Municipal Bond Update 1

The good news is that the municipal bond market has somewhat stabilized, but I've only made .1% on my investment to date. Fortunately the brokerage I am buying through does not charge for purchases of internal mutual funds. Bonds are difficult/expensive to buy for the average investor given the average size ($1000) and transaction costs ($10 and up at many online brokerages). If you are purchasing less than $100K in bonds, it makes much more sense to purchase shares of a mutual fund. Achieving diversification and keeping transaction costs low is incredibly difficult otherwise.

Municipal Bond Market

This may bore most, if not all, of the few people who regularly read this blog, but an interesting event occurred earlier this week. The municipal bond market has tanked in the last 3 weeks. There are a variety of reasons such as the poor condition of municipal finances, Republicans were elected so the Build America bond program will likely end, and the prospect of future inflation. As an example, iShares Tax-Free Municipal Bond ETF, MUB, fell from $106 a share in October to $99 on Tuesday. This may not seem like a significant drop to those who don't follow the market closely, but to give some perspective, the last time the municipal bond market fell this much was October 2008 during the height of the financial crisis.

In a few previous posts I've mentioned that I don't truly believe that the market is efficient in the short term. In other words, I do not think the market price accurately reflects future cash flows at all times. The latest example is the municipal bond market. While I would not speak highly of the long term prospects for many issues, I do not think that the probability of default or debt restructuring (lowering the principal or interest associated with the bonds) increased over the weekend. Of all debt holders who should be worried, it's Treasury holders. They are accepting absurdly low returns while ignoring the certain pricing change that will occur as the bond market wises up. Much like other investments I've made such as BP, GS, GE (during the flash crash), and others, this is a good opportunity to enter the municipal bond market with the intention of selling after a more realistic price level returns in the near term. The municipal bond market is not very liquid, so a minor movement can affect the fair value of others' holdings. This is what I believed has happened in the last few days. Sanity will likely return and I should make a decent return, 2-5% for about 4-6 wks of investment.

With this investment I intend to publish an update every week with the returns I receive. With any luck, I will not be embarrassed by thought process outlined above.

Don't ask, don't tell

I have been besieged over the course of the past 6 months with Pentagon surveys requesting me to catalog my feelings about serving with homosexual military members.

First and foremost, let me say that I support the idea that homosexual Americans should have the exact same rights and opportunities as every other American. It strikes me as peculiar that we can pride ourselves on being a land of liberty for all yet decide that there is a class of citizens who are entitled to fewer liberties than others. In my opinion, the current debate will be viewed by Americans in 50 years in the same way that we now think of woman's suffrage and civil rights.

Having grown up in a very conservative Christian community, I can understand (but not agree with) the anger that homosexuality induces in some. I cannot, however, find in the Bible where I have been authorized  to impose (share, yes) my own religious beliefs on those around me.

With that said, the current policy is terrible. I have served with openly gay individuals and never did I doubt their commitment to their country or feel threatened by their sexuality. I have shared living quarters with gay people and been oblivious to their orientation.  The notion that the Joint Chiefs of Staff could agree in principle with the equal rights of homosexuals yet request time to take surveys to decide a course of action strikes me as incredible. Since when did we decide that popular opinion was the American method of apportioning rights? Either homosexuals deserve the same rights as all of us, or they don't. There's no morally defensible position whereby the general says, "Sure they have rights, but my soldiers are against it, so I'll pass." I would have been completely understanding if they had dropped DADT, but requested time to put in place policies for actual implementation (does the partner get access to Tricare and military housing, how must living quarters be adjusted.....). What the military's leadership actually did was disgraceful. 

A legitimate plan? That's not what we hired you for!

On February 18, 2010, President Obama created a panel called the National Commission on Fiscal Responsibility. It's billed as a bi-partisan panel, but the self-imposed rules governing the appointment of members meant that the Democrats would appoint 12 of the 18 members, though at a minimum 2 of those 12 can not be "Democrats". The other 6 members were appointed by Republican leadership in the Senate and House. In the end the panel is 10 overtly Democratic members, 6 Republican politicians, and 2 CEOs.

If you're the President, you expected the panel to come back with some sort of rubber stamp of your economic policy. Unfortunately, the 18 panel members are capable of simple math and determined that spending cuts and tax increases are required to restore the American economy. This was met by stunned lawmakers, notably the Democrats who put this thing together and schedule the proposal to be delivered after the election (no politics there of course). The proposal from the co-chairs which was released today is far from earth shattering. This is not the final deliverable as that must be approved by a vote from the entire commission. I outlined some of the items below which I found to be fairly good proposals.

1) Social Security: Raise the eligibility age, index benefits to inflation not wage growth, expand the tax base to include state/local government workers, and expand the tax to higher income levels. All of these are necessary in some form or another; it is impossible to fix Social Security without either raising taxes or cutting benefits. The Social Security eligibility age was initially 65 when the program was first introduced in 1935 and life expectancy was between 60-64 at the time (see page 6 here). The eligibility age is now 67 and life expectancy has increased to just over 78. (By the way, life expectancy means how long a child born in that year is expected to live...example: a child born today is expected to live to 78). Social security was meant to keep the elderly out of destitution, so indexing to inflation provides the individual to access the goods which are required to live.

2) Fix the tax system: Use just 3 tax rates, reduce the availability of deductions (including the mortgage deduction), and tax no income under $30,000. I really like this plan. Raising the standard deduction to $30,000 codifies what is already the case, that low income individuals pay no taxes right now. Whenever a Democrat says, "They're trying to raise taxes on the poor to give tax breaks to the rich," I laugh. The poor don't pay taxes and what the Democrat should say but can't is, "They're trying to cut benefits to the poor so they lower taxes for the rich." I like reducing the number of tax deductions available, especially those related to housing. Tell me, why exactly should the interest on a mortgage of greater than $500K be tax deductible? I disagree in general with the mortgage interest tax deduction, but subsidizing the purchases of large homes doesn't seem like smart public policy. I would also suggest that the deduction should be indexed to geographical areas, but in general the principle seems correct.

3) Cut federal budgets: Freeze federal wages/benefits, reduce farm subsidies, make civil servants contribute to their retirement plan, and so on. Again most of these options seem to be reasonable. The gap between public and private sector pay has disappeared, so there's no reason for Federal employees to enjoy hirer pay and lower career risk. Farm subsidies are just plain ridiculous, subsidizing the manufacture of ethanol which requires more energy to produce that it provides simply highlights what happens when a politician tries to solve a market problem. I also like the proposal to increase the premiums for the military's health care plan, Tricare. As discussed here, this alone costs the Pentagon tens of billions each year. The premiums could be substantially raised and still be lower than the market price of a comparable plan.

There are quite of few excellent ideas in their report, most of which will never make it out the committee since the final report requires a vote by the 18 members to be approved. The trouble is that the co-chairs were right, we are in a bad place economically and fixing it requires pain in the form of cuts to federal budgets and increased taxes.

Having recently received an offer for employment, I calculated my expected yearly tax bill and was horrified to learn it will be significantly larger than my salary when I first joined the Army as a 2nd Lieutenant. The upside to this is my purchasing power now is significantly better that of an individual who was born to a lower middle class family anywhere else in the world. So why don't we just buck up and accept that the Ponzi scheme we have allowed our politicians to put in place can't continue?

P.s. Having read this post before hitting the "publish button," I appear to have assigned far more blame to Democrats than Republicans. That is certainly not my intent, indeed were you to simultaneously start two wars and cut taxes you shouldn't even be allowed to utter the words "fiscal responsibility." I will also add that I find Tea Party members to be in the same intelligence league as the beauty pageant member (What do you want? World Peace!). If you pay attention to all the candidates that the Tea Party has put forward, they all recommend cutting taxes. Asked how they'll pay for this, they reply with some inane combination of cut earmarks and reduce waste. I have news for you, earmarks are a pitifully small portion of the federal budget (less than 1% percent) and there is not exactly a Federal program which comprises of people burning $100 bills all day long. Waste in government means ineffective policies and expensive regulations, it's not exactly easy to find or fix.

Government sponsored blackmail

It has been quite a while since my last post. For the first month that I was writing blog posts I was recuperating from a surgery which allowed me numerous hours to read up on various subjects. Since then, however, I got a job and because they do not pay me to read news articles, I haven't written any new blog posts. This past week has been great in terms of material.

To begin, a mere two hours after the Senate approved the financial regulation this past Thursday, the SEC and Goldman Sachs settled the lawsuit I discussed here and here. A quick summary of my arguments: Goldman Sachs didn't do anything illegal (there's a distinction here between legally wrong and providing markets in products with a negative social utility), the SEC case was politically motivated, and finally, Goldman and the SEC would settle after the financial regulation was signed into law. The framework of my assessment appears to be correct, though the SEC didn't drive an industry wide settlement which is strange and they didn't wait until the President officially signed the legislation which doesn't matter. In exchange for a payment of $300 million, Goldman Sachs seems to have exempted itself from further mortgage backed security investigations. A recent article in the NY Times insinuates that settlement discussions began immediately following the filing of the civil suit on April 16th. The fact that the SEC is involved in politically motivated investigations is unsurprising and certainly not confined to the current administration. The larger lesson that Americans should take from this is the danger of relying on regulators to monitor the financial health of corporations and the country as a whole. They are generally not as smart as their opposition and attuned to the desires of their political masters rather than reality. At some point I'd like to write a blog post on the financial regulation and why I think Paul Volcker might have had the right solution, however messy it is to impliment.

Finally, BP appears to have capped the well and is weeks away from permanently plugging it. This may yet prove untrue (the last time I made this assertion was in June with the "top-kill"). The share price has risen dramatically within the past two weeks, swinging from a low of 26.75 during the last week of June to close at 37.10 on Friday. That's a nearly 39% increase in  three weeks of trading. While I didn't buy all my shares at 26.75, the weeks where it traded around 30 allowed me to get the cost basis for the entire position fairly low. This whole episode has confirmed for me that markets are not efficient in the short term. It seems safe to assert that market participants (those who buy and sell assets such as stocks) tend to be very irrational on the margins, when they are either excessively fearful or happy. I would argue that there was not a significant change from the last week of June to the present in terms of the future liability that BP faces. They may have prevented 3-4 weeks of oil from spilling into the Gulf of Mexico, but my belief is that each incremental barrel of oil spilled has less financial impact than the last. Whether you clean 1 ton of tarballs off of the beach in Pensacola, FL or 1.5 tons, you'll pay roughly the same in total cleanup costs. The actual fines from spilling oil are a much smaller component of the overall liability.

BP did get a surprising helping hand from the government in the form of Kenneth Feinburg. For most of May and June the media and political figures assailed the Obama administration for not taking control from BP. Well they did, and now the blessedly short attention span of the American public has moved on and the government is stuck with the mess. At this point BP can deflect blame for those upset with the size of their claims check to the man hired by the President. Because the spill affected what was already a economically depressed area, it should not be surprising that there will still be an awful lot of upset people 2 yrs from now. Their livelihoods weren't exactly doing well to begin with and Kenneth Feinburg won't be quite the sympathetic cash cow that many were hoping for.

More Cowbell

So another post on BP. I was actually going to write this last night which would have been more timely but instead I inflicted my thoughts on my wife during a car ride. I think she'd prefer me to use this venue.

This past week brought to mind the SNL skit "More Cowbell." You probably have seen it numerous times but for me Christopher Walken is the media, demanding more cowbell, aka anger, from Will Ferrell, the President. Probably not a great analogy, but since I just spent 15 minutes watching SNL skits on Youtube, it works for me.

An article written by Andrew Ross Sorkin and published in Monday's NY Times dealbook postulated that BP could go bankrupt due to the spill. Like most Sorkin articles it lacks any factual support other than rumors circulating on Wall Street. Since every banker seems to have 5-10 hare-brained schemes in the works at any point in time, it's not unreasonable to think that somewhere in Manhattan or London some poor analyst is slaving away building a pitch book to use for meeting with potential bidders for BP's possible carcass.

Sorkin has a bad habit of latching on to trends of the moment and pulling back from them later on. On April 16th, Dealbook, of which he is editor, broke the news of the SEC case against Goldman Sachs. If the chief investment officer of one the largest public employee investment firms in the country is to believed, Dealbook published a 1200 word article with 2 minutes of Goldman being served by the SEC, implying that the story was leaked ahead of time to Dealbook for obvious reasons (such as being gullible and sympathetic). Otherwise, the NY Times should be congratulated for employing the world's fastest readers and typists. Since April 16th a number of articles written by Sorkin have begun to analyze the case after realizing that some very savy finance professionals consider the entire case a farce. Most notable was the 180 he displayed in writing this after moderating the Berkshire Hathway annual meeting and listening to Warren Buffett.

I mention all this to say that no sane investor considers BP to be at risk of bankruptcy. Indeed, Sorkin's own article closes with a quote from Robert Bryce, "Yes, BP is a financially sound now. It is unlikely to go bust near term. Instead, BP will spend the coming decades circling the drain, mired in endless litigation, its reputation irreparably damaged, and its finances weakened." This is more than a little dramatic; the idea that the possibility of a bankruptcy decades from now warrants any attention seems over done. The product BP sells, oil, is indistinguishable from any other firm's, countries have yet to produce sensible energy policies that will wean their citizens from it, and it is not a consumer product. Unlike a case of poisoned food, this crisis will not change BP's revenue, only introduce a new cost that will be spread out, according to a number of analysts, over 5-10 years and total some $30-40 billion, far less than the decrease in shareholder value over the 60 days.

Yesterday during testimony before Congress, Ken Salazar stated that he thought BP should pay damages for oil workers laid off due to the administration's moratorium on new deep-water drilling. This was re-iterated by Robert Gibbs during a press briefing. Among other things, this sent BP's stock into a tailspin yesterday afternoon when it closed at $29.20. There's a slight problem with Gibbs and Salazar's assertion, namely the legal logic due to the absence of proximate cause. The moratorium was announced because the President felt that a thorough review needed to be completed of MMS' procedures since they were "obviously" not stringent enough. BP is required to pay damages for claims where its action are the proximate cause of the loss, but here the proximate cause of the laid off worker is the President's moratorium. The President evidently felt that the scandalous behavior of MMS was a contributing factor to the disaster, but now wants BP to make whole everyone affected by his decision to fix MMS. Nevermind the 15 months in which he let them continue in their old "corrupt" ways.

My guess is this won't hold up in court, but it has a nice ring to it when spouted by the media which is the real reason for making the statement. As with most recent news, BP will continue to take accusation after accusation on the chin until the well is capped so there's little reason for substantial improvement in the short-term (witness my belief this past weekend that the share price would pop up). But for an investor with a longer time horizon, say 12-18 months, BP shares should see significant appreciation.

This morning, BP opened at $31.35, up nearly 7.3% overnight. Absolutely nothing good for BP happened in the intervening 15 hours except that the relief well probably went 30 meters deeper. My suggestion is that investors went home and realized that the President had fully transitioned from being the rational, competent leader to Will Ferrell on the cowbell. Instead of trying to weather the temporary storm of frightful stupidity in the press over the past few weeks, he has become a full fledged participant, willing to say or do anything to make the Christopher Walken shut up.

Note: I've written 3-4 posts on the cheapness of BP and overall ridiculousness of the spill. Though I've not explicitly condemned BP or postulated that they be seized so all those poor Louisianans can feel better about their beaches, readers should not construe this as being supportive of the current state of US energy policy or as indicative of my personal views on the relative merits of a large oil company. The current situation is to me a clear cut case of the market severely mis-pricing an asset, and being a capitalist, I see no problem in profiting from another's fear by purchasing at a discount and holding until sanity prevails. When it returns to a fair valuation, I'll most likely sell my position, it wasn't all that well run to begin with.

Fatwas

Another short post, this article is about a Saudi Fatwa that directs females to give breast milk to unrelated males in order to allow unrestricted visiting. I am unsure as to why they settled on breast milk, why not a blood cocktail? Seems easier to produce, no less weird and just as likely to pass disease.

Islamic clerics have a habit of producing crazy fatwas on a regular basis. See this list on Foreign Policy's website. My personal favorite is the one against Mickey Mouse.

All this makes me glad I don't live under a theocracy regardless of the religion of the leadership.

www.Gapminder.org

There's a relatively interesting website, Gapminder.org, for the nerdy among us. The website's creators have found a way to compile data from various organizations and present it in relatively easy to use formats. The technology now seems to be owned by Google.

You can browse through the graphs but the most interesting is the "Wealth & Health of Nations." I am not convinced that the data is entirely accurate, especially prior to 1900 in developed countries and the last 40-50 years in developing nations, but the general trends should be a close approximation of the truth. As an example, if you track the United States from 1800 to 1880 the life expectancy remains constant at 40. This doesn't seem realistic since life expectancy measures expected life span if current mortality rates remain constant. In that 80 year span there were multiple wars, outbreaks of disease, and so on. The US did have an extremely high population growth rate at the time, so it is possible that it remained relatively constant over that period. For those of you who are history buffs, isolate the Russia, Germany, France, and Great Britain, the effect of war on life expectancy is shocking.

Another graph that is interesting to look at is the GDP vs. Cereal Production per Hectare. A hectare is roughly 2.5 acres and cereals are the building blocks of most people's diets. Generally speaking productivity (in this case yield per hectare) rises with GDP, save for countries that have climate issues, i.e. Australia. The data for this graph isn't perfect since different products have different yields per hectare. I am postulating here that this is why Egypt has such a high yield, but it could also be related to the validity of data from countries with uncertain political systems.

Note: I use wikipedia for source information because it represents a pooling of knowledge that for history, science, finance, or other technical subjects is generally accurate. I only post links if the wikipedia article is accurate at first glance and consistent with other sources.

The Lynching Mob and BP

After the failure of the top-kill, the mob otherwise known as the American public has been whipped into a frenzy by media, politicians, and various misguided citizens. Though I am not an apologist for BP's actions prior to the accident (mostly because there is no clear information if negligence was a factor), I have a perverse delight in monitoring the ridiculous behavior that it has caused. So here's a compilation of some of the more irrational positions taken in recent days.

1. Boycott BP convenience stations - First, many if not most BP gas stations are franchisees, meaning they are not owned by BP but by small business owners. I was trying to find specific data from BP's 10K on the numbers of BP branded gas stations, but I gave up after 10 minutes. If I find the numbers I'll post them later. In Minnesota, Ohio and Wisconsin, BP owns none of the stations with its name on the front and that trend is likely similar across the country. Finally, while these franchises are required to purchase BP products, the actual gas is usually a mix of product from various companies (Exxon, Chevron, Shell, and so on) based on the area of the country you live in. The Department of Energy handily explains this on its website, and it makes sense. Refineries, storage stations, and pipelines are far too expensive for a firm to build exclusive yet redundant capacity. Think about how many of each would be needed if each brand of station required their own infrastructure from the well head to the customer.

2. "There are reports that BP will be paying $10.5 billion – that’s billion, with a B – in dividend payments this quarter” - President Obama on 4 June 2010
I like the way he said this statement but have yet to decide that whether its dumb or brilliantly calculating. BP does pay dividends to shareholders, currently $0.84 per share every quarter (May 5th is the most recent ex-dividend date), but it's $10.5 billion for the year, not the quarter. Since he has a number of bright economic advisors who presumably are aware of what dividends are and how they are paid, I am not convinced that this is an innocent mistake of quadrupling reality. "There are reports" seems to me a way to say something which can immediately be "clarified" at a later date while simultaneously whipping up the emotions of citizens. I also would like to point out that the NY Times ran this without clarification. Whether BP continues to pay out its dividend doesn't matter. It has a legal obligation to pay for the cleanup and all legitimate claims which it has publicly stated it will do. BP made $6B in net income during the quarter that ended on March 31st and had $12B in cash or short term investments. Though the reports of large fines and cleanup costs probably awe most people, it is actually not deadly to a company of BP's size. The bulk of the fines and cleanup costs will be paid over a long period of time, leaving BP plenty of time to save for the eventual expenses.

3. Seize BP - Robert Reich started this bizarre movement. It has since blossomed into a movement of fellow knee jerkers, including the Rev. Jesse Jackson. Beyond the insignificant matter of such a move being potentially illegal, the President already has the authority to do what Reich wants. Reich's stated reasons for temporary receivership range from "getting the truth" to making sure that sufficient resources are being used to combat the spill. As previously discussed, BP's interests are aligned with that of the government due to financial penalties so the likelihood of BP hiding some secret well stopping device seems remote. As for "getting the truth" what happened to subpoenas and the legal system that makes our country not a banana republic? Furthermore, if the US government did exercise temporary receivership, it seems likely to face the potential of getting stuck with the bill. BP would be able to argue that the government's erroneous decisions during receivership lead to increased damages.

It is probably not surprising to readers that I think BP's current share price, $37.16 as of Friday's NYSE close, is too low. I expect that given the success this weekend in containing the spill it will rise sharply tomorrow in trading. Full disclosure, this is profitable for me personally so I suppose I should continue to hope for more moments of hysteria in the coming months.

Gerrymandering

One of the more irritating things about politicians is their habit of gerrymandering congressional districts. Gerrymandering is the process of drawing election districts to blatantly favor one political group over the other. If you have ever wondered why your U.S. Representative seems crazier or more unethical than the average person, gerrymandering is the reason (though I'd argue the absence of term limits has an effect as well). Tom Delay, the former Republican House majority leader, presided over the most ridiculous session of gerrymandering in recent history which resulted in, among other things, Texas State Senators fleeing their state for first Oklahoma and then New Mexico to prevent a vote on the newly proposed districts.

43 states have more than one U.S Representative (Alaska, Delaware, Montana, N. and S. Dakota, Vermont, and Wyoming are represented by a single Representative), but of those 43, 7 states (Arizona, Hawaii, Idaho, New Jersey, Washington, Iowa, and Maine) use independent bodies to draw congressional districts. The other 36 have their congressional districts decided by the state legislature. This of course gives rise to some ridiculous looking congressional districts, but the use of independent bodies does not necessarily guarantee reasonable outcomes.

Take for instance the New Jersey 10th and 13th, each of which are comprised of 2 geographically separate areas, which alternate from North to South. Why is this might you ask? Well it turns out that the 10th district was drawn so that 58% of the population is African American and 15% Hispanic while the 13th is 48% Hispanic and 13% African American (2000 Census data). Take a wild guess as to the race of the Representatives from each district. I am not so naive to suggest that the race of citizens should be completely ignored when drawing congressional districts, but designing them to explicitly support one ethnicity over another seems to be at odds with our stated values.

In states where the legislature completely controls redistricting, the results are not surprising to the cynic. The New York 8th is comprised of two parts, the west side of lower Manhattan and a strip of Brooklyn. The New York 9th has 4 distinct parts, one of which is half an island within the Jamaica Bay Wildlife refuge. Both of these districts were designed to have predominantly (70-75%) white middle-class residents. A bordering district, the New York 10th, is 63% African American and has an average income roughly 2/3 that of the 8th or 9th. Basically, New York's legislature deliberately segmented the state's representatives by race and income in order to protect incumbent politicians. All three districts are represented by someone who has been in office for at least 10 years and generally the only time a new person enters office is when the prior representative dies, gets poltically promoted (becomes a Senator for instance), or goes to jail.

I will comment that I do not disagree with the Voting Rights Act of 1965, which ensures that underrepresented minorities have a voice in Congress. However, state legislatures have managed to apply extraordinarily discriminatory policies in choosing districts, stratifying citizens on the basis of their race, socio-economic status, or political beliefs. If you are a politician or work in politics, this makes perfect sense since it allows you to easily manipulate your constituents. But for the poor voter it results in bitterly partisan representatives who spend the majority of their time preening for the press rather than serving Americans.

The hopelessly optimistic and doe-eyed solution is to require congressional district boundaries to match those of counties and be contiguous. For counties in which the population is very high, the county would be represented by multiple representatives. For example, each congressional district currently has about 640-650000 citizens as of the 2000 Cenus. Cook County (contains Chicago) has roughly 6M residents which would mean the county would have 8-9 representatives. This is obviously more difficult for voters who must choose 8-9 total representatives each election cycle, but it decreases the likelihood of re-electing incumbents while requiring the representative to serve a much more moderate constituency. My opinion is that the end result of such a system would be a more responsive and less partisan elected government. This solution is clearly difficult to impliment, and would require a constitutional amendment. The odds of getting a sufficient number of American citizens to take a break from dissecting the sex habits of Tiger Woods and Jesse James to focus on this issue is low, but a voter can dream.

Note: To see the maps of congressional districts in your state go here.

Army Officer Management

Today's blog post will most likely be extraordinarily boring to the vast majority of readers. To those who served or currently serve in the Army, it is a subject that most of you spent countless hours discussing.

In the past 3-5 years there have been several news reports discussing the increasingly grim retention rates among junior officers (as a sample: here, here, here, and here). Three individuals from the Office of Economic and Manpower Analysis at West Point recently published a series (part 1, part 2, part 3, part 4, part 5, part 6) on officer manning which largely validates some of these concerns.

Their research echoes many of the complaints that I heard among fellow officers. Given their positions, they have access to personnel data which has allowed them to verify what was previously anecdotal evidence passed among lieutenants and captains. Their central premise that the Army focuses on quantity rather than quality certainly rings true and the final solution of an integrated officer management strategy focusing on recruiting, training and retaining talent is far from controversial.

Though I agree with their proposed solution, it seems unlikely that the Army's leadership would replace the current system in which they exercise complete control over each officer's career for a more market based system. In my opinion there are few senior officers who believe that their own intellectual abilities can and will be frequently eclipsed by their subordinates. It is a common problem among military officers to misconstrue experience with talent and therefore ignore future ability. For the proposed solution to occur an entire organization must realize that it has been incorrect for the past 10-15 years. That's no small feat without some outside influence.

The research that they conducted leads to some fairly surprising data:
1. ROTC graduates with 4 year scholarships have the lowest retention rates among officers followed by USMA (West Point). I'd always been told that the lowest retention was West Point but here the data is very clear.
2. OCS now accounts for around 40% of commissioned officers, up from 15% through the late 1990s. Of these OCS graduates, 25% were former E-7s (up from 5%), and percentage of OCS candidates who are below CAT II has increased from 15% to 35%. CAT II refers to a rating which is based on the Armed Forces Qualification Test (AFQT). The AFQT ranks individuals based on their potential for future success in the military. CAT II is the top 35% of the pool of test takers. While I can not attest to the validity of the test (that it does accurately predict future military performance), it is still disconcerting to see the quality of the average OCS candidate dropping.

Why you shouldn't pay off your mortgage early

In an earlier post I mentioned that with a mortgage rate lower than 6% you should not pay off your mortgage early. After reading a few articles that mentioned 30 year conforming fixed rates falling below 5% and 15 year at 4.3-4.4%, this is a good opportunity to walk through the math behind my earlier statements.

Generally speaking, mortgage interest is tax deductible. There are some exceptions, but for the vast majority of Americans the deduction is quite significant. The mortgage interest and other itemized deductions qualified for must exceed the standard deduction for the individual tax filing status, otherwise it is more beneficial to use the standard deduction. At the current interest rate of 5%, a $100,000 qualifying 30 yr loan results in 1st year interest payments of $4966.49. Given these rates, it doesn't take a very expensive home to exceed the standard deduction. Use this calculator to get an idea of the yearly tax savings for specific set of parameters. Based on the tax bracket, the after tax interest rate of the mortgage is the mortgage APR times (1-marginal tax rate). So for a 5% mortgage and someone in the 25% tax bracket, the actual rate paid is closer to 3.75%. This is a "back of the envelope" calculation as it does not utilize the effective interest rate as well as the timing of the tax refund vs. mortgage payments. The mortgage is paid every month but tax refund is received significantly later in the following year, though this can be solved by adjusting the withholding rate. A more precise calculation would result in an actual rate somewhat higher, but not by much (probably around 3.8%).

This low actual interest rate is the reason I would generally recommend against paying off a home mortgage with a rate below 6%. The opportunity cost of this move is significant. If you have the capability of paying off more of the loan than required, you are forgoing the opportunity to invest that sum in an asset with a higher return. Your "investment" in your home by making additional payments is capped at a return of 5%, and it will in fact be lower than that, as shown above. Municipal bonds, which are generally federal income tax free, have significantly higher yields and are less risky than your individual residence. Finally, I personally view future inflation rates as highly likely to be significantly higher than the current 2-3%. Should inflation rise above your mortgage rate, you are effectively paying your mortgage off with more expensive dollars, further compounding the mistake.

Beyond the opportunity cost argument for not paying off your mortgage there exists an issue with the fact that additional mortgage payments can not be easily withdrawn at a later date. If, for example, you had been paying an additional $100 per month towards your mortgage for the past 5 years ($6000 total) and you lost your job or had some other emergency which required a significant amount of money, you can not access this $6000 without refinancing or presumably selling the home. Both of these options are likely impossible, difficult or costly on short notice. Had the money instead been invested in a bond fund, you could turn the entire position into cash within days while also earning a higher return than your additional mortgage payment. This same reasoning holds true for analyzing future expenses, such as car purchases or college tuition. The rates on home mortgages are lower than virtually any other type of loan for most individuals, implying that you should save the additional payments to pay up front for these expenses.

As a side note, the expected price appreciation or depreciation of your home has no bearing on this calculation as you will receive the same sale price regardless of the size of your mortgage.

Oil Spill 2

I watched the President's press briefing yesterday and was somewhat impressed. Though a moderate Republican, I voted for Obama in 2008 mostly due to my inordinate love of pragmatic Presidents. Had the John McCain of 2000 shown up it might have been a different story, but the selection of Sarah Palin (and flirting with the even more ridiculous Mike Huckabee) as a running mate was disturbing to say the least.

Peggy Noonan, an occasional Wall Street Journal columnist, wrote an opinion piece today about the disastrous consequences of the oil spill for Obama. From time to time I enjoy her work, such as when she wrote in October 2008 that Palin was a terrible choice of running mate and a symptom of "vulgarization in American politics," but this article is off-base. Her argument that "He attempted to act out passionate engagement through the use of heightened language—"catastrophe," etc.—but repeatedly took refuge in factual minutiae," was silly to say the least. I have a strong aversion to politicians who avoid factual minutiae and recommend the same position to fellow voters. A leader who develops "gut feelings" about situations without considering the facts does not have the intellectual flexibility that we should demand in a President. Obama made some very valid points: the government's role is not to be the technological leader in the energy industry or this specific incident, BP has the proper incentive to fix the issue, the regulation for drilling needs a great deal of reworking, and the MMS is a mess. Where I thought he erred, at least initially, was to resort to the oft-presented prior administration argument:

"When Secretary Salazar took office, he found a Minerals and Management Service
that has been plagued by corruption for years. This was the agency charged with
not only providing permits but also enforcing laws governing oil drilling. And
the corruption was underscored by a recent inspector general's report that
covered activity which occurred prior to 2007, a report that can only be
described as appalling. And Secretary Salazar immediately took steps to clean up
that corruption."

After 18 months in office, it is time to take full responsibility for issues which develop on your watch. Aside: the deficit is clearly inherited, but if you are not attempting to lower it, you should not try to argue that it is not your fault with a straight face.

Noonan went on to take exception to the philosophy that federal government should have a more significant role in American society. This is where my philosophy differs from the rabidly conservative Republican or Libertarian. Certainly the government should not have a role as a direct market participant (running an HMO for instance) because they are subject to market distorting forces (like getting re-elected) which result in irrational positions/policies, therefore damaging the entire market system. But we should be more than happy to accept a regulatory body which serves the common good of the entire market, establishing regulations and laws which protect the rights of all individuals and corporations equally.

At any rate, it was refreshing to hear a more sensible description of the incident and the response than that of Ken "keep our boot on their neck" Salazar. I reiterate my earlier comments about the current pricing of BP shares. Thanks to our judicial system I firmly believe that the clean-up costs will be significantly lower than the market is currently pricing into the stock.

Gulf of Mexico Oil Spill

Two things stand out about the Gulf of Mexico oil spill: the government's fixation on spinning this event and the market's somewhat baffling response to the event.

Since the containment dome failed to work, the rhetoric from various White House officials has escalated with Ken Salazar recently stating that the government might take over the efforts to stop the leaking well. Nothing scares me more than this prospect. BP and the private sector have the best resources to complete the task, especially when compared to the U.S. government, and certainly have a powerful incentive due to the costs of cleanup and the loss of oil. Carol Browner, director of the White House Office Energy and Climate Change Policy, in one interview with CBS states "The government is in charge" then follows this up by stating the obvious, that only BP or the private sector has the technical know how to fix the situation. Thankfully Coast Guard Commandant Adm. Thad Allen has also said that he sees no need to take over BP's response. Though government involvement and leadership in the cleanup effort might be beneficial, we should all fervently pray that Ken Salazar doesn't decide to throw on a pair of swim trunks and fix the well with his fellow bureaucrats. The administration is clearly in campaign mode, but a rational observer realizes that this is not Venezuela and the President can not do whatever he would like to punish BP or any other private firm. The courts will ultimately decide the firms' liability, not the campaigning politician.

The CBS News Poll (same article as above) which finds that 70 percent of those polled disapprove of BP's handling of the oil spill is laughable. As compared to what? If you disapprove of something that implies that some better solution exists or the current process is wrong. I doubt that the 1,000 people CBS accosted during dinner have any clue as to what is happening or what a better solution is. This is about as newsworthy as reporting that most people find tornadoes unpopular.

The market seems to have overreacted with the share price of Transocean (down 39% since April 21) and BP (down 30%). While the price should certainly have fallen, this has wiped out $45 billion of BP's total market value and $11.2 billion of Transocean's. The oil spill, while devastating, seems unlikely to cost either company that much. In my opinion this represents a good opportunity to invest in either firm, especially BP with its 8% dividend yield. Transocean shares will likely recover faster since it bears limited liability in the oil spill and its rig was insured.

I won't bother readers with details but looking at the balance sheets and income statements for both companies leads me to believe that this represents a good opportunity. January 2012 $50.00 calls (for BP) can be purchased for $4.00. This allows you to purchase 1 share of BP for $50 in January 2012 for a cost today of $4. Not a bad deal in my book.

Goldman vs SEC #2

In a post 8 days ago I said the Goldman Sachs SEC case was foolish and wouldn't stand up in court. I also surmised that it would likely be settled instead. Various news reports indicate that this is now likely to occur. The SEC isn't dumb, this case won't go to court but the settlement will not likely occur until after the President signs the financial reform bill which is currently in reconciliation. As politics go, this saga was a shrewd move by the White House but somewhat disconcerting in that it was intended to capitalize on the relative naivete of the typical voter or CNN watcher. Perhaps the best takeaway from the whole episode is just how clueless Senators are, Sen. Levin takes the cake in my opinion.

A few readers asked about a better explanation of the synthetic CDO, how it's built and why I wrote that the case was a farce. It's probably best to explain this in steps.

1) Goldman Sachs acted as a market maker for this transaction. A market maker's job, simply put, is to match a buyer and seller in the market place. Occasionally in the finance world this requires that market maker take one side of the transaction. For instance, assume investor A wants to sell 100K shares of General Electric at $16 per share and hires Goldman Sachs to do this. Goldman Sachs finds investor B who wants 90K shares at $15.90. A and B settle on a price of $15.95, B buys 90K shares, and Goldman buys the other 10K to facilitate the transaction. It will then sell these other 10K shares to another investor. The market maker's central role is to find a counter-party to the trade desired by their client, Investor A. They could care less about the price as long as it is fair according to similar market transactions. This is very different from a fiduciary. Most people are familiar with that term in reference to a real estate agent hired by a buyer. The fiduciary must act only in the best interests of their client, the buyer. For those of you who have been part of a real estate transaction, it goes without saying that the agent can not be a fiduciary for both the buyer (seeking to minimize the price) and the seller (maximizing the price). This then is a very different role than one played by Goldman Sachs as a market maker and logically follows that you can not be both market maker and fiduciary.

2) John Paulson, a now famous hedge fund manager with a negative view of the housing market in 2006/7, came to Goldman Sachs and requested to short (bet against) the housing market through the use of a synthetic CDO. As explained below, a synthetic CDO is a zero sum transaction where two parties with opposite views on an underlying asset (the housing market in this case) construct a legal wager through the use of credit default swaps. A credit default swap is very similar to your standard home/life insurance policy, for a yearly fee the purchaser gets insurance which pays out if the underlying mortgages default or some other credit event occurs (downgrade, etc...) instead of a fire/earthquake/tornado or death. As an example, Jeff Greene, who is now running as a Democrat for the Florida Senate seat, had the same view as Paulson and purchased $1 billion in credit default swaps (insurance on mortgage bonds) for a yearly fee of $12 million betting that the bonds would default (source: The Greatest Trade Ever.) Greene apparently made about $500-800 million through this investment strategy, quite the payoff.

3) Goldman hired ACA, an investment management firm, to select the assets (mortgage bonds) that the synthetic CDO "referenced." (In keeping with our home insurance policy example, ACA was responsible for choosing the house and the occupants which is what determines the risk of fire). Paulson had a hand in choosing these as well, but the final approval authority was ACA. As I explained below, this is not unusual if you think of any other wager. You would not bet on a horse race without knowing the participants, distance, surface type and so on. For a successful bet to take place, both parties must agree to all the terms. Only the fool hardy would blindly accept the conditions first proposed by the opposing bettor, children on playgrounds instinctively know this. ACA had to keep Paulson happy otherwise he would walk away from the transaction which would cause it to collapse since it requires two parties, one short and one long.

4) ACA and Goldman then found parties to take the other side of the bet. These large banks, IKB and ABN (as well as Goldman), sold Paulson the credit default swaps. The banks agreed to pay him if a default occurred while Paulson paid them a yearly fee.

5) The bonds defaulted soon afterward and Paulson made a fortune (around $1 billion according to various news reports.)

This is a very simple explanation of what happened. The SEC's complaint centers around Goldman allowing Paulson to have a say in the mortgage bonds which were used and whether the banks were informed of this. An impartial observer would conclude that banks must have known there was a party shorting the transaction and that the other party must have agreed to the underlying mortgage bonds. To me, a non-lawyer, this about as ridiculous an accusation of fraud as you could make.

Evaluating Historic Return Data

In researching the first post on Dave Ramsey, I came across a score of blogs devoted to propagating the erroneous investing/debt reduction theories he espouses. Most of the blog writers (biblemoneymatters.com or the Christiandollar.com) share his foibles, generally ignoring math and statistics and stating incorrect return data or advice so poor it seems negligent. The statements that are most irritating are those dealing with historic returns. Since he is a multi-millionaire and NY Times bestseller, my intuition tells me that most people believe the numbers he throws out. So let’s set the record straight.

First, when considering the historical returns of any asset, use inflation adjusted figures. The purchasing power of a dollar erodes over time, you clearly cannot buy with the same dollar in the future an amount of goods equal to what you can today. The inflation rate is based on the Consumer Price Index, and while there are some disagreements over the content of the basket of goods that the CPI tracks as well as the way it is calculated, it is generally accurate. Interestingly enough, CPI or inflation is up 126% since the month I was born. This doesn’t mean that everything is 126% more expensive, just that the whole basket is.

Second, historical returns should be calculated using the compound annual growth rate (CAGR), not average annual returns. Averages tell you what to expect, +/- some standard deviation, in any given year. But when you invest, you don’t pick a random year - you invest in yr 1 and withdraw any number of years later. What matters then is how the value of that dollar rose in the time you had invested. CAGR is the annualized rate your investment would have grown if there were a standard deviation of 0%, which is what Dave Ramsey and his ilk would like you to believe average annual rates are. Imagine that you can invest for 10 yrs, the first 9 of those the return will be + 9% and in the last year, -20%. The average annual return is 6.1%, but the value of your $1 is now $1.73 rather than the $1.80 that the average annual return suggests. You can google CAGR if you wish, but broadly speaking, average annual returns ignore the standard deviation of expected returns and give you incredibly inflated numbers.

All that brings us to what return we should use in our long-term planning. The S&P 500 has a CAGR of 6.68% from 1871 to 2009 with standard deviation of 18.83%. The ending point here clearly has an effect on the data, but bottom line, expect 6-8% and around 20% standard deviation. That’s significantly lower than what you see Dave Ramsey preach. Why he says 12% I can’t say. It may be that he doesn’t understand inflation or CAGR, he believes it will make you feel better about investing or that it will makes the other steps of his plan make more sense. Whatever the case, he's wrong and this error is fatal to the rest of his investing advice.

Finally, historical returns on real estate are not great when compared to other asset classes. Robert Shiller, an economist at Yale, has analyzed historical residential returns and found them to outstrip inflation by roughly 3% per year. So when Dave suggests you invest in real estate or pay down your home mortgage, you’d be better off investing in a bond index which would achieve higher returns with less risk. This, in a nutshell, is my argument about why if you have a cheap fixed rate mortgage (anything under 6%), you should never pay it off early. All that money you used to pay it off could have been invested in something with a higher return and less risk (both systematic and idiosyncratic) like municipal bonds or corporate debt. In return for paying off your mortgage, you now have an investment vehicle which returns less than a risk free asset and is exposed to all sorts of risk (especially idiosyncratic).

Note: systematic risk – the risk that the entire country’s residential real estate market falls. Idiosyncratic risk – you bought a house next to the future interstate expansion, put a hot tub in the living room, and painted the rooms that god-awful color scheme.

Secretary Gates and the Sacred Cows of DoD

In a speech on May 8th, Sec. Def. Gates vowed to cut $15B from the Pentagon's annual $550B budget. He is, in my opinion, acknowledging the obvious: the long term economic outlook for the US, regardless of your political affiliation, doesn't support the current level of defense spending even if kept at the current level of GDP. It's not that difficult to grasp that we spend far more than any other country or many combinations of countries, even if some countries (China) disguise portions of their military budget. Rest assured, there are plenty who find Sec. Gates' statements irrational and advocate a significantly higher budget based in part on long-term defense spending to GDP ratios. Maintaining a set ratio is not a credible argument, after all the measure of effective defense spending is DoD's ability to protect national interests. Few will agree that increased defense spending somehow guarantees an improvement in the ability to project power or protect interests, especially in relation to near competitors. In any event, within the medium term (3-7 years), members of Congress who currently defend the necessity of the unwanted C-17 will have to weigh choices forced on us by long-term debt and yearly budget deficits. The cold calculus of voting makes choices between school lunches, social security checks, or toys for generals much easier to decide.

The proper size of defense spending is clearly a subject with no easy answer, however, I believe it should be smaller because DoD is an inefficient user of what it has. Giving an alcoholic an extra case of Jack Daniels won't fix their underlying problem. Gates' comments about the increasing costs of health care are well timed due to a recent sport induced medical surgery. After receiving the first bill, I priced the difference between Tricare (DoD's health care plan for non-Active duty personnel) and other common health care plans. Tricare Reserve charges a monthly premium of $50 (regardless of sex or age), has a 15% cost share, $150 deductible, and caps yearly medical expenditures at $1000 (known as a catastrophic cap). This is significantly better than any other private medical insurance. A Blue Cross/Blue Shield plan with the most comparable coverage costs a 28 yr old male non-smoker from Texas $302 a month, requires a $250 deductible, 15% cost share, and a $3000 catastrophic cap. If that pricing difference tells you anything, it's that DoD must be paying a significant amount of money every year to make up the difference between premiums and medical expenditures for non-Active duty Tricare members. In my case alone, assuming a small profit margin of 5% for a private insurance company (go here and look for "health care plans"), the same level of risk is being priced at a $2850 yearly premium to Tricare by a private sector company. This premium difference is for a 28 yr old male only and Tricare charges all ages/sexes the same amount. That same Blue Cross plan would cost $540 a month for a 38 yr old female; without a doubt, the average Tricare patient is much older and not 100% male. Let's just assume that if there are conservatively 5-7M non-Active duty individuals who DoD insures through Tricare, the yearly cost of undercharging participants is somewhere between $14-39B. The IRS publishes the number of people who actually pay taxes in the US, in 2007 there were roughly 96M filers who paid an income tax of any amount. In 2006, according to the CBO, individuals accounted for 43% of tax revenue directly. All that to tell you this: subsidizing health care for DoD non-Active dependents directly costs the average individual taxpayer $60-168 yearly. The alternative would be to significantly raise Tricare premiums, at least to a more reasonable discount (like 50%) of private insurance plan rates. While no one likes increased bills, subsidizing health care in this manner does not seem efficient. Perhaps it would be smarter to raise the premium and provide need based subsidies, that it would at least be more equitable.

As a side note, this is also an example of why you don't want the Government to run a national health care plan but should prefer instead more regulated co-op like market participants. The rates that people should be charged aren't subjective, some nerdy actuary sits in a room far from sunlight, pours over statistical models and determines the probability of an individual with a specific age, height/weight, gender, and permissible lifestyle choices becoming sick. Alas, sticker shock ensues and your Congressman sticks his running-for-reelection finger in the air and declares the resulting cost far too high. A year later, risk remains the same, you pay a smaller premium that garners your vote and allows you to continue those unhealthy habits , and the "rich guy's" taxes go up to pay for the resulting mis-pricing of risk. In 10 years, everyone's taxes go up because the politician can't keep his hand out of the cookie jar of votes.

Goldman Sachs SEC Case

I wrote this in an email to someone else a few weeks ago, but thought it would make a good post. Most people are probably familiar with the civil fraud case brought against Goldman Sachs by the SEC. This presentation given by a professor at Stanford last month is a useful explaination of the other side of the story - that the SEC brought a highly partisan case against an unpopular firm with little probability of succeeding. Now faced with proving this to an educated judge/jury, a far more likely outcome is that the SEC accepts the futility of this lawsuit and negotiates a Wall Street wide settlement comprised of new (and much needed) rules on derivatives and as well as some meaningless amount of money (like $20B, sounds like a lot to voters but not much when you spread it across dozens of parties).

I personally am unconvinced that Goldman's behavior was illegal in any sense, though the social utility of a synthetic CDO escapes me. While their actions do not look good to mainstream America, people always look bad when they are right and the majority is wrong and looking for a fall guy. If the argument is that market makers in illiquid complex securities should have some fiduciary responsibility to buyers and sellers, then I might find that an interesting point of debate. But unfortunately for the SEC, the law has very different definitions of a fiduciary and market maker, simply put a fiduciary has to act in the client's best interests while a market maker just has to offer a fair market price. I would love to see the flip side of this “fraud” prosecuted wherein investor A mis-prices their securities and through a market maker sells them to investor B whose opinion proves instantly correct resulting in profits, i.e. arbitrage. Should the market maker then be required to inform the participant of the relative wisdom of his decisions prior to executing the order? Of course not, the investor is responsible for evaluating assets prior to buying or selling them.

ACA was the final authority on securities in the portfolio and as much as the SEC would like you to believe otherwise, they had to have approved every single asset in the portfolio. Furthermore, the short position would have to be permitted some input in the formation of portfolio since this was a synthetic collateralized debt obligation (CDO), a zero-sum game where shorts must equal longs. Synthethic CDOs only mirror the performance of other assets, in this case CDOs (click through for explanation of a CDO) comprised of mortgage backed securities (MBS). To grossly oversimplify, this is analogous to wagering on a football game. Two parties each wager $100 and the bets perfectly offset (A bets $100 that team X loses, B bets $100 that team X wins), neither the existence of the bet nor the possibility that Mike Dikta is person B affects the outcome of the actual game. In a similar fashion, who is long or short the synthetic CDO is immaterial, it won't affect the performance of the underlying CDO in any manner. It would make no sense for the person on the short (losing) side of the bet, either football or synthetic CDO, to not care about the identity of the underlying team (bond). No sane investor would give Goldman their money and just tell them to short a random pool of securities. The SEC probably scored some brownie points with its political masters, but the judge/jury that presides over this will have slightly more cognitive ability than your average NY Times reporter or MSNBC talking head.

On a side note, I find it much more disturbing that the Moody’s employee, Eric Kolchinsky, believes a seller or buyer’s identity to be material to the valuation of the asset. That seems to be his argument when he says that he would have rated them differently if he had known that John Paulson would short these. I am frankly appalled that Senators, or at least their staffers, did not recognize the outrageous nature of this statement immediately. For the investing illiterate, imagine that when you purchase a home, the home inspector sizes you up before the inspection. He concludes that you are either very knowledgeable about carpentry, electricity, and plumbing or that you have not a clue. If you are the former, you get a detailed inspection, the latter (95% of all home buyers) just get charged a fee and receive an inspection which is significantly less rigorous. Moody's is supposed to be an impartial observer, evaluating the assets with the same degree of concern regardless of the parties involved. When Kolchinksy attests that he would have paid closer attention to the deal had he know that Paulson held the short position, he is implying that the quality of his work as rater depends on his perception of the investor. It could alternatively mean that Kolchinsky did not understand that a synthetic CDO requires a short investor, but I will go out on a limb and surmise that while he is apparently not a bright individual, he can not possibly be that oblivious. I do personally think Kolchinsky isn't very bright, and offer as evidence his own statement as well as the fact that Paulson's investing prowess wasn't well known until a year after these deals occurred in early 2007. In other words, Kolchinsky is wrong to think Paulson's identity matters, and even less believable for thinking that he would have used it at that time. Be that as it may, if I ever invested in a deal that was rated by Kolchinsky's team, I would begin considering a civil fraud suit against Moody's for any deal that blew up on me.

Interestingly enough, Sen. Levin questioned Daniel Sparks, head of Goldman Sachs' mortgage desk, on this very subject and Mr. Sparks expressed astonishment that a Moody's employee would say something like that. Senator Levin was lost in the sauce (not just at the moment, the entirety of his performance during the panel leads me to question his ability) and the whole episode floated well over his head as well as those of the reporters in the room. It is equally troubling that Pulitzer prize winning reporters don't pick up on this as the real story. Moody's and S&P are the largest rating agencies in the world, and in any given week their credit upgrades/downgrades are responsible for more market movement than the mortgage desk at Goldman Sachs. If they are not competent enough to do their job on a synthetic CDO, what about whole countries like the PIIGS (Portugal, Ireland, Iceland, Greece, and Spain)?

Dave Ramsey

I have noticed to my chagrin the growing popularity of Dave Ramsey in the past few years. While no doubt helped along by the housing crisis and following rise in unemployment, many people have endorsed his program with a zeal approaching that of Jim Jones' followers. I would like to consider myself fairly savvy in personal finance matters so I began to look into his program after being accosted on numerous occasions by his rabid fans. Upon closer inspection, his program is really about instilling discipline in people with none to speak of and certainly not about making optimal financial decisions. In short, his steps are out of order, wrong, or have fairly significant opportunity costs associated with them. Since it is Sunday, this is a good opportunity to discuss a guy who makes millions selling problematic advice to people based on religious commonality.

This example will (hopefully) underscore the points above. One of his mantras is the evil of credit cards, in his view they are so terrible that they shouldn’t be used even if you pay the balance off in its entirety every month. His premise here is that the use of credit cards encourages people to spend more than if they used cash. While research shows this to be true among some individuals, it’s certainly not a universal truth. More about this universal truth thing later, but Dave Ramsey's use of statistics and inability to form a logical argument through the use of actual facts are somewhat distracting to a discriminating reader. So let’s say you’re a person with some modicum of self discipline, if you used cash instead of credit cards you are subsidizing the purchasers who do use credit cards, like me. A retailer has to pay an interchange fee for every credit card purchase, but since he cannot price discriminate among buyers based on form of payment, these costs get passed along to all consumers in the form of higher prices. Operating in this manner also allows you to keep significantly more of your liquid capital in higher yielding savings accounts rather than cash which has a negative yield (inflation). While recent legislative initiatives may eventually free retailers to pursue price discrimination, until then, Dave is costing you money.

There’s another issue, investing, on which I believe Dave Ramsey’s advice is actually more harmful than helpful due to his lack of subject matter expertise. The root cause is his fundamental aversion to math and the degree to which his methods rely on behaviors for which no objective analysis exists. For instance on ETFs, “I do not own ETFs and do not recommend them as part of your investment plan. ETFs are baskets of single stocks that intend to operate like mutual funds; but they are not mutual funds.” This is an unclear, if not erroneous, statement. Mutual funds are also baskets of single stocks in that they own numerous individual equities so what is his point? The problem is that Dave does not understand what most ETFs are and why in many cases they are actually more beneficial than owning a mutual fund with a similar strategy to that of the ETF. Most ETFs track established indices and do so with less tracking error and at a lower cost than a traditional index mutual fund. The downside is that you must pay commission costs for each trade which a no-load index fund wouldn’t charge. Generally speaking, the higher the dollar amount of each individual transaction, the more beneficial an ETF is.

But the most egregious advice that Dave proffers is to invest “25% into each of these four types of funds: growth, growth & income, aggressive growth, and international.” He goes on to mention the criteria for selection: front end load, funds at least 5 years old or older, and solid track record of acceptable returns within fund category. First and foremost, Dave should know his audience. There are some relatively smart people (Fama and French come to mind) that have made careers out of showing the inability of experienced investment professionals to beat the market. Dave’s followers don’t rise to that level of expertise and if they are unsophisticated enough to use his other strategies, they should be investing through indices. The mutual funds that they choose will likely not beat the market index over time and the costs (Dave may be the only person still recommending load funds) will further exacerbate the difference. Furthermore, the four categories listed above (growth…) are not asset categories and his recommended strategy is anything but diversified. Diversification is achieved through investing across different asset classes, industries, geographic areas, and company sizes. The picture above shows the returns of different asset classes over previous years. One thing to note, Dave says “As a category, REITs just don’t stack up to good growth stock mutual funds. I do not own any REITs and don’t suggest them for you. If you really want to invest in REITs, limit them to no more than 10% of your local investment portfolio.” Check out the column on the far right, this shows the annualized returns of different asset classes from 1999 to 2009 (as of 12/31/2009 from Bloomberg). You’ll notice that the top performing asset class is Gold at + 14.3%, followed by REITs at + 10.6%. Way down at the bottom of the list is U.S. Growth at -4.0%. Following Dave's advice results in lowered (if not negative) returns and significant opportunity costs.

Finally, the central theme of his strategy, the debt-snowball. From his website, “the math seems to lean toward paying the highest interest debts first, but ….” The math doesn’t “lean,” it unequivocally supports the notion that you should pay down the highest interest debt first. If you choose another payment strategy it should have some sort of actual financial basis, i.e. terms on the debt (it is variable and the rate will soon adjust), your relationship to the lender (family members are terrible lenders), or the underlying asset. Otherwise, you are paying a significant premium, the spread between the rate on your smallest debt and that of your highest debt interest rate, for supposed momentum. The debt snowball is a judgment call on the psyche of his listeners. Without some sort of empirical analysis, it’s impossible to say whether this is any more likely to encourage repayment of debt than the far more rational notion of attacking the highest interest rate first. My assumption would be that this momentum doesn’t actually result in significantly higher success rates.

If there’s an overarching theme to personal finance, it is that it pays to seek good advice. The opportunity cost of using someone because they espouse your religious beliefs, their books look cool, they don't charge explicit fees, or their CNBC show is some sort of financial voyeurism is far too high. My recommendation is to go find your nearest fee-only CFP. You are paying Dave for advice that’s costing you more than you’re saving.

May 26 update: Dave Ramsey recommends you use what are called ELPs (endorsed local providers). He does this because they pay him a fee for referrals and are granted exclusive geographic areas to service. These are not the best finacial advisors and in fact, most are not certified finanical planners. A financial planner worth his salt doesn't engage in this type of behavior and a legitmate one would steer you away from the type of investments Dave recommends. If you use an ELP, you're getting set up. In return for not making the same return that someone in a lower cost index fund does, your finanical planner gets a commision from the mutual fund, part of which he then kicks back to Dave. If that sounds shady, well it is. That's why you don't find the details of this arrangment in every location where he recommends the service of an ELP.

About me and this blog

Over the past year I have come to realize that I have quite a few opinions and not many people (or more correctly, willing listeners) to share them with. So naturally, the idea of a blog where you can subject the rest of the world to your unedited thoughts seems a natural fit. The goal for this blog is catalog some of my thoughts which should force me to be more disciplined in their formation. While there is no set list of topics that I will cover, my interests are mainly current events, politics and money matters.

I grew up in New England and went to undergraduate where I received a degree in the dismal science, economics. After graduating I became an Army officer, did a few tours in Iraq, and got out. Those are all the personal details I'll offer as I prefer to remain somewhat anonymous for the time being.