Hot Off the Web– May 11, 2010

Personal Finance and Investments

In the Globe and Mail’s “PPNs: The guarantee isn’t worth the price” Fabrice Taylor tells readers that “In the great annals of rip-offs to come tumbling off the Bay Street assembly line, few if any rank higher than principal protected notes. They sound great, especially as we crawl out from the teeth of the greatest financial crisis in eons. Imagine not losing anything, your principal guaranteed! But you do lose. Not principal, but opportunity. You should not buy them”.

Jonathan Chevreau in the Financial Post’s “Our faith in stocks misplaced” and “Zvi Bodie in Toronto to rebut financial myths of “popular literature””discusses Bodie’s unconventional views, which he presented last week in Toronto at a CFA wealth management conference, about how people should be investing especially as enter retirement. Dr. Bodie, a respected professor of financial economics, says skip stocks as they risky even in the long run and advocates inflation indexed government securities like TIPS (RRBs in Canada) or inflation indexed annuities, as a means for a secure retirement. As a blanket approach to investing in retirement, this is certainly radically different from the mainstream financial planning advice which (unless the individual has an extremely low risk tolerance) includes a dose of equities to provide enhanced (expected) returns, and thus provide an expectation (though not certainty) of somewhat higher standard of living that might be possible if one strictly sticks with bonds (indexed or not). (I was in the audience at an Ottawa video link, and Prof. Bodie is always thought-provoking since he challenges his audience to think seriously about the gap between what he advocates and current practice, and the resulting risk associated with that gap. But I am still not ready to implement his recommendations for myself. Some of the reasons why not: (1) 100% annuitization leaves no estate and still leaves you stuck with high cost of annuities and insurance company risk, (2) TIPS ladder using previously issued TIPS would leave one exposed to significant capital losses should Japan-like deflation be in our future, (3) variable annuities with guaranties (like GMWBs) consume your capital due to high fee structure the longer you stay with them and (4) protecting equity exposure with insurance would require availability of credible insurance against some future market failure (what’s the likelihood that the counterparty would pay off). For now I’ll continue to stay on the lookout for future availability of low-cost longevity insurance, which is still unavailable in Canada at any price.

Ben Steverman in Bloomberg Businessweek‘s “Fixed income pros fear ‘bond fund bubble’” warns investors who have recently poured into ‘bond funds’ that they may be taking on significant risk “especially if interest rates rise”. Unlike those who buy a bond and will be paid fully if they hold until maturity, the value of bond funds fall as interest rates rise. “If we get a big spike in rates (and there is no guarantee that we will or if we do then when), there will be a mass panic”, “Before 2008, people were not really recognizing the risk in equity markets…Now, many may not recognize the risk in bond markets”. Of course even those holding individual bond could get hurt in a rising interest rate environment, because “you may miss out on other investment opportunities”. Also, the reader needs to keep in mind that the longer the maturity of the bond the larger the drop in value for a given change in interest rates.

As a reminder of the “interesting times that we live in”, John Heinzl in the Globe and Mail’s “Stop-loss orders turn into double-edged sword” looks at what happened last week to investors who used stop-loss orders to protect the downside of a stock position. “Stop-loss orders are supposed to protect investors when prices plunge, but during Thursday’s market chaos, the strategy may have backfired horribly and contributed to the massive slide in stocks. A stop-loss order instructs the broker to sell a stock or exchange-traded fund when the price falls below a certain level. But when the price level is breached, the order is automatically converted into a market-order, meaning the sale is executed at the best available price.” Some prices dropped 90% due to lack of liquidity resulting in massive losses for investors. “In a tacit acknowledgment that markets had gone haywire, the Nasdaq stock exchange said it would cancel all trades executed between 2:40 and 3 p.m. Thursday, during which shares oscillated more than 60 per cent beyond earlier levels, though it maintained that its systems had functioned normally. The all-electronic trading platform operated by the New York Stock Exchange said it, too, would annul trades.” from “Markets sent reeling after possible trading error” in the Globe and Mail. For those interested in other descriptions of what happened you can read “Trading goes wild on Wall Street”, “U.S. markets plunge, then stage a rebound”, “Computer trading is eyed” and WSJ’s “Did a big bet help trigger ‘Black Swan’ stock swoon?”. The last article suggests that a $7.5M options contract originated by a firm associated with Nassim Taleb (of Black Swan” fame) may have been the trigger for the uncontrollable events that followed. (Sounds either unlikely or we have a highly unstable system, and unless it is changed, we can expect similar and more significant events in our future.)

Real Estate

Steve Ladurantaye in the Globe and Mail’s “House prices drop: TD”reports that TD Bank “had previously expected (Canadian real estate) prices to gain 1.6 per cent in 2011 in inflation adjusted terms, the bank now is calling for a 2.7-per-cent drop”, primarily due to surprising rise in supply (more existing houses put up for sale and rise in new construction).

In an interesting WSJ article “A surprise tax hit on foreclosures”Jeff Opdyke points out that Americans “debating whether to abandon a house that is worth less than the mortgage—should consider the tax treatment carefully before making a move”. “Federal and state tax laws have long viewed canceled debt as income because consumers who borrow money to buy a house—or who pull money out of their house to buy cars and such—and then don’t pay it back “wind up ahead of where they were”. (Quite a surprise no doubt!)

David Rosenberg points his readers to Robert Shiller’s website (the link referred to in the paragraph starting with “Historical housing market…”) which indicates that U.S. home prices are were so overvalued in 2006 they were 3.5 standard deviations on the high side, and even today would still need to fall a further 20% to return to historical averages. Rosenberg also pointed in another article last week to the USA Today piece “In shift, more fill the same home” discussing data which suggests that the number of people living in a home is rising (not a good omen for near-term home prices). On the other hand, the WSJ Emily Peck writes that “John Paulson now bullish on housing”indicating that “house prices have stabilized and could climb 8%-10% nationwide in 2011”. (This is the Paulson who made billions in the last couple of years betting on falling real estate prices.)


The Financial Post’s Terence Corcoran “Beware of ‘pensioncare’” argues against changes to the BIA to give priority to underfunded pension plans in case of sponsor bankruptcy, because this would ultimately increase the number of people without pensions as it would encourage more companies to eliminate DB pensions. (DB pension plan in Canada’s private sector is a train that has left the station some time ago. It would be difficult to envisage circumstances that would make more companies take on new/additional inflation/market/longevity risk on behalf of their employees; to argue on that basis that you want to protect DB pension plans without actually protecting the promised pensions, in case of underfunding and bankruptcy, implied with the pension plans is actually incomprehensible. What’s the point of having more pensions if the promises are not kept?)

If the previous pension article might have been incomprehensible, IFIC’s (Canada’s association of (mutual) fund managers, distributors and industry service organizations”) submission to the federal Department of Finance, would have to be considered somewhere between self-serving and pathetic. Jonathan Chevreau discusses it in the Financial Post’s “1.7 trillion reasons IFIC thinks major pension reform not needed and mutual fund MERs should stay sky high”. You’ll no doubt be surprised that Canada’s mutual fund industry thinks that no reforms of substance are required and the current pension or “retirement income system” works just great (at least for them).

Things to Ponder

In the Financial Times’ “Opportunistic move by consultants”Pauline Skypala discusses the new push by pension consultants to “dynamic asset allocation” which many are ready to label “market timing”. A “consultant acknowledges it risks being accused of promoting glorified market timing, which evidence suggests is rarely consistently successful, so it seeks a rules-based process with little room for subjective judgment. It comes up with two possible approaches: automated rebalancing on a monthly or quarterly basis, and constant proportion portfolio insurance, under which asset allocation is adjusted daily according to a mathematical model. Hewitt similarly defines dynamic asset allocation as being an asset rebalancing strategy that changes as a plan’s funded ratio improves.” “Any approach that increases (portfolio) turnover presumably also increases costs, even if it is done via an overlay using derivatives.”

In the Financial Times’ “‘Sophistication’ debate heats up” Gillian Tett discusses the debate about the definition of the “sophisticated investor” and in the context of the financial reform package winding through the U.S. legislature there are proposals that would “impose a fiduciary duty on all registered broker-dealers, when they deal with investors”. Until now “if you were “sophisticated”, in other words, you were supposed to live by the principle of buyer beware”; what is proposed is to narrow the definition of sophisticated and thus increase the number of customers who would fall into the category toward whom there would be a fiduciary duty under the new law. The article suggests that this would radically change the street’s business model. (That’s not necessarily a bad direction.)

Jason Zweig in the WSJ’s “When global debt shuffle hits home”looks at the implications of the rising U.S. debt levels. “Overall U.S. government debt now stands at 92.6% of projected 2010 gross domestic product, according to the International Monetary Fund. The U.S. now has a heavier debt burden than several of the overleveraged countries that have been branded with the scornful nickname “the PIIGS.” Reinhart and Rogoff have shown that “a rise in government debt above 90% is associated with a decline in economic growth of roughly one percentage point per year”. While the U.S. has advantages over the PIIGS, “we cannot take for granted that these things happen only in places like Greece but can’t happen here. If you flood the markets with more and more debt, its value is going to go down. We are silly to fool ourselves into believing otherwise.” The article also tables an old John Templeton quote “”Those who spend too much will eventually be owned by those who are thrifty.” In terms what one might do in such circumstances, the obvious candidates of gold, commodities and TIPS are already overpriced, so Zweig suggests that “for most investors, at least for the time being, the best thing to do is wring your hands while sitting on them.”

John Parry in the Financial Post’s “Rating agencies no longer useful, says Pimco” reports the recent rating fiasco associated with mortgage backed securities is just the latest in a long sequence of failures caused or not predicted in a timely manner by rating agencies. “Their warnings were more than tardy when it came to the Enrons and the Worldcoms of ten years past, and most recently their blind faith in sovereign solvency has led to egregious excess in Greece and their southern neighbours”.  Pimco’s Mr. Gross also indicated that in addition to being inaccurate, the services provided by rating agencies “”are overpriced as well as subject to the influence of the issuer, which in turn muddles their minds and clouds their judgment”. In the Globe’s “U.S. credit raters under the microscope”Barrie McKenna quotes the leadership of one of the credit raters as saying “These errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both.”

The Financial Post’s John Ratner discusses gold price, its direction, the fears are driving its future price up or perhaps down in “Gold’s future as ‘anti-currency’” .

Matt Phillips in the WSJ’s “Buffett may know more about derivatives than securities law”writes that “Berkshire’s push to soften elements of derivatives regulation shows, Buffett’s relationship with derivatives is more complicated than it first seems.” Mr. Buffett is known for having declared derivatives as “financial weapons of mass destruction”, but Mr. Buffett who is a player in the derivatives market, is now lobbying against some of the proposed regulatory changes which would require certain levels of collateral (at least retroactively). In a letter to shareholders he explains his stand on derivatives as “We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998. The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. At Berkshire nothing like that has occurred – nor will it.”

And finally in the Financial Times’ “Stop turning Goldman into scapegoat for wider crisis” Spencer Jakab discusses his “unease…with the possibility that Goldman has become a scapegoat for millions of homeowners and investors psychologically unable to admit at least partial fault for succumbing to the madness of crowds and lure of easy money. The one investment bank that hedged appropriately and enjoyed a hugely profitable rebound is an obvious target.” “If Goldman is innocent – and they should be presumed so – do they still deserve to be hated? However satisfying it feels to bash millionaires in a recession, vilifying Goldmanites simply for being smarter and richer than the rest of us may be bad for society, not just the Park Avenue set. Projecting our insecurities onto others is the root of scapegoating.” (By the way, by allowing our attention to be diverted to a scapegoat, will also insure that we won’t fix the root cause of what almost brought the financial system to its knees, and leave ourselves exposed for a recurrence.)


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