Archive for November, 2008

  • Our First First Black President
    , November 5th, 2008 at 10:54 am

  • How Stocks Work
    , November 4th, 2008 at 11:15 pm

    Felix Salmon put three questions to Jim Surowiecki on the mechanics of stock valuation. I have some differences with Surowiecki’s answers so here’s my take:
    Felix Salmon: What’s the relationship, in theory, between a company’s return on equity, on the one hand, and its stock price, on the other? Does a high return on equity mean a rising stock price, or is it a rising return on equity which means a rising stock price? Or, to put it another way: if one company has an ROE which is (expected to be) flat at 4%, and another company has an ROE which is (expected to be) flat at 14%, would you expect the latter to rise more than the former, or indeed either of them to rise at all?
    Eddy: A company’s share price is the net present value of all future cash flows. A company’s return-on-equity is a measure of profits for the next year relative to present equity, so the two are connected. However, a high ROE does not translate to a rising share price, but a rising ROE should. Regarding your question, I would assume that the market has discounted both stocks’ net present value which incorporates ROE. Therefore, I would only expect the stocks to rise at the pace of the risk-free rate plus the equity risk premium.
    This may help: ROE can be broken down into three parts; profit margin, asset turnover and leverage. It goes like this:
    Profit margin is earnings divided by sales. Asset turnover is sales divided by assets. Leverage is assets divided by equity.
    Earnings……….Sales…………..Assets
    —————X—————-X————–
    Sales…………….Assets………..Equity
    Note that the sales and assets cancel each other out to give you Earnings divided by Equity.
    FS: What’s the relationship between stock price, ROE, and risk-free rate of return? Would one expect ROEs in a country with a zero risk-free rate to be lower than ROEs in a country with a higher risk-free rate? How does that feed in to stock prices, if at all?
    Eddy: Again, a company’s share price is the net present value of all future cash flows. ROE is the best measure of the growth of future cash flows. How do we discount that? We discount it by the cost of capital which is risk-free rate plus an equity-risk premium. That’s why a lower risk-free rate tends to boost equity prices.
    According to the Gordon Model, it should look something like this:
    Price = Earnings/(Risk Free Rate + Equity Risk Premium – ROE)
    FS: How can a company with a positive ROE destroy economic value for shareholders?
    Eddy: All companies in all industries are in phantom competition with the cost of equity capital. Even though you can’t see it, you’re struggling against it every day. So even if a company manages to squeak out positive ROE, capital will not flow your way if you keep losing to everybody else.

  • Press Release from the NY Fed
    , November 4th, 2008 at 3:02 pm

    Wonderful:

    Michael Alix has been named a senior vice president in the Bank Supervision Group of the Federal Reserve Bank of New York. He will serve as a senior advisor to William L. Rutledge, executive vice president, Bank Supervision Group. Mr. Alix’s appointment was made by the Bank’s board of directors and is effective, November 3, 2008.
    Most recently, Mr. Alix worked for the Bear Stearns Companies, Inc., where he served as chief risk officer from 2006-2008 and global head of credit risk management from 1996-2006. His prior experience included eight years at Merrill Lynch & Company where he was a director, Asia chief credit officer and a vice president, head of North America financial institutions credit. He began his career with the Irving Trust Company where he served as an assistant vice president and lending officer.
    Mr. Alix holds an M.B.A in finance from the Wharton School of the University of Pennsylvania and a bachelor’s degree in economics from Duke University. He is a resident of New Jersey.

  • The S&P Crosses 1,000
    , November 4th, 2008 at 11:02 am

    There’s an election today! How come no one told me? Why wasn’t this in the news? Were there even debates?
    Since I live in Washington, DC, the Electoral College guarantees us the least-important votes in the Union. DC isn’t just a blue state, it’s the bluest blue state possible, and it’s getting bluer.
    For the last four straight elections, the Republican candidate has received 9% of the vote. I really don’t think McCain will be able to top that. Thirty-six years ago, Nixon got 21.5% of the DC vote which seems impossible now.
    The good news today is that for the first time in three weeks, the S&P 500 is back over 1,000. That’s over 19% higher than our intra-day low from October 10.
    Update: Today’s intra-day high was 19.7% above the intra-day low from four weeks ago.

  • Global Marginal Tax Rates Are Falling
    , November 3rd, 2008 at 3:56 pm

    The Danes pay the most:

    Worldwide, top personal tax rates have fallen from an average of 31.3% in 2003 to 28.8% in 2008. But European Union (EU) taxpayers still pay the highest rates, at an average of 36.4%, followed by taxpayers in the Asia Pacific countries with an average of 34.6% and those of Latin America at 26.9%, KPMG said.
    At a country level, the highest tax rates in the world are paid by the people of Denmark, with a top rate of 59% for the whole six years, followed by those of Sweden, whose rate came down last year from 57% to 55%, and those of the Netherlands, who have paid 52% for the whole period.
    Excluding those countries which levy no tax at all, the lowest EU rate is in Bulgaria, with a newly introduced flat rate of 10%, down from 24%. In Asia Pacific the lowest is in Hong Kong, with 16% and in Latin America it is in Paraguay with 10%.
    Of the 87 countries surveyed, 33 have cut their rates in the past six years and only seven have a higher top rate in 2008 than they did in 2003.
    Among the large western European economies, France has made the most significant cut in its rates, from 48.1% in 2003 to 40% in 2007. Germany has gone from 48.5% to 45%, having briefly stood at 42% in 2005 and 2006.
    But across the EU it has been the introduction of flat rate taxes in the Eastern European states that has had the most impact, KPMG said. As well as Bulgaria’s new flat rate of 10%: Estonia has cut its rates from 26% in 2003 to a flat 21% in 2008; Slovakia has gone from 38% to a flat 19%; Lithuania last year fell 6 points to 27% and this year a further 3 points to a flat 24%; Romania has cut rates from 40% to a flat 16%; and the Czech Republic, this year, introduced a flat rate tax set at 15%.

    I have a feeling that marginal rates will soon be rising in the U.S.

  • S&P 500 Total Return Adjust for Inflation
    , November 3rd, 2008 at 2:33 pm

    Here’s a look at how the S&P 500 has done including dividends and adjusted for inflation:
    image730.png
    Historically, the market’s real total return has been about 7% a year. The means it doubles every ten years, but in the last ten years, investors haven’t made a dime.

  • Vote Tomorrow and Get a Free Cup of Coffee at Starbucks
    , November 3rd, 2008 at 1:29 pm

  • The Fall of AIG
    , November 3rd, 2008 at 12:44 pm

    When economic historians pick through the rubble of the Panic of 2008, there will be lots of difficult questions to answers. The one I will never understand is how AIG (AIG) collapsed.
    Sheesh…how frickin stupid do you have to be to ruin AIG?
    Lehman and Bear I get, but let’s face it, insurance isn’t that difficult to make money in. Some companies make a lot more than others, but making a profit is a pretty easy concept in insurance. Manage your risk and charge more than you pay. Repeat.
    Sure, a disaster can hurt or ruin your business, but you have to be an idiot to ruin it from the inside. Sure enough, that’s what AIG did. Actually, their insurance business was doing well. It was their idiotic forays in the CDS market that sank the company.
    The Wall Street Journal looks at AIG’s collapse and Gary Gorton, the finance professor at the center of it all:

    AIG’s credit-default-swaps operation was run out of its AIG Financial Products Corp. unit, which had offices in London and Wilton, Conn. In essence, AIG sold insurance on billions of dollars of debt securities backed by everything from corporate loans to subprime mortgages to auto loans to credit-card receivables. It promised buyers of the swaps that if the debt securities defaulted, AIG would make good on them. AIG executives, not Mr. Gorton, decided which swaps to sell and how to price them.
    The swaps expose AIG to three types of financial pain. If the debt securities default, AIG has to pay up. But there are two other financial risks as well. The buyers of the swaps — AIG’s “counterparties” or trading partners on the deals — typically have the right to demand collateral from AIG if the securities being insured by the swaps decline in value, or if AIG’s own corporate-debt rating is cut. In addition, AIG is obliged to account for the contracts on its own books based on their market values. If those values fall, AIG has to take write-downs.
    Mr. Gorton’s models harnessed mounds of historical data to focus on the likelihood of default, and his work may indeed prove accurate on that front. But as AIG was aware, his models didn’t attempt to measure the risk of future collateral calls or write-downs, which have devastated AIG’s finances.
    The problem for AIG is that it didn’t apply effective models for valuing the swaps and for collateral risk until the second half of 2007, long after the swaps were sold, AIG documents and investor presentations indicate. The firm left itself exposed to potentially large collateral calls because it had agreed to insure so much debt without protecting itself adequately through hedging.
    The credit crisis hammered the markets for debt securities, sparking tough negotiations between AIG and its trading partners over how much more collateral AIG should have to post. Goldman Sachs Group Inc., for instance, has pried from AIG $8 billion to $9 billion, covering virtually all its exposure to AIG — most of it before the U.S. stepped in.
    Such payments continued after the government bailout. AIG already has borrowed $83.5 billion from the Federal Reserve, a little more than two-thirds of the $123 billion in taxpayer loans made available to AIG so far. In addition, AIG affiliates recently obtained from the government as much as $21 billion in short-term loans called commercial paper. Much of the $83.5 billion has been used to meet the financial obligations of the financial-products unit. If turmoil in the markets causes prices of many assets to fall further, the government might have to cough up more money to help keep AIG afloat. Cutting it off would risk renewing the market upheaval the policy makers have struggled to tame.

  • Sysco’s Earnings
    , November 3rd, 2008 at 12:22 pm

    Even for a defensive stock, Sysco (SYY) tends to be pretty defensive. The quarterly numbers tend not to fluctuate much. For the September quarter, the company’s fiscal first quarter, Sysco earned 46 cents a share, which was a penny below Street estimates. Last year, it earned 43 cents a share.
    While the S&P 500 is off by about 34% for the year, Sysco is “only” down around 18%. That’s a rough year but it’s a lot better than most. Sysco is currently going for about 13 times next year’s earnings.

  • The Real Bubble
    , November 3rd, 2008 at 10:09 am

    Arnold Kling spots the real bubble. It’s not finance, but in macroeconomics:

    I would not be surprised to see unorthodox theories of control gain traction. Perhaps, to justify current policy trends, a theory that socialized investment is necessary for stability.
    To me. the logical thing for the economics profession to do is admit that we are nowhere near understanding what is happening. However, taking that position will not get you invited to panels.
    I think that there are two questions. First, what are the generic causes and consequences of bubbles? Second, why did the specific bubble in real estate and mortgage finance occur? The first question is harder. But I would say that 99 percent of the economics profession cannot even correctly answer the second.