Tag Archives: finance

subprime is still suspect (revised)


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.


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


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.





The Murky Waters of Dark Pools

Recently, an article in the WSJ about Goldman Sachs recent strategies had a long section about “dark pools.”  Although I had heard about them briefly, I didn’t really understand what exactly they were, and so I decided to read a bit more about them and learn what they were and how they operated.  The resulting blog post is what I found.

A dark pool is essentially an alternative market where firms can trade with orders that are unavailable to the public market.  On these markets, firms are able to trade more anonymously; when they set and order, others who are in the dark pool can see that someone has placed an order, but cannot tell the position of the order.  This is often used when institutional investors want to move large amounts of an assets without changing the price in the market.  For example, if a large firm like Goldman Sachs wanted to buy a large amount of a certain type of asset, the price of that asset would shoot upward as they repositioned themselves.  However, if they made the purchase in a dark pool, they could buy at a lower price, and the transaction would hit the public books only after the purchase was complete.  Although relatively unknown to laypeople, a substantial portion of trades (12% in 2012, and rising).

Dark pools also play an important role in the current high-frequency trading controversy.  HFTs buy access into Wall Street bank’s dark pools, and then use their access to this private to benefit themselves.  HFTs will send out many small orders to these dark pools, fishing for a counterparty.  If an order gets executed, then the trader can guess that the large firm is taking a larger position that they cannot see.  When a HFT makes this inference, they then take the same position on a public market.  When the large firm’s order is filled in the dark pool, the transaction moves the asset’s price in the market in the way that benefits the HFT.  They pay a fee to have access to these banks dark pools, so both sides end up winning.  In Flash Boys, Michael Lewis argues against this strategy, commonly called “front-running”.

In 2012, Pipeline Trading Systems was accused of front-running people who made orders with their affiliate, and eventually was shut down after pressure from the SEC.

Dark pools seem to be queer bit of financial engineering.  They reduce the amount of information a typical market participant knows about the demand for an asset at any given time, because they don’t have access to who is trying to buy what in dark pools.  Dark pools seem to be a way for large firms to circumvent the market forces of supply and demand in order to buy lower and sell higher than would be possible on the open market.  I understand that someone making a large investment position change doesn’t necessarily want to broadcast it to the rest of the world, but I’m not sure if dark pools are the solution.


The League Of Extraordinarily Lucky Gentlemen

The Wall Street Journal offers investment advice. And it’s not good advice either; or at least, it’s not obviously true that it is. In fact, I very much doubt that it is.

But I’m getting ahead of myself. What’s the article about? The author followed 196 investors since 2007, evaluating how much money they made (and lost) and checking whether they managed to beat the market, as measured by the Wilshire 5000 index. And lo and behold, a “select group” did indeed manage to do so! And these people are willing to give advice to you! The Journal stresses that they outperformed the Wilshire 500 not only during the bull market since 2009, but also during the bear market before. Which is quite a feat:

 “almost without exception, the strategies that have made the most money since March 2009 were big losers in the preceding bear market. For example, the five best advisers over the past five years, among the nearly 200 monitored by the Hulbert Financial Digest, lost an average of 58% during that downturn.”

On a side note: the article just acknowledged that past performance by no means implies future performance, right? Or is the intended takeaway here that past losses by no means guarantee future losses? Which is also true, but it’s hard to make one point without also making the other. Strange as it may seem, the author seems to miss the other side of that particular coin.

Anyway, what about that investment advice? Well, all of these exceptional investors seem to agree on one point, namely that “you should remain at or close to fully invested in your equity portfolios.” Now there are probably good reasons why, depending on your particular situation and available alternatives, you should keep whatever money you can spare right now in equity. So I’m not actually too critical of this. Although I would point out that if you ask a group of people who take “$85 to $299” for their services and tell people to buy stocks for a living, “should I buy some stocks, you think?” they’re probably gonna say, “yes (that’ll be 300 bucks, thank you very much)”.

Other than that, all six advisors seem to be invested in… wait, did you say there’s only six of them who managed to beat the market for that whole period?! Out of 196? Why, that’s… about 2.6%! I’m going out on a limb here, but I assume that that number isn’t statistically significant (-ly different from zero). For the record, I’m of course being polemic here, because I don’t have the data in question; most importantly, I don’t know by how much these lucky few beat the market, which would be what you’d really want to look at to determine whether their exceptional gains were due to chance alone.

But I will say this: I’d take a bet that if I took 196 random stock samples from the Wilshire 5000 right now, 2.6% of them could probably beat the market. Actually, I might go on and compile that list once the semester is over. I’m sure Matlab will be up to the task.

I’ve got another one for you: the initial investors probably weren’t even a random sample of all financial advisors out there. Probably, they’re the ‘good ones’. Which means that even the best of the best don’t have an awesome track record by any means, and what are your chances of drawing an advisor from that pool in the first place, let alone one of the 2.6% that manage to outperform the market? I can’t tell you, but I can tell you that they’re worse than 2.6%.

Oh by the way, it’s a little odd that the article doesn’t mention by how much these guys beat the market. Would it have earned you more than $230? (Not that that’s what you’re really interested in. What you really wanna know is, given that you have to pay a fee, is that fee greater than or equal to your chances of finding an advisor that happens to beat the market, which are smaller than 2.6%, times the amount by which he or she is going to beat the market, which the article doesn’t provide? They’ll need to outperform the market by quite a bit to make that work).

But I digress; I fear that I never got to share the great investment advice, but luckily you can just go and read the article. I do have one last thing that bothers me though: if one of those six really, actually had an awesome secret to making boatloads of money, would they ever tell you? Or even risk that, by observing what happens to your portfolio, you’d ever find out? As soon as the world knew, a) their strategy would probably stop working, and b) nobody would pay them 300 bucks for stock advice anymore! So it’d be in those guys best interest, even if there was a pot of gold at the end of the rainbow, to never, ever, let you get more than a faint glimpse of it.

Which, by the way, also means that anybody who’s letting you in on their big investment secrets is probably either irrational, or lying to your face. Both of which seem somewhat underwhelming traits for a stock broker.

Efficient markets by any other name would smell as sweet

Via the Economist, a nice reminder that it doesn’t make a lot of sense to try and beat the market yourself, and even less sense to pay somebody else to do it (and it’ll cost you dearly). The market’s efficient – it’ll efficiently punish you for trying. I know, somewhat of an old story; you won’t win any shiny gold coins with that one anymore. Yet, people like to tell tales of those exceptional geniuses who defiantly manage to outperform the S&P500 in the epic battle that is the financial market.

On the other hand, you also won’t get any medals anymore for pointing out that many investors seem to behave rather irrationally (for example, they’re willing to pay somebody else to beat the market). Yet we think of the sum total of the chaotic, unpredictable, occasionally (asset) bubbly behavior of those people as a – maybe the one true – efficient market. In finance, it seems to me, familiar words have peculiar meanings.

Beasts of the Stubborn Wilds

Somewhere out there among the canid natives to the wilderness and remote areas of North AmericaEurasia, and North Africa of Wall Street, the mythical market beaters roam. Those who know where the ‘value stocks’ are at. Who have stubbornly resisted efficient market hypotheses. That they exists at all may seem odd for a second, given that I specifically stressed that active trading isn’t a very lucrative prospect. Then, you’ll realize that given the number of people who want to ascend to the ranks of those fabled few, it’s pretty obvious that some of them are gonna make it. It’s just that the overwhelming majority won’t.

There’s another problem: nobody knows who they are! You can’t look at past performance, because that’s not an indicator of future performance. More importantly, it’s no good if you know that somebody outperformed the index for the last ten years. You wanna know that they’re going to do well over the next few years! Unless you found a golden tablet inscribed with the names of all the great hedge fund managers that were, are, and will be, you’re screwed.

Overall, the whole idea of active investing doesn’t seem like a terribly efficient deal. But if people just like playing Leo DeCaprio, why not let them? So long as the underlying market is efficient, we’re golden, right?

The boy who cried grossly overvalued

Because stock returns move around so wildly (while things like GDP usually rise over time), it might seem that the process creating those returns can’t be terribly efficient. They don’t seem to follow a pattern. Paul Samuelson of course resolved that puzzle, proving that prices that incorporate all available information at any point in time will seem to fluctuate randomly. Samuelson was a really smart guy though. Which is why, in that same paper, he also said:

One should not read too much into the established theorem. […] It does not say that speculation […] or that randomness of prices is a good thing. It does not prove that anyone who makes money in speculation […] has accomplished something good for society. All or none of these may be true, but that would require a different investigation.

That part of the paper seems to get less press. Fama and Shiller of course both tried to deliver that ‘different investigation’. Are stock movements unpredictable because they instantly soak up new information? Or do they seem crazy because investing fads and bubbles are simply crazy, crazy things?

I won’t try to resolve that age-old debate here. Although I will say that it doesn’t seem overwhelmingly rational (or even smart) to buy a bunch of dot.com stocks, then have someone tell you that that’s crazy (“those companies are grossly overvalued!”), and then go nuts with fire sales. Unless, of course, you only bought them because someone else (or possibly the same person, if your broker’s really good) told you that dot.com wasn’t crazy at all.

You can’t cheat an honest man with a dictionary

My point is this: how on earth did we ever decide to use the term efficiency in this context?! Of all the wonderful words we have at our disposal to describe what’s going on with stock returns, why did we choose one that makes absolutely no sense? Let me illustrate:


 noun \i-ˈfi-shən-sē\

: the ability to do something or produce something without wasting materials, time, or energy : the quality or degree of being efficient ( technical )

Does that really seem like the perfect description of financial markets, when all we can really say is that stock movements can’t be predicted based on their past values? You know, I don’t wanna go out on a limb here, but it has at times occurred to me that financial markets can, you know, occasionally, I guess, engage in activities that, on the surface, seem rather like a giant waste of materials, time and energy, with an absolute lack of the quality or degree of being efficient.

Here are a few alternatives that I propose to replace the term ‘efficient market hypothesis’ until we have determined which ‘different investigation’ was right:

  • unpredictable markets hypothesis
  • random stuff happens hypothesis
  • index funds rule (on average) hypothesis
  • ARIMA(0,1,0) hypothesis (that last one’s a little too nerdy to really catch on with Wall Street types I fear)

So please, take your pick. I’m also open to suggestions! But let’s find an expression that’s more accurate, and less of an abuse of the English language.

College Grads Financial Disaster

With a presumably large portion of this class expecting to graduate college in the near future, one common worry is our financial success after we walk down the isle and pick up our diplomas. Graduating for many marks the first time they will be out on their own, either entering the workforce or moving on with their schooling taking out substantial loans to pay for the continuance of their studies. Just like all other new beginnings, this one will be scary at first.

On top of being financially independent for the first time, there are many other complicating factors. Our economy is finally recovering from a recession and the job market looks optimistic for many. However we are all at an age where we understand what just happened. Seeing the market dive in 2009 has left many of us skeptical of investing money in stocks. A study found that most millennials are investing like their grandparents losing significant gains. Buying into an exchange-traded funded following the S&P 500 would have realized a 30% return, while many millennials money sat on money in savings accounts realizing very limited returns. After a shaky January the account would be down 4%, still having a sizable advantage over the out dated savings fund.

Aside from the market being a big scare, we also face the new age of electronic money. Something not many our age are afraid of and most of us embrace, however when not used properly it is easy to find ourselves in a financial disaster. If the class is anything like me, cash is becoming a scarcity in my wallet with most purchases being funded through debit or credit cards. As college graduates, its not likely were going to make a big ticket purchase right off the bat and bankrupt us for the future, however it is easy to lose sight of the every day purchases. The purchases add up over the month and it don’t have to be faced until it is summed at the end of the month in our bills. It’s likely that electronic currencies such as bitcoin will only further complicate this making it even more difficult to track our spending.

As scary as the first portion of this may seem, all hope isn’t lost for us. By acting responsible with our finances we can set ourselves up for long term success. The first recommendation for college grads is to get educated on personal finances and the stock market. I’d say our class has a solid leg up on our piers, however it is important that we remain informed about the status of the economy post graduation. The second piece of advice is to to work with a financial advisor and set  goals for yourself, both long term and short term. Weather its paying off grad school loans, owning your first home, paying for a big wedding, or retiring to a home on the beach in Florida, you just need something to work towards. Working towards your goals will not only help you eliminate impulse spending but also be rewarding when you finally reach them.


Although we will be up on the stock market, saving for things like retirement can be tricky. When we graduate it may seem to early to start saving, but if you have the extra money the investment could pay dividends in the long wrong. The problem is we most likely be as informed on the retirement type funds as some seasoned financial advisors. They will be able to explain the differences between 401(k)s, IRAs, Roth IRAs, and emergency savings funds. There is no perfect combination to use, each individual can use a unique combination to maximize their investment. Financial advisors can also help decide the benefits between things like professionally managed mutual and funds following a set index.

My last piece of advice is to have faith in the stock market. We’ve seen the troubles its caused in the recent years which scares us, but remember there were booming times too that we are too young to remember, and these times will return.

If You Love Something, Set it Free: Avoiding Loss Aversion

Today Mark Hulbert ran an intriguing post in the Weekend Investor section of the Wall Street Journal suggesting that investors should take the opportunity to do some spring-cleaning of their asset portfolios.  Hulbert outlines a very common problem that both lovers and investors face: both are often afraid to end bad relationships. From a romantic context this is ancient wisdom, but to economic and financial researchers, understanding the aversion many investors have to selling their stocks is a relatively new development.

Terrance Odeon, a professor of finance at New York University and principal at AQR Capital Management, describes this concept very succinctly: “for most investors, buying is a forward-looking activity and selling is a backward-looking activity.” Odeon maintains that there are a lot of strange things investors do when they’re faced with selling a stock they own, especially when faced with realizing a loss. For instance, in his article Once Burned, Twice Shy: How Naïve Learning, Counterfactuals, and Regret Affect the Repurchase of Stocks Previously Sold, Odeon and Michal Ann Strahilevitz explain that investor’s previous experiences with a stock affect their willingness to repurchase a stock. After surveying the trading records of several tens of thousands of individual investors, Odeon and Strahilevitz found that investors are reluctant to repurchase two types of stocks: those that they sold for a loss, and those that had risen in price soon after their sale. This phenomenon appears to occur regardless of whether these stocks are reasonably good investments after the initial sale. The reason for this behavior, according to the authors, is the cognitive dissonance, or negative and disappointed emotions, that investors feel when reflecting on their previous investing actions. Many investors are easily manipulated by these emotions, and as a result often tend to follow reinforcing behavior in which they purchase stocks associated with positive emotions and avoid those that inspire negative emotions.

This behavior seems consistent with Amos Tversky and Daniel Kahneman’s research in their article The Framing of Decisions and the Psychology of Choice. In their article, Tversky and Kahneman describe how individuals tend to switch from risk aversive behavior to risk taking behavior depending on how a problem was phrased. For instance, when presented with a hypothetical problem in which a flu outbreak is expected to kill 600 people, with a choice between solutions A: “saving 200 people with 100% probability” and B: “saving 600 people with 33% probability” (which has the same expected value as the other option: 600 people * 33% = 200 people saved), individuals tend to choose option A. In this case, the bias of the participants towards picking the “most positive sounding” answer seems consistent with the Odeon paper where investors tend to choose stocks that they have the most “positive emotions” towards. On the other hand, when participants in the Kahnemann study are presented with the same question but are offered equivalent “negative sounding answers,” they tend to switch their preferences. Here, participants are more likely to choose option B: where there is a 1/3 probability that no one will die (same as the option B in the previous question, since 600 people * 33% = 200 people not dying is equivalent to 600 people * 33% = 200 people saved) over the option A: where 400 people will die for sure (equivalent to option A in the previous question in which 200 people will for sure be saved). In this case, much like in the Odeon paper, individuals tend to avoid the options that inspire negative emotions (the “negative sounding “option where 400 people are certain to die, and the “negative sounding” option to avoid a stock on which they had previously lost money), and tend to choose those that appear “more positive.”

In order to combat these mental biases and to identify stocks to sell, Hulbert offers a few tips to investors. First, he suggests that investors pay attention to the companies  financial analysts have given “sell” ratings to. This is because even financial analysts are reluctant to tell investors to “sell” stocks, so the logic is that if they actually do muster up the courage to give a stock a “sell” rating then the stock likely deserves it.  Along these same lines, Adam Reed, a finance professor at UNC-Chapel Hill, suggests to look at short-interest data (number of people who are “shorting” the stock and hope to profit from a fall in its price) as an indicator of whether or not you should sell a stock. Despite all of the tips offered in Hulbert’s article, it’s probable that the best advice is to take a tip from Tversky, Kahneman, and Odeon: don’t be afraid to cut your losses; the only thing that you should avoid is loss aversion.

Overall, what holds true in love appears to hold true in investing as well: if things are truly not working out, it’s often better to end your love affair (with a stock) than to prolong your suffering.


Recovery on hold with profits overseas

The United States’ recovery from the recession of 2008 has been painfully slow. It has been a period characterized by persistent unemployment that has weighed on the economy.  Companies are not adding the jobs they shed during the recession.  During this same period American companies have made healthy profits.  However, what modest growth there has been has not translated into jobs.  Below is the labor participation rate, which is a measure of what portion of the population is working.  The shaded areas are recessions, and coincide with drops in the participation rate.  The recoveries that follow show sharp increases in the rate.  After this most recent recession is clear that this recovery is different.

Civilian employment to population 16 years or older ratio.


One thing that is different now then in the past was that companies like Apple, Google, and Exxon Mobile weren’t  hoarding their profits overseas (an estimated 1.9 trillion as of May 2013). All this “cash on the sidelines” could stimulate the economy and create jobs if it was just put to use.

When multinational companies bring their profits back from over seas, the government takes what is called a repatriation tax. This tax rate is currently 35% of what ever is left after the company pays taxes in whatever country it earned them.  This is one of the highest in the world.  Since the money is taxed as soon as it is brought into the country, then there is going to be over a third less of it when it gets here.  Further eroding these mountains of cash is the debt that is taken out to do share buy backs and pay dividends to shareholders.  Investors want some of the profits if the company isn’t going to use them, and borrowing is cheaper then moving the money and paying taxes.  If the government is serious about stimulating the economy, it may have to get out of its own way.

The repatriation tax is preventing corporations from bring these profits back to the United States.   In order to stimulate the growth that the United States needs, the federal government should provide a tax holiday for corporations to bring their profits home.  This could amount to almost a trillion dollars returning to the United States.  Opponents to this may see it as only helping the rich; that there is not guarantee the companies won’t just pay lavish dividends to shareholders and boost their share price.  Some of that probably will happen, but at least those profits are being distributed, and most likely to a great deal of Americans.  With almost 2 trillion, companies will also invest some of the money in mergers and research for the future.  This is prosperity that has already been earned, it is just held back because no rationally operated company would pay a 35% tax unless it absolutely had to, they do owe that much to their shareholders. The federal government may hate the idea of letting that much money in with such a little slice going in its coffers, but how much of this cash do companies even need to bring back?

The United States government should provide corporations with the incentive they need to bring their profits back to the United States by providing a tax holiday for the profits they are currently keeping over seas.  They should also modify existing policies to make America competitive again with regard to corporate taxes.  It is only driving money away (IBM, Chrysler are examples). This money and these policies could be the missing ingredient for the United States recovery.  The wealth can’t trickle down through a border.

Peer-to-peer lending comes of age

Many people think peer-to-peer (p2p) lending is the democratization of finance.  This species of crowd funding allows almost anyone to loan money to interested borrowers. It can work for almost anything, even student loans. It is even possible now to loan money directly to an entrepreneur in another country.  Potential lenders log onto a website and see all the loan requests, vetted by the platform based on credit worthiness.  A person can invest as little as $25 to fund only part of a loan, or the whole thing, with principals of up to $35000.  However, many are worried the p2p lending may be a victim of its own success.

One of the main attractions of peer-to-peer (p2p) lending is that it allows investors to be matched directly with borrowers, leaving credit agencies and banks on the sidelines.  Until recently, p2p lending consisted of mainly of loans to pay off credit card debt and payday loans.  However, as it has matured and proven itself as a source of financing, small business loans have started to be offered.  Lured by a return diversified from existing markets, private equity groups have begun to participate in p2p markets.  As reported in the financial times, the two largest p2p lending platforms in the United States, Lending Club and Prosper, have both had to take steps in order to curb “sophisticated investors” from snapping up the best opportunities.  By sophisticated investors the author most likely means computer algorithms programmed by veteran high-speed traders at a hedge fund.  They even have funds that specialize in the p2p market.  A secondary market for p2p loans is in the works as well.  While many feel that this will crowd out the retail lender, one of the main draws of this type of financing is the sense of community that one gets from not dealing with a financial institution.  The funds also add legitimacy and much needed liquidity to the market, and competition amongst lenders should ultimately make rates better for borrowers.

Much has been said about the desire for the FED to stimulate the economy more through low interest rates and quantitative easing.  Negative interest rates are even discussed as a way to get money off the sidelines.  Peer-to-peer lending is one way to get money working again. It offers people looking to start or grow their business the chance, and it even provides a better alternative to those struggling with credit card debt, as the interest rates can be much cheaper then a carrying a balance on the card. Originally all the funding came from regular people. However, due to their success, private equity groups have taken notice of the opportunity, and are stepping up to provide more money and opportunity. In order to stimulate the economy further both at home and abroad, a greater portion of investors should follow suit and pursue peer-to-peer lending and other crowd sourcing methods.  These methods provide diversification from equity markets and allow anyone to directly invest in small business across the world.