  Augmenting the quality of a company’s workforce increases productivity and profitability, generating greater tax revenue for the government (while lowering the tax burden for others) and maximizing value for shareholders.

Furthermore, according to Jeff Segal of, “many visa holders eventually settle permanently in the U.S., make money and pay lots of taxes.”  Why discourage that?

In a weak economy, especially, the government should take actions to ease, not restrict, the employment of the best and brightest minds from working in the United States.  They should resist temptations to practice discrimination which would keep both innovation and productivity from an American economy when it most needs it.  Hindering competition will simultaneously lower the quality of work while raising its cost for producers — a cost which is inevitably passed on to consumers in the form of higher prices and lower quality goods.

But what of the argument that foreign workers are simply providing the innovation/productivity that would otherwise have been produced by domestic wage earners, and thus “steals their jobs and compensation?”  This week’s Economist, citing a study by Harvard economist William Kerr and University of Michigan (Go Blue!) economist William Lincoln, argues that access to employment of foreign workers actually has synergistic effects on domestic innovation:

When the federal government increased the number of people allowed in under the programme by 10%, total patenting increased by around 2% in the short run. This was driven mainly by more patenting by immigrant scientists. But even patenting by native scientists increased slightly, rather than decreasing as proponents of crowding out would have predicted. If anything, immigrants seemed to “crowd in” native innovation, perhaps because ideas feed off each other. Economists think of knowledge, unlike physical goods, as “non-rival”: use by one person does not necessarily preclude use by others.

Senator Grassley’s legislation is frighteningly reminiscent of the infamous 1930 Smoot-Hawley Tariff Act, but with a side order of xenophobia.  Smoot-Hawley greatly exacerbated the country’s economic recession by restricting the international flow of goods via record tariffs, decreasing imports and exports by over 50%, and contributing to the decade-long Great Depression.

The dangers of protectionism, both economic and social, are risks the country can ill-afford.  While prejudice against foreign workers and foreign goods might serve political expediency, it is a short-sighted and ineffective solution to economic trials, even if it does garner a few extra votes in Dubuque, Iowa for Mr. Grassley.

"Speak American, son"

"Speak American, son."

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All We Need Is One Pin, Rodney

Bailouts, Investing

It has been nearly two years since the beginnings of the current economic crisis.  And while many culprits have been put forth to assume the mantle of blame, the most critical item now on the agenda is the jumpstarting of the U.S. and global economies.

With equity prices down over 50% from their highs and residential/commercial real estate not far behind, asset price deflation is the most visible symptom of today’s economic malaise.  While dismal unemployment statistics certainly play an integral role in consumer confidence and spending, the public is bombarded with daily report cards on the nation’s (world’s) economic health by way of asset price reports, particularly those of equities.

Whether it has been the ubiquitously mentioned Troubled Asset Relief Program (TARP), the Commercial Paper Funding Facility (CPFF), or any other government-led attempt to kickstart the economy, the major flaw in each has been the lack of capital to purchase assets which serve as the backbone for so much of this nation’s daily lending — securitized products.  Knocking down this one pin, the theory goes, will raise asset prices, stimulate consumer and business confidence, and grease the country’s economic gears.

Arguably, a big enough pool of capital aimed squarely at these assets would be sufficient to break the financial logjam and get capital flowing again.  Up to this point, the problem hasn’t been that assets were not cheap enough for investors to buy, but that funding was not available to lend to those who wanted to purchase these assets at current market prices.

Now, the Fed and Treasury have launched the Term Asset-Backed Securites Loan Facility (TALF) to provide as much as $1 trillion in funding for specific, highly-rated asset-backed securities (ABS).  The program certainly has holes — funding will only be available for newly issued securities (not secondary paper), and only for securities rated AAA.

However, as the Fed provides investors with advantageous funding for ABS, prices for these securities should rise, potentially dragging the prices for other similar assets higher as well.  While the TALF is far from a sure thing, its success could represent the knocking down of that one all-important economic pin.

Come on, Rodney!

How many athletes/personalities can you identify in this commercial from the 1980s?  Click here for a list, and contact The Lamb if you recognize others.


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The Only Sure Investment

Bailouts, Investing

“Remember, anyone can do it.  Not everyone will.  The only question is:  Will you?” — Gary Keller, The Millionaire Real Estate Investor

Yesterday, President Obama pledged $75 billion to help alleviate the financial hardships caused by the decreasing value of a single asset class — residential real estate.  The goal is to ameliorate the unfortunate burden of homeowners having to pay monthly mortgage payments that the government says could cause them “financial ruin.”

Among other things, the scheme calls for allocating this $75 billion to as many as 9 million homeowners (less than $139 per family per month, spread over five years — the length of time this program is scheduled to remain in effect).  Call The Lamb naive (he’s been called worse), but does this really do anything to solve the long-term dilemma that home prices remain far above their long-term average of two-and-a-half times median household income?

Quoting a summary of the plan:

“This initiative is intended to reach millions of responsible homeowners who are struggling to afford their mortgage payments because of the current recession, yet cannot sell their homes because prices have fallen so significantly” (emphasis added).

Responsible?  Many of these borrowers purchased an asset, real estate, at a price that was three to four times the amount of their gross annual incomes!  Exacerbating their financial risk (which is now being dispersed to more responsible taxpayers to foot the bill for them), many of these borrowers were leveraged more than the usual four to one (via a 20% down payment).  In fact, some (euphamistically described) “brave” souls even went with the then-ubiquitous (for 2005-2007) no-money-down or negatively amortizing mortgages. 

Responsible, indeed.

Can it really be that surprising to these borrowers that they can no longer afford the payments on that asset?  Several of the bobble heads on CNN and CNBC have posited that banks and other mortgage lenders bear the brunt of the responsibility for homeowners taking on such large debt burdens — if the money wasn’t offered to them, these homeowners would not have borrowed it.

The Lamb calls B.S. here.  That argument is akin to a policy holder blaming a life insurance company for costing him money because he didn’t die in a timely manner!

As long as money is being transferred from the responsible to the irresponsible (or from the economically fortunate to the economically unfortunate, if that is more tasteful), why not give taxpayer money to those that suffered losses in other markets?  Raise your hand if you lost money in the stock market in the past few years.  At least these investments were not nearly as highly levered.  And why stop with equity investments?  How about those that were burned in corporate bonds, commodities, or even art?

Why is real estate being held out above all others as a sacrosanct investment in which people are insulated against loss?  Do we really want a system in which the most leveraged investment opportunity available to most people is insured against loss by other taxpayers?  Is this not the very definition of moral hazard?

Many argue that “you gotta live somewhere.”  Fair enough.  But despite its spelling, RENT is not a four-letter word.  Let’s look at renters for a moment.  Here is a group of people that, for whatever reason, chooses not to purchase a home.  Maybe they can’t afford the down payment (although that certainly was not the issue earlier this decade when a down payment was apparently only for suckers).  Maybe they don’t want to take the risk of fixed monthly payments for thirty years.  It doesn’t really matter why.

What matters is that by not targeting real estate prices as they zoomed skyward for a decade, and then unilaterally attempting to stop their rational descent, government is essentially punishing renters for making what in hindsight was the correct economic decision.  Renters who did not chase irrational (or “unaffordable” if that term is friendlier) prices earlier and could otherwise afford to purchase a home today, are being unfairly kept from doing so by government’s artificial price floor.

“Everyone wants a piece of land.  It’s the only sure investment.  It can never depreciate like a car or a washing machine.  Land will double its value in ten years.  In less than that.  Land is going up every day.” — Sam Shepard, Curse of the Starving Class


Remembering John Galt

Regulation, Taxes

Over fifty years have passed since Ayn Rand penned her classic criticism of government interference in economic matters,  Atlas Shrugged.  For those unfamiliar with this seminal work, it illustrates how government’s proliferation of myriad programs and regulations sabotages the creativity and production of the very economic well-being it desires to improve.

Friday, Congress ratified, and the President is about to sign, the $787 billion economic stimulus bill.  Concealed in the bowels of this 1,000+ pages of legislation is a restriction on executive compensation — thank you, Senator Christopher Dodd of Connecticut.  Proudly announcing his vanquishing of Wall Street gluttony, Dodd crowed:

“The decisions of certain Wall Street executives to enrich themselves at the expense of taxpayers have seriously undermined public confidence in efforts to stabilize the economy.  These tough new rules will help ensure that taxpayer dollars no longer effectively subsidize lavish Wall Street bonuses.”

While at first blush, curtailing pay packages for employees at firms receiving government (taxpayer) funds might make sense, a closer examination reveals more problems than solutions.

James F. Reda, an independent compensation consultant, responded to the new legislation (via The New York Times):

“These rules will not work.  Any smart executive will (a) pay back TARP money ASAP or (b) get another job.”

This highlights just two of the major difficulties with government dictating how companies compensate their employees.  Talented workers will abandon a company shackled by government handcuffs for greener pastures at hedge funds or foreign banks.  This exodus would occur at the very time when their abilities are most needed to help ensure that TARP money is protected and paid back to the government.

Perhaps more importantly, do we really want to incent banks to return TARP money before it is fiscally optimal for them to do so?  Prematurely returning TARP funds carries with it the dual disadvantages of weakening banks’ capital structures and reducing the amount of money available for lending.  The latter cancels out the very purpose of replenishing bank capital — ameliorating the dearth of credit in the system, thereby turning off the lending spigot.

Many of the banks that received TARP funds did not want the funds to begin with.  Back in October when nine bank CEO’s were summoned to Washington, then-Treasury Secretary Paulson stuck a $125 billion gun at their collective heads, ordering them to take the funds.  Furthermore, the money was not given to the banks.  Uncle Sam received preferred stock, paying a 5% dividend (for 3 years, then stepping up to 9% for as long as the firms retained the funds).  Given that the government’s 3-year cost of capital at the time was less than 3%, taxpayers stand to earn more than 2% annually on their money.

If bonuses are limited, companies will be forced to pay higher salaries in order to lure the top professionals to their firms.  This will simultaneously raise banks’ fixed costs, increase their risk, and diminish the incentive for employees to work harder to maximize shareholder value as well as their own remuneration.  Commission-based employees such as loan officers will have little reason to maximize credit availability once their commission compensation approaches the government imposed ceiling.

Dagny Taggart knows how they feel.

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Convexity Bank

Bailouts, Regulation

As the country (world) remains mired in an economic morass, there are as many opinions as to how to extricate ourselves as there are beggars at the collective government trough.  That said, the two most oft-mentioned problems dragging down the economy are the decline in real estate values (both residential and commercial) and the rotting of so-called “toxic” assets on banks’ balance sheets.

The Lamb has written about the former problem.  He remains adamantly opposed to the unilateral rewriting of mortgage terms, especially the reduction of any principal amounts.  Regarding the latter situation, the consensus view now is that, for better or worse, the FDIC will run a so-called “bad bank” that will purchase these toxic assets from banks.  The banks, with cleaner balance sheets, would then feel more comfortable lending, and this, the thought is, will help jump-start the economy.

As has been noted since the initial days of the government’s Troubled Asset Relief Program (TARP), the primary difficulty with a government asset purchase program is coming up with the “correct” price to pay for these assets.  Paying too low a price will leave the banks undercapitalized and do nothing to solve the problem.  Conversely, paying too high a price would saddle taxpayers with losses and reinforce moral hazard issues.

The Lamb discussed the latter problem back in September when the TARP was first brought into existence.  In a nutshell, The Lamb argued against paying 125 cents for a dollar bill.  So, how does this Bad Bank come up with the “right” price to pay for these assets?  The “right” price being one that is acceptable to the banks selling these assets, but one that also carries it with it taxpayer protection.

No financial institution should be forced to sell assets to Bad Bank that it doesn’t want to sell.  Banks that want to sell assets to Bad Bank should submit the asset and the amount of it that they are interested in selling.  Bad Bank would then bid for assets in a ratio equal to the amount of TARP money the Treasury has already invested in these banks in the form of preferred stock (i.e. — banks that have received the most TARP money would be able to sell the most assets).  This would have the effect of bolstering/protecting the preferred stock positions that the Treasury (taxpayer) has already taken.

In order to achieve transparency and reduce the use and risk of taxpayer funds, all Bad Bank bids should be public.  Additionally, any ready, willing and able third party should be allowed to “top” Bad Bank’s bid for any asset.  This will keep as great a portion of the troubled assets as possible in private hands, minimizing the role of the public sector.

Arriving at Bad Bank’s bid price for assets could be done by any of several proposed methods.  As Treasury Secretary Timothy Geithner detailed in his January 21 hearing in front of the Senate Finance Committee, Bad Bank could:

“Look at how the market is pricing similar assets; use computer model-based estimates from independent firms; and seek the judgment of bank supervisors.  They all have limitations.  I think you need to look at a mix of those types of measures.”

Whichever method or combination of methods is used, they must provide positive convexity (the upside for a given degree up-move in the assets’ values is greater than the downside for the same degree down-move) to Bad Bank, hereafter called Convexity Bank.  All increases in asset values will be retained by Convexity Bank.  However, if after a set period of time (say, three years), a given asset has declined in value (as determined by an auction), the bank that originally sold the asset will then have to issue to Convexity Bank common equity in the amount of 110% of the asset’s decrease in market value.  The same downside protection would not be afforded the hypothetical “private” buyer mentioned earlier.

While this may seem to be a bad deal for banks, let’s remember two things.  First, banks have argued that current market prices are not reflective of the potential value of these troubled assets due to extreme and unprecedented market conditions.  This would be an opportunity for them to sell at prices above otherwise-available market bids.  If the banks’ assessment of the situation is correct, they will have succeeded in selling these assets at prices above what the current market price would be in the absence of Convexity Bank’s bid.  Second, banks will not be forced to sell any assets they don’t want to, or at prices they don’t want to.  They would be free to take the risk themselves.

Since common shareholders are the ones that will most benefit from the disposal of these bad assets, they are the ones that should bear the risk of the assets’ decline in value via the risk of future share dilution.  This plan solves the problem of clearing troubled assets from banks’ balance sheets while also addressing the trillion dollar question of determining the “right” price for Convexity Bank to pay for the assets in question.  Furthermore, this plan alleviates the major risk of taxpayers subsidizing the bad investment decisions of banks while aiding in protecting the hundreds of billions of dollars that they have already invested via preferred stock.

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Hope Is Not A Hedge

Investing, Rule #2

In the early 1990s, when The Lamb first began trading, his boss gave him a piece of advice that he has kept in the forefront of his mind ever since:  hope is not a hedge.  The message was simple — if you want to protect a position, then take specific action.  Don’t just hope and pray that things will work out — they usually don’t.

As has been mentioned ad infinitum by the ubiquitous talking heads, today is a historic day for the United States.  A new administration takes the reins of a shaky economy and an equally optimistic constituency.  Comparisons of Barack Obama to FDR and Ronald Reagan have been tossed about as if to signify that all is about to be right in the world.

But despite revisionist history, let us recall that economic difficulties continued or worsened during the first few years of each of the above two administrations.  In fact, economic conditions deteriorated significantly during FDR’s second term in office as Americans came to realize that his alphabet soup public works programs were an ineffectual short-term bandaid for a lethal long-term wound.

Regardless of your political affiliation in general or opinion of Obama specifically, we are all rooting for this administration’s success.  The multi-trillion dollar question, however, is what steps will be taken and, more importantly, what will be the ramifications?

Will we have tax cuts (individual and corporate) or tax increases?  Increased government spending or less?  (OK, I think we all know the answer to that one).  What will the Federal Reserve and the Treasury Department do if/when the dollar begins to slide as short-term interest rates remain near zero while budget deficits and the cost of entitlement programs soar?  Remember, the Fed can control either the price or the supply of money — not both.

As we leave a trying 2008 and enter a (perhaps) riskier 2009, take the time to review your finances.  Remember The Lamb’s Rule #2 — Know and understand what you own, and what you owe.  Determine what can hurt you and actively take steps to protect yourself.  Don’t look back a year from now and regret that you had too much money in equities, inadequate protection from higher interest rates or a weaker dollar, or too much/little fixed-income credit exposure.

Remember, hope is not a hedge.

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