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.
Friday, May 28, 2010
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:
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.
Tuesday, May 25, 2010
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.
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.
Monday, May 24, 2010
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.
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.
Friday, May 21, 2010
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.
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.
Tuesday, May 18, 2010
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.
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.
Sunday, May 16, 2010
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)?
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.
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.
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