November 2008 – OneMint

Interesting Reads this Week – 29th Nov

Here are some interesting articles that I came across during the week.

1. Grocery Shopping in New Delhi: This is a hilarious account of grocery shopping in New Delhi; narrated by an American lady, which, appeared in the Get Rich Slowly blog.

2. Credit Default Swaps, Herald of Doom (for beginners): An interesting and fairly simple explanation of Credit Default Swaps by The Baseline Scenario.

3. When Black Friday Deals Are Not Worth the Risk: The Digerati Life talks about Black Friday Deals and how some of them, are just not worth the risk.

4. Quarterly GDP Down 0.5% in Third Quarter: Sun talks about the latest GDP numbers that were released this week.

5. Staff emerge as heroes in Mumbai hotel siege: I am sure all of you would have heard about the terrorist attacks in Mumbai. This is a story reported by Reuters which talks about the courage of ordinary men and women who risked their own lives to save the life of others.

Diversification with respect to asset prices

Diversification is often thought of, in terms of asset classes and age groups. You will normally hear that the weight of equities in your portfolios should decline, as your age increases.

So while it is fine for a thirty year old to have 70% equities, a 50 year old is much better off with only 30% equities.

So if you are thirty years old, should 70% of your portfolio be invested in stocks, regardless of stocks being at all time highs or lows?

Asset Prices and Diversification

I have never heard of diversification with respect to asset prices. The point is that asset prices move in cycles and you should diversify keeping the current cycle in mind.

About a few months back, stocks were trading at all time highs, and a lot of people made a lot of money. At that time it would have been prudent to reduce exposure to equities and move into safer instruments like money market funds. That would have been true, regardless of age or the other asset classes in your portfolio.

The fact that you are just 25 years old doesn’t protect you from sliding stock prices. It helps you because you can wait a longer period for stock prices to recover. But it doesn’t protect you from the slide that happens at that point in time.

The fact that stocks are at 11 year lows today; make them cheaper than other assets. This should be the time to increase your exposure to stocks because stock prices are lower and the value of “money” is higher.

IfÂ you view money as an asset class (which most people don’t) you’d realize that today you can buy more stock per dollar than any other time in the last 11 years. That makes money expensive and stocks cheap.

Which indicates that you should move out of money and move into stocks.

Assumptions

I know that the key assumption that I make here is with respect to stock earnings. The assumption is that in the long run; the earnings will continue to rise. In the next few quarters the earnings may go down, but in the next 11 years they will rise steadily.

If you disagree with this assumption and see a deep recession or depression coming, then you are better off without stocks. The other reason to stay away from stocks would be, if you thought something else could make you more money; like gold. Else, investing in stocks at this time may not be a bad idea at all.

How do you think about diversification? Do you think in terms of asset prices or in terms of asset classes and age groups?

What is quantitative easing?

Quantitative easing refers to the actions by Central Banks that create liquidity in the economy by printing money. This is usually used by central banks after they fail to inject liquidity in the economy by lowering interest rates. Bank of Japan used this quite a bit to fight deflation and now the Fed seems to be using it too.

The bad effects of deflation make every central bank avoid it. Creating money supply in the economy is the way to create inflation, which, in turn fights deflation. Usually the Fed lowers interest rates to create inflation by boosting borrowing, but after lowering interest rates to 1% or lower, there are not many options left, but print money.

I don’t want money, even at 0%!

The big question is that why wouldn’t banks borrow from the Fed at 0%? At that rate money seems virtually free and why wouldn’tÂ anyone want free money?

The answer is deflation.

During deflationary times the price of all goods and services go down. That means you can buy more with a buck tomorrow, than you can buy today. Since the price of things that money can buy goes down, the value of money itself goes up.

Think of gas prices. If gas was $4 at the pump three months ago and it is $1.50 now, your $1.50 today is equal to $4 of three months back.

Now, imagine that there is a deflation rate of 10% and you borrow $100 at 0%. You will repay $100 in about an year, but you really lose 10%. Since, you could buy much more in one year from now, than today, even borrowing at 0% means that you are losing money.

Quantitative Easing

When banks are not willing to take money at even 0% and credit markets have frozen, the central banks don’t have any other option but print currency.

This is pretty much what the Fed has done with its bailouts. The latest one with the Fed promising to inject $800 billion more to boost credit; points in that direction too.

Risk

The biggest risk of such a strategy is the chance that it will create uncontrollable inflation. Till date the total value of the US bailouts amount to $7 trillion! That is 70% of the size of the entire economy and when dealing with such huge sums, anything can go wrong.

I have used the term – print currency, very liberally in this article. Central Banks create liquidity with a wide variety of means, which are much more complex than simply printing currency. However, I believe that all these measures lead to the same impact as printing money and hence the liberal use of the term.

Debt Securitization

A lot of the current financial crisis has been attributed to the securitization of debt. This means that debt that is ordinarily illiquid has been converted into a trade-able security and then sold off in the open markets.

In order to sell a security; there should always be an underlying asset that generates income or cash flows. That is the reason why such securities are also known as Asset Backed Securities (ABS). Securitizing debts has several benefits and this concept has been around from the 70’s. It is only recently that things started to go wrong and that was primarily because the underlying risk was not understood properly.

How does it work?

Suppose there is a bank which has given out mortgages worth a $100 million. Ordinarily, the bank can’t resell these mortgages. That is because there is no market for individual mortgages. However, the banks can convert these mortgages into tranches of debt and securitize them.

So that means the banks will create tranches of debt according to the risk that they carry and then sell them off in the markets. These tranches will carry credit ratings to show how risky they are.

It may look something like this:

AAA:Â 20 million dollars
A:Â Â Â Â Â 30 million dollars
BB:Â Â Â Â 40 million dollars
Junk: 10 million dollars

Now, assume that this bank has got a BB rating. So that means that it has got securities worth 50 million dollars which are better than the rating of the bank itself. That means that this bank may be able to raise money on better terms on such securities, than it will be on the strength of its own name. And this was one of the main factors for the popularity of these ABS.

Investment banks were the big buyers of such securitized instruments and that is why investment banks like Lehmann were the first ones to get hit by the current sub prime crisis. They had bought a lot of the sub prime securities and when the bottom fell out, those securities were worth nothing.

Adding Layers of Complexity

During the housing boom, banks never expected the kind of defaults that we are seeing today. That led many to believe that some part of the “A” rated tranche should be worth “AAA”. So then banks took their A tranche and created synthetic tranches out of it and hived some of the A rated tranche as AAA.Â These were then valued at more than they should have.

Then there was the issue of credit default swaps and all these things pretty soon added up to complicated asset structures that became very difficult to value.

Conclusion

The original plan of the US Treasury was to buy the AAA securities (also referred to as Toxic assets) from the banks and transfer the risk of default to the Treasury instead of the bank.

However Paulson and Co later changed this plan to directly infuse capital into the banks. This was most probably due to the realization that valuing the AAA securities was a much more difficult task than originally thought. A lot of these AAA securities went into default and that led to a ‘crisis in confidence’.

There are several asset classes that have been securitized. There is a big fear that mortgages are only the tip of the iceberg. The next wave of defaults may come in credit card debt defaults and the derivative instruments that have credit card debts as their underlying asset.

Why is Deflation bad?

With the Japanese economy contracting for two consecutive quarters, the focus of many economists has shifted to Deflation. Why does deflation worry economists so much and what are the consequenses of deflation?

Deflation is a broad based decline in the general price level of goods and services. This decline is both sustained, and constant. A temporary fall in the prices of goods and services does not constitute deflation.

So, that means that it makes sense for consumers to delay their purchases. If you can buy something tomorrow for a buck, you will not buy it today, for two.

The real trouble starts when tomorrow comes and you still don’t make the purchase, because you hope to get it even cheaper in a week.

This attitude causes a deflationary spiral and in theory can cause a free-fall in the demand of goods and services in an economy. That also means a free fall in prices and an even more contraction of the economy.

If you take this argument further, you will realize that by simply hoarding money; you are making it more valuable. If you save hundred dollars today; you will be able to buy much more with those hundred dollars tomorrow. This creates an incentive to hoard money and risk the stoppage of all economic activity.

That is why you see the Fed rushing to slash interest rates, when they fear deflation. If they slash interest rates, and you can’t get good returns on your Savings account; you will be forced to either spend or invest your money. This will again boost demand and help the economy come out of its downward spiral.

Good Deflation

There is such a thing as good deflation also. When price levels fall because of technological improvements; that boosts productivity and helps stimulate demand too. That was seen when the prices of cars or computers went down. When that happened; more and more people bought cars and computers and stimulated demand. This is an example of good deflation. However it is not broad based and does not occur in the entire economy.

Deflation and Unemployment

Due to the slack in demand and rise in real wages, businesses find it increasingly difficult to pay wages and keep people on their payrolls. This creates a situation of lay-offs and that further reduces demand. Another situation that creates a vicious circle.

Loan Defaults

As deflation rises the “price” of money increases and the price of assets decrease. So if you have taken a mortgage to buy a house, you will see your house price dropping constantly and the stuff your dollar can buy increase constantly.

Such an environment is really conducive for loan defaults and invariably a lot of debtors default on their loans. That further worsens the situation as there are more problems in the economy now.

Difficult to control

Deflation gets very difficult to control for central banks. They can only lower the interest to 0% and after that there is not much that they can do. It becomes hard to jump-start the economy and stimulate demand. Once, in deflation, countries tend to come out of it really slowly.

All these factors make deflation really undesirable and all attempts are made to keep the economy in moderate inflation.

Interesting reads this week – Nov 23

There have been quite a few interesting articles that I read this week. I am listing out a few here.

Inspiration and Passion and Whatnot: A post about passion and inspiration from the creator of Dilbert – Scott Adams. In this post Adams says that “When I had a full-time job, before Dilbert, I awoke at 4 AM, sat alone in a comfortable chair with a cup of coffee, and waited. I did that for a year or two, just emptying my mind and freeing my imagination. I don’t remember the day I picked up a pencil and started drawing instead of sitting during those hours, but I’m sure I didn’t have a choice.” This is something that I have been thinking about all week. Freeing up your mind of junk – a very intriguing thought.
When is the right time to start a business: A very interesting post about starting up a business during tough times by The Digerati Life. It was a very measured post; of something that is quite close to my heart – entrepreneurship.
When will the stock market stop falling? The Baseline Scenario had this interesting post about the loss in stocks this week.
Transfer a Brokerage Account: How much does it cost?: Sun wrote this informative post about transferring your brokerage account.

These were some interesting posts that I enjoyed reading this week.

Warren Buffet’s hamburger example

One of the most classic Buffet analogies is the hamburger example. In his example Buffet says that everyone who eats hamburgers will be happy if hamburger prices were to go down for the next five years.

However, investors will not be happy if stock prices were to go down for the next five years, even if they are long – term investors. The way investors think about stock prices is at loggerheads with the way they think about anything else.

Normally, when stock prices are down, there is a plethora of bad news in general and there is a depressing mood in the markets. In such circumstances it is difficult for investors to go out and make purchases in the stock market. It is difficult to value companies and know when the economy will recover, and all this makes it very difficult to boost investor confidence.

So even though the burgers are cheap, no one wants to touch them.

Hamburgers are cheap now

If P/E multiples are anything to go by, then stocks are really cheap at this point in time. Here is a graph that shows you how the P/E of Nifty (which is a key Indian stock market index) has fared from the beginning of this century. One glance at this will tell you that stock prices, relative to their earnings are at their lowest in the last eight years or so.

Despite this there is very little investor interest in the stock markets and there is a negative mood in the markets. A lot of this can be attributed to the recession which is expected in the coming months. There are fears that the recession may turn into a depression and most of these companies will lose their earnings and P/E chart will adjust itself, not because the prices go up, but because the earnings will go down.

Even if that happens, for a long term investor who recognizes a deep recession or depression as part of an economic cycle, this may be the best time to buy stocks. The prices seen today are the lowest in about a decade. They may go lower but in the long run, just as we must face a recession, we will see a recovery too.

The hamburgers are cheap, but are you willing to buy them now?

Russia’s tax cuts

Russia is the first country to announce tax cuts to combat the current financial crisis. While several countries have announced bail-out packages, no one has announced a tax cut yet.

Russia has announced a cut in corporate taxes though, and not personal income taxes. The Corporate Income Tax has been slashed by 4%. It will drop from 24% to 20%, beginning January.

The better news is for small businesses, who will see their tax rates go down from 15% to 5%.

These tax cuts are on top of the $200 billion bail-out package announced by the Russian government to help tide through the current crisis.

This is a good step forward and is expected to free up at least 15 billion dollars in the economy. It is interesting to note that no other government has announced a tax cut so far.

The primary reason for that seems to be that governments around the world have had to announce bail-out packages, which poke a hole in their budget. If corporates don’t have the money to pay their bills in the short term; they will be bankrupt much before the time comes for them to pay taxes.

The other reason for this is that tax revenues form a lower percentage of GDP for Russia than for most other countries. Sweden tops the list with about 51% and US is 26th with about 27%.

Russia may have the right idea as reducing tax rates for corporates will provide “stimulus” money to the economy without having to bail out incompetent managements. It won’t be surprising to see more countries follow Russia’s lead in the days to come.

Can you take a loan on a Simple IRA?

The short answer to this is no, you can’t take a loan on your Simple IRA. There are several restrictions on the Simple IRA and one such restriction is that you can’t take a loan against it.

Taking a loan against something that protects your retirement such as the Simple IRA is not a good idea and is not advised by financial planners. However, in dire circumstances, you may have to take a premature distribution from your Simple IRA.

This means that you can take out money from your Simple IRA if you are younger than 59 1/2 years once in a 12 month period.

If you take a premature distribution, then you need to replace the money that you borrowed within a sixty day period. If you fail to do that then you will be charged a 10% penalty.

Tax Implications

If you decide to take an early distribution from your IRA before you reach the age of 59 1/2, there will be tax implications. You will need to fill out IRS form F5329 and declare the amount that you have taken as early IRA distribution. Normally, the tax liability will be 10% over and above your normal income taxes that you pay on your regular income. However this will depend on your specific case and you need to fill out Form F5329 to get a correct estimate of how much extra you will have to dish out.

Exceptions to the Tax

There are certain exceptions to the tax implications if you withdrew money from from your Simple IRA. These are conditions such as death or disability, payment for medical expenses which exceed 7.5% of gross income, payment for divorce settlements and retirement at the age 55 or above. Whether you qualify for these exceptions depend on your specific case and you need to consult a tax expert to get an exact picture of your case.

Conclusion

Taking a loan on a Simple IRA is not possible and early distribution is fraught with penalties in the form of excess tax or repayment default. All this makes tapping into your retirement fund such as the Simple IRA, the absolute last resort.

Why does the Fed Reserve cut interest rates?

The Fed Reserve cuts interest rates to provide more money supply in the economy and stimulate consumer spending. The Fed usually fiddles around with two interest rates, which in turn impact all other consumer interest rates.

Federal Funds Rate: The Federal Funds Rate is the rate that is used to ultimately determine the rate of interest that people pay on their credit cards, home equity lines of credit and car loans. On October 29, 2008, this rate went down to 1%, which is the lowest it ever got during the last twenty years or so. The highest it got in the last twenty years was in July 1990, when the Fed Funds Rate was 8%.
Federal Discount Rate: Federal Discount Rate is the rate of interest at which banks borrow money from the Federal Reserve. Banks have to maintain certain statutory cash reserves with them. In order to do that, they usually borrow money from other banks. Using the Fed for this, is usually the last resort. They go to the Fed when the liquidity in the market dries up and other banks are reluctant to lend to them. A recent example of liquidity drying up was seen during the credit crunch.

Fed uses these interest rates to control the supply of money in the economy and that in turns influences the interest rates, inflation and even the currency exchange rates in the economy.

In times of economic downturn, Fed cuts the interest rates in the hope that people will have access to cheap money. Once they have access to cheap money they will spend it in stores like Circuit City and Linens-N-Things and help them stay afloat.

When the economy stabilizes, the Fed will slowly start hiking up the interest rates to control the inflation and not let the economy over-heat. These are tools used by central banks all over the world with the same effect.