K Marx The Spot

Market Watch

If you have a 401(k) plan at work, you cannot help but notice the incessant cheerleading for equity investment from your 401(k) provider.

But over the last 10 years, how good an investment have equities been? The answer is not that hot, even though the last two quarters have been quite good. As I have done before, you can see here the actual returns for five Vanguard mutual funds—their S&P 500 fund, their total stock market index fund, their total international stock index fund, their total bond market index fund, and their money market fund.

The graph shows that the bond market fund has done the best by far over the last 10 years, with the international fund just beating out the money market fund for second place (its last 12 months have only somewhat regained its dramatic losses over the previous 12 months, whereas the money market fund has paid very low dividends recently). But, still, if you parked $10,000 of retirement money in the money market fund 10 years ago, you would have $13,652 now. If you had invested that in the S&P 500 fund, you would have lost money, not just before inflation, but overall, with a position of $9,776.

Labels: investment advice, investment returns, money market funds, stock market, stupid financial tricks

Why Investment Advice Stinks

If you are lucky enough to be an American with a 401(k) plan at work, you have heard for years the continuing mantra that it is best to be in equities over the long haul. Bonds, never mind money market funds, are for losers who will never retire comfortably.

Take a look at this link and click on "Growth of $10,000 chart view": it shows the return over 10 years ending on 30 September 2008 of hypothetical investments in Vanguard's Prime Money Market fund, and its Standard and Poor's 500 fund, its Total Stock Market Index fund, its Total International Stock Index fund, and its Total Bond Market index fund.

Vanguard is famous for having low fees for all of its funds, so these returns are probably a bit better than the typical stock, bond, and money market funds, but they represent returns of investments one might actually have made. And they do not include the awful month that the stock market had had in October.

The money market fund—surprise—outdid the Standard and Poor's 500 fund, and was barely below the total stock market index fund (but would be ahead for the 121 months ending today). Anyone who bought the total bond market fund would be well ahead of either of the domestic stock funds. And only the international fund beats the bond fund over the 10-year period (but it declined about 20% in October, while the bond index fund fell only 3%).

Some lucky ducks surely have done better than the indices: anyone who bought a mid-cap or small-cap index fund 10 years ago would be ahead of each of these funds, but a lot of 401(k) participants do significantly worse than market benchmarks.

When Republicnas or Vlue Dog Democrats speak wistfully of putting Social Security funds into the stock market, remember that chart.

What is truly remarkable about these returns is that the last five years have featured lower taxes on pital gains and dividends. In essence, the federal government has goosed stock market returns by taxing most of its dividends and all of its capital gains at only 15% for investors investing outside their retirement accounts. Imagine how lousy the stock market might look if the 2003 changes had not gone into effect.

Labels: investment advice, investment returns, money market funds, stock market, stupid financial tricks

Suckers

Last week, General Electric announced that Berkshire Hathaway would make a $6 billion investment in General Electric. The financial press reported this in two ways, both correct in their ways.

One slant was that the investment represented a vote of confidence in General Electric by Berkshire Hathaway and its Chief Executive Officer, Warren Buffett.

The other slant was that Berkshire Hathaway was getting excellent terms. First, it bought $3 billion in preferred stock that pays a 10% dividend and that can only be redeemed at 110% of par. Second, it received warrants to buy $3 billion of common stock at 90% of the current share price. A 10% dividend rate is particularly high, and costs the payer more than debt at 10% per annum because the dividends do not reduce the tax liability of the payer. (There are other reasons to issue preferred stock rather than debt, most notably that preferred stock counts as capital and has its dividends paid only after interest payments are made on debt.) It is worth noting that Berkshire Hathaway's recent investment in Goldman Sachs was on remarkably similar terms. What this seems to mean is that firms like General Electric, which were not supposed to be as exposed as investment banks like Goldman Sachs to the credit crisis, are in fact very exposed.

To put it another way, in December 2007, when Freddie Mac faced a dire need to raise capital, its preferred stock issue bore an initial coupon rate of 8.125%—and Freddie was obviously in dire trouble at the time.

While big investors like Berkshire Hathaway are getting very good returns on their money, what do small investors get from general Electric when they react to advertisements for investing in "Corporate Notes"? Not nearly that good a deal, it turns out. Investors are promised coupon rates of 3.05% to 3.45%, not much better than money market funds that might even be insured thanks to a recent guarantee program. There may be only one Wizard of Omaha, but General Electric hopes there are a lot of suckers out there who are willing to settle for a lot less.

Labels: Berkshire Hathaway, General Electric, stupid financial tricks

Perfect Information

If you want an exemplar of the difference between theory and practice and the financial markets, consider what Alan Abelson writes in his Barron's column (behind the paywall) this week:

[T]he roof fell in on housing and the curtain began to come down on the jolly times for Freddie and Fannie. Today, they own or guarantee 45% of all U.S. mortgages, or a cool, $4.8 trillion worth. Looking at their balance sheets, Porter [Stansberry] points out, you find mortgages
with a face value of $1.7 trillion, supported by assets of about $70 billion in core capital. On a combined basis, they're leveraged 24-to-1, but when you toss in their off-balance sheet guarantees, that figure balloons to 68-to-1.

Since the stock market is a perfect-information market, every buyer and seller of FRE and FNM knew not only that the leverage ratio was 24-to-1, but also knew the footnotes to the annual reports well enough to understand the 68-to-1 ratios including the guarantees. And they knew that if, say, those mortgages were worth 95% of their stated value that Fannie and Freddie would have no equity left, even if their guarantees were never called.

Labels: Fannie Mae, Freddie Mac, Perfect information, stupid financial tricks

The So-Called Middle Class

I understand why the affluent want to call themselves middle class. Some even think that their very cushy lifestyle is the norm. But supposedly knowledgeable observers should be pointing out what the real situation is.

Business Week profiled a few affluent families and how the possibility of tax hikes (or the expiration of the Bush tax cuts) might affect them and their lifestyle. The first is a family of four from suburban Philadelphia.

By any measure, Dr. Howard Hammer and his wife, Hope, have a comfortable life. Hammer, 40, has built a thriving practice as an ear, nose, and throat specialist, while Hope, 39, has switched to part-time work as a real estate lawyer after years at a big firm in order to spend more time with Arielle, 7, and Matthew, 9. Home is a four-bedroom house in the Philadelphia suburbs, and between them, they bring in over $300,000 a year. "We can't complain," he says. "We're certainly not struggling."

But are they wealthy? That's far more debatable. Hammer, who feels the same pressures squeezing Americans up and down the income ladder, says he's anything but. Ever-rising prices for gas, health insurance, and other expenses are hitting hard, as are the $3,000-a-month mortgage and the $2,000 he still pays monthly to whittle down his $160,000 medical school debt. A six-year residency gave Hammer a delayed start saving for retirement, so he worries if he's stashing enough in his 401(k). By the time the couple contributes to the children's college fund, there's little extra at the end of the month.

According to the Census Bureau, in 2006, there were 203,051 families in Montgomery County, of which 20,828 had incomes over $200,000, let alone the $300,000 that Dr. and Mrs. hammer pull down annually. The Hammers paid $655,000 for their home in August 2004. In 2006, 34,552 owner-occupied homes out of 225,939 in the county had values over $500,000. If the Hammers are feeling pressures from the economy, it is because they paid a lot for a house that is a lot nicer than most of the houses in the area.

A second family lives in Pelham, New York, and its patriarch makes a truly astounding claim.

[F]or many close to that $250,000 cusp, what sounds like a lot of money often doesn't feel like it. "Depending on where you live, $250,000 is middle class, at best," says Michael Ginn, 49, a longtime media executive who lives with his wife, Dafne, 34, and 3-year-old daughter, Erin, in the New York suburb of Pelham; their second daughter is due in July. Though his income has topped $300,000 for more than a decade, Ginn says he's never felt so stretched. With the cost of everything from health insurance to upkeep on his 90-year-old home surging, even as he takes on new expenses for his growing family, Ginn can't stash away anything near what he once did for retirement, let alone save for college. "We're just dog paddling now," he says. He argues that if Washington is going to raise high-end taxes, then the local cost of living should be taken into account.

Pelham is a bit different from much of the country. In 1999, the median family income nationwide was just over $50,000, but it was over $111,000 in Pelham. But the idea that "$250,000 is middle class, at best" should be accompanied, by any magazine that takes itself seriously, with a rhetorical smackdown. Let us grant Mr. Ginn some room and not wonder whether he thinks $250,000 is working class or lower middle class; let us assume that "at best" slipped his lips wholly in error.

In 2000, there were 4,141 households in the town of Pelham. Of this number, 890 had $200,000 or more of annual household income. It is about right to equate $200,000 in 2000 with $250,000 in 2008, after inflation—in fact, the consumer price index increase from January 2000 to January 2008 was 25.04%.

Now, 21.5 percent of households in the $200,000 and up category means that Pelham has a lot of affluent people. But even here, these folks are in the top quintile of income.

Cry poor if you want, but if you are pulling in $300,000, you have very little truly in common with ordinary people. How hard would it have been for Business Week to have done even a bit of fact-checking about these claims?

Labels: Business Week, so-called middle class, stupid financial tricks

Stupid Transportation Tricks

An impassioned reader asks the Boston Globe why the Massachusetts Bay Transportation Authority (MBTA is not considering expanding the heavily used garage at Alewife station.

"Re: 'Desperately seeking parking' [March 30] and the complaint from William Elliott of Acton about his problems finding a garage, the T's Joe Pesaturo is misstating the facts if he says the reason for no increase in the size of the Alewife garage is, as you quote him, 'the T is not in a financial position to acquire land for parking,'" Sue Bass wrote in an e-mail.

"In fact, the Alewife garage, though it now is only five levels, was designed to accommodate seven levels of parking. The elevator shaft, stairs, etc., go up that far—in fact, the existing elevators have blank buttons that could be used for levels six and seven.

"The T should have increased the size of the garage 15 years ago when level five started being used a lot. The argument I've heard from T planners is that the adjoining communities would protest—but I doubt that's true.

"Belmont and Arlington would use the garage a lot, if there were room; Cambridge and Somerville suffer from people driving through because they can't get into the garage. The intersection of routes 2 and 16 is jammed, all right, but getting people off the roads and onto the T would reduce the crunch, not worsen it."

Pesaturo, the MBTA's spokesman, responded: "While the garage was designed to accommodate two additional levels, no structural analysis or code review has been done to verify if the existing structure can still meet that objective.

"The existing top deck has about 650 spaces, so the potential expansion would be for approximately 1,300 spaces.

"At current construction industry pricing, the estimated project cost would be in the range of $30 [million] to $35 million. Burdened with a current debt load of more than $5 billion, the T has little financial capacity for expansion projects."

Well, at least the MBTA spokesperson is no longer claiming that more land is somehow the constraint. But the idea that the structure would not accommodate two more levels is a bit dubious: the original structural engineers seem sanguine enough about the precautions taken to ensure that the loads were properly accommodated.

The spokesman does ignore that the MBTA spent $3.6 million to address flooding and other issues at the garage, issues that more decks and appropriate design might alleviate.

But, worst of all, the idea that the MBTA could not service $30 million to $35 million of bonds is a bit silly—parking garages at busy transit stations are sure sources of revenue. Let us assume that the MBTA maintains its current parking rates ($5 per car) for the new 1300 spaces, and that each space is occupied once per weekday and once per weekend. (This is probably a very conservative estimate.) So each space generates $1,560 of revenue per year, for $2,028,000 per year for the 1300 new spaces.

If the MBTA can float debt at 4% per annum (its fixed-rate swap on recent recent 15-year floating rate debt backed by sales tax receipts was 3.84%), then we can figure its annual debt service by considering the term of the underlying debt. For bonds that amortize over 30 years, the annual debt service on $30,000,000 would be about $1,726,000. For the $35,000,000 figure, the annual debt service would be about $2,014,000. The MBTA has not floated 40-year debt in a while, but it would provide additional leeway on the debt service in exchange for a higher interest component.

Of course, the MBTA hires a contractor to manage the garage, so the entire $5 is not available for its use. But certainly the MBTA would demand a substantial cut of the added revenues, and its absolute share could increase over time, because $5 now for parking will be equivalent to a higher number in future years. And this ignores the added ridership (and fair income) that would come with additional parking spaces at a garage that has to turn away commuters most mornings.

(Note that this does not involve any financial shenanigans that the MBTA has employed in the past, such as leasing its rolling stock to banks to get a little cash at the time of its acquisition.)

In short, the idea that the MBTA is somehow constrained from financing an addition to the Alewife garage is not as obvious as the MBTA would like us to think.

Labels: Alewife, MBTA, stupid financial tricks

I Have Heard this Story Before

I think that I know the ending of this one. Financial institutions tell everyone that they really, really know what they are doing. Then they foul up, egregiously. And taxpayers wind up bailing them out.

Just some more detail from the WSJ: Mortgage Securities Back Fed Loan to Bear Stearns.

The securities backing a $29 billion Federal Reserve loan to Bear Stearns Cos. consist primarily of "mortgage-backed securities and related hedge investments," the Treasury Department said.

...

The Fed has declined to provide any underlying detail so far.

JPMorgan will take the first $1 billion in losses on the $30 billion portfolio, and the U.S. taxpayers will pay for the remaining losses (if any).

Yes, it is a good thing that the soi-disant grown-ups are fouling up the government again. Of course, they are the same people who do not believe in government, so there is no reason to think that they have any incentive to show that the government can do things right.

Labels: bailout, mortgage-backed securities, stupid financial tricks

AAA Ball

Now there's a shock. Did anyone really think that just $15 billion would somehow avoid the financial train wrecks now known as Ambac and MBIA?

America's biggest mortgage bond insurers collectively need a $200 billion (£101 billion) capital injection if they are to maintain their key AAA credit ratings, a figure that dwarfs a plan by New York regulators to put together a capital infusion of up to $15 billion, a leading ratings expert said yesterday.

The ratings expert is hardly the alpha and omega of company ratings, of course. But it is clear what Ambac and MBIA have insured a whole lot of junk: collateralized debt obligations and mortgage-backed securities, none of which is getting better as the housing crisis deepens. And just wait until the option ARMs start resetting in earnest in the next 12 to 24 months.

Labels: Ambac, MBIA, stupid financial tricks

This Is Not Good

It is time to put the bear back in bear-left.com.

Ambac Financial Group Inc. said on Friday that it's scrapping plans to raise new capital by selling equity after the bond insurer's shares collapsed in recent days.

Fitch Ratings cut the AAA ratings of Ambac's main bond insurance subsidiaries after the announcement and Standard & Poor's warned that it may do the same.

Hundreds of billions of dollars of municipal bonds and mortgage-related securities guaranteed by Ambac may now be downgraded too. That sparked concern about more write-downs at banks and brokers and added to turmoil in the muni bond market.

That reminds me. From Vanguard's fund returns page, through 31 December 2007, the 500 Index Fund returned 5.83% annually over 10 years. The Total Stock Market Index fund returned 6.25% annually. Its Total Bond Market Index returned 5.71% annually, and its Intermediate and Long Bond Funds returned 6.32% and 6.97%, respectively.

Since the beginning of the year, the two stock funds are down about 10% each, and the bonds funds are up slightly. Remind me why equities are always supposed to outperform bonds over long stretches. And definitely remind me why investing Social Security funds in the stock market is supposed to be such a great idea.

Labels: Ambac, stocks, stupid financial tricks