Author Archives: davus

subprime is still suspect (revised)

ss-subprime

The housing market has seen a rise in subprime lending recently. As banks slowly returned to the market, they offered harsh terms involving large down payments (25% or more) and charged rates between 8-10%. As reported in the Wall Street Journal, the down payment requirements have recently been dropped to 5% of the loan. The individuals in the article that took the loans gave reasons such as “I wouldn’t have been able to get the place I wanted without this” and being “ priced out” of the market if they waited. By analyzing subprime mortgages more closely, we can get a better idea of the assumptions these buyers are making.

Assume that it is possible to repair a borrowers credit in 2 years. This is reasonable, assuming there are no bankruptcies or judgments in the borrowers recent history. Using the average housing price of $272,000, I assume a subprime borrower would have a down payment of 5%, or 13,600, and that they borrow at 8%. Assume that the loan will be refinanced no sooner then 2 years; banks often require such a condition on subprime loans to ensure they get enough interest for the risk they are taking. I will not include a prepayment penalty for simplicity, but there will generally be a prepayment penalty.

Whether the subprime loan is better comes down to whether or not the buyer can accumulate enough equity to refinance the home out of the subprime loan and into a prime loan as soon as possible. The amortization schedule of a subprime loan with the above assumptions is in this Google doc. Assuming the house price stays the same, the schedule shows when various equity milestones occur.

Assuming that the loan is for 30 years, the subprime borrower would have a monthly payment of almost $1,900, yet all but $173 of the initial payment goes to interest, assuming it is not an interest only loan. By month 24, the borrower has paid about $41,000 in interest equivalent to $1,708 a month. With all that interest, they have only paid about $4,500 on the principal. With the down payment, they now have $13,600+$4,500= $18,100 or about 6.65% equity. The situation could be even worse if any of the payments where interest only.

In order to refinance, the owner needs to have equity in the house, typically around 20%. Since the borrower isn’t going to have anywhere near that amount of equity, the house would also have to appreciate to roughly $317,000, a return of 16.5% on the purchase price. To put this in perspective, the highest growth rate over two years in the national composite home price index was 29.5%, between Q1 2004 and Q1 2006. Whether 16.5% is a reasonable assumption is up to the borrower, but in a sense the subprime borrower is speculating on the value of the house in two years, where the payoff is the ability to refinance their mortgage before it ruins them.

fredgraphMany subprime borrowers cite the investment benefits of owning a home. They are tired of paying rent, and want to start building equity. However, by taking on a subprime loan, they are gambling with their financial future for very little payoff. Since so much of the early payments go to interest, the owners may end up paying more in interest then they may have in rent for the same period. More over, should they fail to refinance the loan, they will most likely lose thousands, if not the house. The analysis presented here shows some of the math that needs to be done by subprime borrowers.  Subprime loans are not inherently bad, but borrowers need to understand the assumptions they are making about the value of their home in the future, their ability to refinance. The gains may not be worth the cost.

 

 

 

 

MPT and retirement planning

In a previous post, I questioned how diversified a portfolio of just three assets could really be.  This wasn’t really fair, since the whole point was to avoid such an analysis.  To provide a fairer test, I will use 15 assets for this analysis, all of which are choices taken from an actual retirement plan. The 15 securities listed here consist of 14 mutual funds and a stock.  Choices are predominately focused on US equities, though is a REIT fund (FARCX), two international funds (RERGX, VTRIX), a bond fund (PPTRX), and a money market account.  Given this expanded universe of choices, what will theory tell us is best?

I used Matlab and it’s financial toolbox to retrieve four years of monthly prices for each of the funds.  Since one of the funds is a target date fund, data was not available for it before then.  The data was provided free of charge by Yahoo Finance.  These prices where used to calculate monthly returns, which were in turn used to get means and covariance of the assets.  Once this was done, Matlab’s financial toolbox was used to find the optimal weights.  If you really want to get in to the details of such a calculation, this book explains it well, but be warned:  linear algebra and calculus is required, so in practice, this problem is best left for software.  Below is a screen capture of the results, as well as a graph of the efficient frontier.

 efrontierweightsAndNames

The results of the analysis show that fewer assets are better, but raise a few questions as well.  Efficient portfolios generally consist of 3 assets.  This seems to support the idea that a few assets will do.  Yet while these portfolios are efficient with respect the risk reward trade off, they take no account for where the return comes from.  In this case, the funds are for the most part positively correlated over the time period, so funds that would provide diversification are ignored for the higher yielding choices. This points to the period being too short, or more importantly, the number of choices is too small.  The needed number of assets to consider may be close to 100! This seems to indicate that for retirement planning, MPT may be a nice theory, but it’s real value is as a lesson about the value of diversification.

But what’s this say for our choices? There is no substitute for true diversification.  Getting exposure to assets that are uncorrelated is key.  Considering the 15-asset universe, almost every portfolio on the efficient frontier consisted of 3 assets, but a truly diversified portfolio consisting of the choices offered may be better off with a couple more funds.  In this case, examining the top holdings of the funds would provide as much insight as this analysis did!

subprime is still suspect

ss-subprime

Subprime lending has been making a comeback.  As banks slowly returned to the market, they offered harsh terms involving large down payments (25% or more) and charged rates between 8-10%.  As reported in the Wall Street Journal, the down payment requirements have recently been dropped to 5% of the loan. Considering subprime borrowers will most likely want to refinance as soon as possible to get better terms on the loan, would prospective subprime borrowers be better off taking out the loan or waiting and rehabilitating their credit to become a prime borrower?

Assume that it is possible to go from subprime credit to prime credit in 2 years.  This assumption is convenient to use because of terms in subprime lending contracts, but it is reasonably realistic, assuming there are no bankruptcies or judgments in the borrowers recent history.  If there are, then the borrower’s ability to refinance out of the loan in a timely manner is questionable to begin with. Using the average housing price of $272,000, I assume a subprime borrower would have a down payment of 5%, or $13,600, and that they borrow at 8%.  For this analysis I will include the requirement that the loan be held for 2 years.  This is not unreasonable; banks often require such a condition to ensure they get enough interest for the risk they are taking.  I will not include a prepayment penalty for simplicity, but for subprime loans, there will generally be a prepayment penalty. Calculations are done in nominal terms, as that is what the borrower would see on their statements.

Whether the subprime loan is better comes down to whether or not the buyer can accumulate enough equity to refinance the home out of the subprime loan and into a prime loan at the 2-year mark.  The amortization schedule of a subprime loan with the above assumptions is in this Google doc.  For those that wish to play with it, the values at the top can be changed as inputs, but there must be a % symbol with the rates.  Assuming the house price stays the same, the schedule shows when various equity milestones, as well as credit rehab events would occur in the life of the sub prime loan.

Assuming that the loan is for 30 years, the subprime borrower would have a monthly payment of almost $1,900, yet all but $173 of the initial payment goes to interest, assuming it is not an interest only loan.  By month 24, the borrower can finally get out of the loan, but they have paid about $41,000 in interest, and only about $4,500 of the principal.  With the down payment, they have $13,600 + $4,500 = $18,100 in equity, or about 6.65% equity.  They have also spent the equivalent of $1,708 a month in interest.  While shorter loans would result in equity accumulating faster, it would also result in a much larger monthly payment. The results would only get worse if we included a prepayment penalty.

In order to refinance the loan, the owner needs to have equity in the house, typically around 20%.  Since the borrower isn’t going to have anywhere near that amount of equity, the house would have to appreciate to roughly $317,000, a return of 16.5% on the purchase price.  This is possible, but in a sense the subprime borrowers are speculating on the value of the house in two years, where the payoff is the ability to refinance your mortgage before it ruins you.

Contrasting that with a prudent alternative, a borrower that lived in a modest apartment with only $1,200 per month rent would accumulate an additional $12,000 to add to what ever else they had saved, resulting in a much larger down payment.  Assuming they rehabilitated their credit to prime, they get a much lower rate, and a more manageable monthly payment.

Many subprime borrowers cite the investment benefits of owning a home, tired of paying rent, they want to start building equity.  However, by taking on a subprime loan, they are gambling with their financial future with very little to gain.  Since so much of the early payments go to interest, the owners may end up paying more in interest then they would have in rent for the same period, and should they fail to refinance the loan, they will most likely lose thousands, if not the house entirely.

The analysis presented here shows some of the math that needs to be done by subprime borrowers.  Subprime loans are not inherently bad, but borrowers need to understand the assumptions they are making when they sign up for them.  They may find that patience could pay off.

 

 

 

 

What does labor market slack look like?

In her remarks at the Economic Club of New York Wednesday, Janet Yellen focused on the things that the FED would be watching closely going forward.  The chairwoman made it clear she was more concerned with continued low prices then with inflation exceeding the 2% target set by the central bank. However, the FED’s primary focus remains on the labor market.  Fixing this market might take more then just monetary policy.

The Labor market has been characterized as having significant “slack” in it.  This term accurately describes the ability for businesses to add jobs with out having pulling up wages.  An increase in wages could cause inflation, so the FED is closely watching the labor market for signs of tightening.

What makes up this “slack”?  The Federal Reserve Bank of Atlanta publishes what is known as the Labor Market Spider Chart.  The chart provides a comparison of many labor market metrics at various times in one chart.  An image is shown below, but the link is interactive, so I encourage you to check it out.

Levels-Spider-Chart-from-the-Atlanta-Federal-Reserve-961x1024

This chart has a lot of information in it.  Most notably that there are a large amount of people working temporarily and part-time then would be in a healthy labor market.  There is also a dramatic decrease in marginally attached workers, are the discouraged workers who have worked or looked for work in the past year.  Given the other factors in this chart, some of this decrease may be due to workers giving up entirely and dropping out of the labor force, as opposed to actual hires, which are slightly worse then in 2012.

Janet Yellen would also mention that she believes that the economy can reach healthy levels in the employment market by 2016.  If the spider chart can be used to visualize labor market slack, then it can show tightening as well.  The Other parts of the circle need to shift out to their pre-recession levels as well.

There is a slight symmetry to the above graphs.  Hires on the right have to have some effect on job finding rate on the left.  Similarly with job openings and job availability.  Whether the FED alone can institute the policies needed to bring about the needed changes is unclear.  There is a lot of work to do.  The president of the Minneapolis Federal reserve bank, Narayana Kocherlakota has suggested certain fiscal polices that models suggest could result in the needed growth.  However, even if these policies where implemented, 2016 may be a very ambitious goal.

 

Delaware: incorporate for the taxes, stay for the arbitrage

cooperecon-fig10_004

A little known court ruling in Delaware from 2007 has had some big consequences.  While it has provided some benefits for investors, it also results in the inefficient use of resources, increased costs for mergers and acquisitions, and arbitrage.  After examining the source of these effects, it may be possible to reduce the costs while keeping the benefits.

The case, which found that a shareholder could vote on a proposed deal if they held stock on the date of the vote, as opposed to the date of record (when the offer was made). This has allowed hedge funds and activist investors to take positions in a target companies after a deal price has been announced, then vote stop the deal in order to determine a fair price through what is called an appraisal.  This has resulted in what is known as appraisal arbitrage. While this plan can backfire if the judgement decreases the price, professional investors are in as good a position as anyone to decide whether a price is too low, and there is an additional incentive that mediates the cost of the appraisal and the possibility off loos.  However this outcome is actually quite rare: 80% succeed in getting a higher price.

Hedge funds argue that investors can actually be made better off by these deals because it allows bad deals that would have otherwise gone through to be recognized by professionals and provides an avenue to rectify the situation (with interest!).  Recent examples in the news demonstrate this. The threat of appraisal by Carl Ichan didn’t prevent Dell from going private, but it did secure a higher price per share for investors. Currently, Dole is in court over its acquisition last year being too low, and Darden Restaurants is currently dealing with Starboard Value LP, a hedge fund who wants to stop the sale of its Red Lobster Chain of restaurants.

While such actions by activist investors and hedge funds have made investors better off in the past, it’s called arbitrage for a reason.  Once the case arrives in court, the price is arrived at via the discounted cash flow method.  According to David A. Katz, a partner at Wachtell, Lipton, Rosen, and Katz, “Discounted cash flow analyses, however, often produce values in excess of what a buyer would be willing to pay or the value of the company’s stock in the public trading markets.”  In addition to the inflated measure of value the company has to pay 5.75% interest on the judgment, even if the original price is found to be fair.  This amounts to a practically risk free profit if the deal was even close to fair to begin with.

Appraisal arbitrage can be seen as less an economic issue and more of a legal anomaly.  To fix this problem, while preserving the economic benefit for consumers, the court should allow for the use of whatever valuation method is most appropriate to the company in question.  Most importantly, it must reduce the interest rate that it pays on the judgments to be pegged to treasuries to end the arbitrage opportunity.  In this way, activists and funds will intercede only when investors need them most.

 

 

 

 

 

Changes for an equal opportunity retirement

retirement

Over the past few decades, how Americans prepare for retirement has changed, shifting the responsibility for things like portfolio choices and risk management to workers.  In response to these changes, the American retirement system should be modernized with means testing for social security benefits and mandatory saving for workers above a threshold.  While ultimately the responsibility will always rest the individual, these changes would ensure availability and access to a minimum of retirement planning for all.

A logical way to begin this modernization of the American system is to implement some sort of means testing in for social security benefits.  The top 10 countries already do some sort of income/wealth based benchmarks for benefits.  By phasing out the benefits with income, the top earners would be forced to save more.  This is especially attractive option given the expected short falls of social security, though there are political considerations due to what would essentially be a transfer of wealth.

Adjusting people’s social security payments won’t be enough by itself to make up for the deficit.  The most direct way to increase saving for retirement is to make people save more.  The United States should update the current system with the addition of mandatory saving for all workers above some poverty threshold. The groundwork for such a program has already been laid.  In January, shortly after the state of the Union address, President Obama announced the MyRA.  The account can be opened with a minimum of $25, and is effectively an IRA that is invested only in treasuries. The account allows for the accumulation of $15,000 over 30 years until it is rolled into a Roth IRA.  The Marketwatch article mentions that a key difference between workers with savings and those without is access to such an account.  This account is a sort of IRA on training wheels, allowing savers time to learn and gain experience building wealth for the future.

There are some drawbacks to a mandatory savings program however.  As seen in Australia, who use a similar program has resulted in lower wages.  The United States certainly doesn’t need lower wages, but this can be avoided by not implementing Australia’s mandate that employers contribute at least 3% of pay to the plan.  Instead the a portion of the amount of social security that is phased out due to means testing can just be discounted back to its present value and then saved.  In this way, the United States can ensure American’s that make enough money to be saving are saving something for their futures, with out effecting wages.

Americans are not prepared for retirement.  Roughly a third don’t even have $1000 saved, and the majority have less then $25,000.  It should come as no surprise that when world rankings of retirement preparedness were released in February 2014, the United States ranked 19th.  Part of the problem is that people don’t understand the complex plans and decisions that need to be made.  However the United States can reverse this trend by implementing policies that have already been proven to work in other countries.

 

Comcast and Time Warner merger could have far reaching effects

Regulators are currently reviewing the merger of Comcast and Time Warner Cable, the largest two providers in the country.  This merger could affect millions of Americans due to the popularity of cable TV and the desirability of a broadband internet connection.  The popular opinion of this merger is that it will be allowed to occur.  Unfortunately, the merger is not in consumers’ best interests. The government needs to evaluate the effects of the merger on more then competition, as there is more at stake in this merger then consumer surplus.

Even though I argue that the government should consider more then just the effect on competition of the merger, a compelling case against the deal can be made solely from a competitive standpoint.  The companies have argued that consumers won’t lose choices because the companies don’t compete head to head in the same markets.  That doesn’t mean the deal wouldn’t result in a combined company too much market power.  When the two largest companies in an industry merge, competition can’t help but be effected (see graphic).

MK-CK077_COMCAS_G_20140213120607

click to enlarge

Using the Herfindahl-Hirshman Index (HHI) as a measure of competition in a market, the merger of Comcast and Time Warner would increase the measure in both the cable TV market (639 points), and broadband (695 points).  The DOJ has advised that an increase of over 200 points would be likely to increase market power, and therefore competition.  The combined company would also have over 60% of the cable market and around 40% of the broadband internet market.

This increased market power could have a number of effects beyond competition.  Even though It would surely be harder to compete against the combined company, the merger could touch businesses that don’t even compete with either company.  Court decisions have taken away regulation, and Comcast has already had Netflix pay for service.  This is a direct violation of net neutrality, the idea that all traffic on the internet is treated the same. It becomes easier to implement these fees on certain web traffic if there is less competition for their business.  The merger would make consumers worse off through less new content on the internet, or content at a higher price. These costs could even represent a barrier to entry into a medium that used to be prized for its openness and accessibility.

Ultimately, the merger, as is, should be rejected because it decreases competition and doesn’t make consumers better off.  There are a number of ways that the merger could be altered to avoid the above concerns, the most obvious of which is separating internet from cable service.  The DOJ should reject the deal, but if they do decide to approve the merger, it should at least include provisions to ensure the internet stays open and accessible for customers and content providers.

 

In search of diversification

In this past weekends Wall Street Journal, I came across an article entitled Funds Investing:  Make More Money and worry less.   At first glance this article seemed to be stating the obvious.  However, after reading it, I began to wonder.  Can one really get diversification from as little as 3 assets?  After some rough analysis, it seems people may need to worry a little bit more then the article suggests.

The article is actually a summary of ways “lazy” people save for retirement.  Lazy, here does not indicate sloth, but rather to retirement ideas named “the margarita”, “the coffeehouse” and “the no brainer”.  The idea of these “lazy” portfolios is that they don’t require a lot of attention or financial know how to set up.  Given the state of most people’s retirements, lets compare the ideas of these retirement plans, requiring little more then your contributions, to conventional wisdom about what it takes to have a solid retirement.

But suppose we have some time, as well as a computer with Matlab or Excel installed on it.  The question I want to ask is:  given these small quantity of assets that make up these lazy portfolios, what do other philosophies about portfolio management say about theses savings ideas?

What follows is based Modern Portfolio Theory, as told in Burton Makail’s “A Random Walk down Wall Street”.   The mathematical analysis, carried out in Matlab, can be done by hand using a general optimization technique called the method of Lagrangian Multipliers.

Modern Portfolio Theory says that the best portfolios lie along the efficient frontier.  This is a line representing the portfolios that invest all the available funds lie on a hyperbola.  The top half of this hyperbola represents what is called the efficient frontier.  These are the portfolios that invest all money, and receive a higher return then the one that lies on the bottom half.  The portfolio located at the “point” is called the Minimum variance portfolio.  The efficient frontier for a portfolio consisting of the 3 mutual funds is shown below.

effcientfrontier

Taken from Matlab 2012

So consider the portfolio mentioned specifically in the article.  It is a portfolio of 3 vanguard funds, (40% VTSMX (Total Stock Market), 40% VGTSX (Intl. Stock Index), and 20% VBMFX, a bond fund). Using Matlab to calculate things like mean, variance, and covariance of the three assets, using data from Morningstar, we can optimize the weighting of the assets to get the optimal combination.  The weights of the portfolios that lie on the efficient frontier are listed below.

Capturedaweights

Using the Vanguard funds listed in the article, as well as data on historical returns from Morningstar, I computed the efficient frontier for the 3 assets given in the article.  This analysis shows that while the portfolio may provide exposure “…to every major equity offering in the world”, it is not exactly efficient.  The second asset (the international stock fund) seems to have very little place in this portfolio despite the unique exposure it brings.  Clearly blindly quantitatively optimizing your portfolio may not leave you diversified, but being lazy may not get you there either.

College is still worth it (just not at Shaw University)

Since the year 2000, tuition at the University of Michigan has increased an average of 6.7% a year.  If the average starting salary of a graduate where to have kept up with that (40,000 in the year 2000) then it would be $76,507.53/yr currently!  While a college educations should allow a person to earn and save more over our lifetimes, at what cost?  With the cost of tuition raising every year, and the job market struggling to add jobs, the cost of college is starting to affect the payoffs.  The increasing cost of a college degree has reached a level where for some programs, student would have been better off putting all that college money under a mattress and joining the workforce.

While education is inherently good, some people may have been better off staying away if money is the metric.  There are those that bristle at using money, but it is not an unreasonable measure to use.  A method of valuing college attendance should be measured against not going.  This study considers adults who had not attended college, and asked about their attitudes about going to college presently.  The main them was the reason for going was the desire to make more money or advance their career.  Even though a well-rounded education is desirable, the benefits might not justify the costs.

An article in the economist emphasizes this tradeoff.  Pointing to a research firm called Payscale, highlights that the “return on 46 programs generated a return on investment worse then plunking the money in 20-year treasury bills.”  18 were negative, indicating a net loss on investment after 20 years!  Shaw University, mentioned in the title of this post, had the lowest ROI, an astonishing -10.6%.

Yet there are those that say a college degree has never been more valuable. As much as I hate to agree with the former president of that school down south, he has a point that a society is dependent on its educated citizens, and that the universities themselves provide a very important function in society.  And that is before you add in the ability to retire to the University’s retirement community!  Education has and should continue to be a foundation of our society.  We just have to figure out a way for everyone to afford a good foundation.

An increase in college tuition has contributed the most to the return on investment a college degree produces.   Tuition prices have almost doubled, while salaries and benefits have remained the same.  Something has to give; Tuition can’t keep rising.  I think the key driver of decreasing tuition expenses will be the invention that leverages technology to create a virtual classroom as engaging as the real thing.  An environment that permits interaction with the professor, yet on a scale that we see in todays online classrooms of hundreds of students.

 

Ryan’s budget ignores reality, still might not work

Members of both parties agree the deficit spending that the federal government continues to engage in is not sustainable.  It was necessary given the recession the economy was in, but it soon could weigh on the economy.  As the United States economy limps along after the great recession, the short term decrease in output that would result from balancing the budget cold further exacerbate the situation.  The question is how much debt is too much debt.  Research as to what level of debt the negative effects would begin at has been found to be unreliable.  The budget laid out by Sen. Paul Ryan on Tuesday touts the elimination of deficit spending in 10 years.  However this Ryan’s budget is both politically and economically unfeasible.

It seems fitting that Ryan’s budget plan was released on April fools day.  This budget has no chance of ever being implemented, as even if it where to get through the house of representatives, it stands no chance in a Democratic Senate that will not even vote on it.  This is fortunate given the research the budget is based on.  Released the same day, the report from the Congressional Budget Office (CBO) claims to have examined the effects of Ryan’s budget.  While most of his assumptions are agreeable, such as using the current projected budget as an extended baseline, the source of the spending reductions are “unspecified fiscal policies” and the budget is balanced via a line item “macroeconomic fiscal impact”. The fiscal is said to be the due to increased growth that the economy would receive due to the deficit reduction.  This has not been included in previous budgets.

While this may all seem vague, it’s of little real value.  The report clarifies that “the illustrative paths do not incorporate effects from differences in incentives to work or save that might be generated directly by differences in policies relative to those of the extended baseline.”   It goes on to mention, “Chairman Ryan’s specified paths for revenues and spending would require major changes to current law.” Given Ryan’s plans, requiring massive changes to healthcare spending, there will be an effect to an individual’s choices concerning working and saving.  These effects will cancel some of the effects Ryan attributes to growth out.  The budget that Paul Ryan is pitching calls attention to an important problem, but the claims he is making may be a little exaggerated.

What can be inferred from the paper is that even in Sen. Ryan’s dreams, deficit spending could be eliminated in 10 years.  This budget shows how large the problem is.  The government must either raise revenue (taxes), or decrease spending.  Given the productivity of congress, it may take much longer then 10 years for the government to balance its budget.