Quotes of the week:
"The first of April is the day we remember what we are the other 364 days of the year." - Mark Twain.
In Honour of April and the financial crisis. (I wouldn't take the quote personally. After all, Mark Twain was an American).
Commentary for the Week:
The Nature of Risk:
Risk is one of those phenomena that leap into any and all discussions on finance even before logic can intrude. When we ask of someone what the Risks vs. Rewards of certain actions are going to be, we are frequently clear on what we mean by rewards but are usually not so clear about what we mean by risk. We frequently confuse risk with uncertainty, volatility and general gut-feeling. These are all important factors on their own, but surely Risk means a bit more. It is not enough to say that things will go up and down, or that one kind of action is 'secure' whereas another is 'risky'. The Truth (and you know that your humble correspondent is all about the Truth) is that there is always risk. Risk is even more pervasive than body odour at my gym, or smelly socks at Juma (no thanks to me I might add - I do my bit for the environment).
Two weeks ago, I recommended to you all a simple (but hopefully not simplistic) model for judging investments. But how does one go about categorizing and defining the risk factor within that model? Usually, there is reference made to words and phrases such as 'secure', 'guaranteed', 'not likely', 'not guaranteed', 'past performance is no guarantee', 'phenomenal', 'spectacular' and my all-time favourite - 'risk-neutral'. But what does all this mean and how can we as investors make some sense out of this? After all, people are paid millions to manage risk at Insurance companies, Trust Companies, Investment Banks and even at our favourite Actual Banks (I know - InshAllah). What makes me think we can second-guess them when they say 'secure' or worse - when they say nothing at all?
Well, it's simple really, the money around which they manage all this Risk is ours, and although one would like to think that they know what they are doing better than us, that is not exactly 'guaranteed', so to speak. So how do we manage Risk for our own money, ourselves - even before we seek help from 'professionals'?
5 Simple questions come to mind:
1. Do I understand the investment, how it works, how my money is supposed to grow, what makes it grow? etc.
a. Failing at this question is called the Risk of Ignorance. It is usually very expensive. If not in this world, then definitely in the next. To guard against it, we must understand fully how something grows in value. If the investment is Real Estate, why that particular location will increase in value more than one 17 blocks away for example. If it is a stock, why that company as opposed to its competition. If it is a mutual fund, why that particular fund manager or strategy as opposed to the other 4000. If it is a portfolio, why each component fits with the others.
2. How many ways are there in which what is being said to me can turn out to be false, or if not false then at least not Totally True?
a. Failing at this question means you are at Risk for False Expectations. For those of us who are married, we are very familiar with this risk. In financial matters, however, this risk is frequently overlooked when discussions about Rewards begin (again, just like marriage). My advice would be to rewind a bit and go over whether you understand how many ways the rewards can be undermined by fairly common situations. Think of it as buying a cow - if it doesn't pass on into Bovine heaven immediately (which would be a catastrophe such as the one we discussed last week), it will still produce milk. But if someone is feeding the cow pop-corn instead of hay, it will not perform by producing Grade 'A' milk but by producing manure. Definitely not the reward we were hoping for.
3. How likely is it that any of these 'Reward-reducing' situations will arise?
a. This question begins to quantify the Risk of Loss and its probability. The loss can be of faith, of returns, of principal or of face - the key is to figure out the probability for each situation that can reduce rewards. Using our beloved cow once again, what is the probability that someone will sneak into the barn and substitute hay with pop-corn? On the other hand, what is the probability that the hay is genetically-modified and may induce madness? Once you have these probabilities figured out, you can determine what the most likely scenario for the cow really is - whether it is reasonable to expect that the cow will actually produce the Grade 'A' milk you desperately want.
4. How severe will the loss be if it is 'Reward-reducing'?
a. This question leads us to determining whether we are at Risk for Catastrophic Loss - which is perhaps the most important determination of all. This is when amounts at risk or issues at risk are of the kind that induce butterflies in our tummies even when we are already full of Biryani. Usually, these involve some form of leverage / loans / margin. They can also involve life-savings. For those who are some way along life like my balding, grey-haired self, this becomes more and more of an issue. Personally, I try and stay away from anything that exposes me to catastrophe, particularly cows. One must try and spread one's nest-egg into a few baskets that one understands fully. Personally, I do not always succeed, but at least I know that the responsibility, decisions and blame are mine alone.
5. What is my alternative?
a. Failing at this question puts us at Risk of Opportunity Loss. If we dither, over-analyze and over-complexify, we will lose the opportunity to act in a timely manner. Ideally we want to buy the cow when it is reaching milk-producing age, not when it is entering its pop-corn driven Madness. Similarly, if we are in the path of an oncoming train, whether we jump to the right or the left, or whether it is expected to reach the next station on time is quite besides the point.
Armed with this knowledge and framework, I am sure you will make if not Trillions, then at least better decisions. You can even take the last two questions and make a nifty 2x2 Risk-Matrix. Please don't get excited about Cows as the investment vehicle of choice - send me neither Milk, nor the other By-product, I am partial to Soya Milk myself.
Finance News:
1. Have no fear, new regulations are here. Too bad more power is being given to the people who got us into this mess in the first place ... Even though we protest to the contrary at every opportunity, I guess at heart, we really believe that the politicians know what they are doing ... Just like marriage, a triumph of 'Hope over Experience' ... read more here
2. Blanket immunity is about to be granted for the Canadian version of the Sub-Prime mess ... read more here
3. Lehmann Brothers, the investment bank that is just larger than Bear Stearns was, raises over $3B (I think it took Bear Stearns something like 80 years to become worth $3B) ... read more here
4. Useful advice to guard against identity theft ... a growing problem in North America ... read more here
Economic News:
1. Some evidence that food prices have been bid-up by small scale investors. An interesting but ultimately unsatisfying explanation ... read more here
2. An excellent article on how Alberta's Oil Sands are using up both Natural Gas and the Province's fresh water. Did you know that the largest dammed (as in water-dam) pool in the world right now is not the Three Gorges in China but rather Syncrude's pool of contaminated water? ... Shocking ... read more here
3. Are Student Loans going to be the new sub-prime? ... (hat-tip to Suhail Ahmad) ... read more here
4. Story about some homes in the US that are worth less than their copper pipes ... read more here
Islamic & Middle East Finance:
1. An insight into Saudi Arabia's economic debates ... the burning issue of the day is not the almost suicidal peg to the US$ but whether women should be allowed to drive ... come on people ... read more here
2. UAE Takaful Company IPO oversubscribed 43X ... irrational exuberance anyone? ... read more here
Miscellaneous:
1. How to start up your own country ... (recommended only for reading purposes, not for hatching actual plans) ... read more here
2. The best advice that the CEO of PIMCO - William Thompson ever received ... (this is particularly good for young readers starting out in life) ... read more here
Showing posts with label investing. Show all posts
Showing posts with label investing. Show all posts
Tuesday, May 6, 2008
How to judge an Investment ...
Quote of the week:
"When the Fed is worried about the state of the economy, it basically responds by printing more of that green paper, and using it to buy bonds from banks. The banks then use the green paper to make more loans, which causes businesses and households to spend more, and the economy expands. This process can be almost magical in its effects: a committee in Washington gives some technical instructions to a trading desk in New York, and just like that, the economy creates millions of jobs. But sometimes the magic doesn't work. And this is one of those times." - Paul Krugman in the NY Times.
A carefully chosen, selective misquote. Just in case you didn't believe those of us who have said that the overleveraged financial system doesn't really work.
Commentary for the Week:
How to judge an Investment ...
Judging whether something is a good investment for your hard earned money is a skill that is critical in importance but seems to be in quite short supply. Especially from the way the markets have developed in the last year, it is obvious that with the exception of some truly good asset managers, most financial types that portray themselves as experts are quite clueless. They get away with this because their clients, us, are equally unsophisticated when it comes to financial matters. This is compounded by the complexity of our economy, which ensures that people who are geniuses at their non-financial jobs, turn to mush as soon as they begin to discuss their finances. In order to rectify this problem as much as one can, here are my humble suggestions for a few characteristics one should look for when judging the quality of a potential investment.
Most investments can be judged according to 5 fairly straightforward criteria. A perfect investment for you would be one in which all 5 qualities of the investment match perfectly with your particular needs. Also, there is no such thing as a perfect investment (perhaps because Ittihad hasn't developed one yet, and if we can't do it, I am sure you know that other's have little chance). More seriously though, even a 'perfect' investment will require you to make tradeoffs because sometimes the criteria work against each other - so you can have some of one and some of another, but not all of all. Anyway, good criteria against which investments should be judged are:
1. Income: Does the investment provide you with regular income?
2. Growth: Will the investment grow over time? Will it grow to what you want it to grow to? (Infinity is NOT a good answer here)
3. Liquidity: Will you be able to sell the investment quickly for a fair price if you have to sell in a hurry?
4. Safety: Is this a safe investment? Is your principal protected in some way? Will the investment be volatile?
5. Responsibility: Will your investment harm society or will it be beneficial?
Usually, you can find an investment that performs decently in maybe two or three criteria. A real estate investment for example, can provide you with rental income, some growth and some safety. But you cannot sell a house efficiently for its full price in the middle of February for example. Similarly, mining exploration stocks can provide you with a lot of growth if the companies in question find resources, but the environmental damage of a mine and the lack of safety keeps most investors away. This is all fine and dandy you say, for simple investments such as stocks and houses, but how would this model work for complex derivatives such as CDO's, you ask? Well, let's try - and then you can be the judge of whether the model can help you the next time someone tries to sell you something that is the 'Best Thing Since Google'.
CDO - Collateralised Debt Obligations (of subprime fame)
1. Income: Yes, they provided higher income than Bonds of similar credit rating (this rating was found to be problematic later but let us imagine that we are not judging in hindsight).
2. Growth: Absolutely Not. Growth was usually quite limited through embedded call options that allowed the seller to buy them back if they started increasing in price.
3. Liquidity: Yes, the promise of liquidity was always there (even though in practice it turned out that nobody wanted to buy the things)
4. Safety: Yes and No. Credit rating suggested yes. Exotic nature of products suggested that safety was lacking. Definitely not an unqualified Yes.
5. Responsibility: Extremely Irresponsible. Loan products do not add benefit to the economy, they add debt, which has to be repaid at a much faster increase than the rise of wages. Also, the introduction of complexity for the sake of hoodwinking investors is hardly an ethical practice.
I think it is safe to say that the model has some potential. If you begin to apply it with discipline to the things that you are thinking of buying for investment purposes, it might help bring out some features of the investment that are not-so-shiny under that gloss. In other cases, it might actually show you how good a potential investment really is, just the way it happened here at Ittihad this morning. But then saying anything more would be telling ...
Finance News:
1. The Storm before the Lull? ... The Dow climbs 400 pts in one day ... If it takes $200Billion of free money to buy you 400 pts ... how much to break the Dow Record? ... read more here
2. This is priceless ... The notorious Carlyle Group (of elder Mr. Bush fame), leverages its initial capital 32X (this means borrowing an amount 32X larger than one's own equity) for one of its investments ... with somewhat predictable results ... read more here
3. Say hello to the 40-Yr Mortgage. Home affordability the lowest it has been since 1990 ... read more here
Economic News:
1. Investors looking away from US$ investments ... the question to ask your broker / financial advisor is - how much of my retirement savings is invested in the US? ... read more here
2. The CDN federal government proposes changes in immigration policy ... may have grave effects on economic growth ... less capital inflow / less housing demand = lesser growth ... read more here
3. S&P says that the market panic is almost over ... 'pure hogwash' - as they say in the land below us ... read more here
4. Why the Fed's recent actions might fail to produce a recovery ... read more here
Islamic & Middle East Finance:
1. All the 'Islamic' countries of the world have gotten together to build an anti-poverty fund (which is less than 1/6th the size of the Bill and Melinda Gates Foundation) ... well, it's a start ... let's see how they help the people they say they want to help ... read more here
Miscellaneous:
1. Essential advice for Small and Medium business - owners from the Harvard Business Review ... read more here
2. Yet more entrepreneurial advice ... from a more personal perspective this time ... read more here
"When the Fed is worried about the state of the economy, it basically responds by printing more of that green paper, and using it to buy bonds from banks. The banks then use the green paper to make more loans, which causes businesses and households to spend more, and the economy expands. This process can be almost magical in its effects: a committee in Washington gives some technical instructions to a trading desk in New York, and just like that, the economy creates millions of jobs. But sometimes the magic doesn't work. And this is one of those times." - Paul Krugman in the NY Times.
A carefully chosen, selective misquote. Just in case you didn't believe those of us who have said that the overleveraged financial system doesn't really work.
Commentary for the Week:
How to judge an Investment ...
Judging whether something is a good investment for your hard earned money is a skill that is critical in importance but seems to be in quite short supply. Especially from the way the markets have developed in the last year, it is obvious that with the exception of some truly good asset managers, most financial types that portray themselves as experts are quite clueless. They get away with this because their clients, us, are equally unsophisticated when it comes to financial matters. This is compounded by the complexity of our economy, which ensures that people who are geniuses at their non-financial jobs, turn to mush as soon as they begin to discuss their finances. In order to rectify this problem as much as one can, here are my humble suggestions for a few characteristics one should look for when judging the quality of a potential investment.
Most investments can be judged according to 5 fairly straightforward criteria. A perfect investment for you would be one in which all 5 qualities of the investment match perfectly with your particular needs. Also, there is no such thing as a perfect investment (perhaps because Ittihad hasn't developed one yet, and if we can't do it, I am sure you know that other's have little chance). More seriously though, even a 'perfect' investment will require you to make tradeoffs because sometimes the criteria work against each other - so you can have some of one and some of another, but not all of all. Anyway, good criteria against which investments should be judged are:
1. Income: Does the investment provide you with regular income?
2. Growth: Will the investment grow over time? Will it grow to what you want it to grow to? (Infinity is NOT a good answer here)
3. Liquidity: Will you be able to sell the investment quickly for a fair price if you have to sell in a hurry?
4. Safety: Is this a safe investment? Is your principal protected in some way? Will the investment be volatile?
5. Responsibility: Will your investment harm society or will it be beneficial?
Usually, you can find an investment that performs decently in maybe two or three criteria. A real estate investment for example, can provide you with rental income, some growth and some safety. But you cannot sell a house efficiently for its full price in the middle of February for example. Similarly, mining exploration stocks can provide you with a lot of growth if the companies in question find resources, but the environmental damage of a mine and the lack of safety keeps most investors away. This is all fine and dandy you say, for simple investments such as stocks and houses, but how would this model work for complex derivatives such as CDO's, you ask? Well, let's try - and then you can be the judge of whether the model can help you the next time someone tries to sell you something that is the 'Best Thing Since Google'.
CDO - Collateralised Debt Obligations (of subprime fame)
1. Income: Yes, they provided higher income than Bonds of similar credit rating (this rating was found to be problematic later but let us imagine that we are not judging in hindsight).
2. Growth: Absolutely Not. Growth was usually quite limited through embedded call options that allowed the seller to buy them back if they started increasing in price.
3. Liquidity: Yes, the promise of liquidity was always there (even though in practice it turned out that nobody wanted to buy the things)
4. Safety: Yes and No. Credit rating suggested yes. Exotic nature of products suggested that safety was lacking. Definitely not an unqualified Yes.
5. Responsibility: Extremely Irresponsible. Loan products do not add benefit to the economy, they add debt, which has to be repaid at a much faster increase than the rise of wages. Also, the introduction of complexity for the sake of hoodwinking investors is hardly an ethical practice.
I think it is safe to say that the model has some potential. If you begin to apply it with discipline to the things that you are thinking of buying for investment purposes, it might help bring out some features of the investment that are not-so-shiny under that gloss. In other cases, it might actually show you how good a potential investment really is, just the way it happened here at Ittihad this morning. But then saying anything more would be telling ...
Finance News:
1. The Storm before the Lull? ... The Dow climbs 400 pts in one day ... If it takes $200Billion of free money to buy you 400 pts ... how much to break the Dow Record? ... read more here
2. This is priceless ... The notorious Carlyle Group (of elder Mr. Bush fame), leverages its initial capital 32X (this means borrowing an amount 32X larger than one's own equity) for one of its investments ... with somewhat predictable results ... read more here
3. Say hello to the 40-Yr Mortgage. Home affordability the lowest it has been since 1990 ... read more here
Economic News:
1. Investors looking away from US$ investments ... the question to ask your broker / financial advisor is - how much of my retirement savings is invested in the US? ... read more here
2. The CDN federal government proposes changes in immigration policy ... may have grave effects on economic growth ... less capital inflow / less housing demand = lesser growth ... read more here
3. S&P says that the market panic is almost over ... 'pure hogwash' - as they say in the land below us ... read more here
4. Why the Fed's recent actions might fail to produce a recovery ... read more here
Islamic & Middle East Finance:
1. All the 'Islamic' countries of the world have gotten together to build an anti-poverty fund (which is less than 1/6th the size of the Bill and Melinda Gates Foundation) ... well, it's a start ... let's see how they help the people they say they want to help ... read more here
Miscellaneous:
1. Essential advice for Small and Medium business - owners from the Harvard Business Review ... read more here
2. Yet more entrepreneurial advice ... from a more personal perspective this time ... read more here
Takes 2 to Tango
Dear Friends,
I know that many of you have probably missed the Ittihad Briefing so much that these last two weeks have been lost in a haze of both depression and disorientation. I assure you that this was not a planned attempt to prove how valuable the Briefing is by taking it away from you. The reason for our absence from your Inbox was quite pedestrian. It was just that I was moving my office to a new location, which resulted in a back injury which required further time off. As that logistical odyssey has now come to an end, my humble self is back at your service. I hope you will forgive this unannounced hiatus.
Quote of the week:
'Particularly egregious, at least to me, was the implicit claim that the capital markets are there in large part to help people save for old age. No they're not, and if regulators or governments ever decided to enforce that particular view we would likely have a market crash. The markets are there to provide liquidity. Period. And if by doing that people are able to buy stock and bonds in companies whose value appreciate, that's great. But markets whose core notion is wealth accumulation for individual savers, and markets whose main object is liquidity creation, are very, very different things, ...' - Paul Kedrosky from Infectious Greed.
People may not like this view but amid the confusion and noise relating to 'the Market', this is an important distinction between the primary function of markets and what we use them for.
Commentary for the Week:
Banks around the world announce more than $100B of losses, but what's the Bad News?
In these past couple of months we have witnessed many admissions of guilt by financial sector types. The CEO of Citigroup resigned, Bear Stearns has announced major write-downs, UBS, Credit-Suisse and now even Societe Generale has announced losses in the tens of Billions. These admissions of losses are meant to reassure investors that company managements are forthright about issues and that problems are being dealt with. This is all well and good, but is it the 'Truth'? More specifically, if the banks and Hedge Fund types are finally being truthful, who is not? You will of course remember that many of these banks spent quite some time denying that the softening real estate situation would have 'significant' effect. $100 Billion and counting in losses later, lawyers are now googling 'significant'. The question for us is - where else in the economy are there undeclared losses that are festering?
To get to the bottom of this, or nearer to the bottom anyway, we have to first discuss what has caused these losses in the first place. This is not generally a simple discussion, but I will attempt the impossible and keep it both brief and somewhat intelligent. Institutions that forward credit used to have a simple role in the economy. They used to take in deposits and advance loans to people based on those deposits. This simple equation has been changing over the last century. Where we are today is that institutions now take in deposits, lend a lot more money than they have on deposit, and then package the loans and sell the package to someone else as an investment. Where it gets positively mind-blowing and makes people dizzy, is that the 'investment' (package of loans) that Bank A just sold to Bank B, can be treated by Bank B as a 'deposit', against which more loans can be forwarded, and more 'Investments' can be manufactured. Also, as these packages were designed to produce income, anyone with a fixed-income need has been a regular buyer. Indeed, one doesn't know whether to laugh or to cry at the ridiculousness of this scheme that passes for the N. American financial sector. As to why people would do this, well - even though simple lending is still profitable, the packaging and selling of loans at inflated prices is where profits are obscene.
This almost makes one wish for a simpler time when the banker was making some money but he was still your friend. Now there are no friends and no enemies, just electrons and financial models. The funny thing about financial models is that they are only worth money if they can show growth. Therefore, guess what most financial models show? If you said growth, you are a genius. If you said the 'Truth', you get to be an Investment Banker - which is yet another kind of genius altogether.
The recent problem of course stems from the fact that the financial models and thus the 'investments' that rest upon them depend on a few simple variables to drive growth. The important ones are 1. cheap credit, or low interest rates; 2. Ready buyers for the investment and 3. Debtors making their loan payments. What has been immensely demoralizing for financial types recently has been that none of these fairly simple assumptions have held. There are few buyers for 'loan packages', interest rates have been cut but by too little too late, and broad swathes of US homeowners are unable to pay the interest on their loans. To add to the general misery, since almost everyone has been using similar models for investment planning, almost everyone has lost money because the assumptions don't hold.
What is truly fascinating in this story, and what makes one's nose all itchy with bad smell, is that only the banks and investment houses (for the most part) have declared losses. This means that only the people who sold these packages and kept a few for themselves are admitting losses. The regular buyers are quite mum. Most of these packages were fixed-income products, which means Insurance Companies and Pension Funds would have been natural buyers. This leads to the inevitable question of why the quietude? If the sellers of a rotten product are declaring losses on their inventory, why are the people who have been buying these for years not saying anything at all? As I am sure the more astute among us realize, it takes two to tango, two hands to clap, and two parties to complete a trade.
Of course, this does not mean that you all go out tomorrow and start to short Insurance Company stocks on margin. That would be exceedingly foolish. Unless, of course, you made lots of money doing that, in which case it would exceedingly brilliant. Just remember, the losses are from the same packages that were called 'Financial WMD's' by Warren Buffet. As WMD's, they have a long radioactive, half-life. The bank losses are only the first stage and you already know my suspicions for stage 2. One could be wrong of course, but I still feel a bit like Hamlet - 'Something is rotten in the state of Denmark ...'
Finance News:
1. The ability of banks to package and sell off their loans to others comes under more stress ... Private Equity firms refuse to back Bond insurers ... read more here
2. Remember the Rio Tinto buyout I spoke about in a previous issue? ... Well, the price just went to $150 Billion. What is interesting is that Rio Tinto management is still rejecting the offer as too low ... read more here
3. Thinking of borrowing for your RRSP this year ... read this first ... read more here
4. The CPP announces very meagre gains for the year. I thought they were the 'smart money' ... read more here
Economic News:
1. National Bank catches up to my opinion of the Gold Price ... (Refer to Issue 3.) ... read more here
2. The Loonie listens to wisdom and crosses back over into above-par territory ... read more here
3. After more than 10-15 yrs plus of overspending, US consumers are taking a break, throwing all sorts of financial forecasts, models and assumptions off kilter. Does the Japan scenario look more likely? ... read more here
4. The funniest financial 'journalist' writes about the connection between interest rates, inflation, the US$, Gold and about the American Economy ... absolutely priceless ... read more here
Islamic & Middle East Finance:
1. One particular and not very well-known vision of the future of 'Islamic Finance' definitely becoming an agenda item in the US election ... not exactly light reading but very interesting nevertheless ... read more here
Miscellaneous:
1. How often do you make a mistake and learn from it? ... read more here
2. A very nice story on a Canadian retailing competitor to the Bay. Many of you who go cottaging or camping up north will recognize the name ... read more here
I know that many of you have probably missed the Ittihad Briefing so much that these last two weeks have been lost in a haze of both depression and disorientation. I assure you that this was not a planned attempt to prove how valuable the Briefing is by taking it away from you. The reason for our absence from your Inbox was quite pedestrian. It was just that I was moving my office to a new location, which resulted in a back injury which required further time off. As that logistical odyssey has now come to an end, my humble self is back at your service. I hope you will forgive this unannounced hiatus.
Quote of the week:
'Particularly egregious, at least to me, was the implicit claim that the capital markets are there in large part to help people save for old age. No they're not, and if regulators or governments ever decided to enforce that particular view we would likely have a market crash. The markets are there to provide liquidity. Period. And if by doing that people are able to buy stock and bonds in companies whose value appreciate, that's great. But markets whose core notion is wealth accumulation for individual savers, and markets whose main object is liquidity creation, are very, very different things, ...' - Paul Kedrosky from Infectious Greed.
People may not like this view but amid the confusion and noise relating to 'the Market', this is an important distinction between the primary function of markets and what we use them for.
Commentary for the Week:
Banks around the world announce more than $100B of losses, but what's the Bad News?
In these past couple of months we have witnessed many admissions of guilt by financial sector types. The CEO of Citigroup resigned, Bear Stearns has announced major write-downs, UBS, Credit-Suisse and now even Societe Generale has announced losses in the tens of Billions. These admissions of losses are meant to reassure investors that company managements are forthright about issues and that problems are being dealt with. This is all well and good, but is it the 'Truth'? More specifically, if the banks and Hedge Fund types are finally being truthful, who is not? You will of course remember that many of these banks spent quite some time denying that the softening real estate situation would have 'significant' effect. $100 Billion and counting in losses later, lawyers are now googling 'significant'. The question for us is - where else in the economy are there undeclared losses that are festering?
To get to the bottom of this, or nearer to the bottom anyway, we have to first discuss what has caused these losses in the first place. This is not generally a simple discussion, but I will attempt the impossible and keep it both brief and somewhat intelligent. Institutions that forward credit used to have a simple role in the economy. They used to take in deposits and advance loans to people based on those deposits. This simple equation has been changing over the last century. Where we are today is that institutions now take in deposits, lend a lot more money than they have on deposit, and then package the loans and sell the package to someone else as an investment. Where it gets positively mind-blowing and makes people dizzy, is that the 'investment' (package of loans) that Bank A just sold to Bank B, can be treated by Bank B as a 'deposit', against which more loans can be forwarded, and more 'Investments' can be manufactured. Also, as these packages were designed to produce income, anyone with a fixed-income need has been a regular buyer. Indeed, one doesn't know whether to laugh or to cry at the ridiculousness of this scheme that passes for the N. American financial sector. As to why people would do this, well - even though simple lending is still profitable, the packaging and selling of loans at inflated prices is where profits are obscene.
This almost makes one wish for a simpler time when the banker was making some money but he was still your friend. Now there are no friends and no enemies, just electrons and financial models. The funny thing about financial models is that they are only worth money if they can show growth. Therefore, guess what most financial models show? If you said growth, you are a genius. If you said the 'Truth', you get to be an Investment Banker - which is yet another kind of genius altogether.
The recent problem of course stems from the fact that the financial models and thus the 'investments' that rest upon them depend on a few simple variables to drive growth. The important ones are 1. cheap credit, or low interest rates; 2. Ready buyers for the investment and 3. Debtors making their loan payments. What has been immensely demoralizing for financial types recently has been that none of these fairly simple assumptions have held. There are few buyers for 'loan packages', interest rates have been cut but by too little too late, and broad swathes of US homeowners are unable to pay the interest on their loans. To add to the general misery, since almost everyone has been using similar models for investment planning, almost everyone has lost money because the assumptions don't hold.
What is truly fascinating in this story, and what makes one's nose all itchy with bad smell, is that only the banks and investment houses (for the most part) have declared losses. This means that only the people who sold these packages and kept a few for themselves are admitting losses. The regular buyers are quite mum. Most of these packages were fixed-income products, which means Insurance Companies and Pension Funds would have been natural buyers. This leads to the inevitable question of why the quietude? If the sellers of a rotten product are declaring losses on their inventory, why are the people who have been buying these for years not saying anything at all? As I am sure the more astute among us realize, it takes two to tango, two hands to clap, and two parties to complete a trade.
Of course, this does not mean that you all go out tomorrow and start to short Insurance Company stocks on margin. That would be exceedingly foolish. Unless, of course, you made lots of money doing that, in which case it would exceedingly brilliant. Just remember, the losses are from the same packages that were called 'Financial WMD's' by Warren Buffet. As WMD's, they have a long radioactive, half-life. The bank losses are only the first stage and you already know my suspicions for stage 2. One could be wrong of course, but I still feel a bit like Hamlet - 'Something is rotten in the state of Denmark ...'
Finance News:
1. The ability of banks to package and sell off their loans to others comes under more stress ... Private Equity firms refuse to back Bond insurers ... read more here
2. Remember the Rio Tinto buyout I spoke about in a previous issue? ... Well, the price just went to $150 Billion. What is interesting is that Rio Tinto management is still rejecting the offer as too low ... read more here
3. Thinking of borrowing for your RRSP this year ... read this first ... read more here
4. The CPP announces very meagre gains for the year. I thought they were the 'smart money' ... read more here
Economic News:
1. National Bank catches up to my opinion of the Gold Price ... (Refer to Issue 3.) ... read more here
2. The Loonie listens to wisdom and crosses back over into above-par territory ... read more here
3. After more than 10-15 yrs plus of overspending, US consumers are taking a break, throwing all sorts of financial forecasts, models and assumptions off kilter. Does the Japan scenario look more likely? ... read more here
4. The funniest financial 'journalist' writes about the connection between interest rates, inflation, the US$, Gold and about the American Economy ... absolutely priceless ... read more here
Islamic & Middle East Finance:
1. One particular and not very well-known vision of the future of 'Islamic Finance' definitely becoming an agenda item in the US election ... not exactly light reading but very interesting nevertheless ... read more here
Miscellaneous:
1. How often do you make a mistake and learn from it? ... read more here
2. A very nice story on a Canadian retailing competitor to the Bay. Many of you who go cottaging or camping up north will recognize the name ... read more here
Spring, Summer, Fall, Winter and RRSP
Quote of the week:
'If half the available farmland in Germany were used to grow rapeseed, the total production would be 1,500 million litres of biodiesel, less than five percent of the total annual consumption of gasoline in Germany. On that same land it is possible to grow 6.8 million tonnes of wheat, or 41 million tonnes of potatoes. Germany has to choose between producing food or vegetable oil to run its cars.' - Michael Hopf from Greenpeace speaks about Biodiesel crops in Germany.
Surely this cannot be ... a choice no civilized nation should be asked to make! Drive on the autobahn, or eat food?
Commentary for the Week:
Spring, Summer, Fall, Winter and RRSP
Get ready my friends, RRSP season has arrived. This is the time of the year that most of us suddenly realize that the daily grind we go through to get out of our warm, cosy beds will come to an end one fine day. We will retire, - and no, I do not mean to a better place, although that too. I mean retire to the carefree, unemployed, cruising lifestyle that the TV and the millions spent in advertising the latest investments promise us as soon as we develop enough grey hair. For that remote hope, and our somewhat shameless tax-avoidance tendencies, every year we break out the cheque-book and spend 1 hour with our financial advisors investing our money. The TV and the ads with beautiful people assure us that we are on the right track and this RRSP season, we are good in hands. Alas, if only this were true.
For most of us, the RRSP is just a tax avoidance tool, a 2008 deadline to invest if we want to save 2007 tax, so that we can enjoy watching TV for the rest of the year without being asked for money by people too beautiful to say no to. People who, in my opinion, are so gorgeous and maddeningly happy that they have probably never been in finance, don't know a thing about the economy and don't know that the markets are crashing and that all our savings depend on what happens to the TSX, the DOW and maybe even an unknown Cow that is slowly and secretly going Mad (as in BSE) in an impossible place such as Shropshire, England. Also, these people cannot have my best interests at heart as they are always telling me that I want something sickeningly fatty to eat, or that I want to go for a speeding-ticket inducing drive in a tank-inspired SUV that probably needs a quarter of Kuwait's oil to get me to work tomorrow, even though they know that its already 8:30 pm and I just ate and the traffic was so terrible that it took me 40 minutes to cover the distance that would have taken me 4 minutes if I was in Germany and that there is no army on God's green Earth that can make me get into anything with wheels again this day ... but I digress.
Let's get back to RRSP's ... and the myths that surround their complexities. I know that we will all be bombarded with RRSP advice over the next month - I just think we should be prepared for battle.
RRSP's are a legal, 'approved by the government', tax-sheltered, trust account that allow us to save taxes while at the same time saving for retirement. Essentially a trust account held by a third-party for the purpose of providing us income during our retirement, RRSP's are like a basket that someone else is holding for you. Pushing this analogy a little bit more, think of me dutifully pushing around a shopping cart at the grocery store as my wife buys the latest organic mushrooms with the money I was saving for migration to Germany. My wife is the proverbial client, the shopping cart is the RRSP and I am the third party custodian of both the shopping cart and whatever she decides to put in it. She can fill it with good stuff like chocolate, or mouldy growths called mushrooms that pass for agricultural output in our advanced economy. What is in the cart is the actual food, whereas the cart itself is a mere vehicle. Similarly, what are placed inside an RRSP are the actual investments, the RRSP account itself is just a receptacle. The advantage of this receptacle is that whatever one puts in, can be written off against one's income for taxation purposes. This decreases one's taxable income, resulting in a larger tax refund because we have a progressive income tax regime. The other advantage is that whatever is placed in the RRSP also grows tax-free until withdrawal. This means that all growth of the investments inside the RRSP are tax-sheltered and no tax is payable on their growth and rebalancing on a yearly basis. This is true even if there is buying and selling within the RRSP and whether the growth is interest, capital-gains or dividends. Once you withdraw money however, the story changes quite a bit. Withdrawals are considered income by the CRA and so even if most of the growth in the investments held inside the RRSP is from capital gains, you will be taxed as if your withdrawal is income and at your marginal income tax rate. The idea here is to make your original investment grow to such an extent that this higher taxation still leaves you better off.
The other myth about RRSP's is that they have a season (this year's only goes to Feb 28th by the way, not March 1st). Saying that an RRSP contribution should have a season is like saying retirement will have a season, or that 1hr / year thinking about this stuff will allow you to live like the non-people on TV. I find this philosophy extremely problematic. Suppose your investments were like mushrooms instead of stocks or mutual funds, but that you still had to pay for them with your hard-earned money - this will make it more fun. For the first 2 months of the year, everyone else along with their Grandfather buys mushrooms. If the price of mushrooms is high at this time, you overpay for the mushrooms; if the price is low, you buy them at discount. You do not however, know whether the price is high or low at the time you are buying because you do not know if the price will be higher or lower the next month, the next year etc. etc. If you have consistently overpaid for mushrooms over 20-30 years of your working life, not only do you have a biggish collection of mushrooms, you have also spent relatively more to buy them. If you have underpaid relative to the average price however, you have mushrooms as far as your eye can see and they did not even cost you as much as they did in the earlier scenario. This last scenario allows you to either buy more mushrooms (so you can be even more comfortable), or have extra cash lying around. Since there is no predictable way or easy secret that I can give you about how to always be in the underpaying category - you have to be creative. Instead of risking all your cash in one go in Jan or Feb for the previous year's taxes, you have to be pro-active. Instead of buying $19,000 (this year's max contribution limit for some people) of mushrooms in Feb, buy only $1583.3 of mushrooms every month instead. This will ensure that you are buying mushrooms not at one price that might be high, but at an average yearly price. You gamble less with your money this way.
To me, the average price method called Dollar-Cost Averaging (you can ask Sheikh Google) is safer, otherwise you might be stuck with only a few mushrooms in retirement. Surely, having many is better.
(Please do not be offended if you are one of the non-people on TV, I listen to the radio and I am pretty sure that there are some non-people in there as well. Also, for those who did not like the mushroom analogy, I reply that many investments are just like mushrooms - quite mouldy. If you prefer, you can read the name of your favourite stock instead of the word mushroom whenever you come across it because the principle still stands. Also, for those who need discuss their RRSP strategy, if you can get 5 new people to subscribe to this newsletter, I will help you for mere mushrooms - we are sitting at around 1800 subscribers, I would like to get at least another 200 soon).
Finance News:
1. The geniuses that invested in Citi last month are probably not too pleased with this piece of news ... a $10 Billion loss at Citibank with an $18 Billion write-down of assets ... (in addition to all the others that they have announced already) ... http://www.nytimes.com/2008/01/15/business/16citi.html?fta=y
2. Must read story of the week ... about the fund manager who made over 500% for his investors over the subprime issue ... http://online.wsj.com/article/SB120036645057290423.html?mod=hpp_us_pageone ... and how he has hired Alan Greenspan, the man many blame for that mess in the first place ... http://online.wsj.com/article/SB120036783112890507.html?mod=hpp_us_whats_news
3. Who was it that said that subprime would have no effect on the TSX? ... Jeffrey Rubin - Chief Economist at CIBC? ... (refer to IWB issue 3. or http://www.advisor.ca/news/article.jsp?content=20071108_152122_5120 ) ... and now for more of the truth ... http://www.financialpost.com/story.html?id=242110 ... (although since it is the Post, I use the term truth quite loosely) ...
4. Doing an Alwaleed? ... the investment behind the Saudi Prince's fortune ... http://www.economist.com/daily/columns/businessview/displaystory.cfm?story_id=10522716&fsrc=nwl
Economic News:
1. Shocking ... a good article from Marcus Gee?! ... shocking ... do read the article of course because it speaks to how Canadian businesses can begin to expand into foreign markets using the HR resources they have at here at home ... still can't believe it was written by Marcus Gee though ... http://www.reportonbusiness.com/servlet/story/RTGAM.20080116.wibasia0116/BNStory/robColumnsBlogs/home?cid=al_gam_mostview
2. Need some explanation about currency movements and what the loonie's rise means for the Canadian economy? ... a thought-provoking article about a professor with whom many would disagree. Nevertheless, there is some insight here that we can learn from ... http://www.reportonbusiness.com/servlet/story/RTGAM.20080116.wrreynolds0116/BNStory/robColumnsBlogs/home
3. Notional amount of credit derivatives = $43Trillion (yes, trillion), declared losses to date = $100 Billion (approx) ... How much of the former will be recognized as the latter? - Remember, our RRSP's, company pensions, taxes and standard of living depend on the answer ... http://www.economist.com/finance/displaystory.cfm?story_id=10498541
4. US inflation highest in 17 years. Do you remember now that Rio Tinto shareholders walked away from $150B (US)? Do you see why? In the present fight between US money and Gold / Oil / Real Stuff ... which would you pick? ... http://www.canadianbusiness.com/markets/market_news/article.jsp?content=b011628A
Islamic / Middle East Finance:
1. Has Islamic Finance become an issue in the 2008 US presidential election? ... maybe just a little bit ... http://www.ronpaul2008.com/issues/inflation-tax/
2. Mr. Usmani says that 85% of 'Islamic Bonds' are not Islamic, setting off a debate in Bahrain and the international Islamic standards setting body ... http://www.washingtontimes.com/apps/pbcs.dll/article?AID=/20080114/BUSINESS/688156932/wt.test@yahoo.com
Miscellaneous:
1. Time to become vegetarian my friends ... the US has allowed the entry of cloned animals into the food chain ... be afraid - very afraid ... http://www.reuters.com/article/healthNews/idUSN1444947520080116?feedType=nl&feedName=ushealth1100&sp=true
'If half the available farmland in Germany were used to grow rapeseed, the total production would be 1,500 million litres of biodiesel, less than five percent of the total annual consumption of gasoline in Germany. On that same land it is possible to grow 6.8 million tonnes of wheat, or 41 million tonnes of potatoes. Germany has to choose between producing food or vegetable oil to run its cars.' - Michael Hopf from Greenpeace speaks about Biodiesel crops in Germany.
Surely this cannot be ... a choice no civilized nation should be asked to make! Drive on the autobahn, or eat food?
Commentary for the Week:
Spring, Summer, Fall, Winter and RRSP
Get ready my friends, RRSP season has arrived. This is the time of the year that most of us suddenly realize that the daily grind we go through to get out of our warm, cosy beds will come to an end one fine day. We will retire, - and no, I do not mean to a better place, although that too. I mean retire to the carefree, unemployed, cruising lifestyle that the TV and the millions spent in advertising the latest investments promise us as soon as we develop enough grey hair. For that remote hope, and our somewhat shameless tax-avoidance tendencies, every year we break out the cheque-book and spend 1 hour with our financial advisors investing our money. The TV and the ads with beautiful people assure us that we are on the right track and this RRSP season, we are good in hands. Alas, if only this were true.
For most of us, the RRSP is just a tax avoidance tool, a 2008 deadline to invest if we want to save 2007 tax, so that we can enjoy watching TV for the rest of the year without being asked for money by people too beautiful to say no to. People who, in my opinion, are so gorgeous and maddeningly happy that they have probably never been in finance, don't know a thing about the economy and don't know that the markets are crashing and that all our savings depend on what happens to the TSX, the DOW and maybe even an unknown Cow that is slowly and secretly going Mad (as in BSE) in an impossible place such as Shropshire, England. Also, these people cannot have my best interests at heart as they are always telling me that I want something sickeningly fatty to eat, or that I want to go for a speeding-ticket inducing drive in a tank-inspired SUV that probably needs a quarter of Kuwait's oil to get me to work tomorrow, even though they know that its already 8:30 pm and I just ate and the traffic was so terrible that it took me 40 minutes to cover the distance that would have taken me 4 minutes if I was in Germany and that there is no army on God's green Earth that can make me get into anything with wheels again this day ... but I digress.
Let's get back to RRSP's ... and the myths that surround their complexities. I know that we will all be bombarded with RRSP advice over the next month - I just think we should be prepared for battle.
RRSP's are a legal, 'approved by the government', tax-sheltered, trust account that allow us to save taxes while at the same time saving for retirement. Essentially a trust account held by a third-party for the purpose of providing us income during our retirement, RRSP's are like a basket that someone else is holding for you. Pushing this analogy a little bit more, think of me dutifully pushing around a shopping cart at the grocery store as my wife buys the latest organic mushrooms with the money I was saving for migration to Germany. My wife is the proverbial client, the shopping cart is the RRSP and I am the third party custodian of both the shopping cart and whatever she decides to put in it. She can fill it with good stuff like chocolate, or mouldy growths called mushrooms that pass for agricultural output in our advanced economy. What is in the cart is the actual food, whereas the cart itself is a mere vehicle. Similarly, what are placed inside an RRSP are the actual investments, the RRSP account itself is just a receptacle. The advantage of this receptacle is that whatever one puts in, can be written off against one's income for taxation purposes. This decreases one's taxable income, resulting in a larger tax refund because we have a progressive income tax regime. The other advantage is that whatever is placed in the RRSP also grows tax-free until withdrawal. This means that all growth of the investments inside the RRSP are tax-sheltered and no tax is payable on their growth and rebalancing on a yearly basis. This is true even if there is buying and selling within the RRSP and whether the growth is interest, capital-gains or dividends. Once you withdraw money however, the story changes quite a bit. Withdrawals are considered income by the CRA and so even if most of the growth in the investments held inside the RRSP is from capital gains, you will be taxed as if your withdrawal is income and at your marginal income tax rate. The idea here is to make your original investment grow to such an extent that this higher taxation still leaves you better off.
The other myth about RRSP's is that they have a season (this year's only goes to Feb 28th by the way, not March 1st). Saying that an RRSP contribution should have a season is like saying retirement will have a season, or that 1hr / year thinking about this stuff will allow you to live like the non-people on TV. I find this philosophy extremely problematic. Suppose your investments were like mushrooms instead of stocks or mutual funds, but that you still had to pay for them with your hard-earned money - this will make it more fun. For the first 2 months of the year, everyone else along with their Grandfather buys mushrooms. If the price of mushrooms is high at this time, you overpay for the mushrooms; if the price is low, you buy them at discount. You do not however, know whether the price is high or low at the time you are buying because you do not know if the price will be higher or lower the next month, the next year etc. etc. If you have consistently overpaid for mushrooms over 20-30 years of your working life, not only do you have a biggish collection of mushrooms, you have also spent relatively more to buy them. If you have underpaid relative to the average price however, you have mushrooms as far as your eye can see and they did not even cost you as much as they did in the earlier scenario. This last scenario allows you to either buy more mushrooms (so you can be even more comfortable), or have extra cash lying around. Since there is no predictable way or easy secret that I can give you about how to always be in the underpaying category - you have to be creative. Instead of risking all your cash in one go in Jan or Feb for the previous year's taxes, you have to be pro-active. Instead of buying $19,000 (this year's max contribution limit for some people) of mushrooms in Feb, buy only $1583.3 of mushrooms every month instead. This will ensure that you are buying mushrooms not at one price that might be high, but at an average yearly price. You gamble less with your money this way.
To me, the average price method called Dollar-Cost Averaging (you can ask Sheikh Google) is safer, otherwise you might be stuck with only a few mushrooms in retirement. Surely, having many is better.
(Please do not be offended if you are one of the non-people on TV, I listen to the radio and I am pretty sure that there are some non-people in there as well. Also, for those who did not like the mushroom analogy, I reply that many investments are just like mushrooms - quite mouldy. If you prefer, you can read the name of your favourite stock instead of the word mushroom whenever you come across it because the principle still stands. Also, for those who need discuss their RRSP strategy, if you can get 5 new people to subscribe to this newsletter, I will help you for mere mushrooms - we are sitting at around 1800 subscribers, I would like to get at least another 200 soon).
Finance News:
1. The geniuses that invested in Citi last month are probably not too pleased with this piece of news ... a $10 Billion loss at Citibank with an $18 Billion write-down of assets ... (in addition to all the others that they have announced already) ... http://www.nytimes.com/2008/01/15/business/16citi.html?fta=y
2. Must read story of the week ... about the fund manager who made over 500% for his investors over the subprime issue ... http://online.wsj.com/article/SB120036645057290423.html?mod=hpp_us_pageone ... and how he has hired Alan Greenspan, the man many blame for that mess in the first place ... http://online.wsj.com/article/SB120036783112890507.html?mod=hpp_us_whats_news
3. Who was it that said that subprime would have no effect on the TSX? ... Jeffrey Rubin - Chief Economist at CIBC? ... (refer to IWB issue 3. or http://www.advisor.ca/news/article.jsp?content=20071108_152122_5120 ) ... and now for more of the truth ... http://www.financialpost.com/story.html?id=242110 ... (although since it is the Post, I use the term truth quite loosely) ...
4. Doing an Alwaleed? ... the investment behind the Saudi Prince's fortune ... http://www.economist.com/daily/columns/businessview/displaystory.cfm?story_id=10522716&fsrc=nwl
Economic News:
1. Shocking ... a good article from Marcus Gee?! ... shocking ... do read the article of course because it speaks to how Canadian businesses can begin to expand into foreign markets using the HR resources they have at here at home ... still can't believe it was written by Marcus Gee though ... http://www.reportonbusiness.com/servlet/story/RTGAM.20080116.wibasia0116/BNStory/robColumnsBlogs/home?cid=al_gam_mostview
2. Need some explanation about currency movements and what the loonie's rise means for the Canadian economy? ... a thought-provoking article about a professor with whom many would disagree. Nevertheless, there is some insight here that we can learn from ... http://www.reportonbusiness.com/servlet/story/RTGAM.20080116.wrreynolds0116/BNStory/robColumnsBlogs/home
3. Notional amount of credit derivatives = $43Trillion (yes, trillion), declared losses to date = $100 Billion (approx) ... How much of the former will be recognized as the latter? - Remember, our RRSP's, company pensions, taxes and standard of living depend on the answer ... http://www.economist.com/finance/displaystory.cfm?story_id=10498541
4. US inflation highest in 17 years. Do you remember now that Rio Tinto shareholders walked away from $150B (US)? Do you see why? In the present fight between US money and Gold / Oil / Real Stuff ... which would you pick? ... http://www.canadianbusiness.com/markets/market_news/article.jsp?content=b011628A
Islamic / Middle East Finance:
1. Has Islamic Finance become an issue in the 2008 US presidential election? ... maybe just a little bit ... http://www.ronpaul2008.com/issues/inflation-tax/
2. Mr. Usmani says that 85% of 'Islamic Bonds' are not Islamic, setting off a debate in Bahrain and the international Islamic standards setting body ... http://www.washingtontimes.com/apps/pbcs.dll/article?AID=/20080114/BUSINESS/688156932/wt.test@yahoo.com
Miscellaneous:
1. Time to become vegetarian my friends ... the US has allowed the entry of cloned animals into the food chain ... be afraid - very afraid ... http://www.reuters.com/article/healthNews/idUSN1444947520080116?feedType=nl&feedName=ushealth1100&sp=true
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