Hot Off the Web– April 27, 2010

Personal Finance and Investments

Jason Zweig in the WSJ’s “Full disclosure: Most risks hide in plain sight” argues that while “full and proper” disclosure is necessary, it is still insufficient for many investors to make an “informed decision”. The reasons are related to: too much information reduces ability to process it, difficulty in identification of the really important information, and not asking “If I am buying, someone else is selling. What, exactly, do I know that this other person may have overlooked?”

The WSJ’s Tom Lauricella looks at “The pitfalls of fixating on income” and suggests that a “portfolio that kicks off a big stream of income, whether through interest on bonds or stock dividends” can result in “a collection of investments that aren’t sufficiently diversified, one where returns are eaten up by taxes or where savings fail to grow fast enough to outpace long-term inflation”. Another problem is the risk to capital invested in fixed income instruments if interest rates rise, and reaching for higher dividends comes with higher risk!

David Rosenberg in his recent Market Musings pointed out that S&P 500 is now about 35% overvalued given that the Shiller P/E ratio updated in April stands at 22 versus the historical average of about 16.5 (i.e. it’s not cheap, but not wildly overvalued and there no guarantee that it won’t go higher, yet cautionary signs have been posted).

In the Toronto Star’s “Money fund investors missing out”James Daw writes that Canada’s Money Market investors have been losing money (perhaps as much as $500M) for the “privilege” of having immediate access to their money, due to exorbitant fees. Money Market funds are mutual funds and they come with Canada’s notoriously high mutual fund fees. “Manulife Financial offers a money market fund inside one of its guaranteed income fund investment products (with 2% fee) that lost 1.25 per cent in the 12 months ended Feb. 28. Industrial Alliance Insurance and Financial Services Inc. has a fund that lost 1.51 per cent.” (Should this be illegal? By the way, in the U.S. money market funds carry the implicit promise of “not breaking the buck”, and when in 2008 Primary Reserve fund “broke the buck”, the Treasury Department started offering fund managers access to insurance against such losses. Not in Canada? Pithy.)

In the NYT’s “How to find out if you have unclaimed funds”, Jennifer Saranow Schultz points out, that New York State alone has $9.9B of unclaimed assets in its custody. “With most states now offering searchable unclaimed property databases and online claim forms, all you need to do is search the databases of states where you have lived. The non-profit National Association of Unclaimed Property Administrators offers nicely organized links to such databases here. Just click on the map where you want to search”. (By the way the Bank of Canada also has an Unclaimed Balanceswebpage where you can search for overlooked accounts at financial institutions.)

Real Estate

The U.S. S&P/Case-Shiller Home Price Indicesfor February 2010 were released today. “For the first time since December 2006, the annual rates of change for the two Composites are positive. The 10-City Composite is up 1.4% from where it was in February 2009, and the 20-City Composite is up 0.6% versus the same time last year. However, 11 of 20 cities saw year-over-year declines.” “As of February 2010, average home prices across the United States are at similar levels to where they were in late summer/early autumn of 2003. From their peak in June/July of 2006 through the trough in April 2009, the 10-City Composite is down 33.5% and the 20-City Composite is down 32.6%. The peak-to-date figures through February 2010 are -30.7% and -30.3%, respectively.” However “It is too early to say that the housing market is recovering” says David M. Blitzer, Chairman of the Index Committee at Standard & Poor’s. “Nineteen of the 20 MSAs and both Composites declined in February over January…sending a more cautionary message compared to the annual figures….we are not completely out of the woods.”

In the Herald Tribune’s “Home sales boost cheers region’s realtors” Michael Braga reports that real estate agents are more optimistic in Southwest Florida due to a surge in both sales and prices in March, relative to March 2009 (the point of maximum pessimism and stock market bottom). The agents are also encouraged by lower inventory to sales ratios. Not all of Florida was as positive:  “Sales rose by 24 percent in Florida, but the median price fell 3 percent to $137,000. The only other major market in Florida that saw appreciation was West Palm Beach, where prices rose 8 percent to $246,100.” But more foreclosures (currently about 50% of the market) are looming, and many expect that this will continue to dampen market prices. Whatever improvement is visible, it is primarily limited to lower price points.

Similarly in WSJ’s “New home sales jump 27%”Hagerty and Watapka report an increase in the annual rate of U.S. new house sales in March from the previous month’s low, but the rate is still less than a third of the 2005 peak. Also, much of the recent gain may be due to the expiring tax “credit (which) is simply moving sales forward that otherwise would have occurred later in the year”.

For those interested in seeing and comparing house price indices in 20 countries
since late 80s, the Economist’s “Bouncing back”has an excellent interactive house price tool which also includes prices in real terms, prices against average income and % change. The graphic is fascinating, especially when you start playing the range of dates covered by data (“select dates”). Also interesting that their data shows that “In half of the 20 countries we monitor, house prices are higher than they were twelve months earlier.”

In the Globe and Mail’s “Appreciate your house, but don’t expect it to appreciate a lot”Dan Richards looks at a range of perspectives on Canada’s housing prices, but the title of this article summarizes well his take of where we are heading.


Jonathan Chevreau in the Financial Post’s “Pension reform for dummies: 5 simple “no-brainer” proposals”lists a set of BMO proposals for pension reform. While these are “no brainers”, these proposals are a little like polishing the outside of an apple which is rotten at the core. To fix the core: (1) for existing DB plans we need to fully secure existing (earned) commitments even if the sponsor is unwilling to continue the plan, while (2) for the next generation retirement income system we need some form of DC plan without the rotten core (i.e. without): inadequate savings (required: use combination of mandatory, inertia driven defaults, education), high-cost investment vehicles (required: access to large scale employer independent low-cost professionally managed investment vehicles like CPP, Teachers, etc), lack of reasonably priced longevity insurance options (required: e.g. either a compulsory or voluntary national scale longevity insurance by: (i) offering a non-refundable single or multi premium annuity-like life-contingent income stream starting around age 85, or (ii) its simplest form is to allow deferral of CPP to age 80-85 with the corresponding higher payout for life or (iii) a deferred payout annuity riding on CPP that one could buy into at any time to deal with the transition to new system. In all cases investment and longevity risk could be borne by plan members collectively/cross-generationally like in the CPP, or collectively by cohort.)

In the Financial News’ “Could rising gilt yields end pension crisis”Gavin Orpin refers to a Barclays study which “argues the case that long-term government bond yields could more than double from current levels over the next decade, to reach around 10% by 2020.” This would result in much higher (actuarial) discount rates, which in turn would reduce the size of liabilities and might even allow trustees “to buy out all their scheme liabilities with an insurer. The pensions crisis, at least as we know it currently, would be over.” Of course, not everyone agrees that interest rates will necessarily rise (e.g. look at Japan’s last 20 years), or on the overwhelmingly positive impact of rising interest rates on funded status of pensions. If interest rates rise significantly, pension plan asset values will likely fall and (indexed or even partially indexed) liabilities can increase if rates increase (as they usually do) with rising inflation.

Things to Ponder

In the Financial Times’ “Jeremy Grantham: We add nothing but costs”Grantham quotes “Paul Volcker’s observation that the only truly useful financial innovation in the past 20 years is the cash machine. The rest, was only of benefit to the guys who came up with it, and who paid the price when it all went wrong?” it’s refreshing to hear from a financial industry insider that “The business is a zero-sum game, he points out, and “we collectively add nothing but costs”. Costs have grown because there is no fee competition, due to the agency problem and the information advantage the agent has over the client. Growing complexity has increased the client’s dependence on the industry.” The article also raises the issue of valuation and horizon; so while risky assets over the (very) long-term can be expected to out-perform riskless ones, instantaneous valuation is an important determinant of the actual return received and is a function of investor’s horizon.

Similar sentiments are expressed by Martin Wolf in the Financial Times’ “The challenge of halting the financial doomsday machine”where in reference to banks he writes that “The combination of state insurance (which protects creditors) with limited liability (which protects shareholders) creates a financial doomsday machine. What happens is best thought of as “rational carelessness”. Its most dangerous effect comes via the extremes of the credit cycle. Most perilous of all is the compulsion upon the authorities to blow another set of credit bubbles, to forestall the devastating impact of the implosion of the last ones. In the end, what happens to finance is not what matters most but what finance does to the wider economy.” Wolf also quotes UK FSA’s Adair Turner that “Financial systems are important servants of the economy, but poor masters. A large part of the activity of the financial sector seems to be a machine to transfer income and wealth from outsiders to insiders, while increasing the fragility of the economy as a whole.” (Martin Wolf sure calls them as he sees them, and he pulls no punches. An interesting article that you may want to read; he also discusses with what’s wrong with current reform proposals.)

In an article on the related subject of regulations, WSJ’s “Why government regulation fails”Gerald O’Driscoll Jr. says that we have “an economy of liars” and “crony capitalism”. He argues that regulations have failed in the past and will fail again. Instead, “Better than multiplying rules, financial accounting should be governed by the traditional principle that one has an affirmative duty to present the true condition fairly and accurately—not withstanding what any rule might otherwise allow. Financial institutions should have a duty of care to their customers…. Piling on more rules and statutes will not produce something different than it has in the past. Reliance on affirmative principles of truth-telling in accounting statements and a duty of care would be preferable. Deregulation is not some kind of libertarian mantra but an absolute necessity if we are to exit crony capitalism.”

The debate continues on who is responsible for the recent financial crash, whether Goldman Sachs acted illegally as charged by the SEC and what regulatory changes should be enacted to prevent a recurrence. But there is relatively little discussion about the critical negative contribution made by rating agencies which designated these toxic securities as AAA-rated. The FT’s “Moody’s chief admits failure over crisis”, WSJ’s “Paulson role not made clear” and FT’s “Nixon moment for rating agencies” articles discuss: the inherent conflict of interest of rating agencies, the relentless pressure exercised on them by the originating banks to get AAA ratings on their engineered products, the rating agencies’ push to maintain/increase market share, publication of rating agencies’ rating models giving the banks opportunity to game the outcome, and at times models were even changed to benefit the issuers to gain future rating business. The investment vehicles were first over-rated at AAA, and then (according to a U.S. Senate panel) when over a short period of time in 2007-2008 were downgraded by the thousands (sometimes on a single day) the downgrades “wrought havoc on markets and marked the start of the financial crisis”.

And finally, the related Goldman story which appears to have soaked up most of the news ink over the past week. In Financial Times’ “Goldman versus the regulators” Jenkins and Guerrera analyze the various positions in this epic battle between Goldman and the SEC. (Guilty? Perhaps not. Reputational damage? For sure. Customers will discard the previously naïve notion that Goldman, and other similar but less successful investment banks, are selling advice to them, rather than a “product” to earn a fee or even take the other side of the trade. Banking and the broader financial services world will likely be forever changed (as it needs to be). This is because people will realize that they live in a Darwinian world, where caveat emptor mentality will likely be stronger than before, and SEC’s case will no doubt affect the outcome of the drive for regulatory changes in the U.S. And by the way, you might also want to read John Gapper’s perspective on why “Greed is not good for Goldman”. Gapper argues that Goldman, by mixing its “client advisory and asset management work” with its “risk-taking with its own capital”, has inevitably failed to manage the inherent conflicts. Goldman treated some customers in this deal as a counterparty while others as a client, but it argues that it had no fiduciary duty to buyers of what turned out to be a toxic product and the buyers and sellers were “qualified” (i.e. professional investors) and “consenting counterparties operating in a sophisticated market”. As one of Goldman’s ex-partners quoted in the article suggested ““The SEC may be trying to cure unethical behavior by treating it as illegality.” But the law is all the SEC has; ethics are Goldman’s responsibility.” (The transferable lesson from this for individual investors: when you are dealing with your banker, stock broker, mutual funds salesman you should remember while you might think that you are getting advice, when in fact you are just a source of fees or even worse a counterparty in opaque trade based on asymmetric information.) However Alan Abelson in Barron’s “Wanna bet?”quotes Barry Ritholtz that “the case against Goldman, far from weak, is very strong.”Based upon what is in the complaint, parts of the case are a slam dunk. The claim (by Fabrice Tourre, a former Goldman VP pushing the deal) that Paulson & Co. was long $200 million when it actually was short is a material misrepresentation — that’s Rule 10b-5, and it’s a no-brainer. The rest is gravy.” (Now, that sounds a lot different than not disclosing that Paulson was shorting the deal.)

William Hanley in the Financial Post’s “Goldman profits. Who knew” brings the Goldman story down to its essence. “It (Wall Street or Bay Street for that matter) does whatever works, mostly within the rough guidelines set out by toothless and feckless federal watchdogs. That Wall Street is a paragon of self-interest should come as no surprise to anyone with a pulse. The Street is there to make money for itself, with most clients and the small investor on Main Street mere sources of funds to produce more money for the Street. If the clients and small fry make money, it’s basically a byproduct of the process of squeezing as much out of the system for the investment banks, their principals, employees and, (way) down the line, their shareholders. Ostensibly, Wall Street once was there to gather capital to finance America’s great expansion. But that has been turned on its head, with the capital fuelling the Street’s expansion.”

The Financial Times’ John Authers in presents arguments “Why side bets on synthetic CDOs should be banned”; this not about whether Goldman broke the law or the SEC charges are politically motivated, but about the safety of the financial system. “But was it a sensible thing to do? Does the public have any interest in investment banks behaving like this? The answer to both questions is “no”. The sum effect of this transaction was to increase the risk and instability of the financial system. The banks who accepted the bet were more exposed than they had been in the first place…Generally, financial products either provide someone with capital or allow the investor to manage their risk. Nobody received any capital out of this transaction (and there are other ways to manage the risks)…There should be no need for bankers to use their depositors’ funds to make bets on one-off deals…Nothing would be lost, and systemic risks would be reduced, if such transactions (bets) were barred in future (for banks).”

And the LA Times reports that “Goldman played key role in mortgage meltdown, Senate investigators say”  “The evidence shows that Goldman Sachs helped build and operate that conveyor belt that fed toxic mortgages and mortgage securities into the financial system, and then made large bets against the market it helped create … reaping the profits from it,” said Sen. Carl Levin (D-Mich.), the subcommittee’s chairman. “The ultimate harm here is not just to the clients who were not well-served by their investment bank. The harm here is to all of us.” (The list of culprits is a lot longer than just Goldman. Time will tell if what Goldman did was illegal or just unethical. Scapegoating Goldman alone doesn’t explain what actually happened, and certainly doesn’t shine the necessary light to the incompetence, stupidity, questionable ethics and/or even illegal acts of some/all the other players, a long list, starting with the mortgage brokers, to rating agencies and all the way to the Fed, and many others in-between.)


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