Uncle Alan's Legacy at the Federal Reserve

This week, on Tuesday (August 7, 2007), the Federal Reserve Open Market Committee meets to decide where to set the Fed's target for the federal funds interest rate. That is the rate that heavily influences other short term interest rates. The consensus expectation is that the Fed is going to hold the fed funds rate steady at 5.25%, where it's been for a year.

There are some that would like the Fed to lower interest rates. They point to the turmoil in the debt markets, especially the market for mortgage backed securities, and argue that lowering rates would boost investor confidence and give relief to financial institutions that now face significant potential losses. Further, the simple arithmetic of investing dictates that lower interest rates mean that equity investments like stocks will automatically become more valuable. Given the 6% drop in stock prices since the Dow Jones Industrial Average hit its peak a little over two weeks ago on July 19, 2007, and a 281 point drop last Friday (8/3/07), stock investors wouldn't mind a little extra octane in the financial system.

On the other hand, the Fed continues to see inflationary risks. While gasoline prices have eased off a bit in recent weeks, they remain high, as do crude oil prices. And food prices have been rising nastily (check out bread and milk, for example). Moreover, the economy remains steady, and unemployment is comparatively low. Productivity growth has tailed off from the high levels of the 1990's, which means that increases in labor costs are more likely to be covered by increased prices than by more production per employee. The first increment in the federally mandated minimum wage increases became effective on July 24, 2007. This, along with other wage and salary increases, could have inflationary effect.

Most importantly, the American consumer continues to do yeoman's duty at the mall. Surveys of consumer confidence indicate consumers have yet to meet a sale they don't like. Even though gas price increases have reduced spending for some other items, and stagnant or dropping home prices now limit the ability to spend one's home equity on cheese curls and DVDs, Americans on average have a negative savings rate while keeping steaks and shrimp on the dinner table.

Consumer spending constitutes 70% of the U.S. economy. It's the locomotive that pulls the rest of the economy along. If consumer spending stays strong, the Fed won't be strongly inclined to lower interest rates. Even if the Fed has to arrange a bailout of financial institutions as a result of the mortgage market's belly flop, it might keep interest rates steady in order to tamp down any inflationary sparks. If, however, the consumer loses momentum, then the Fed will find the going toughter.

Will the consumer keep spending? The evidence is mixed. Numerous statistical studies indicate that median household income in America has hardly risen in the last 30 years. And, as we mentioned, savings rates have been going negative (which means people are spending their savings, not adding to them). The rich have been getting richer, but even then they can't buy all the . . . well, stuff . . . that retailers have been selling. So where the heck have consumers, with their hardly rising median incomes, been getting the smackeroos for their flat screen TVs, $2,000 grills and $40,000 kitchens?

The answer is two-fold: (a) debt and (b) equity. The debt in this case is credit card and other consumer debt. Consumer debt reaches new record levels with each passing year. This debt is funded to a large degree by the packaging of credit card debt into pools of loans that are sold to investors. This is essentially the same process by which mortgage loans are packaged into CDOs and sold to investors. And investors have been willing to buy credit card debt for the same reasons why they've bought mortgage loans--the availability of easy money and the idea that if it's risky, that's good.

The second source of consumer money--equity--includes equity from stocks and home equity. The equity in stocks came in the late 1990's, with the dot com stock market boom. A lot of people stopped saving then, and went on a spending spree because the increased value of their stocks made them feel wealthy. When the stock market went bust in the early 2000's, this feeling could have gone bust. But it was immediately propped up by the real estate boom that began around 2000, which offered the potential to convert one's home equity into shoes, cars, pizza, football tickets, imported vodka, and a never-ending array of portable electronic devices. The real estate boom, as we now realize, was instigated to a large degree by an array of confusing but eagerly underwritten mortgage loans containing time-delayed fuses that blew up on the borrower two or three years later with unmanageable payment increases. These poorly conceived loans, remarkably, were sought after in the mortgage markets for packaging in CDOs that were avidly bought by hedge funds and institutional investors, often using borrowed money. As we discussed in our earlier blog (http://blogger.uncleleosden.com/2007/07/those-pesky-cdos-and-how-theyre-ruining.html), easy credit made all this possible.

Easy credit was the key, and easy credit was the product of Federal Reserve policy. Let's take a look at history. Shortly after Alan Greenspan became Chairman of the Fed, the markets crashed on October 19, 1987, dropping 22.68% in one day. Not an easy introduction to the Chairman's job. Chairman Greenspan made clear that the Fed would supply liquidity to the banking system in order to prevent any financial panics. He eased interest rates, which soothed market fears and instilled confidence that the Fed was on the job. His quick action helped prevent a larger market meltdown, and the market eventually rallied to boom into the 1990's.

Lowering interest rates became a Fed response to adversity. When the economy slid toward recession in the early 1990's, the Fed lowered interest rates. When the stock market bust of 2000 began, the Fed eased interest rates. In the aftermath of the 9/11/2001 terrorist attacks, the Fed lowered interest rates. And, throughout the 1990's and 2000's, the Fed kept interest rates at historically low levels. This willingness to keep the cost of borrowing low and lower helped to prevent financial panics and recession. But it also allowed increasingly large amounts of credit to become available. People grew accustomed to the idea that if bad things happened, the Fed would lower interest rates and bail them out. So they became more reckless. This is the moral hazard problem that we've discussed before. http://blogger.uncleleosden.com/2007/07/why-fed-wont-bail-out-stock-market.html.

Chairman Greenspan's success at keeping things on a relatively even keel made him as much of a hero as an economist can become. He was famously ambiguous, expressing three or four thoughts in two sentences or less whenever pressed by Congress on important questions. That way, he left his options open. But he sounded confident, which was all that seemed to matter. Over time, he became an avuncular figure, whose bow-tied social appearances were as likely to be reported in the society pages as his enigmatic ramblings were to be reported in the business pages.

Part of his legacy, however, is the vast pool of easy credit that has roamed throughout the world economy in recent years, creating bubbles in the stock, real estate, debt, commodities and derivatives markets. These bubbles, like all bubbles, have popped. There is no question that Greenspan's intentions were the best--he wanted to prevent economic downturns. And he largely succeeded. By all appearances, he was aware of the risks of too much easy money, and tried to raise rates to reduce the bubbling. The stock market downturn in 2000 was preceding by Fed rate increases, and the real estate and mortgage markets downturns in 2006 and 2007 were preceded by a series of Fed rate increases that Greenspan started in June 2005 (which Chairman Bernanke continued for a few Open Market Committee meetings in the first half of 2006).

But Chairman Greenspan may have misjudged the extent to which Wall Street, government policy makers, investors, and others would come to rely on quick injections of credit to fix economic problems. When things go wrong, there's a tendency now to expect the government to fix problems. Conservative that he is, Greenspan nevertheless fueled this tendency with his adroit interest rate adjustments. In so doing, he created moral hazard that he surely would not endorse.

This is a part of his legacy that now confronts Chairman Bernanke and the other members of the Open Market Committee. One strongly suspects that Chairman Bernanke would like to wean the financial markets off their expectation that the Fed will cure all of their boo-boos. The more the U.S. and the world economies depend on governmental monetary policies to function, the less well they will ultimately function. Wealth--as in the wealth of nations--cannot be built on inflating asset values or financial engineering. The Dutch found this out a few centuries ago in their dalliance with tulip bulbs. Wealth is built on innovation, investment and productivity. Yet, much of the U.S. economy has been propped up in recent years by easy credit and the resulting asset bubbles and the financial engineering that easy credit fosters. While houses don't usually resemble tulip bulbs, exceptions could have been found in the ARM-drenched real estate markets of a few American cities at the height of the recent lunacy.

Easy credit is now becoming a thing of the past. Mortgage borrowers are actually being asked to demonstrate that they have a modicum of creditworthiness. Real estate values have stopped rising and could be dropping, so the home equity gravy train has slowed to a crawl. As investors in the debt markets pull back from all varieties of packaged debt, credit card borrowers may find it harder to get new or higher credit lines. The booze for the consumer party is running low.

Will consumers curtail spending because of the subprime train wreck? Not if they can help it. CDOs and hedge funds are far removed from the daily lives of most people. The losses from the subprime mess have thus far appeared to fall on Cartier's clientele much more than on Wal-Mart's. Bentley dealers in the New York metropolitan area may be concerned, but Toyota dealers probably aren't. In spite of recent stagnation and losses in home values, consumers armed with their debit and credit cards have continued to charge ahead, disregarding the cannon to the right and the cannon to the left.

But if the subprime mess metastasizes into the broader economy, the Fed may be forced by the moral hazard of its own creation to lower interest rates once again, even if doing so fuels inflation or creates more easy credit to bubble around in future years. Only once in the last 30 years has the Fed truly held the line and asked American financial institutions, investors and consumers to act like adults. That was in the early 1980's, when Chairman Paul Volcker and the Fed of that era raised interest rates and triggered a sharp recession that squeezed the nasty inflation of the 1970's out of the economy and laid the foundation for the prosperity of the last 25 years. The American public of the Volcker era still had vivid memories of the Great Depression and World War II, and understood that sacrifice was sometimes required to make the world a better place. That principle hasn't changed, but does today's American public--which has never met a sacrifice it didn't admire someone else for making--understand it?

Crime News: now, you can't even trust the ice cream vendor. http://www.wtop.com/?nid=456&sid=1209389.

Speculating with Derivatives in the Mortgage Markets

News reports tell us that a third Bear Stearns hedge fund that invested in mortgage-backed securities has suffered serious losses and stopped honoring investor requests for withdrawals. A number of hedge funds are reported to have suffered losses in the mortgage markets. Among those affected are funds operated by hedge fund veterans Paul Tudor Jones and Bruce Kovner, who were tangling with market volatility when many of today's newer hedge fund operators were dabbling in acne remedies. European banks have reported sizable losses, as have Australian hedge funds. Mortgage brokers and mortgage companies have suffered heavily, and bankruptcy lawyers are sharpening their pencils. The financial press hints at many more losses yet to be reported.

The cascading losses from the subprime mortgage mess reveal a flaw in the rationale commonly provided for derivatives. Derivatives are said to be socially beneficial because they diffuse risk and place it in the hands of those that want to carry that particular risk. The impact of losses is spread out and market volatility is damped. It all sounds good.

But if losses are diffused, then how could all these big players in the financial markets have been clobbered as badly as they were? Or, in a few cases, forced to file for bankruptcy?

Derivatives have sometimes been used as hedges, and many of the earliest derivative contracts were conceived as hedging mechanisms. Why didn't the hedge funds hedge their mortgage market exposures? There are so-called credit derivatives contracts that are like an insurance policy against a CDO default. A hedge fund or other investor that had held CDO credit derivatives when the yogurt hit the fan would have been out of pocket the cost of the credit derivatives. But that beats paying midnight retainers to bankruptcy lawyers.

The apparent answer is simple, if disturbing. Derivatives contracts, although in many cases originally developed as hedging or risk shifting mechanisms, are now frequently used to speculate. Investors can start off with a neutral trading position and invest in a derivatives contract that gives them exposure they hope will be profitable. In other words, they seek out risk. This is the opposite of hedging.

Hedge fund operators appear to have used CDOs holding subprime mortgages largely for speculative purposes. Although these investments are risky, they'd probably have been priced at attractively low levels that would allow for big potential returns.

The fact that derivatives contracts can be leveraged also would have played a critical role. In a world flush with cash (until perhaps recently), it would have been easy for the hedge fund kings to line up credit from investment banks to buy derivative contracts sold by the investment banks that were offering credit. (Furniture stores do the same thing--sell you their sofas and love seats on the installment plan; but sofas and love seats usually don't turn around and bite your butt into bankruptcy.) With the availability of easy credit, hedge funds could leverage up their derivatives speculations, and go in for a dollar instead of a dime.

Using credit-financed derivatives to speculate takes us to the back hills of Virginia, into hollows and ravines where moonshine is still made by truck driving men who don't talk a lot, and who transport it to Washington by the light of the Big Dipper to be sold to select bars where you can get a taste of white lightening if you know what to ask for and how. Leveraged speculation in derivatives is 180 proof stuff, and so potent you might not even taste it. You'd just get a burn in your mouth.

Although hedge fund operators are aggressive, why would they take such large risks? In part, the answer probably involves things like ambition, testosterone, hubris and an affinity for adrenalin rushes. Some soldiers like the thrill of combat, even though the consequences can be extremely prejudicial.

But a crucial part of the answer is competition. Hedge funds compete with, of all things, index funds. The hedge fund industry has grown exponentially in the last ten years. As experienced investors know, the more money that crowds into the field, the fewer good investment opportunities there are. Thirty years ago, the Peter Lynchs of the world could drive around their home towns, see which fast food joints were drawing big crowds, and figure out what companies to invest in. Investing has become a lot harder than that. Hedge fund operators who just read 10-Ks and annual reports will have a tough time surpassing the S&P 500. In that case, why would their clients pay them 2% of assets and 20% of returns? The Vanguards and Fidelitys of the world are much less expensive and a whole lot less risky.

So the hedge fund guys need to use leverage and invest in alphabet soup esoterica like CDOs, CLOs, etc. in order to have a shot at beating the indexes. And hedging their exposure would only reduce the potential for them to beat the indexes. If you hedge, you necessarily start to lose money roughly around the same time you start to make money. You can try to play the game of investing in arbitrages a la Long Term Capital Management, in the hope of probably making small amounts of money at the risk of possibly losing large amounts. But that, too, requires leverage if the returns are going to give you bragging rights.

So, it would appear that the hedge funds and other mortgage market players must have made unidirectional hope-these-CDO-things-work-out bets. Maybe they had some hedges, and maybe they had other investments that were unrelated (or, "not correlated" in the parlance of risk management junkies) to the mortgage backed investments they had. These holdings would have provided some degree of protection or diversification. But, net net, if you don't take some above average risks, you won't get above average returns. So these folks eventually had to place their chips on either red or black.

Some hedge fund investors may have thought that the hedge fund operators had special insights or could do especially diligent research. And it would not be surprising if some hedge fund guys may have encouraged such beliefs. But, with a large, mature market such as mortgage backed securities, is it really likely that a 36-year old newly minted hedge fund operator, founder of the 2,500th hedge fund to be created in the last ten years, would truly have an informational advantage over the rest of the herd?

So, where does this leave us? First, if we didn't figure it out after the 1998 Long Term Capital Management bailout, let's figure it out now: the derivatives market is as capable of reckless irrationality as any other market, whether it be dot com stocks, real estate or tulip bulbs. The old chestnut that derivatives disperse risk and damp volatility has gone the way of the American Chestnut. Say it now and say it loud: derivatives are speculative instruments.

Second, even though the tamales in the debt and derivatives markets are getting red hot, no one knows who's going to end up holding them. These markets are substantially unregulated; there's no disclosure or reporting. The yogurt has hit the fan, but none of the Fed, SEC, Treasury, CFTC or any other governmental body knows where it will land.

The lack of transparency is not lost on investors. As we noted at the beginning of this blog, investors in a third Bear Stearns fund were sending in so many withdrawal requests that Bear Stearns ceased to allow withdrawals. That's akin to an old-fashioned run on a bank, where the bank simply tells the depositors to go home. Closing the doors doesn't reduce investor anxiety. If anything, it may heighten it. But we're no longer in the 1930's and Jimmy Stewart isn't with us any more to calm things down.

As a practical matter, we can only wait and see how things turn out. If they turn out badly, perhaps we can hope that the Fed's likely interest rate cuts give us a real-life Miracle on 34th Street. But some things happen only in the movies.

Record News: let's get away from this Barry Bonds stuff for a moment. The kazoo record seems safe. http://www.wtop.com/?nid=456&sid=1208243.

Private Equity's Traffic Jam in the Bond Market

Four score and seven months ago, the U.S. stock markets peaked and began to fall. They fell for a long time thereafter, and have only recovered this past spring, measured by the numerical value of stock market indexes. Adjusted for inflation, they still haven't recovered. During the late 1990's, the managements of many companies became fabulously wealthy by going public. With the end of the dot com boom, the allure of becoming a public company faded. While many companies continue to go public today, and enjoy the benefits (and burdens) of being public, a lot of the recent action for management has been taking their companies private.

To go private, management usually teams up with one or more investors (typically a private equity firm), borrows a large pile of cash, and buys out the public shareholders. Management and the private equity firm invest a comparatively small amount of money, but hold the stock of the newly privatized (so to speak) company. With the public shareholders out of the picture, management can have a larger stake in the company than before. They work to make the company more efficient and profitable, sell off unwanted lines of business, and do other things that may be easier once they're outside the glare of the quarterly reporting process and those pesky stock market analysts. Then, after one, two, three or however many years, they take the company public again, presumably at a big profit to themselves and their private equity backers.

Skeptics might point out that public stockholders don't share in the big pinata at the end of the process. And the employees may suffer a round of layoffs or two, and maybe some cutbacks on health and retirement benefits. But the human interest side of the story doesn't change the fact that the numbers for these deals have been very good for management and the private equity firms. As discussed one of our earlier blogs, a private equity firm bought Hertz from Ford in 2005 and brought it public about a year later, getting something like a 200% return. http://blogger.uncleleosden.com/2007/07/bond-market-tremors-hit-private-equity.html.
That sure beats savings bonds.

Because of the relatively small capital investment by the private equity firm and management, going private transactions require financing--a lot of it, as in billions--mostly to take out the public shareholders. A lot of public companies now trade at average to above average multiples of earnings, measured by historical standards. So it costs quite a bit of dinero to buy one. This isn't like 1982, when you could buy a public company, do a sale and leaseback of the parking lot next to corporate headquarters, and pay off the acquisition debt.

The financing for private equity deals generally came from institutional investors that bought bonds issued as part of the going private transaction. Until recently, raising the financing wasn't hard. The industrialized world was awash in cash, and big investment banks would line up to provide financing. The banks would promise to find investors to buy the millions or billions of dollars of bonds needed for the deal. They agreed that, if they failed, they'd pony up the money themselves (through an arrangement called a "bridge loan"). The fact that they might also get advisory fees, underwriting fees and perhaps other compensation for their participation in these deals probably wasn't entirely unrelated to their willingness to commit to provide these potentially enormous bridge loans.

The banks didn't really want to make bridge loans, since with a bridge loan, a large part of the risks of failure of the private equity deal would fall on them, instead of on bond holders. However, for a while, finding bond investors was fairly close to shooting fish in a barrel, with a shotgun. Bond investors were a dime a dozen, and so eager to invest they'd agree to deals where they'd have less than normal protection (so-called "covenant-lite" bonds). They even invested in deals where the borrowing company could avoid paying interest by issuing additional debt to the bond holder. In other words, the borrower would provide another promise to pay instead of cash on the barrel head. Even though they might not have much protection, bond investors still lined up to play in the private equity sand lot.

The private equity deals exemplify a process on Wall Street of structuring transactions so that risk is transferred to passive investors while rewards are concentrated on the deal makers. The public stockholders would be eased out of the picture, so that the jelly beans wouldn't have to be shared with them. New financing for the company would consist mostly of debt. Classic B-school analysis would tell you that when debt is readily available and cheap, you make more doubloons for yourself by using debt instead of equity to capitalize your company. The people in the private equity firms are very good at this kind of arithmetic. Reduce the amount of equity capital, concentrate equity ownership in the hands of management and their new best friends at the private equity firm, and finance the rest of the venture with debt. The cost of most of the capital (i.e., the debt part) is low, so the profits that accrue to the holders of the equity are leveraged. And if the transaction should fail, your equity investment would be relatively small and much or most of the loss would likely fall on the bond holders.

In essence, the going private deals largely separated risk from reward. The arithmetic of going private deals had an irresistible logic for management and the private equity firms, because they could get concentrated, low risk and leveraged rewards, while the bond holders were served rice and beans. Vast herds of bond investors abounded, and investment banks easily drove them into corrals and branded them with any deal the private equity firms wanted to do.

Consequently, going private deals were done early and often, over breakfast, lunch, dinner, and in-between meal snacks. Even though stock market price-earnings multiples were relatively high, as long as the debt was cheap, you might as well take the concentrated, low risk, leveraged profits while you could. A pipeline, almost assembly line, of deals was created, with transactions queuing up for their turn at securing financing in the debt markets. Stock market prices rose, as if every public company in the nation thought that it would be the target of the next deal.

Then, a funny thing happened on the way to the forum. Interest rates began to rise worldwide, especially for corporate debt. There are a lot of reasons for this, but it happened. And the rise in interest rates changed the profit-loss equation in private equity deals. Deals that could be successful with cheap credit might fail with more expensive credit. To make things worse, the private equity firms began to pay higher and higher prices for public companies, which meant taking on higher levels of debt to finance the deals. That only compounded the effect of rising interest rates. And, with large number of deals in the pipeline, bond investors began to pick and choose, looking for ones where the deck wasn't stacked quite so badly against them.

Next, a very ugly and evil troll named Subprime emerged from a swamp and stormed down Wall Street, stomping everyone in his path and consuming everything he stomped. The more he ate, the larger he grew. Subprime got bigger and bigger. Maids on Maiden Lane screamed for help. But the doyens of the markets trembled and dropped their bids, fleeing as fast as their limousines could navigate the treacherous pavement of the FDR Drive while desperately searching for any bridge across the East River that wasn't clogged with traffic. Subprime continued on his rampage, becoming even more gargantuan, and reached across oceans to consume a European bank or two and an Australian hedge fund. Many bond investors were also invested in the mortgage markets and learned that having a troll chew on your toes because you bought some risky investments might make you want to stay home and sip tea in the garden for a while.

Bond investors all of a sudden started to balk, and demand greater protection for their money. Greater protection for their money would mean less potential profit for the private equity guys and management. The private equity guys are no pushovers, and caving in to the demands of bond holders could reduce the potential amounts of their hard-won (well, maybe not so hard-won) profits. So the bond market stalemated. Bond investors and private equity firms couldn't agree on terms for bonds, so no bonds were sold. One recent example is a private equity acquisition of Chrysler by an outfit called Cerberus, which was left with no bond financing. Other examples are the acquisition of a British pharmacy chain called Alliance Boots and an acquisition of Allison Transmission (a GM subsidiary that makes car transmissions).

That meant the banks that made financing commitments to the private equity firms had to pony up bridge loans. Large amounts of them. The Chrysler deal involved something like $12 billion of debt, the Alliance Boots deal involved around $10 billion of debt and the Allison Transmission deal involved around $3 billion of debt. Press reports (Wall Street Journal, 7/26/07, P. A1) indicate that there are around $200 billion of deal debt that banks have committed to provide. If they can't find purchasers for the bonds, they'll have to fork over bridge loans themselves. As a result of this traffic jam in the bond market, the banks, who are the heart of the financial system, could find themselves sitting on a rather large pile of unexpected risk.

The private equity phenomenon is another manifestation of the financial markets' recent propensity to create unusually large amounts of risk. The going private transaction, as explained above, largely separates risk from reward. The private equity crew and management get the rewards, while the bond holders (or the banks, if they had to extend bridge loans) take most of the risk. The private equity guys could make truckloads of money by doing a large number of highly leveraged deals of the "heads I win, tails you lose" variety. And they did. Those deals now overhang the corporate debt market.

We've discussed in an earlier blog how the allocation of risk and reward in the mortgage markets, with the rewards concentrated the market pros if they write and underwrite high risk mortgages, led to the creation of a lot of bad mortgage loans that never should have been made. http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html. The impact of those bad loans now has the market sagging. The going private phenomenon has a similar separation of risk from reward, where the private equity firms are rewarded for doing highly leveraged and potentially risky deals without the risk to themselves of more than comparatively modest losses. In such a situation, it can only be expected that they would follow the scent of money and do a lot of those deals. The problems is that the risk of loss was transferred either to passive investors, or to the banking system. For the moment, the consequences now weigh on the banking system.

There must not be many people on Wall Street named Murphy, since Wall Street, despite a long history of panics, corrections and crashes, doesn't seem to understand that if something can go wrong, eventually it will. The fact that risk has shifted from away from oneself doesn't mean that the risk has been eliminated. Once financial risk is created, there is no way to eliminate it. It can be transferred to someone else, and then again to others. But it will always lurk somewhere. If a lot of financial risk is created, that means a lot of risk is lurking somewhere. A lot of risk can inflict a lot of pain, even if it is diffused. We are seeing this happen now with the massive losses in the mortgage markets.

No disasters have yet occurred in going private transactions. The banks that made bridge loans apparently have been able to handle the burden. But there is a serious traffic jam in the road to the bond market, and the banks' bridge loan exposure seems likely to rise. Will the private equity guys help the banks out by agreeing to take bonds with terms more favorable to the bond holders and therefore potentially less profitable for private equity? Well, remember the adage that if you want a friend on Wall Street, get a dog.

Maybe all this will just blow over. The U.S. and world economies are doing okay, and American consumers continue to do yeoman's duty at the mall. But now risk abounds, and more trolls may be stirring.

Personal Finance in the News: man receives 2,000 credit cards he didn't ask for. http://www.wtop.com/?nid=456&sid=1200699. No wonder there's a consumer credit problem.

The Pricing Fog in the CDO Market

Once upon a time, there were two hedge funds sponsored by Bear Stearns that invested in the mortgage markets. In March 2007, they reportedly had a combined value to investors of around $1.6 billion. In June 2007, delinquencies among mortgage borrowers had impaired the investments of these two hedge funds. The deterioration got to the point where, Merrill Lynch, which had loaned money to one of the funds to finance investments in mortgage-backed securities, reportedly seized about $850 million worth of these investments and sold them off to secure repayment of its loan. Then, with other lenders to the funds hovering closely, Bear Stearns stepped in with a $3.2 billion loan to one fund (apparently, only $1.6 billion was actually loaned). The loan was made to stabilize the situation so that the funds could pay off other lenders in a more orderly manner.

Fastforward to late July 2007. The two hedge funds are now reported to have lost all (in the case of one fund) and over 90% (in the case of another fund) of their investor value. In other words, the investors were left with zero cents on the dollar for the one fund, and less than a dime on the dollar for the other fund. An equivalent drop in the Dow Jones Industrial Average would have been from its approximate average in March 2007 of 12,300 to somewhere around 1,200 or less within four months. If that had happened, sales of the Communist Manifesto and pitchforks for the proletariat would have skyrocketed.

How could the values of these funds go into a tailspin like this? The fact that the funds were heavily leveraged was one important reason. When the value of the funds' investments began dropping, the creditors of the funds started to demand more collateral. If the funds couldn't provide the additional collateral, the lenders wanted their loans to be repaid. If they weren't repaid, the lenders could seize the collateral and sell it to pay down the debt. The speed at which things deteriorated indicates that the funds and the lenders may have overestimated the value of the collateral, particularly the value it could command when put on sale for immediate cash payment.

CDOs don't trade on any active market. They are bought and sold on an ad hoc basis, not in a public market where price quotations are displayed to the world. Instead of using market transactions as a guide to establishing values of CDOs, hedge funds and other market participants use mathematical models. The models tend to be based on expected future performance, and not the cash price the CDO might receive if it were put up for immediate auction.

The use of mathematical models to price derivatives isn't new. The dealers and specialists in markets for standardized stock options have, for some 30 years, used mathematical models to establish their price quotations. One important difference between the stock options markets and the over-the-counter derivatives markets, though, is that the options markets are public. They provide continuously displayed bid and ask quotations to the world, and all trades are reported publicly on the consolidated tape. The open market imposes discipline. If one dealer's mathematical model produces incorrect prices, he gets clobbered early and often by other market participants who trade with him to his disadvantage. He either fixes his model or finds a new line of work.

In the unregulated world of CDOs, there is no continuously trading open market to impose discipline. Mathematical pricing models are based on assumptions, and the numbers they generate will vary depending on the assumptions made. We discussed in our July 27, 2007 blog (http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html) how the CDO market created incentives to write vast quantities of low quality mortgage loans--loans that are now defaulting in many cases and pushing the market down. Was this proclivity toward outsized risk incorporated into pricing models?

Hedge funds and other players probably can exercise some discretion over their valuations. Would they have moved promptly to reflect downturns in values? Well, how are they compensated? 2% of what and 20% of what?

Were there any controls over the valuation issue? Many CDOs were rated by the rating agencies--outfits like Standard & Poors, Moody's and Fitch. Since the Bear Stearns hedge fund debacle, the rating agencies have been downgrading billions of dollars of bonds. Why did they wait until the yogurt hit the fan? The full story may not be out yet, but it seems that the rating agencies, too, were using mathematical models.

The critical problem with mathematical modeling is that, at some point, cash has to enter the picture. When a hedge fund uses leverage, the lender can't rely on a mathematical model to ensure that its loan is repaid. It needs cash. For a collateralized loan, if worse comes to worst, the lender has to be able to convert the collateral into cash. When values deteriorated this past spring from increasing mortgage defaults, the hedge funds' lenders protected themselves by demanding more collateral or selling off the collateral they had. Either option would have involved getting cash (or hard assets readily convertible to cash). This is the point where the rubber hits the road, and mathematical modeling and $5 buys you a cup of coffee.

The CDO market was mispriced. That much is clear. The world of hedge funds and derivatives has been left essentially unregulated--by both Republican and Democratic administrations and Congresses. Absence of regulation facilitates innovation and growth. The plethora of derivatives contracts now available is a bewildering alphabet soup array of financial instruments. The dollar value of transactions in the derivatives markets today probably exceeds the dollar value of stock market transactions. Derivatives are said to diffuse risk and allocate it to market participants that are willing to take it on. All this sounds good.

But the world of CDOs has fostered the creation of risk--a lot of it--as we discussed in our July 27,2007 blog (http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html). And a lot of risk diffused and allocated nevertheless remains a lot of risk. When it materializes, a lot of people will say "ouch." Did the investors in the two Bear Stearns hedge funds that collapsed think there was a reasonable chance they'd lose everything or almost everything?

This isn't just a problem for Wall Street firms, hedge fund operators and the wealthy people and large institutions that invest in hedge funds. The stock and bond market losses of recent weeks affect everyone that has a stake in the financial markets. Every IRA and 401(k) account invested in the stock markets has probably taken a loss due to the mortgage market mess. Every pension fund and university endowment has probably suffered losses. Every small business with a SIMPLE IRA or SEP-IRA plan invested in the stock market has been hit, meaning that the employees of the small business have suffered. A lot of people who have no idea what a CDO is, or if they do, have no interest in them, now have been affected--negatively.

No one knows how this situation will turn out. Prognostications have been made that more mortgage market losses are in the offing. One thing that's clear is that the pricing mechanism in the CDO market needs improvement. We now have a situation where hedge fund managers may be taking compensation based on the valuations of their mathematical models, but investors are taking losses based on cash prices. It's one thing to play "heads I win, tails you lose" with a quarter. But the amounts involved in the CDO mess are much larger than $0.25. These pricing disparities should be reconciled. Since you can't persuade lenders to take repayment in the form of a mathematical model, hedge funds that use leverage (which would be about 100% or so of them) should move toward a cash pricing model. Cash prices may be difficult to establish on a continuing basis, unless CDO and similar products are standardized and quoted on electronic markets. But perhaps these would be good ideas, now that the instruments are proving to be so risky.

Many players in the derivatives markets will recoil at these thoughts, since they would viscerally sense a reduction of profit margins. Nonstandard products traded in an opaque market are likely to be more profitable for dealers than standardized products traded on a transparent market. But the widespread damage that the mortgage market mess is causing will leave the industry with fewer and fewer choices. The perspicacious on Wall Street will get ahead of the curve.

Strange News: a haunted penthouse: http://www.wtop.com/?nid=456&sid=1203832.

How the CDO Market Increased Subprime Mortgage Risks

CDOs have been much in the news lately, because of the subprime mortgage mess. Mortgage loan losses, especially among subprime mortgages, have shaken the real estate markets and contributed to the 311 point drop in the Dow Jones Industrial Average on July 26, 2007. While the market turbulence and losses have gotten plenty of headlines, what has been less discussed is how the market for CDOs increased risks and likely exacerbated current problems.

CDOs, as you may know, are entities (usually trusts) that hold pools of mortgages and other loans. The stream of payments (interest and principal) from this pool is subdivided into different segments called "tranches" (which is French for slices). Each tranche has different rights to the stream of payments from the pool. The highest tranche has the best claim, and is the most expensive to buy while offering the lowest rate of return. That's because it also has the lowest risk of nonpayment. As one descends through the tranches, claims to the stream of payments from the pool become ever more subordinate, prices drop and potential rates of return increase. But risks of loss also increase, so you can do very well or very badly in the lowest tranches.

How do the banks that package CDOs sell these things? It's easy enough to understand why someone might buy the highest tranches. They are often comparable to highly rated corporate debt (although the rating agencies seem to have been caught slightly flat-footed by the drop off in the mortgage markets). But where do buyers for the riskier tranches come from?

Some investors seek out risky investments. Hedge fund operators look for risky investments because they have to beat the S&P 500 in order to attract investor money. Pension funds, university endowments and other institutional investors, often seen as bastions of investment prudence, also seek out risk. Here's why.

The 1929 market crash and subsequent Great Depression cured an entire generation of any interest in risky investments. Even the go-go days of the 1960s didn't involve anything approaching the derivatives boom that led to the creation of CDOs. Starting in the 1970s, an idea evolved that taking some degree of risk was good. A well-rounded investment portfolio, it was argued, should include a speculative fillip, something that could boost returns above the boring level of the S&P 500. Sure, greater risk could lead to losses. But if the amount of the portfolio invested in dicey bets was confined, to say 5% or 10%, then the investor would have a good chance of being better off.

The idea that increasing risk was good was marketed by hedge fund operators and other market players who sold risky investment opportunities. Gradually mainstream institutional (and wealthy individual) investors began to accept the idea. Money flowed into the "alternative investment" sector. The hedge fund industry boomed.

As more money flowed into hedge funds and other alternative investments, they needed to find risky investments. After all, a hedge fund operator who claimed to be an investment genius couldn't put his investors' money into S&P 500 index funds. He had to find something that made him look like he deserved the annual 2% of assets and 20% of gains he charged his clients.

The result was that demand for risky investments grew. CDOs, among other things, attained popularity. Subprime mortgages, with their apparent higher risk levels, looked like a good play. They had higher interest rates because they were riskier. But the rising real estate market of the early 2000s usually gave the borrower an escape hatch--if the borrower couldn't repay the loan (especially after an increase in monthly payments), he or she could refinance or sell the house, and the rising real estate market would make that easy. In this way, subprime mortgages appeared to have low risks, even though they were priced as high risks. In the minds of a money manager, that meant they were cheap in comparison to the risks they supposedly had. And if they were cheap, it would make sense to buy a lot of them and generate larger profits. The CDO was a convenient way to sell these high-risk loans to the investment community.

One thing about institutional investors is that they have a lot of money. Even if they divert only 5% or 10% of their portfolios into alternative investments, the result would be a flood of cash. And that's what happened. Money flooded into the alternative investments market. The banks packaging CDOs began looking for more subprime loans. Commissions paid to mortgage brokers for subprime loans increased, and gave them the incentive to steer more customers into subprime mortgages. No doc loans and low doc loans, popularly known among mortgage bankers as "liar loans," became more commonplace. These loans often wouldn't have been made in the past. Now, though, since they weren't being held by the loan originator, but were being sold--first to the banks packaging the CDOs, and eventually to the investors who thought they should be taking more risk--no one had an incentive to exercise caution. The borrowers thought--perhaps erroneously, perhaps because of fraud--that they were getting a good deal. The mortgage brokers collected big commissions while selling the doggy loans to someone else, so they thought they had offloaded the risk. The banks packaging the CDOs made more money with each new deal, while passing the risk onto investors. The hedge funds and institutional investors thought risk was good, so they wanted to buy more risk. Many hedge funds borrowed heavily to buy even more subprime mortgages (or their CDO derivatives), thinking that the more leverage they used, the greater the return on capital they would achieve. The use of leverage magnified demand for subprime loans.

The result was that a ton of imprudent, reckless, ridiculous, and downright stupid mortgage loans were made. The numbers are perhaps impossible to determine at this point, but the rising default rates show that the losses are and will continue to be very large. Because risk came to be seen as a good thing, the market responded to demand and provided more risky investments. A lot more. It literally paid the mortgage industry to create a lot of bad loans. Now there are a lot of losses that have to be suffered.

The sheer quantity of losses is having systemic impact. The bond market is fleeing toward high quality debt and the stock market is becoming more turbulent. Will the world collapse? No. No need to freshen up your secret stocks of batteries, distilled water and freeze-dried food. But the pain will probably increase before it decreases.

The idea that some risk is good for your investment portfolio is a valid idea in a textbook sense. Historical financial data can be used to demonstrate, in a mathematical way, that you would have been better off with a bit of risk during the last 25 years than without it. But the last 25 years have been exceptionally good ones for the financial markets. The 25 years from 1929 to 1954 were little more than break-even, after adjusting for inflation. Past performance is no indication of future performance.

But what happened in the subprime mortgage and CDO markets wasn't just the manifestation of a boilerplate disclosure in the prospectus for every SEC-registered securities offering. We're where we are today because the idea that risk is good became fashionable--too fashionable. And prudence fell out of fashion. Skirts can be made shorter, but there's a limit to how short. And there's a limit to how much risk is good. Investor appetite for risky investments--fueled by incautious marketing by Wall Street--created the monster that we now must deal with. Since the CDO market and hedge fund industry are essentially unregulated, it's unclear how things will play out and who will ultimately hold the bag. One senses that the legal profession will feast; but many others will have a taste of Oliver Twist's gruel.

Skirts eventually became longer, and financial prudence is making a belated re-appearance. Prudence would be advisable for individuals as well as institutions.

Crime News: bad boys sentenced to do the funky chicken. http://www.wtop.com/?nid=456&sid=1201466.

The Derivatives Problem Wall Street Might Have Fixed

One of the largest, and least visible, of the financial markets is the derivatives market. Financial derivatives are contracts that "derive" (or measure) their value by reference to something else. A simple example is the stock option. The option gives its holder the right to purchase the stock on which it is based for a specified price within certain time parameters. The option's value is based primarily on the value of the underlying stock. If the stock increases in value, the option will generally increase in value. And if the stock decreases in value, the option will generally decrease in value.

A more sophisticated kind of financial derivative is the credit derivative. This is a contract that gives the holder protection against loss from defaults in the debt of a company or a country. For example, let's say an investor (usually a large institution) holds bonds of Company A. The investor decides to get some protection in case Company A can't repay its bonds. The investor can engage in a "credit-default swap," which is a transaction where another financial market participant (the "counterparty") agrees to take the risk of a default on Company A's bonds. In other words, the investor buys a kind of insurance against a default by Company A. In this sense, the credit derivatives contract resembles the credit life insurance that many mortgage borrowers are required to buy (if their downpayments are less than 20%)--if the borrower passes away, the credit life policy pays the mortgage loan.

Credit derivative transactions, until recently, were done largely by phone. There is no stock exchange floor, with people running around frantically and dropping slips of paper. There was no electronic quotation system, where bid and ask prices are displayed, and trades are reported. Setting aside the fact that many of the phones have new and strange ways of ringing, the credit derivatives market was much like the over-the-counter stock market of the 1920's and 1930's.

The credit derivatives market was virtually nonexistent ten years ago. Today, it is big--very big. It's reported to involve trillions of dollars of risk coverage, like maybe $35 trillion. Even at $5 a pop, that buys a lot of cups of coffee.

The credit derivatives market has had a wee problem stemming from its rapid growth. Recordkeeping wasn't given exactly the highest priority. Why does recordkeeping matter? After all, enough trees are being killed as it is. But the reason why recordkeeping matters is that records let you figure out who owns what. Today, almost all financial assets consist of entries on paper records or in computerized recordkeeping systems. The green stuff in your wallet is becoming less and less important. If the records aren't good, you don't know what you own. Think about how p.o.'d you'd be if you steadily and patiently saved and invested 10% or 15% of your income each year for 40 years, and then, upon reaching retirement age, found that your financial records were all messed up and you couldn't tell what you had. As boring and painful as it may be, recordkeeping is essential to a sound financial system.

What impact could recordkeeping problems have in the credit derivatives market? Recall the essential purpose of credit derivatives. If a company defaults, the bondholder or other debt holder who bought the default protection would turn to the counterparty on the contract (the insurer, if you will) and smile while extending an open hand. If, however, the counterparty says, "you can't prove I owe you anything because there's no record of the credit derivative transaction," then the bondholder enters a deep vat of yogurt. Lawsuits may be filed, but the only sure winners are lawyers.

In the fall of 2005, Federal Reserve officials got nervous about the recordkeeping in the credit derivatives market. Apparently there were something like 97,000 transactions that were unresolved more than 30 days after they supposedly occurred. As reported in the Wall Street Journal (9/15/05, p. C1), the Federal Reserve Bank of New York convened a meeting and invited 14 major financial institutions to attend. If you're an American financial institution, you never turn down an invitation from the Fed. The Fed had a little credit derivatives coffee klatsch. At the gathering, everyone agreed that they would do better about recordkeeping. Here's how they did, as reported in the press.

Wall Street Journal, Dec. 13, 2005 (P. C6): the 14 major financial firms aim to resolve at 30% of the backlog of open trades by January 31, 2006.

Wall Street Journal, Feb. 17, 2006 (P. C5): the New York Fed said that a 54% reduction in the open trades had been attained.

Wall Street Journal, Sept. 28, 2006 (P. C5): the New York Fed said that 70% of all open trades had been resolved and 85% of the open trades that hadn't been settled for over 30 days had been resolved.

It sounds pretty good. But it isn't entirely clear that all the open credit derivatives trades have been settled. If the counterparties for a small number of large credit derivatives trades cut and run when they should step up to the plate, large amounts of default insurance evaporate and things can become rather unpleasant. Further, there was also a problem of recordkeeping in the equity derivatives market (reported in the Wall Street Journal, Nov. 22, 2006, P. C4). Equity derivatives, as you might guess, are contracts where the risk of a stock, or a basket or index of stocks, falling is covered for a price. If the underlying stock or stocks fall, the counterparty has to compensate the holder of the equity derivative. The New York Fed had began pushing the financial firms to begin straightening out recordkeeping in the equity derivatives market, but it's not clear if those problems were resolved.

The bond markets are getting shakier, with the economy slowing, inflation threatening, consumers running out of home equity to spend, and the mortgage markets having fits. Some companies might not make it. There have been major companies that declared bankruptcy in recent years, which meant defaulting on their bonds. Collins & Aikman Corp. and Delphi Corp., two car parts manufacturers, are examples. One interesting vignette reported in the Wall Street Journal (Dec. 13, 2005, P. C6) is that when Delphi declared bankruptcy, it defaulted on $2 billion of bonds, but the resulting claims on credit derivatives contracts covered $28 billion. That suggests that a lot of people were using credit derivatives to speculate on whether or not Delphi would go in the tank. The ability to use these derivatives to speculate leverages the risks to market players and even the financial system from a big event like a major bankruptcy.

The stock market has been manic-depressive, being irrationally exuberant one day and jumping with a frayed bungee cord the next day. There's a lot of stress in the financial system and the stock market may be more likely to go down than up in the near future. If the market drops significantly or there are more bond defaults, some investors may end up trying to collect on their credit and equity derivatives contracts. If the recordkeeping isn't good, though, they may be in for some bad tummy aches. Recordkeeping cuts into Wall Street's profits. But a loss of investor confidence cuts much deeper. Time will tell whether we'll have a problem.

Strange News: If you're having a bad day, walk by the compliment machine. http://www.wtop.com/?nid=456&sid=1199177.

Those Pesky CDOs and How They're Ruining the Party

You may have read about CDOs in the financial news recently. They're the investment where investors (mostly institutions like hedge funds, pension funds and the like) purchase interests in the stream of payments coming from a pool of mortgages and other loans. Rising delinquency rates among mortgages, especially subprime mortgages, have led to losses for CDO investors. A pair of big losers were two hedge funds sponsored by the investment banking firm, Bear Stearns, which last week announced that the funds had lost all (in the case of one fund) and over 90% (in the case of the other fund) of their investors' money. Less than six months ago, these funds reportedly had more than $1.5 billion in investor money. But now, it appears that anyone that invested in these funds is holding nada, or darn close to nada.

The investors in these two funds have plenty of company. Press reports indicate that lots of investors and maybe some financial firms have lost money in the CDO markets. Lots of it. Chairman Ben Bernanke of the Federal Reserve reportedly said on July 19, 2007 that some estimates of the losses from the subprime lending mess could run up to $50 billion to $100 billion.

Even these days, $50 billion plus is more than lunch money. Many of the losses appear to come from mortgage loans that were poorly conceived. Adjustable payment loans with low initial "teaser" rates offered to borrowers with shaky credit histories, along with little or no documentation of the borrower's ability to repay the loan, created a scenario where the lender (or, more precisely, the investors in the funds that bought interests in CDOs) were speculating on a continuation of rising real estate prices to ensure repayment of their investments. This risk was heightened by funds that used leverage to increase the quantity of high risk mortgages they held--the greater the leverage, the lower the delinquency rate on the mortgages that would be required to blow up the fund. Of course, as long as the real estate market kept rising, things would have remained copacetic. And we all know that once a market starts rising, it never stops. At least, not for a while. A lot of very smart people were involved in creating the subprime mortgage, CDO situation, but the strange thing is that they didn't seem to see this train wreck coming. Or, if they did, they surely didn't do enough to stop it.

Whenever a tamale heats up, it gets passed around because no one wants to be burned. Put another way, chickens are of the habit to come home eventually to roost. It's safe to assume that the investors that have recently been told that they lost 90 or 100 cents on the dollar won't just sit quietly and sip some tea. Lawyers of the plaintiffs persuasion are now surely boning up on the fine points of CDO investments, while lawyers of the defendants persuasion are now surely boning up on the fine points of CDO investments. Well, at least someone will benefit from this mess.

As for Mom and Pop, standing somewhat bewildered behind the counter of their store at the corner of Main and Elm Streets, things will change. Easy credit, especially in the mortgage markets, will dry up, because Wall Street investors will refuse to buy easy loans. With interest rates rising, fixed 15 and 30 year mortgages make more sense anyway. People with weaker credit histories may be unable to get mortgage loans. But if the only loan they could get was a snare that would ruin their finances and wreck their lives, perhaps it's better if they spend a few years building up some savings for a down payment and improving their credit ratings. See our blog on how the right mortgage loan helps you build wealth. http://blogger.uncleleosden.com/2007/05/how-right-mortgage-loan-helps-you-build.html.

It was the availability of cheap credit that allowed risky mortgage loans to be made, and then packaged into CDOs that were the subject of investment strategies offering little more than a speculation on real estate values. The torrent of cheap credit that flooded the world in the last few years is drying up. European and Asian governments have been raising interest rates. While the Fed has held rates level for the last year, it by all indications is more likely to raise them than lower them. Easy money seemed to come in the last few years from owning real estate or, more recently, investing in blue chip stocks. A lot of people spent their home equity while real estate prices were rising. This almost casual use of home equity-based credit epitomized the adage, "easy come, easy go." But real estate values are flat or dropping in many markets and there's not likely to be much more easy money in the foreseeable future. At the risk of sounding like Ward Cleaver talking to the Beaver, caution and prudence in finances are now advisable. The thrifty squirrel has the best chance of surviving the winter. Store up some extra acorns, and sleep better.

For more detail about CDOs, read our blog at http://blogger.uncleleosden.com/2007/06/subprime-mortgage-mess-on-wall-street.html.

Animal News: More evidence that a pooch is your best friend. http://www.wtop.com/?nid=456&sid=1196569.

Commodities for Individual Investors

The global economy has grown vigorously in recent years, and the prices of commodities have risen sharply. We all know about oil and gasoline prices. Gold, uranium, silver, corn, cattle, and soybeans have also seen significant price rises. Rising prices attract investors the way shiny objects attract magpies. Nowadays, some people see commodities as the next hot thing. Are they a good idea?

1. Commodities Futures Contracts. The traditional way of investing in commodities is to buy a futures contract. Some view these contracts as a way to make fast money because you can buy one for only a 10% downpayment, or maybe even less. If the contract rises 10% in value, you have a 100% return on your investment. But the reverse is also true: if the contract drops 10% in value, you just lost everything you invested. Further, it's important to understand the nature of futures contracts. You either commit to buy a fixed amount of the commodity at a predetermined price, or to sell a fixed amount of the commodity at a predetermined price. The contract will specify a date on which you have to fulfill this obligation to either buy or sell, called the settlement date. You are locked into the contract--you must buy or sell at the specified price on the settlement date. There is no exit. This is the kicker in commodities futures contracts. If you are in a losing position on the settlement date, you have to take the loss (which could mean forking over more cash in addition to your downpayment if the contract has dropped by more than the value of your downpayment). When a stock drops, you can hold onto it in the hope that it will rise again. When a commodities futures contract is a loser on settlement date, you are stuck with the loss.

Big players in the financial markets can have a hard time figuring out which direction commodities prices will move. Remember the hedge fund called Amaranth, which collapsed because it guessed wrong on the direction of natural gas prices? Individual investors have an even harder time figuring out where commodities prices will go. Some individuals have lost $1 million or more playing with commodities futures contracts. You should avoid them.

2. Stocks with commodities exposure. A safer way to invest in commodities is to buy stocks of companies that have significant interests in commodities. The oil companies are obvious examples. Their stocks have generally done well with the rise in oil prices. Of course, part of the return from investing in oil companies comes from the skill (or lack of skill) of its management and other factors. But if you're looking for a commodities play, oil companies and other natural resources companies are a much safer way to make that bet than a futures contract.

3. Mutual Funds and ETFs. There are mutual funds and ETFs that specialize in providing investors with a chance to profit from commodities by investing in a portfolio of companies with interests in commodities. Since these funds are diversified to some degree, they may be less risky than the stocks of individual companies. They are certainly safer than futures contracts. Of course, you must consider their fees and expenses, as you always would with any mutual fund or ETF.

4. Mattress Stuffers. If you flirt with survivalist tendencies, you can buy gold coins. The 1 ounce 24 carat coins issued by some nations provide a convenient way to own gold--there's the American Eagle, the Canadian Maple Leaf, the South African Krugerrand, and the Australian Nugget. All can be purchased for a little more than the spot (i.e., cash) price of gold in the wholesale market. Owning gold coins presents problems of storage and insurance. And you should buy from a reputable dealer because most people can't tell gold from a bunch of other substances. But if you think the end of civilization is near--or you just want the fun of having some gold to stare at--you can buy gold coins and stick them in your mattress, or in the closet along with your freeze-dried food, bottled water, portable generator, camping gear, compass, flint and steel, tomahawk, coonskin cap, and Pennsylvania long rifle.

Is it a good idea to invest in commodities? If you put a small portion of your portfolio (5% or maybe even 10%) into commodities, you might acheive a degree of diversification that could pay off. Remember, however, that commodities prices are notoriously difficult to predict, and the financial markets have seen long stretches of time when commodities were not winners. Numerous investors have done just fine without investing in commodities.

Crime News: hot dog vendor arrested for parking meter scam. http://www.nbc4.com/news/13716705/detail.html?dl=headlineclick

Building Wealth by Going Green

You don't usually associate environmentalism with saving money. Solar panels and windmills aren't cheap, and after you install them, you have to cover legal fees to do battle with the zoning board and the subdivision's architectural committee. The premium you pay for a car with a hybrid engine is often greater than the savings in your gas budget. On a smaller scale, organic fruits and vegetables cost more than the ones grown with chemicals. And fair trade coffee isn't exactly easy to find in the big box discount stores.

There are ways, though, to go green while saving some money. Basically, lighten your footprint on the environment. Here are some suggestions:

1. Drink tap water. The New York Times reported on July 15, 2007 that the annual cost of drinking 8 glasses a day of tap water in New York City is 49 cents. You can have a year's supply of drinking water for less than the cost of a candy bar (and it's better for you). An equivalent amount of bottled water would cost around $1,400. That's the cost of a new desktop PC and a printer, with some money to spare. The plastic used to make the bottle comes from petroleum, the fuel used to transport the bottle to the store comes from petroleum, and the electricity used to keep the bottle cold comes from coal, petroleum or water power. (And if you think water power is benign, remember that the dams that generate electricity and the massive electrical grid system that transports it hundreds of miles mess up a lot of wildlife habitat.) Then, when you're done, many of those convenient bottles you throw away will wait patiently for centuries to be discovered by archeologists, who will be puzzled why the people of the twenty-first century worshiped the bottle. After all, only religious fervor could explain such vast accumulations of unnecessary containers.

2. Cook from scratch. When you cook from scratch, you'll have a freshly made and better tasting meal, which contains fewer chemicals. Do you put alpha tocopherol, disodium inosinate, or sodium nitrite in your home-cooked meals? If you do, don't worry, because they're safe--we hope. It's okay if you have no cooking experience. Just make sure you eat what you prepare and you'll move up the learning curve fast. Prepared foods impact the environment a number of ways: they are cooked twice (once at the factory and once more in your home), so they consume more energy; they are heavily packaged, which means more trees killed for cardboard and more petrochemical products like plastic wrappings; many of them need electricity to keep them frozen at all times (until consumed); and they create more waste (the containers and wrappings have to go somewhere). They also are likely to cost more per serving.

3. Make good use of plastic bags. Plastic bags are now everywhere. Hardly a store uses paper any more. And few make it easy to recycle their plastic bags. Re-use the plastic bags--they can carry your lunch, line waste baskets, hold used kitty litter, and pick up dog poop. Many trash collection services require that you bag trash in large plastic bags. Fill up the bags. They're bigger than you might think. If you fill them only three-quarters of the way up, you'll use 33% more bags per year. That costs money and adds to the pollution of the environment.

4. Re-use containers. Many cardboard, plastic and glass containers can be re-used. When you re-use something, you're running an at-home recycling operation. No need for you to bag stuff for other people to collect. Forget the mindset that everything has to be new and extravagantly wrapped. Clean water, breathable air and safe food have value, too.

5. Drive 65 or 70. One of the primary factors affecting your vehicle's mileage is speed. Greater speed increases the amount of wind resistance you encounter. That's why higher speeds reduce your mileage. We all know the reality of American highways. The few drivers going 55 have shortened life expectancies. But the ones that are driving 80 or 90 mph are both road hazards and environmental hazards. Keep your speed down, and save a little on your fuel costs.

6. Mind the thermostat. Those who lived through the OPEC oil boycotts of the 1970's can probably remember thermostats set at 78 in the summer and 68 in the winter. That was part of the malaise of the times, and no one wants a return to that. But if the house will be empty during the day, turn the thermostat up in the summer and down in the winter. No need to maintain a constant temperature for the furniture.

No one can be perfect. If you're stuck at an airport after your connection was inexplicably canceled, you'll probably have to resort to bottled water and prepared foods (especially if it's late and all the bars are closed). If you're working 50 or 60 hours a week, you won't have time to prepare many meals from scratch. If you live in a small apartment, it's hard to find space to store empty containers until you can use them. And if there's a big tractor trailer swaying all over the road right in front of you, it's understandable if you momentarily bump the speedometer above 80 to get past the danger. You don't have to be perfect. But try to step more lightly on the environment. You'll save some money, your wealth will grow, and you'll have a cleaner world to live in.

Crime News: pilot reportedly steals passenger's iPod. http://www.nbc4.com/news/13694007/detail.html. We've got crowded flights, narrow seats, no leg room, no food service, frequent cancellations, lost luggage, and lousy service. And now this?

Why the Stock Market Bounces Around

On Thursday, July 12, 2007, the stock reached a record high, with the Dow Jones Industrial Average rising 283.86 points to close at 13,861.73. What the heck happened? News reports attributed the market jump to positive news about retail sales and the announcement of a planned acquisition of a Canadian aluminum company, Alcan Inc. But were those stories really the cause? People still flock to the malls and someone wants to buy an aluminum company? Or was there more to it?

The stock market is the aggregation of the interactions of many thousands of persons and institutions. They buy and sell stocks, options, ETFs and other investments. All of their transactions, put together, create the image of beehive activity that you get from the financial news on cable TV. But the markets today are dominated by large, institutional investors--hedge funds, mutual funds, investment banks, pension funds, insurance companies, and the like. These players are so big that sometimes one of them can alone have a noticeable impact on the market.

For example, let's look at an enforcement case brought by the SEC in 1996 against an investment fund management firm called Tudor Investment Corporation. The SEC's order in this case told the following story. Tudor Investment had a trading strategy that involved selling a large quantity of stocks included in the Dow Jones Industrial Average. It believed that on a particular day, March 16, 1994, the prices of the Dow Jones Industrial Average stocks were going to swing upwards at the end of the trading day (i.e., 4:00 p.m. Eastern Time). Beginning at approximately 3:39 p.m., Tudor Investment traders began to sell, in the hope of profiting from the expected upswing in prices. They managed to sell over 1 million shares of stock in the last 21 minutes of the trading day. In the last 4 minutes of the trading day (i.e., from 3:56 p.m. to 4:00 p.m.), the Dow Jones Industrial Average dropped 16.45 points (or about 0.43%) of the index's value at that time. The SEC asserted that Tudor Management's sales toward the end of the trading day "were a significant factor" in the 16.45 point drop.

The SEC charged that Tudor Investment violated the short sale rule, a regulation that limits the circumstances in which a person or institution can sell stock they don't own. (As odd as it may sound, you are allowed in the stock market to sell stock you don't own--it's a way of betting that the stock will drop in value.) Tudor Investment settled the case without admitting or denying the SEC's charges. (That's another oddity of the stock markets--legal settlements where a party neither admits nor denies breaking the rules.) If you want to read the SEC's order in this case, here's the link: http://www.sec.gov/litigation/admin/3437669.txt.

The important point here is that a single player in the market "was a significant factor" in a noticeable market move. Taking the July 12, 2007 closing value of the Dow Jones Industrial Average, 13,861.73, a 0.43% change would be about 59 points. If you could apply the events of March 16, 1994 to today's market, a single player might be able to move the Dow by 59 points. Today, it would probably take much more than the purchase or sale of 1 million shares. But, these days, big institutional investors command portfolios containing much more than 1 million shares of stock.

The stock market has undercurrents and riptides that are difficult or impossible to see from the outside. If you're an active market player, you might feel their tug. But you'd probably have a hard time figuring out where they are coming from or where they are going. Only in those unusual situations where the SEC or another regulator finds something to frown about will information surface publicly as it did in the Tudor Investment case. The rest of the time, you probably won't know what happened, and will probably never learn. Retail sales and the Alcan acquisition probably did help to push the market up on July 12, 2007. But were there other factors? Did some foreign investors, anticipating interest rate increases in their home countries, decide to shift money into the U.S. market? Did some large institutional investors decide to reallocate their increasing exposures to rising foreign markets and move assets into the U.S. markets? Did some institutional investors losing money in subprime mortgage-backed CDOs decide to cut their losses and shift their money into stocks? These are only a few of the possibilities.

So how can you get a read on the markets? One way to separate the wheat from the chaff is to look at market movements from week to week. Pick one day a week--Friday is a good choice--and look at the closing prices on that day for each week. You'll see that week-to-week movements of the market are much smoother than day-to-day movements. By looking at the market on a weekly basis, you sift out some of the riptides and undercurrents caused by large investors, and can get a better handle on overall market trends.

Another lesson here is that day trading stocks, and other short term trading, is very dangerous for the individual investor. If you try to profit from one day's news about retail sales or aluminum companies, you're playing bumper cars where you have a subcompact and the big investors are driving tractor trailers. They can easily overrun you and never notice. You can't predict where your stocks will go short term because you never know when a big tractor trailer will barrel over your trading strategy. Pick an investment strategy that smooths out the bumps in the road. Invest for the long term, on a diversified basis.

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