Are You Smarter Than a Fifth Grader?Congressional Edition

From Politico reprinted in its entirety for non-subscribers:

Rep. cries foul over Nets naming rights

"Maybe they should just call it TARP Arena.

Rep. Bill Pascrell Jr. (D-N.J.), wary of taxpayer anger over the AIG bonuses, wants the New Jersey Nets to reconsider selling naming rights to the British bank Barclays for an NBA arena being built in Brooklyn.

Barclays received $8.5 billion in bailout funds from the Treasury Department, and Pascrell believes the $400 million it cost to have the naming rights for the soon-to-be Brooklyn Nets arena should be used, say, for lending to consumers instead. Pascrell was quick to make an exception for the new Citi ballpark the New York Mets are building, because that ball yard was already well under construction under the Citi name before the bailout money was approved.

“I believe that any further payments of taxpayer money, whether through TARP or the Federal Reserve System, be conditioned on the cancellation of any stadium or arena naming-rights agreements that may be in place,” Pascrell said.

It’s worth noting, of course, that Pascrell represents a lot of New Jersey Nets fans quite unhappy about losing their NBA team to Brooklyn."


Actually, Congressman, Barclays did NOT receive any "bailout" funds from the Treasury Department. Nor have they accepted any bailout money from the government of the UK, where they happen to be domiciled. To their credit, they have steadfastly resisted taking money that comes with governmental strings attached; and with each passing day and every congressional comment like yours, the wisdom of their strategy becomes more clear.

True, Barclays received $8.5 billion from AIG, presumably as collateral against or settlement of AIG's contractual obligations under trading arrangements. But to suggest that this is the same as a bailout is just wrong. To further imply that any organization that does business with a recipient of bailout funds is thereby subject to mindless Congressional meddling is either stupid or frightening, depending on how serious you are.

Oh, and Congressman, pretty much all "payments of taxpayer money" are made "through the Federal Reserve System." In fact, when you give a one-dollar tip to the guy who shines your shoes in the Congressional cloak-room, you're using what we in this country call a "Federal Reserve Note". It's actually printed on the top of the dollar bill in capital letters to help you remember.

Perhaps you'd like to regulate what he does with that too?

A Lesson in This Recession?

During economic booms, certain publications and political parties can be counted on to point out that the growing wealth produced by the expanding economy is being inequitably bestowed upon various segments of the population. This (unsurprising) observation usually leads to journalistic hand-wringing, cynical campaign slogans and calls for a more progressive tax code and redistributionist spending programs.

The breadth and depth of the current recession provides an interesting opportunity to observe the results of an experiment no sane policy-maker would ever intentionally conduct.

Last week, the Federal Reserve released its latest triennial analysis of changes in family income and net worth:

Changes in U.S. Family Finances from 2004 to 2007: Evidence from the Survey of Consumer Finances

Trust me, you probably don't want to read it all (I haven't yet either) but I'll share one of the authors' observations. The report is based on household surveys conducted in 2007 and focuses on changes in household finances since the 2004 survey. In light of the significant changes in housing and equity prices during 2008, the study's authors also make an attempt to estimate the impact of 2008's market meltdowns through October.

A number of assumptions are required, which can be found on pages A10-A12. The authors conclude, "...these assumptions imply large drops in median and mean net worth since the 2007 survey — 17.8 percent and 22.7 percent, respectively."

These numbers feel about right. From January to October 2008, the S&P 500 declined 34.0% and the Case-Shiller 20-city composite house price index declined 14.5%.

Many commentators get tripped up when confronting means and medians, and politicians are probably responsible for statistics being lumped together with lies and damned lies. So here's a little refresher (page A6) on interpreting means and medians that most students should've had by ninth grade.

"Where a comparable median and mean are given, the gain of the mean relative to the median may usually be taken as indicative of relatively greater change at the top of the distribution; for example, when the mean increases more rapidly than the median, it is typically taken to indicate that the values in the top of the distribution rose more rapidly than those in the lower part of the distribution."

This is equally true in reverse, i.e., when the mean decreases at a greater rate than the median, it is typically taken to indicate that the values in the top of the distribution fell more rapidly than those in the lower part of the distribution.

So by certain conventional measures of inequality, the concurrent meltdowns in the financial and housing markets plus the economic recession have increased "fairness" in the United States.

This is not a headline I expect to read soon.

I make this observation not in defense of the well-to-do compared to the less fortunate. To be sure, this recession is hurting every family at every level. And the hardship at the lower end of the income and wealth spectrum is undoubtedly more palpable and immediate. What's more, the magnitude of federal aid being provided to companies like AIG evokes uncomfortable echoes of the "Welfare Queens" who figured in class warfare debates of the '70s and '80s. It seems we all live in a glass house now; so maybe everyone should put down his stone.

But when this economy recovers, as it certainly will, maybe we'll have learned that although prosperity inevitably benefits the prosperous, it's better (for everyone) than the alternative.

Yearning for the Good Old Days When the Glass was 130% Full...

From today's WSJ (link)

"The rise in the stock market, even if it isn't always a reliable predictor of the direction of the economy, could offer a sorely needed boost to confidence. "What you're trying to do is reverse psychology," said Robert Barbera, an economist at ITG, a research and trading firm. "You're trying to get people to think of the glass as a third full instead of 97% empty. ..."

Are Investment Advisors Worried Enough?

According to a survey by discount brokerage Charles Schwab summarized here,

Fifty-five percent [of independent financial advisors polled] said it could take as long as three years for portfolios to return to their levels of last September..." (emphasis mine)

Assuming that the "levels of last September" are the Dow's closing price of 10,851 on September 30 and the poll was taken when the Dow was hovering around 7,000, that implies that 55% of the respondents think the Dow will recover 3,851 points in three years. That's a 55% return over the period, or a 15.7% compound annual return.

What are the odds?



The graph above is the distribution of rolling 3-year compound annual price changes for the Dow Jones Industrial Average since 1930, according to Yahoo! Finance. (This captures only the change in the index, not reinvestment of dividends). Based on the past 78 years of market history, the odds of a 3-year return of this magnitude are about 15-16%.

Which makes the following quote pretty hilarious.

“Advisers don’t have a GPS to guide them, but they have the experience and savvy to see that there are still potholes on the road ahead,” said Bernie Clark, senior vice president for Schwab’s adviser services, which supports 5,700 independent investment advisers. “Their long-term view, reasoned outlook and steady approach will serve their clients well in this environment.”

Despite the gloom in the economy and markets these days, sell-side optimism appears undimmed.

Dumb and Dumber

I don't know which is sillier.

1) The outrage professed by certain politicians that banks receiving government assistance engage in marketing activities, which might include entertaining clients and fulfilling obligations made months ago to sponsor a golf tournament, or

2) The ridiculous statements made by the PR departments of banks that "... the money for these activities comes from operating profits, not TARP funds."

One expects the grandstanding from politicians, but the bankers really ought to know better. What percent of the population do they think buys the notion that TARP funds are "balance sheet" cash distinct from cash used in operating activities? Please just stop it.

It suffices to say, as Northern Trust recently did, "We came to the conclusion that no public purpose would be served by canceling the Northern Trust Open and related events.” But then they blew it by trotting out the "No TARP funds were used..." defense.

Marketing your business, raising money for charitable purposes and supporting your local community are valid reasons for sponsoring a golf tournament and remain so today. Here's my suggestion. Take away the single malts in the courtesy tent: your customers will gladly drink blended scotch in these parlous times. Make your employees double up in hotel rooms; none of them will WANT to go without a compelling business reason for doing so. Keep it low key, and maybe get the local hospitality and restaurant businesses to highlight the dollars and jobs that are supported by a major golf event.

Then, shut up.

Taxpayers are not stupid. Eventually someone will observe that government assistance is not exactly a novel idea. Farmers receive agricultural subsidies, households receive tax credits, not-for-profits enjoy their tax-free status. If the receipt of a financial benefit from the federal government is sufficient reason for Barney Frank to weigh in on every recipient's every expenditure, then maybe he should personally do the grocery shopping for every family on food stamps.

Finally, I have to reprint comment 8. to the NYT article linked above. I can attribute it only to "Joe", but it bears quoting in its entirety.

"Money is fungible, idiots! Either give them money, or don’t and take them over. This false outrage is really getting tiresome. I say let them golf. But force them to tee off from the blue tees and make Barney Frank go along with them, in bright Madras shorts and cap, to provide oversight and prevent them from taking mulligans. That ought to freak them out a little bit. Then post their scores publicly. Bankers need all the humiliation they can get these days."

The Equity Risk Premium Puzzle-Who are the Long-term Holders?

One of the unsolved mysteries of modern finance theory is the "Equity Risk Premium" puzzle. In a sentence, the puzzle is why equities have historically outperformed bonds (in real, dividend-adjusted terms) by such a large margin? For an elegant illustration of the concept, see Brad DeLong's 2006 blog post here.

Of course, stocks should deliver a larger return since they are riskier claims than bonds; and the variance of stock returns -- the measure of risk in modern finance theory -- is manifestly greater than the variance of bond returns. But the magnitude of stocks' outperformance is the puzzle, especially in light of the well-known fact that the variance of stock returns can be mitigated by long holding periods. (note 1)

This latter notion is most famously articulated in Jeremy Siegel's "Stocks for the Long Run" and more infamously in Glassman & Hassett's "Dow 36,000".

Barring a quick rebound in the US stock markets, the Equity Risk Premium puzzle is likely to be a hot topic in finance departments over the next few years. And if the US experiences another decade of meandering stock price performance to match the current Japanese experience, it may be decided that there's no puzzle at all. The major Japanese market indices are hovering at the same levels they first reached twenty years ago and are roughly 80% below their all-time highs. The current generation of Japanese investors are probably not scratching their heads over the inexplicably high historical returns of common stocks.

Recent news events may shed some light on the issue as well. Like many universities, Harvard has recently reported that it's endowment shrunk 22%, or $8 billion, in the last half of 2008 and that it may shrink by as much as 30% when illiquid assets such as private equity and venture capital positions are marked to market. Geraldine Fabrikant has covered this story for the New York Times here

"Harvard Endowment Loses 22%"

and here.

"Endowment Director is on Harvard Hot Seat"

What I find interesting in this news is the fact that "Harvard depends on its endowment for about 35 percent of its operating budget..." representing $1.4 billion of endowment income contributed to annual operating expenses according to this letter from Drew Gilpin Faust, the university's president.

"Letter to the Community - February 18, 2009"

Now, $1.4 billion per year equals 3.8% of Harvard's endowment of $36.9 billion as it stood on June 30, 2008. But $1.4 billion per year comes to 5.4% of the $25.8 billion that Harvard's endowment will shrink to if realized losses are in fact 30%. At current prices, I suppose it's possible to construct a diversified portfolio of this size that would generate a pre-tax return of 5.4% without touching the endowment principal; but it wouldn't be easy and, more importantly, the income stream likely would not grow as fast as the operating expenses it funds.

Hence, Harvard is selling off a number of its endowment positions in public and private equity and borrowing in the debt markets to provide short-term cash. On the operating front the university is tightening its belt, suspending some ambitious construction plans and instituting certain pay freezes. The university will undoubtedly be reaching out to the alumni base for increased giving as it celebrates its 373rd anniversary this year.

But if Harvard, whose endowment is managed with a multi-century time horizon, finds its liquidity affected by the current crash in financial asset prices, who exactly are the long-term holders who can ignore the current volatility in stock prices and sit tight for the long term? Insurance companies like, for example, AIG?

There may simply be an insufficient amount of investment capital with a multi-generational investment horizon that is indifferent to market volatility like we're experiencing today. This alone could explain a good bit of the Equity Premium Puzzle. Moreover, the NYT "Hot Seat" article on Jane Mendillo, Harvard's new endowment manager, suggests a related agency issue. Even if Harvard University can take a truly long-term view, ultimately the investment decisions are made by individuals (or committees) whose career horizons are quite a bit shorter than Harvard's. Even if one truly, truly believes that in the long-run stocks will deliver premium risk-adjusted returns, it's no fun to report a 30% decline on your watch.

So for all those young investment bankers who intend to wait out the current recession in business school for the next two years, start reading up on the Equity Risk Premium Puzzle and the Liquidity Preference Function. They should be hot topics for the next couple of years.

**********

Some more comments by RHH on this topic over at Seeking Alpha

Annals of Rank Hubris, Larry Summers Edition

Larry Summers's Billion Dollar Harvard Gamble



(note 1)
Much, though not all, of the data used to analyze the Equity Premium Puzzle comes from US stock returns from the mid-1920's, or in some cases stretching back to the Civil War. This is largely due to data availability and reliability. Some commentators on the Equity Risk Premium Puzzle have noted that returns for US equities over this period may be related to country-specific factors, specifically the evolution of the US from an agrarian, emerging economy into a political and economic super-power. As such, US returns may reflect a "success bias" making them unrepresentative of global equity returns over the same periods. For a good discussion of global equity returns, see "Global Evidence on the Equity Risk Premium" (pdf).

It should also be noted that even 160 years of stock price data represents only eight non-overlapping 20-year observation periods, a relatively small data sample. Likewise, the commonly used U.S. data back to 1925 represents less than five non-overlapping 20-year periods. This means that new, extreme data points can dramatically change our view on the odds of their occurring. This time last year, one could say that a 50% peak-to-trough decline in the S&P 500 had occurred only once in 88 years, and that was associated with the Great Depression. As of today, it's occurred twice.

Well, duh...

"Hands criticises 'pass the parcel' inflation effect" - FT.com


"Guy Hands, one of Europe's top private equity bosses, has criticised "pass the parcel" deals, in which buy-out groups sold companies to each other for ever increasing prices, for inflating the bubble that left investors facing big losses."

"'We saw an increasing number of pass-the-parcel transactions between general partners [in private equity firms], where limited partners [investors] essentially retained the same asset while paying fees and carry each time it changed hands,' he said."


What is most puzzling is why the largest, and presumably most influential, limited partners in private equity funds permitted this to happen. As noted by the esteemed Mr. Hands, many LPs -- who had investments in both the selling and the buying PE firms -- were essentially paying 20% carry for the privilege of moving their investment from their left pocket to their right. Surely there must be some cases where an LP investor actually increased his net investment in a particular company and paid a carry on the step-up in value.

If anyone has an example, please let me know.