Lions and Tigers and Mortgages

A recent story by NPR breathlessly reports that Freddie Mac is profiting from the continued troubles in the housing market. They reported that the mortgage giant retained interest in some mortgage derivatives while selling off the super-safe portion. If mortgages refinance more slowly, these bonds do well. And of course, Freddie has tightened their credit standards over the past couple years. So doesn’t this represent a conflict-of-interest?

On the face of it, yes. Owning derivatives that benefit from lower prepayments when you set underwriting standards that permit or deny prepayments for millions of homeowners is a conflict. It looks lousy—and demonstrates the political tin-ear that the mortgage giants have often displayed to the world.

But there are many reasons to own these securities. One reason could be that you can’t sell them. When an originator slices and dices mortgages into various pools, some can be left over. With interest rates at record lows and defaults running high, it might be pretty hard to sell tranches that lose money if prepayments accelerate. So Freddie might have to hang onto them.

Also, the analysis of underwriting overstates Freddie’s control of the market. Fannie Mae is much larger; banks also underwrite a significant portion of the market for their own portfolios. Underwriting standards are part of the competitive banking landscape. If Freddie is too restrictive, they’ll lose business to someone else. Could a .6% portfolio position lead them to tighten them? Not likely.

Once you look at the details, you see a lot of reasons to own these bonds that have nothing to do with profiting from keeping borrowers in “mortgage jail.” Owning the bonds may be foolish, but it isn’t evil.

Douglas R. Tengdin, CFA
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Strong Safety

The answer to this question is far from obvious. In the past ten years we’ve seen some spectacular failures among large companies: Lehman, Fannie Mae, Enron. And even more companies fell dramatically in price never to recover, like Citigroup and AIG. Small stocks have typically been pegged as a volatile asset class. But when the giants fail, where do you go for safe, blue-chip growth?

The short answer is, there is no such thing as safety. Our selective memories erase the spectacular failures of the ‘90s and ‘80s because—well, they haven’t been in the news for 15 or 20 years, and we just forget. And our minds tend to recall facts that have strong emotional associations. For good or ill, the sound made by a random tree falling in the forest a mile away isn’t as likely to make an impression on us as a limb from the maple out front crashing down on our car in the driveway.

The fact is that small companies have less experienced managers and more volatile business conditions. They tend to be regionally focused so local economies affect them more intensely. Since they slip under the radar screen of many auditors, accounting fraud and malfeasance are more likely. As a result, business failures among small firms are more common. They also grow at a faster rate, however, since expansion is not limited by the size of the economy. It’s much easier for revenue to double from $5 million to $10 million than from $500 billion to $1 trillion.

So small stocks are more volatile. Investors who buy them need to pay close attention to their balance sheets, business plans, and manager integrity. But there are no sure things in investing. It’s all a matter of managing your risk while you look for returns.

Douglas R. Tengdin, CFA
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Tax Man

One reason is taxes. The typical cell-phone user pays an FCC tax, a couple of state taxes, a 9-1-1 charge, and a couple other charges. Those tax bills can add up: in New York City the average burden is over 20%!

And it’s not like people have a lot of choice about paying them. Sure, you can monitor your usage and choose plans, but for many people cell phones are an essential part of doing business—like having a driver’s license or using a computer.

What we seem to have here is a tragedy of the anti-commons: lots of small, overlapping tax jurisdictions taking a small slice of an overlapping pie, with no central authority tasked with the charge to minimize charges. That’s up to the individual. And the monthly bill is so confusing that consumers are lucky if they get the right payment to the right address, much less figure out who’s billing which usage fee or status charge.

The same kind of overlapping tax burden can be seen in with rental cars, hotel rooms, and other services. Often the expense is borne by the business, which passes it on to the consumer via a regulatory charge or service fee.

The tragedy is that all these overlapping fees are likely high enough that they actually reduce the underlying activity. That is, some people just say the heck with it, it’s too expensive to rent a car or or use a cell phone. They never use the underlying service, and the economy misses out. Economists call this a “deadweight loss.”

Congress could invoke the commercial clause and simplify things, but don’t plan on it—the Feds are short of cash, too. Instead it’s up to each of us to read our bills, watch our usage, and plan our lives.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Open Market Committee

In their post-meeting statement, the Fed explicitly acknowledged that their long-run inflation target is two percent. This has long been suspected by Fed-watchers. But now the Fed is publishing its goal. Are there problems with this uber-transparency?

One issue is that we are now drowning in data. We’ve gone from guessing what Fed policy is based on “system rp’s” and “coupon passes” to a turgid, 500-word essay. What’s next? Stream-of-consciousness writing a la James Joyce? Live tweets from the FOMC’s Board Room? There’s so much disclosure that observers can now see whatever they want to see in the Fed’s releases. TMI!

The Fed is also playing with words. Along with its 2% inflation target, the Fed is also defining full employment as 5 ½ to 6% unemployment. This gives an “Alice In Wonderland” impression: full employment means 7 million people are looking for work and stable prices means they double every 35 years. I know there are good economic reasons for these goals, but still!

Finally, excessive visibility has its downside. Arguably, the Fed’s “extended period” language of mid-decade (when Fed Funds were at 1%) led to an over-leveraging of the economy as investors safely borrowed short and lent long. This leverage was disastrous when the economy turned down.

I’m afraid the collegiality of the Princeton faculty lounge is not right ambiance for the nation’s central bank. Bernanke is overseeing a grand experiment in openness. Let’s hope it doesn’t backfire.

Douglas R. Tengdin, CFA
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Investing in Themselves

Dividends, I get. When a company wants to give money back to its shareholders (on a regular basis) it initiates a dividend. When the business grows, it increases the dividend. But if the business is growing so fast that management might need the cash quickly—for investing in new equipment, or for an acquisition—then the dividend might be pretty small, or they might not even have one.

But stock buybacks are different. With a stock buyback the company buys its own shares, in the market or via tender. It’s a way for the company to use its cash to reward shareholders—buy only shareholders that are selling. They come about when the company has more cash than it needs, but only temporarily.

But companies also use share repurchase to take advantage of undervaluation. When managers think their firm is trading below its intrinsic value, they can buy shares in the open market. Indeed, researchers examined when companies announce buybacks combined with employee purchases. The results were striking: from 1991 to 2010, value stocks that announced buybacks when managers were also buying the shares for their own portfolios significantly outperformed the market in all kinds of conditions.

This makes sense. If executives are selling their shares, or exercising stock options and then selling, then share repurchases just transfer company cash to management. But if managers are buying and the company is buying, then they likely think the stock is cheap. Presumably, managers would be in a good position to know this.

Share buybacks are a legitimate way for a firm to give back cash. They can also signal that the company is undervalued. When managers and the firm are both investing in themselves, it’s a good sign.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Either/Or

When it comes to the Euro there are two schools of thought: either the Europeans are going to work things out and hold things together, or it’s all going to break up. Either the politicians rise to the occasion or there is a catastrophic break-up, with serial sovereign debt defaults and financial contagion spreading around the world.

But this is the fallacy of the excluded middle. There may be a way for countries to make fiscal and monetary adjustments that doesn’t sound like a cock-eyed optimist. There may be a way for countries to leave the Euro that doesn’t involve a second round of the financial crisis and Depression 2.0. In short, there may be a middle ground

I still believe that there are strong institutional and economic reasons to believe that Europe will pull through. But if it does not a European core could still remain integrated: Germany, Holland, Finland, and France. Of the 300 million or so consumers in the Euro-zone, this includes over half, and it includes the fastest growing economies. Italy and Spain are problems—their combined population is almost equal to France and Germany, but their economies are stagnant and mired in debt.

But should the core countries hold together in a “Nouveau Deutschmark” while the periphery drop off and devalue their currencies, the core would retain many of the benefits of the Euro—a large monetary space for corporate finance, a facile way to facilitate intra-European trade, and a potential competitor to the Dollar as a reserve currency—without tying the highly-productive Germanic economies to the over-indebted periphery.

The dream of a United States of Europe would be over, but waking up from this dream need not necessarily involve an economic and financial nightmare.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Up To Our Ears?

That’s what many seem to believe. They note that the average credit card debt per household with a credit card is over $15 thousand. Since the median household only makes $50 thousand a year, surely that’s too much.

But Mark Twain once famously noted that there are three types of lies: lies, damned lies, and statistics. Averages can be misleading. Average debt takes the total debt outstanding and divides by the number of households with a credit card. It’s pulled up dramatically by a few outliers. About half of these households pay off their credit cards every month—that means that the median household has no credit card debt. What’s more, the numbers cited count only households with credit cards; they ignore the 25% of all households that have no debt at all: no mortgage, no credit cards, no car loans.

Third, the average credit card debt figure is based on the average daily balances in bank reports. But when people use their credit cards as “plastic cash” and pay them off each month, their balance is really zero. So the bank averages are biased upwards. Finally, these aggregate numbers also include corporate credit cards, which people use for expense accounts. Although they are technically part of the consumer figures, this debt is really business debt, not consumer debt.

Consumer debt did rise during the housing bubble and has fallen since the bust. But that’s normal during economic expansions and declines. We aren’t drowning and we don’t need a life jacket.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Calling Alexander Hamilton (Part 2)

Whenever nations have consolidated their currencies, they’ve needed to establish their credit in order to manage their finances. Shortly after the discovery of America, Spain issued debt under a hybrid city/state model to finance its exploration. In 18th century England Parliament issued bonds through earmarked taxes: each new bond issued was funded by an excise tax on specific items. In the new United States, the Federal Government purchased, at par, the debts that the states had accumulated during the American Revolution.

Financial markets today are far more sophisticated. But one thing that hasn’t changed is the importance of the credibility of the debt. When a central institution issues bonds, a number of things happen. First, of course, the government obtains cash to manage its affairs. The central bank also acquires a means to manage the money supply. The bondholders hold an interest-bearing asset with an implied real return. And the financial market achieves a level of credibility over the years as the government services its debt and financial transactions take place in a transparent and efficient manner.

Eurobonds would give the Euro-zone financial credibility. They need not be issued to assume all the member countries’ debts, but their issuance could cover a certain percentage, say, 50%. They would be guaranteed by the Euro-zone as a whole but would be supported by a dedicated tax, like England’s earmarked bonds. And most importantly they would allow participating countries to lower their financing costs.

Hamilton was only able to get his planned debt assumption through Congress via a grand compromise. It’s likely that Europe will need similar statesmanship. But consolidated debt could help the Euro-zone establish the credibility it needs to move forward.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Bottom’s Up!

No, you won’t see a reduction in foreclosure sales. And no, you won’t see prices rising. But there are some early signs that the housing market is (finally) improving. And that’s great news for the US economy.

Housing is one of those funny markets. There’s one market for contract sales, another for distressed sales. There’s one market for starter homes in the Cleveland suburbs, and there’s another for Bel Air mansions overlooking the UCLA campus. But one thing about the housing market that is common to all types of homes is that activity precedes pricing. That is, before prices rise, activity needs to pick up. And before prices fall, activity drops off.

Lately, housing activity has improved, especially for lower-end houses. In New York and New Jersey, the number of homes under contract that cost less than $400 thousand rose dramatically compared with a year ago. This makes some sense—record low mortgage rates apply especially to smaller mortgages. Jumbo loans don’t qualify for 30-year rates under 4%. The combination of extremely low loan rates and lower prices has created record affordability in entry-level homes.

But prices continue to show modest declines, belying hopes for a recovery. On a year-over-year basis, home prices are down about 4% across the country. Many fear that if prices decline much more, it might spark a new wave of bank insolvencies which could further hurt the economy.

But it’s always darkest at dawn. And when housing activity picks up even as prices keep falling, you know that a true recovery isn’t far off.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Looking for Balance (Part 2)

How often should you rebalance a portfolio?

Rebalancing a portfolio is a good idea, and it takes some time for things to work out. But when should you do it? We know rebalancing is important. It forces us to trim our winning positions and buy segments of the market that haven’t done so well. Buying low and selling high is a good way to add value.

But timing is important. If you rebalance too often, you’re just adding trading costs, not value. But if you wait too long, you miss the opportunities to capitalize on market turns that rebalancing captures.

Many people look at rebalancing annually, around year-end, or quarterly, or even monthly. But that doesn’t make sense. There’s nothing magic about December 31st or January 1st. They’re days like any other, and the analytic software that recommends rebalancing around year-end does so because we have year-end performance numbers to calibrate our models.

It makes much more sense to use the actual performance of the markets to determine when to buy and sell. Your targets should be set strategically, based on what kind of investor you are. But rebalancing is a tactical operation, based on market conditions. Our research shows that when the market has moved your target 5-10% away from your strategic objective is usually a good time to adjust. This allows a trend time to develop, but allows you to benefit from the trend’s reversal.

Markets move on their own schedule. By waiting until your portfolio shows that it needs to be adjusted you avoid excessive activity. Once again, patience is the intelligent investor’s best asset.

Douglas R. Tengdin, CFA
Chief Investment Officer
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