Archive for the ‘Uncategorized’ Category

The One Good Outcome of the Healthcare Debate

August 20, 2009

In a recent post, I alluded to the need to have a meaningful public debate about healthcare choices in America.  Unfortunately, I think that opportunity has now been lost as what could have been an opportunity to forge a national consensus has devolved into a shouting match with our polcymaking class eagerly jockeying for political gain.  So goes Washington…

In our financial planning practice we often talk with clients about “playing the movie” of what happens at their death.  I’m generally a little less diplomatic and go with the “let’s say you’re hit by a bus…” approach.  Either way, while the focus is on estate planning, it also gets into end-of-life choices.  While this is an important to discussion to have, I’m not sure it should government-sponsored in the way that some of the House bills propose.   Depending on which side of the shouting match you’re on, this element of the healthcare debate is either about empowerment and dignity or the promotion of a death culture.

So what’s the good outcome?  This end-of-life discussion has renewed interest in “Soylent Green,” a 1973 movie with Charlton Heston and Edward G. Robinson, in which the government facilitates suicide of the elderly as a population control method.  The whole movie was a great reflection of the zeitgeist of the 1970s — Malthusian visions of limitations, starvation and an environmentally decimated Earth.  As 36 years have passed since its release, we’re now much closer to movie’s 2022 setting, and I’m happy to report that the screenwriters dismal vision of the future is not on track!  I have not seen the movie since being a teenager, but it has always stuck with me, particularly the haunting demise of Edward G. Robinson’s character, Sol.  Courtesy of the healthcare debate, you can now find this scene on YouTube:


My Boston Globe Op-Ed on Wall Street Compensation

March 20, 2009

If you have an interest in reading more about the Wall Street compensation issue, the Boston Globe published my op-ed piece today:  please click here

Housing Hopefulness and Helplessness

February 2, 2009

Mark Perry, the author of the Carpe Diem blog, has written a number of very good posts about the housing market.  Yesterday’s post highlights how bad the housing market was in the early 1980s.  This is good perspective — we’ve been here before and lived through that housing decline as well — that’s the hopeful news.  I think it is worth remembering that many borrowers in the ’80s became “upside down” in their mortgages (i.e. the mortgage balance on the home was greater than the value of the property) but did not default on their loan.  I remember friends needing to save money to be able to sell their condo since the proceeds from the sale would not cover their mortgage. 

If history is any measure, fears of massive mortgage defaults may be overblown.  Many people view their contractual debt obligations as moral obligations.  Even those who have a less principled view recognize that there are huge practical consequences to defaults: ruined credit, etc.  We may even be surprised by the resiliency of households in the face of job loss — the increase of dual-income households over the past few decades theoretically should lower default rates as the likelyhood of both earners losing a job is exponentially smaller than just one loss.  

Where I fear we may be helpless is in preventing high foreclosure rates among sub-prime borrowers.   The Mortgage Bankers Association has already chronicled enormous differences in foreclosure rates between prime and subprime mortgagees.  The real question is why borrowers are rated subprime.  A seasoned corporate lender once told me that loan repayment is largely a matter of character (he was speaking of business borrowers, not individuals with mortgages) — there are some borrowers who will go to the ends of the earth to repay their obligations, while others quickly walk away in a downturn.   It is a very 19th century notion that credit worthiness is a matter of character, but there’s some truth to this.  This is not to disparage people who have genuine unexpected hardships and are forced into default, merely to point out that in aggregate, forestalling default poor credit borrowers may be more than a matter of economics.   The Comptroller of the Currency recently reported that over half the mortgages that were modified in the first quarter of ’08 are already delinquent with many having redefaulted.

There’s good and bad news in all this.  The good is that, based on history, we hope that many borrowers will stay current with their mortgages despite the steep decline in their home values.  Unfortunately, though, we may also find that, among subprime borrowers, no amount of intervention will be effective.

Deconstructing the “Crisis”

January 26, 2009

Economist Alan Blinder posted a good op-ed in Saturday’s New York Times (registration may be required).  In the piece he stresses the importance of identifying policy mistakes that have brought the economy to this point.  He infers that virtually all the mistakes relate to loose regulation or poor administration.  Blinder lists six: 1) lack of derivatives regulation, 2) excessive balance sheet leverage, 3) growth of subprime lending, 4) failure to stem foreclosures, 5) letting Lehman fail, and 6) mismanagement of TARP.  While this explanation is certainly in the spirit of the times, I don’t think it accurately represents the complexity of the mistakes which have been made.  I think a closer examination, too, will show that many of the mistakes were the result of bad or excessive regulation, not lack of regulation (more on this in future posts). To give but one example, you cannot divorce the growth of subprime lending from the CRA (Community Reinvestment Act), which acted as an important catalyst in lowering lending standards.  However, Blinder makes an excellent point — if we’re going to restore integrity and faith in the financial system, we better understand the root causes of our system’s failure.

An Unresolved Issue

January 7, 2009

Reuters carried several stories (here, for example) which remarked on yesterday’s rally in copper prices, a move upward of over 8% in a single day, and a 24% gain since Christmas.  The move flies in the face of weak economic numbers (copper, as an industrial metal, is fairly sensitive to the economic cycle), a strengthening dollar over the period, and a rise in inventories.  So why did copper go up?  According to Reuters and others, the move up is linked to the reweighting of commodity indices which will occur mid-month. 

This is an interesting explanation.  For most of the first half of this year, the investment banks, which sponsored and promoted commodity index investing, vehemently denied that there was any link between investor buying of futures and the dramatic rise of commodity prices.  In a deeply flawed report, the CFTC (the regulatory body which governs commodity futures) also argued that the $300 billion or so in commodity index investments had no price impact, defying common sense.   An economist who testified before the House Agriculture Committee argued that, “in theory, there are an infinite number of contracts that can be written” without impacting price.  For those of us who don’t live in “theory” but live in the real world, assuming an infinite amount of capital to an infinite amount of participants doesn’t make a lot of sense.

The copper story reflects a growing recognition that index investing in commodities does indeed impact price.  If it is true for copper now, it must also have been true for oil when crude leapt over 50% in a matter of months.  It must have been true in March when, in an incident that the CFTC has yet to explain, the cotton market’s integrity was compromised, causing tremendous harm to the cotton industry.  There have also been widespread assertions that the exodus of hedge fund and investor pools from commodity indices have been partly responsible for the depth and speed of the decline in commodities; investment flows into commodity futures and swaps cause unnecessary volatility and harm in distorting prices both to the upside and downside.

Understandably, despite this growing recognition and body of evidence, among our policymakers this issue has been superceded by the general financial crisis.  It needs to be revisited, and the sooner the better.  The use of commodities as a core investment asset class is a flawed concept.  If this were only a matter among investors, like the dot-com frenzy of the late ’90s, it might not be a legitimate area of government involvement.  However, the price distortions caused by commodity index investing involves basic goods — food, energy, raw materials — that affect everyone, consumers and producers.  Moreover, these price moves disproportionately impact the world’s poor.  Distorted commodity prices can send policy makers false indications of inflation or deflation, leading to bad economic policy choices. 

It’s time to readdress this issue, both in the press and in the halls of Congress.  Did the use of commodities as an investment asset distort prices?  If so, what should be done to improve the integrity of these markets?

Whole Lotta Stimulatin’ Going On

December 23, 2008

It seems like a day does not pass without our hearing about plans for expanding the proposed fiscal stimulus.  Apologies to Jerry Lee Lewis, but it seems to me like there’s already a whole lotta stimulatin’ going on.  I don’t deny that fiscal policy can be effective, just that, in this instance, it may well be unnecessary.  The economy is already getting some healthy doses of support, and it seems likely that those will be impactful well before federal spending can be deployed. 

In the past few months, we’ve had 3 significant stimuli for the consumer and the economy as a whole.  The first has been the combination of Fed easing coupled with the TARP package, which has finally brought commercial interest rates back under the central bank’s control.  Below is a chart of 3-month LIBOR, the most commonly cited measure of short-term commerical interest rates.

3-month LIBOR, 20 year history

3-month LIBOR, 20 year history

While much has been made of restraints on banks issuing new credit, the drop in LIBOR to 1.47% provides a boon to the many consumers with outstanding debt.  LIBOR is the most common base rate for adjustable rate mortgages, home equity lines, as well as other forms of revolving debt.  A drop in LIBOR means a drop in payments for these borrowers.   So too does the massive refinancing of fixed rate mortgages put more money in consumer pockets.

The general drop is commodity prices has created a second source of economic stimulus.  In particular, gasoline and heating oil costs have dropped precipitously.  In a post on his Carpe Diem blog, economist Mark Perry shows that every penny of lower gas price puts about $1.5 Billion in the hands of consumers.  While it may not be fair to use the absolute peak of gas prices this summer as the starting point, prices at the pump have rolled back by years so the effective stimulus is probably still in excess of $100 Billion.   The third, related, stimulus, is the general drop in prices, which effectively increases real wages.

Economist Greg Mankiw has written quite recently about his skepticism over a fiscal stimulus package .  Among the well known criticisms of stimulus through government spending are: 1) fiscal policy is a one-way street, easy to spend but hard to cut back, 2) the actual injection of money can take months and years to be allocated and have an impact, and 3) spending is politicized and not economically efficient.  Interestingly, Mankiw also points out that there is significant evidence that the more effective stimulus route is not through government spending but rather through tax cuts. 

It would be one thing if a fiscal stimulus had no associated costs.  Unfortunately, there’s no free lunch here.   The type of stimulus being discussed would significantly add to the federal deficit, could potentially ignite inflation, and could also weaken the dollar, just as it is trying to stabilize after a 7-year decline.  This Panic of 2008 has often been compared to a heart attack in a person.  To continue this analogy, the stimulus we’ve already injected (primarily monetary) has done the work of a defibrillator.  There’s still plenty of healing needed, more medicine required, and the patient needs some fundamental lifestyle changes.  But it’s time to stop using those defibrillator paddles to zap the patient — or we’ll find we end up doing much more harm than good. We’d be better served by a pause, allowing time for the existing monetary-based stimuli to have an impact.  Congress certainly has enough on its plate simply addressing the regulatory distortions and lapses which led us here in the first place.

A Questionable Strategy

December 17, 2008

In our travels, we’re running into a lot of people who are advocating that investors recognize all their portfolio losses whether they can use them in 2008 or not. 

I conferred with Al Cappelloni, the director of the tax practice at my parent company, Vitale Caturano & C0., the largest regional accounting firm in New England.  We concluded that, in many cases, this is a flawed strategy.  Certainly, investors should consider recognizing portfolio losses if they can use them this year to offset realized gains and to offset income to the $3,000 limitation.  But taking losses with the sole intention of generating a loss carryforward (“banking” losses) may not be the best strategy for investors.

To a large degree, investors will reap the benefits of losses whether they are taken or not.  A cost basis above current price means that, going forward, the gains will be sheltered up to the basis.  Consider a hypothetical situation of an investor who has owned IBM for over a year at $100/share when the current market price for IBM is $80, an unrealized loss of $20.  Assume that the same investor has no realized gains to offset and has maximized his ability to use capital losses against income.  

   1)If  IBM goes back to $100 and the investor sells, he will have no tax liability.  

   2) Consider a loss-harvesting alternative: the investor sells today, recognizes the loss which is carried into the next year, buys IBM back 31 days later (assumed at unchanged price of $80/share), enjoys the rebound to $100 share and sells.  The investor now has a $20 gain which is offset by the $20 loss, so also no tax liability.

On the face of it, it would seem that the investor should be indifferent to harvesting unneeded losses or standing pat.  However, the example does not incorporate transaction costs.   It also assumes that this investor will be able to repurchase his security at the same price.  Both of these are unrealistic — even in fee-based accounts, there is some trading cost in selling and repurchasing a security, although it is generally small.  More troubling is the risk of being out of the market, or if a proxy is used to stay in the market (an index fund, for example), the risk of not being in the optimal portfolio.  In the current environment, this is a particularly large consideration since maximizing the recognition of losses might require selling out all of an investor’s positions.

In addition, the loss-recognition strategy will restart the holding period for the security owned, making that security vulnerable to the higher short-term gains rates should it be sold for investment reasons within a year.   Consider again, the above hypothetical IBM holding, but in this instance IBM quickly rebounds to 110 and is then sold.  In scenario 1 above,  the investor will have a long term capital gain of $10/share.  In scenario 2, the investor will have a $30 short-term gain, offset by a $20 long term loss, netting out to a $10 short term gain.  In this case, the investor is clearly disadvantaged by having “banked” losses as his gains are now subject to the higher short-term capital gains tax rates. 

There is another problem with the take-all-losses strategy, an issue more subtle yet potentially more important.  When investors carry forward unused capital losses, they are forced to use them against any recognized future gains.  With a new administration entering Washington that has expressed an interest in raising capital gains, there may well be an advantage to timing the use of losses.  For example, if in 2009 I were to believe that the maximum capital gains tax rate would increase in 2010, I might choose to pay taxes on recognized 2009 gains and postpone realizing losses until they are of greater value under a new tax regime.  Investors who excessively recognize losses this year will be denied this flexibility.

There are some situations where banking losses makes sense.  For example, if an investor knows with some certainty that he will be generating short term capital gains in future years.  Going back to our IBM example, the investor might want to bank losses in IBM, after 31 days return to that security the long term (so if sold it will qualify for long-term tax rates) and have the losses available for use against future short term realized gains.   However, this is indeed an unusual situation — consistent short-term treatment is more commonly associated with certain alternative investments or non-traditional trading strategies rather than long-term investment approaches.  It is difficult to  imagine having sufficient confidence in the ability of such vehicles to produce consistent gains as to influence the loss-realization decision.   However, even with such confidence it is unlikely that the optimal course would be to bank all available losses.  

One could also envision a scenario where it would be advantageous to bank losses before they disappear.  However, given the current state of most portfolios, it seems likely that investors will have some time in 2009 and beyond to make those calculations.  At the end of the day, there are few cases where banking all unneeded losses is optimal.  The belief that this is a risk- and cost-free strategy is misguided.  There is indeed a downside to such transactions, and these are risks without any real offsetting benefits.

So why is this take-all-losses strategy being promoted?  It was possibly born in the days when financial advisors operated largely on commissions — December was typically the top revenue month for brokerage firms on the strength of loss recognition transactions – more losses recognized, more transactions, more revenue.   Even in our fee-based world, I think there’s a desire of many advisors to try to demonstrate some value to their clients in an otherwise dismal year.  From the narrow viewpoint of the investment advisors, it is quicker and simpler to take all available losses rather than coordinate with a client’s tax advisor.  Finally, there may also be a desire to “reset the clock” psychologically and not have securities showing on the statement with large losses. 

There’s a saying in poker that is often applied to investing:  you can play your hand or you can play the bank, but you can’t play both.  Investors should focus on holding the best portfolio to fit their risk tolerance and financial goals.   Poorly conceived tax strategies needlessly disrupt this focus.

Taking Bad TIPS, part 2

December 8, 2008

As discussed in my earlier post, the yield on TIPS are being widely misinterpreted as signaling long-term deflation.   Last week Greg Mankiw pointed out further data problems with TIPS and specifically with the Treasury’s constant maturity series.   Part of the challenge in analyzing TIPS  has to do with the imbedded option in their price.  The maturity value of these securities is adjusted by an index ratio tied to the CPI; on issuance date, that ratio is 1.00.  However, at maturity the investor can never get back less than face value.    This means that there is much greater principal risk for an investor buying a seasoned bond with a high index ratio (e.g., a ratio of 1.20 could go to 1.00, with an associated loss of principal as the maturity value would go from 1.20 times face to 1.00 times face), while a new issue bond offers less risk (e.g., even if the ratio goes from 1.00 to 0.80, the investor still gets back face value, not face times 0.80). 

This pricing complexity no doubt contributes to investor preference for conventional treasuries.  Also related is the superior liquidity of conventional Treasury securities — at current low interest rates, liquidity and simplicity premiums play a larger role in pricing (e.g. a 30 basis point preference is a small component in a 5% yield environment, but a large one in a 2% yield environment).

 The most compelling reason to distrust any deflation interpretation of TIPS data are those stated in my earlier analysis — the recognition that over the very short term TIPS, which lag CPI by three months, must incorporate the decline in commodity prices, particularly oil.  My friend Lincoln Anderson was kind enough to send me this chart which shows the close correlation between short term moves in oil and CPI:


Current TIPS prices are reflecting the past drop in commodity prices, not future deflationary trends.

A Picture is Worth a Thousand Words

December 3, 2008

Catharine Mulbrandon runs a consistently fascinating site, Visualizing Economics, where she takes complex economic data and presents them in graphicly enlightening ways.  Here’s an example, depicting the slide of the U.S. economy into recessions as depicted by gradients representing different levels of state unemployment.  It’s immediately apparent that there are strong regional differences, but a clear national trend.  The high unemployment rates in areas where much of the home building excesses occurred (Florida, California, Nevada) at least superficially suggests that turning around housing will continue to be a tough slog.    Be sure to check out her site.

On Thanksgiving

November 26, 2008

There was a women, Judy, who worked as a sales assistant in my branch office in Chicago 10 years ago.  I have no reason to believe that her life was any easier than any other — quite possibly it was harder.  I’m sure she had her bad times and good times.  Yet, every day, when I would see her, and ask, “How are you?” — she always had the same reply, “I’m blessed.”  And she meant it.

It’s been a tough year for those of us who are connected to the financial markets, and for many others as well.   I try to remember Judy’s wisdom and remind myself of my many blessings.   Just in case you’re not feeling blessed, please accept this blessing from Irish poet John O’Donoghue.  And have a happy Thanksgiving.

Beannacht (“Blessing”)

On the day when the weight deadens on your shoulders and you stumble, May the clay dance to balance you.

And when your eyes freeze behind the grey window
And the ghost of loss gets into you,
May a flock of colours, indigo, red, green, and azure blue
Come to awaken in you a meadow of delight.

When the canvas frays in the currach of your thought
And a stain of ocean blackens beneath you,
May there come across the waters
A path of yellow moonlight to bring you safely home.

May the nourishment of Earth be yours,
May the clarity of the light be yours,
May the fluency of the ocean be yours,
May the protection of the ancestors be yours.

And so may a slow wind work these words of love around you,
An invisible cloak to mind your life.