Most of what we’ve talked about is the “macro” sector of the economy, the big picture, the government and its role, the greater economy in which we all participate. While these macro pieces provide the economic framework to produce the goods and services—the food, cars, and wine—you choose to consume, our capitalist system also requires private enterprise.
Private enterprise produces the goods and services we all want, and hires the majority of us as labor to produce those goods and services. It also depends on capital we supply as savings and investments. But the allocation of labor and especially capital between millions of households and hundreds of thousands of private-sector businesses is a vastly complex enterprise. The need to move money around to the right places gives rise to the financial markets and the financial services industry.
The history of the financial markets and the financial services industry is full of success and failure, and as we emerge from the Great Recession, the pendulum has clearly swung from success to failure and back in the direction of success. The financial services industry grew beyond its traditional role as facilitator of the public and private economy into a large part of the economy in and of itself. Newfangled financial instruments and an excessive liberalization of credit served to fill the coffers of the industry to the point where in 2005 the industry made some 40 percent of all profits made by America’s top corporations. This distortion came home to roost in a big way when the resulting real estate bubble popped. It’s enough to make you or anyone else mad, but that energy would be better spent understanding what happened, why, and what should be done to prevent a repeat performance.
As we move forward, the financial industry has retrenched, and new regulation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (see #39) will likely serve to curb the excesses of the past. That said, most of the markets and instruments of the financial services industry will continue to exist and play an important part in capital allocation and economic growth. What follows takes a look at these important private-sector building blocks of the economy.
Anybody who’s read even the slightest bit of economic or financial news in the past couple of years has run across the term derivative. Derivatives have been in the news a lot ever since the early days of the 2008–2009 financial crisis.
So what is a derivative, anyway? Simply, it’s a financial contract or asset whose price is determined by the price of something else. Want to buy a thousand barrels of oil as an investment, or to use in your business, or to resell? You can, but you’d have to pay the full price for the oil, perhaps $100,000, and you’d have to find a place to store it. As an alternative, you can buy a derivative based on the price of oil, perhaps a futures contract, specifying delivery of that oil at a future date at a specified price. If the price of oil goes up, the price of your derivative will go up too.
Derivatives can be based on almost any kind of underlying asset—a physical asset like a commodity, a financial asset like a stock or mortgage or bond or some other debt security, an index like a stock or interest rate or exchange rate index, or just about anything.
There are three primary types of derivatives:
Derivatives can be used to hedge or to speculate. Farmers will hedge against the decline in the price of wheat, for example, by selling a futures contract on what they are producing. That allows them to pocket some cash now, giving some insurance against a price fall, or even a crop failure. On the other side of the trade, a brewery might hedge by buying a futures contract to protect against price increases, or even to guarantee supply in times of shortage.
As a tool to speculate, investors not in the brewing or farming business may also “play” the wheat futures market, betting on a rise or decline in wheat prices based on a host of factors. Derivatives offer leverage. Leverage allows you to enjoy the price gains or suffer the declines of the underlying asset with as little as 5 or 10 percent of the value invested, a key attraction for speculators. You can buy that interest in $100,000 of oil for a tenth of that, but if it goes down, you’ll lose your entire investment, and sometimes more.
Aside from helping farmers and brewers, the existence of derivatives gives investors and financial institutions ways to invest in things, and ways to manage risks. They also help bring more participants to any given market, making that market and its prices more truly reflect supply and demand. However, the broad array of derivatives and the opaque nature of some of the customized derivatives created through “financial engineering” in the last decade have caused considerable trouble. Additionally, derivatives traders overplayed their hands, writing more contracts than they could possibly cover. Forthcoming regulation will likely standardize trading and trading rules for some of the exotic derivatives, particularly swaps (see #69 Credit Default Swap). This will give a more favorable name to these instruments and help them move away from the “financial weapons of mass destruction” moniker assigned by billionaire investor Warren Buffett in 2002.
The size of the world derivatives market is phenomenal, estimated at some $1,200 trillion face or nominal value (although some estimates claim it to be higher). To put that figure in perspective, it is about twenty times the size of the entire global economy.
With so much bad news circulating about derivatives, it’s a good idea to understand what they are, and know how they can cause trouble. That said, certain derivatives like stock options can actually be used to reduce your risk—that is, to hedge on your stocks. That can make a lot of sense for ordinary investors who know what they’re doing.
Asset-backed securities (ABSs) were once a dark corner of the financial world, a financial tool most people wouldn’t commonly know or care about. But the 2008–2009 financial crisis put ABSs center stage, particularly the real estate versions known as mortgage-backed securities (MBSs) and so-called collateralized debt obligations (CDOs) (see #68). For the most part, ABSs aren’t consumer products—they are bought and sold by large financial institutions—but in the interest of understanding the financial news, and understanding how “engineered” financial products like this can affect you, read on.
An asset-backed security is a specially created financial instrument, or security, custom-built upon a pool of underlying assets. Those assets serve as collateral, and the income they generate is passed on to the ABS holder. Individually, the assets contained in the ABS, like mortgages or car loans, are small and difficult to sell in the open market. The ABS is designed to package them into a single, larger security so they are large enough to interest institutional investors, and if packaged clearly and carefully, to spread risk. If one asset in the portfolio fails, it will be only a small fraction of the portfolio. ABSs were created out of mortgages, car loans, credit card financing, and commercial loans and leases.
ABSs played a key role in the mortgage crisis. To lend more money on mortgages, banks engaged in the mortgage market learned to package mortgages into ABSs (or MBSs) and sell them as a package. The process is known as securitization—the offering institution created a security out of a number of individual assets. This accomplished two things: first, it helped the banks get funding for the loans, and second, it transferred the risk of default to the buyer. Investment banks and institutional investors (see #28 Investment Bank and #75 Institutional Investors) bought these securities because it was a handy way to tap into the mortgage market and chase higher returns than currently offered by the bond market or other fixed-income securities.
Prior to the crisis, as it turns out, the idea of ABSs caught on rapidly as a way to expand the mortgage market and lend into the real estate boom. In fact, this helped cause the boom, because it became easier to get funds to lend. Unfortunately, the buyers of ABSs did not fully understand the underlying risks in these securities; neither they nor the ratings agencies (see #77 Credit Rating Agency) factored in the notion that real estate prices might decline, and didn’t perform a “due diligence” on the credit risk of assets that lay beneath the covers of the ABS. The result was a collapse in the value of ABSs held on bank and institutional books, and that as much as anything else led to the banking crisis. This was made worse by the fact that all ABSs are unique. Each is constructed on a specific batch of assets; no two are alike, so there is no market to value them, and little “transparency” as to their true worth.
The expansion of asset-backed securities led to “easier” lending terms, but also ultimately led to the financial crisis when the tide washed out on underlying asset values. The 2008 banking crisis led to a severe contraction in asset-backed security markets, which in turn caused a severe contraction in credit extended to businesses and consumers. It’s a big part of why it got very difficult to get a loan during that period. Today, the ABS market has loosened somewhat, but tighter standards for underlying asset quality, necessary to make the markets work, has caused it to remain somewhat difficult to borrow if you have bad credit—and that’s a good thing. Bottom line: ABSs are not necessarily a bad thing if risks are properly assessed. There is also a well-placed call to standardize ABSs and create more liquid, transparent markets to trade them.
Collateralized debt obligations are a form of ABS (see #67 Asset-Backed Security) that might be analogous to a stealth fighter jet compared to a small Cessna prop job. They are highly engineered, highly customized, securitized assets based on fixed-income securities, with mortgages again taking center stage in the recent boom.
For the average consumer, CDOs are one of those topics that the more you know, the more you don’t know. As it turns out, that phrase also applied to many in the financial world who didn’t really understand nor could properly value the CDOs they bought and sold, and we now know the result.
Like ABSs in general, CDOs are carefully created packages containing underlying securities. A financial institution, and most likely a “special purpose entity” residing off the books of a major financial institution like an investment bank, would package a series of underlying assets into a security. These assets could be individual loans and mortgages, or they could be other ABSs. They were often called “structured investment vehicles.” But it would be too simple to stop there. The CDO was then divided into segments, or “tranches,” according to risk and rank of underlying assets, and these assets could be sold individually to other buyers. It gets worse—there were “synthetic” CDOs, “market value” CDOs, “arbitrage” CDOs, and “hybrid” CDOs; the financial engineering details are beyond the scope of this discussion.
The now-defunct Drexel Burnham Lambert engineered the first CDOs in the late 1980s. The market grew furiously in 2004–2006 as CDOs became the favorite tool to resell and transfer the risk of real estate mortgages. Buyers of CDOs included commercial and investment banks, pension funds, mutual funds, and other institutional investors seeking higher returns, which ranged from 2 to 3 percent higher than corporate bond rates at the time. Suffice it to say that, due to the complexity of these products, buyers often did not know what they were really getting.
The boom in CDOs is made clear by the statistics. In 2004 some $157 billion in CDOs were sold; that figure rose to $272 billion in 2005, $521 billion in 2006, $482 billion in 2007—then dropped to $56 billion in 2008 as the market came to appreciate the risks and complexities of these securities. It has remained somewhere near that size.
The lucrative fees paid to the creators of these securities helped lead to the boom and subsequent downfall. Investment banks and individual investment bankers made millions capturing their percentages of these securities as they were sold; the incentive was to build them as big, and sell them as fast, as possible. Those who created these products simply passed on their risks, which now have ultimately been borne or at least backstopped by the taxpayers. Now that these characteristics have come to light, it is likely that CDOs will continue to exist, but in a more transparent, standardized, and regulated form.
You’ll never be approached to buy a CDO, but it’s good to know what goes on in the world of high finance. Once the fallout from the credit crisis becomes clear and turns into appropriate regulation, transparency, and controls, CDOs should continue to be with us, although not at “boom” volumes, and their existence will help make credit more available to all of us.
There are CDOs, CDSs, ABSs, MBSs, and more. The three-letter alphabet soup of high finance reached all-time proportions in the middle part of the first decade of the twenty-first century. It became hard to keep track of what these new innovations were, how they worked, and how they led to the financial downfall at the end of the decade. It’s especially easy to assume that CDOs and CDSs—credit default swaps—were much the same thing, but in fact they were quite different. We examined CDOs in the previous entry; now it’s time to move on to CDSs.
A credit default swap is a special kind of derivative contract (see #66 Derivatives and Derivative Trading) in which the buyer pays a sum, known as a spread, for a contract specifying that if a certain company defaults on a credit instrument, like a bond or loan, the buyer gets a payoff. For example, a buyer might pay a spread of $50,000 to $100,000 for $10 or $20 million of default coverage. If this sounds like insurance, it is, and as a legitimate financial product, CDSs help bond buyers insure their risk.
Like insurance, CDS contracts were custom-written for the situation; they were not set up as standardized, market-tradable securities. And like insurance, most CDSs were developed and marketed by insurance companies. But unlike insurance, CDSs do not require the buyer to have an insurable interest—that is, a stake in the matter being insured. You can’t buy life insurance on your next-door neighbor, but you can buy a few million in CDSs on company XYZ without owning any bonds or stock in that company whatsoever.
Because buyers of CDSs did not have to have an insurable interest, CDSs were used as a tool to speculate on the demise of companies. At the same time, in a manner similar to CDOs, financial companies and the individuals who work for them make huge commissions and bonuses for developing and selling CDSs. Hedge funds, among other large investors looking to boost returns, bought CDSs. Also, insurers like AIG looked at them as a way to generate relatively low-risk cash by collecting spreads against what were felt to be highly unlikely defaults. This turned out to be a dangerous combination—a handful of employees in a UK branch of AIG sold CDSs with a face value more than twice the value of the entire company, and we now know where that led.
Making matters worse was the fact that many CDSs were written not just to protect against default, but against the change in a credit rating or any other change in a company’s financial condition. These triggers, to the surprise of most involved, were hit far more often during the financial crisis than anyone anticipated. CDSs were the primary factor in the $180 billion federal bailout of AIG.
JPMorgan Chase created CDSs in 1997; the face value of assets insured grew to some $45 trillion by 2007. Their spreads became a de facto indicator of a company’s financial strength—or weakness; it was the rise in CDS spreads for Bear Stearns in early 2008 that spooked the credit markets, starved the company of credit, and led to its forced sale to—ironically—JPMorgan Chase. Today, financial regulators recognize the need for CDSs to provide the insurance intended, but are examining ways to regulate the market, including standardization of contracts and trading on an open and more visible exchange.
Like CDOs and most other asset-backed securities, you probably won’t receive any offers to buy CDSs in your mailbox. But it’s important to know where our financial system troubles came from, and to know that even the best and brightest of our insurance companies got caught with their hands in the proverbial cookie jar. Most likely the lessons have been learned, but if you hear of heavy CDS activity from an insurance or financial services company you’re dealing with, look out.
You may have money to invest and you want to participate in the American economy, or perhaps other economies beyond American shores. But you don’t have millions; more importantly, you don’t have the expertise, the time, or the interest in becoming your own investment adviser. You just want to throw that job over the wall to someone else, and you’re happy to pay a small fee for the privilege.
That’s where mutual funds come into play for the typical consumer-investor today. Mutual funds are a popular vehicle for the investment of individual wealth, and have become a standard for investing retirement wealth, particularly the assets of 401(k)plans and other employer-sponsored retirement plans. Whether you intended to or not, you probably own a mutual fund somewhere, somehow.
Mutual funds are the predominant form of what’s known as an investment company. Investment companies are investment pools designed to achieve certain investing objectives, usually to capitalize on growth, income, or some combination of the two. They were chartered under and are governed by the Investment Company Act of 1940. The act is very specific about how investors are treated, how the fund discloses results, and how investors are paid by these funds. Compliance is strong, because the act is actively enforced by the SEC (see #44). There are about 14,000 mutual funds in existence today, and they have become a mainstay of Main Street, especially for retirement plan investing (see #51 Retirement Plans).
If you’re a typical retail investor, you’ll probably have to settle for the fairly ordinary returns these funds generate. They’re largely safe, but tend not to outperform the market. They diversify your holdings, they’re convenient, and they save you a lot of time. They work well when you have modest amounts, say $50,000 or less, to invest. And they’re clearly better than not knowing what you’re doing and getting stuck with the wrong individual stock investments—like Enron, AIG, or Washington Mutual, for instance.
With mutual funds, you do indeed pay for their services. Management and marketing fees can be typically 0.5 percent to 1.5 percent of your investment balance—whether or not your investment does well. If you lose 20 percent along with the markets, you still pay the fee, albeit on a smaller balance. Mutual funds also may create tax surprises if held in taxable (that is, nonretirement) investment accounts. Each year they buy and sell stocks, and if there are gains, you pay taxes on those gains. Since the fund share price is based on the “net asset value” of all securities in the portfolio, if you buy shares late in the year after a good market run, you will pay a higher price for the shares—and pay taxes on the capital gains that the previous owner realized when selling you the shares! Thus, it’s better to buy mutual funds in the beginning of the year, and to do some research on the so-called tax efficiency of the fund—that is, whether they take shareholder tax considerations into account when buying and selling shares. Again, this is only for mutual funds not held in a tax-deferred retirement account—an IRA, 401(k), or some such.
Mutual funds are a good way for an individual investor to gain exposure to stocks, and to invest in challenging sectors of the market, like international stocks. Mutual funds make it much easier for the typical consumer to invest, and, along with the growth of individually directed and employer retirement plans, have indeed raised the share ownership among U.S. households from 10 percent or so in the 1960s to some 65 percent in 2007, but it has fallen off a bit to 54 percent in the wake of the Great Recession. Still, the high percentage of stock ownership is a good thing in terms of making capital available for businesses, and for allowing the ordinary individual to participate in prosperity. So far as mutual funds are concerned, like any product you buy, you should know what you gain and what you give up by investing in a given fund.
Exchange-traded funds are an increasingly important and relatively new investment “product” designed, like mutual funds, to give you an easy, “prepackaged” way to participate in the world economy or certain segments thereof. Exchange-traded funds are closely related to mutual funds, but there are important differences. The first widely available ETF, the SPDR S&P 500 ETF Trust, commonly known as the “SPDR,” released in January 1993. Since then, about 1,400 new funds have entered the fray, with some $1.6 trillion in assets—a large sum, but still only about a tenth of what’s invested in the traditional mutual fund universe.
Exchange-traded funds are pretty much what the name implies. Like mutual funds, they are groups or “pools” of investments that you can buy a share of for yourself. Unlike traditional mutual funds, their shares trade on exchanges, like the NYSE Arca electronic exchange. As such, the prices fluctuate throughout the day, and you can buy and sell them like any individual stock. So if you decide that agriculture is your thing but don’t begin to know which company to invest in, you can simply buy shares of the Market Vectors Agribusiness ETF (ticker symbol “MOO”) and let your investment harvest a few bushels of cash for you.
The 1,400 or so ETFs available cover a wide variety of market segments; you can invest in anything from agriculture to European stocks to bonds to physical gold to certain baskets of commodities priced in Australian dollars. Most ETFs own individual stocks, but some may own physical commodities or futures contracts for those commodities. ETFs can be grouped into General Equity (like the “SPDR” mentioned at the outset), International Equity, Dividend, Fixed-Income (mostly bonds), Commodity, Strategy (for example, low-volatility investments or companies that buy back their own shares), and Sector (companies in certain industries, like auto manufacturing).
Most ETFs are tied to specially created indexes; that is, rather than being actively managed by a fund manager (a professional human), they are simply modeled after a pre-existing index, like the S&P 500 indexes mentioned in the SPDR example. Financial firms have created indexes for almost anything; the index determines what investments are owned, and in what proportion. The ETF manager simply buys and sells securities in the open market to track the index. There are more than a dozen financial services firms offering ETFs to the public; the three largest and best known are BlackRock (branded “iShares”), Invesco (“PowerShares”), and State Street Global Advisors (“SPDRs,” now an entire family of funds).
ETFs offer several advantages to investors:
ETFs are easy for individual investors, and offer a low-cost way to participate in the segments of the market best for you. They’re easy to use and an excellent and relatively safe way to diversify. For the economy as a whole, they provide a low-cost and lower-risk opportunity for many more investors to invest and participate. Availability and use of ETFs in employer retirement plans (like 401(k)s) is growing, so you’re more likely to run across them as investment choices if you haven’t already. But because it is so easy to rotate, they can cause faster swings in the markets and between different sectors of the market—in short and to a degree, ETFs “speed” change in the markets.
Suppose you’re fortunate to have a great deal of “investable wealth.” A million or more, tens of millions, even better. You aren’t content to just perform with the market. And picking individual stocks and managing your own investments just isn’t your thing. You want to be “in” with the big boys, scoring way better than average returns. You want 10, 15, or 20 percent or more, rather than the 5 percent everyone else is settling for. You want to invest the way other rich, famous, and privileged people do. A hedge fund might be your answer.
As it turns out, hedge funds are the privileged-class answer to the ordinary mutual fund. In the interest of not meddling too much in the world of private wealth and capital, the 1940 act has two commonly used exemptions excluding certain types of funds from close regulation. These exemptions gave rise to what are now known as “hedge funds.” As a result, hedge fund governance is limited primarily to two areas: who can invest and how they’re sold. The early hedge funds did what the name suggests—they helped investors “hedge” against market downturns or other unforeseen events, because rules and predominant investing strategies made it difficult for ordinary funds or individual investors to do so.
There are two types of funds that exist under these relatively light rules. One type of fund is limited to 100 or fewer investors, and can only be marketed to investors with more than $1 million in investable assets, or verifiable income exceeding $200,000 a year. The other can have an unlimited number of investors, but each must have $5 million of investable assets. The first type doesn’t have to be registered with the SEC at all, the second only if it has more than 499 investors. Furthermore, there’s no requirement for the managers of either type of fund to be registered or otherwise qualified or credentialed with the SEC, or with any other regulatory body or trade organization. For most of their existence, the rules stated that neither type of fund could be “offered or advertised to the general public,” but that rule was overturned in mid-2013 by the SEC, and advertisements will be permitted going forward.
As a result, hedge funds are largely left to do what they want, and the managers can charge some pretty hefty fees for their services. Common was the “2 and 20” compensation rule, where the manager is guaranteed a fee of 2 percent of the fund’s net asset value plus 20 percent of the investment gains over a specified amount. That’s a pretty powerful incentive.
Without close regulation, hedge funds are allowed to sell short, borrow money, and invest in “derivative” instruments like futures and options to enhance returns. Effectively, they can leverage their portfolio, controlling, say, $10 million in assets with, say, $2 to $5 million in equity. That’s great when things are good, not so great when things go bad. Bottom line: hedge funds allow wealthy investors to chase high returns using exclusive private investments administered by managers with few boundaries, who tend to chase the highest returns possible to get the biggest fees. It’s a potent combination for success, but also for failure.
Despite some of the horrendous losses incurred by some hedge funds in the Great Recession, not all hedge funds are bad, and they do bring a lot of capital to market from the coffers of the wealthy. However, their power and numbers, some 10,000 funds managing some $2.5 trillion in assets, can cause some pretty outsized market moves and distortions, such as the oil price run-up in mid-2008. When markets do well, most hedge funds do well—and vice versa. When things start turning south for hedge funds, because of leverage they’re often forced to dump conservative investments, a factor that probably amplified the 2008–2009 stock and commodity market collapse.
Legislative attempts have been made to regulate hedge funds, and the 2010 Dodd-Frank Act (see #39) started to require managers of larger hedge funds with more than $150 million in assets and/or more than fifteen clients to be registered as Registered Investment Advisers, but not much else has happened in terms of regulatory oversight; hedge funds are still mainly in the “Wild West” corner of the investment markets.
Private equity is a general term for equity, or stock investments in businesses not traded on a stock exchange. Private equity is an important source of investment capital for distressed firms or brand-new companies, because they don’t have to go through the rigors of public listing, accountability, and disclosure. Venture capital, investments made in new business ventures, is one form of private equity.
Private equity companies can be firms or funds that typically get their money to invest from large institutional investors or very wealthy individuals, and in turn make investments in or acquire companies outright. Private equity firms may acquire already existing “public” companies or the majority of a company through leveraged buyouts (see #74), and usually use venture capital to take a smaller stake in order to minimize their risk.
For sure, private equity firms and their investors don’t make their investments out of the goodness of their hearts; they are looking for a return, typically a substantial one, on their investments. If they simply wanted stock market or fixed-income returns, they would invest in stocks or fixed-income securities. Most private equity deals, including venture capital deals, seek to earn a large return, either by harvesting profits from the companies they invest in, or by selling them at a better price at maturity or after a turnaround.
Private equity was made famous by the many so-called “corporate raiders” who emerged in the 1980s—Carl Icahn, T. Boone Pickens, Kirk Kerkorian, Saul Steinberg, and others. These investors would buy large stakes of a company, in some cases enough to get themselves or their own people on the board of directors, and push for change. If successful, and especially if they employed leverage by borrowing to help finance their purchase, they reaped enormous profits. But that strategy didn’t always work, as shown by the recent experience of Cerberus Capital Management, which bought Chrysler out of the Daimler-Chrysler merger only to put it into bankruptcy shortly afterward. More recently, Michael Dell teamed up with private equity investor Silver Lake Partners and certain other investors, including Microsoft, to buy Dell and take it private—such transactions and attempted transactions are not infrequent. Beyond Cerberus and Silver Lake, some of the larger names you’ll read about in the private equity space today include Kohlberg Kravis Roberts (KKR), Bain Capital, Warburg Pincus, the Carlyle Group, and the Blackstone Group.
Private equity is important—and has become more important—as a source of corporate capital over the years. More often than not a company that “goes public”—starts selling shares to the public to trade on a stock exchange—has gone through a considerable incubation in the hands of private equity. You should know that when that firm goes public, it’s a sign that the private equity firm has maximized its return on investment—which may not bode well for the company’s immediate future. Also, while private equity serves a useful purpose in rescuing failing companies (when successful), when that company is taken public again, it may not be the best time to buy. Finally, there have been some cases where firms have been bought strictly for the short-term gain of the individual or private equity firm, then plundered for their cash and assets. Watch carefully if you invest in—or work for—one of these firms.
Want to sound suave and sophisticated at a cocktail party when the subject comes around to finance? Just mention the words “leveraged buyout.” A leveraged buyout is simply the purchase of a company by another company using “leverage,” or borrowed money.
The acquiring company may be a company in the same industry, or it may be a conglomerate or holding company (like Warren Buffett’s Berkshire Hathaway), or a private equity firm specializing in LBOs. The borrowed money may come from traditional sources like banks or investment partnerships. Sometimes at least some of the money may come from the cash coffers of the company being acquired, and sometimes it may come from selling off some of the acquired company’s assets. Finally, the acquired company’s assets may be used as collateral on any debt issued to make the transaction. In some cases, an investment bank (see #28) might put together a consortium of lenders. Typically the debt ranges from 60 to 90 percent of the purchase price, and any debt issued in an LBO is considered high risk.
LBOs are more likely to be used when the acquired company has significant cash, stable cash flows, or quality “hard” assets that can be sold or used as loan collateral. Acquiring firms are often looking for good corporate assets in need of a turnaround, new management, or other operational improvements.
LBOs hit their stride in the 1980s, culminating with the $31 billion buyout of RJR Nabisco by LBO specialist KKR in 1989. The next big wave of LBOs hit during the 2005–2007 boom, with such names as Equity Office, Hertz, and Toys“R”Us being “taken out” by various acquirers.
More recently, leveraged buyout activity continues at a brisk pace because of relatively cheap borrowing rates, but no real big names have been “taken out.” Some have involved major parts of companies, such as a recent $4.8 billion buyout of DuPont’s auto paint business by the Carlyle Group.
LBOs have changed the corporate landscape, affording more companies more power to make more acquisitions, and cleaning the corporate “forest floor” of some companies past their prime. If you work for a company that is a target of an LBO, watch out; the acquiring company may look to streamline and trim assets (including you).
Institutional investors are large organizations, public or private, that amass funds for an assortment of purposes and invest them in the markets. Their objective in most cases is to invest money on behalf of others, and their success is determined by market performance.
The importance of institutional investors becomes clear when looking at some of the different types of institutions:
Other types of institutions include investment banks and trusts, and some refer to hedge funds and private equity as institutions.
Institutions still make up the lion’s share of stock, bond, and commodity investment in the markets. They weigh heavily on market performance and overall economic performance, and on the allocation of capital to public and private enterprises. Your fortunes in these markets will depend in part on what institutions are doing, and in some cases, like insurance investments, investment performance may affect your personal finances.
Money market funds (MMFs), or money market mutual funds, specialize in investing cash assets in short-term securities to provide investors with slightly higher returns than banks, and liquidity—that is, unrestricted deposits and withdrawals. As a place for investors to park short-term cash, which is then used by public and private enterprises to fund short-term operations, money market funds perform a vital role in the economy.
Money market funds are technically mutual funds, regulated by the Investment Company Act of 1940 (see #43) and subject to price variations based on performance of underlying assets. However, because money market funds invest in very price-stable, short-term debt securities (usually a “weighted average maturity” of ninety days or less), the asset base is extremely stable. As a result, the price of most money market fund shares is $1, and it is highly unusual for such a fund to “break the buck.” It did happen, however, to two funds in the 2008 crisis as a result of investments they had made in failed investment bank Lehman Brothers. Reserve Primary Fund fell to ninety-seven cents and the other, BNY Mellon, fell to ninety-nine cents—so you can see how stable these holdings are.
Most money market funds pay yields based on short-term interest rates, which in 2013 were practically nothing, below 0.2 percent in most cases. In more normal interest rate environments, money market funds pay 0.5 percent to 1.5 percent more than comparable bank savings instruments.
Money market funds are different from the assortment of money market accounts (MMAs) offered by banks. The bank MMAs pay slightly less than MMFs, but are not for the most part covered by FDIC insurance (see #45 Federal Deposit Insurance Corporation). Most money market funds are sold by mutual fund companies or are available through brokers, retirement plan administrators, and others. Most money market funds are taxable—that is, the interest earned is taxable—but some are based on government securities (for stability) or tax-exempt securities (for tax preference). Most MMFs charge modest fees, but in today’s low interest rate climate, even a tenth of a percent makes a big difference.
Money market funds are a good place to park reserve cash—reserved either to invest or to handle unexpected emergencies in your personal finances. They offer stability and liquidity, and did offer somewhat better yields in the past.
Credit rating agencies are specialized companies that evaluate the financial strength of other companies and of the debt instruments they issue. These ratings are used by banks, lenders, and others interested in corporate strength to judge the safety and quality of debt. While credit rating agencies are important to the proper function of the financial system, they might not have been mentioned in this book, except for the large role they played in the 2008–2009 financial crisis and the Great Recession that resulted.
Credit rating agencies evaluate the overall strength of credit and credit risk of a company, similar to the so-called “credit rating” you might receive as a consumer, and they also evaluate the strength and quality of specific debt issues, like bonds or commercial paper. The “big three” ratings agencies evaluating U.S. companies are Standard & Poor’s, Moody’s, and Fitch Ratings. They each have their own set of rating criteria, and each issues ratings more or less analogous to school letter grades, although the exact grading scale used by all three is different. Companies will usually get a credit risk rating as a whole, and most large corporations are rated by all three agencies. Individual securities will also get ratings, but typically from only one agency. Special securities issued by companies, like asset-backed securities (see #67), also get ratings, and it was these ratings that brought credit rating agencies into the spotlight after the financial crisis.
Credit ratings are, in theory at least, convenient and independently calculated tools to help others make fast decisions about whether to lend to or invest in companies. For the most part they work, and have been the standard for years. But ratings agencies and their ratings came into question in the wake of the 2008–2009 crisis for two primary reasons. First, they tend not to change fast enough to reflect current economic or corporate conditions. Second, and perhaps more damaging, is the apparent conflict of interest in their creation: the firm issuing securities hires the rating agencies to provide the rating. Naturally, the agencies try to please their customer for the sake of future business and the business relationship. But those attempts to please have been called into question, particularly with the number of highly rated mortgage-backed securities that blew up in the crisis.
To be fair, it isn’t just the conflict of interest at fault—most likely, these securities were just too complex, and backed by assets too difficult to value, for any such rating to be accurate. Legislative reform of the ratings agencies has been slow in coming, but since reputation is the chief asset these companies have to sell, there has been a fair amount of self-reform, and their public image and effectiveness has returned to a large extent since the crisis.
Agencies rate debt securities that ultimately may include loans or mortgages you take out, and the ability of a rating agency to rate them fairly will determine how easily they can be sold to investors, ultimately affecting your ability to get financing. So there’s no direct impact on you or your household, but ratings agencies are part of the machinery that makes financing—money—available to you at an appropriate price.
As recently as 1960, only about 10 percent of all households owned shares of stock in corporations. Today, due in part to individual retirement savings needs, that figure has grown to exceed 50 percent; that is, one in two households across the United States own shares of corporations.
The discussion of stocks and stock markets cannot be possibly completed in this small of a space; it’s the subject for an entire book. What’s important to know is that stock represents the owners’ interest in a corporation, that interest is divided into shares, and that those shares are traded on one or more stock exchanges that comprise the stock market.
Stocks can be listed on stock exchanges if they meet certain criteria in terms of size, volume, and share price given by the exchange. The exchange is a corporation or organization set up to bring buyers and sellers together, either in person or electronically. The exchange handles all incoming orders, executes them by matching a buyer to a seller, and routes the proceeds as funds to the appropriate parties.
The two major U.S. stock exchanges continue to be household names: the New York Stock Exchange (NYSE EuroNext) and the NASDAQ, which originally stood for the National Association of Securities Dealers Automated Quotations. In addition, the over-the-counter (OTC) and Pink Sheets markets and a series of regional exchanges handle specialized trading situations in the United States, and a network of online-only electronic exchanges has emerged, such as BATS Global Markets and Direct Edge, which have recently announced plans to combine to become the second-largest exchange in the U.S. by trading volume, ahead of NASDAQ. Most countries also have at least one major stock exchange.
How stock trades are actually executed varies by exchange. The original approach begun in the early 1790s on the corner of Wall and Broad Streets in Lower Manhattan eventually became the mainstay of the NYSE. That approach uses a specialist—an individual with assistants who manually matches buy and sell orders with each other and with a personal inventory when such external orders don’t exist or are too few. Each stock has one specialist and one only; that specialist is assigned the task of maintaining orderly markets.
The specialist system obviously predates computers; the advent of computers naturally brought new, faster, and more transparent technologies to stock trading practice. The first change came in 1971 with the advent of the NASDAQ. Prior to the NASDAQ, the only alternative to the specialist system was a network of securities dealers hooked to each other by telephone; these dealers traded the stock, mostly of small or emerging companies “over the counter.” The NASDAQ created a virtual marketplace accessed by computers where buyers and sellers, mostly dealers, posted quotes and executed trades against those quotes. Dealers could trade with the big brokerage houses to fill end-customer orders, and the late 1990s advent of personal computer and networking technology enabled individual traders to also access these markets. The day-trading craze of the late 1990s was the end result, and such high-powered direct access trading still goes on today.
Gradually and not surprisingly the specialist system is quickly becoming outmoded and replaced by faster, cheaper, and more transparent electronic tools; even the NYSE has evolved to electronic trading for a significant share of its volume. The specialist system still survives mostly to handle larger institutional trades.
The stock market and its effective operation are vital to a capitalist society. It is how capital is allocated between individuals, their representatives, and the corporations that need that capital. Without a fair or efficient market, that allocation wouldn’t work well, and people would be fearful of investing in companies.
Bonds are securities bought and sold by investors promising repayment by a certain date (maturity) with a certain yield, or interest amount, paid usually semiannually. Not surprisingly, bonds and other debt securities are sold in the bond market.
Trading in the bond market sets the price of the bond, which in turn sets the effective yield on the bond. Suppose a bond pays 7 percent at par—that is, at $100 in price, the typical original sale amount and ultimate value paid back at maturity. That means that the bond pays $70 per year in interest on a $1,000 bond (the normal trading increment). If the market thinks that bonds are worth less, and drives the price down to $95 ($950 face value), the effective yield rises to 7.37 percent—interest rates go up. Remember, when bond prices go down, interest rates go up, and vice versa.
Carrying the discussion one step further, even if the bond falls to $95 ($950), eventually $1,000 will be repaid to the bondholder. So the yield to maturity captures not just the interest paid, but also the additional $50 recovered at maturity. Suppose the 7 percent bond matures in ten years. The yield to maturity would be 7.72 percent—a fairly complex calculation best done on a financial calculator.
Most bonds are traded “over the counter” between individual securities dealers, rather than on a transparent, electronic-driven market like the NYSE or the NASDAQ. Today’s bond market looks more like the stock market of the 1960s and 1970s. Bonds are traded this way because each is unique—different issuer, different interest rate, maturity, and other terms and conditions. And most bonds are held longer and traded less frequently than stocks. The bond markets are less consumer-friendly—in part because consumers participate less in the bond markets; it is more of an institutional investor playground (see #75 Institutional Investors).
There are four categories of bonds and bond markets—corporate, government and agency, municipal, and asset-backed securities (see #67). The U.S. Treasury sells a lot of bonds, and has made the purchase of Treasury bonds among the most friendly of bond markets for the average consumer with its bond purchase website www.treasurydirect.gov.
Aside from being a place to buy and sell bonds by matching supply and demand for bonds, the bond market effectively determines interest rates. A rising bond market means falling interest rates; a falling bond market signals that interest rates are on the rise. If you’re in the market yourself to “sell a bond of your own”—that is, to get a mortgage or some other large loan—watching the bond markets to see the direction of interest rates can be especially helpful.
Commodities are physical materials and assets used in production of goods and services (like oil or corn or platinum) or as a store of value (like gold) or both (like silver). Many businesses buy commodities in large quantities to support their production, while other businesses, like mining companies or farms or agricultural producers, sell commodities in large quantities; that’s their business.
Commodity futures are derivatives (see #66), securities products designed to provide a convenient way to buy and sell commodities, while commodity futures markets provide a way for buyers and sellers to trade those commodity futures.
Futures contracts are standardized contracts to buy or sell a specified item, usually but not always a commodity, in a standardized quantity on a specific date. Commodity futures include agricultural products, shown in some listings as grains; “softs,” like cotton, sugar, and coffee; meats; and mineral and mining products like metals and energy products. Futures contracts also go beyond commodities into financial futures, which include interest rates, currencies (see #81 Currency Markets/FOREX), and stock index futures. In fact, many more exotic futures products are coming to market for things like the weather, pollution credits, and so forth.
Futures contracts are typically set up for larger quantities of a commodity than any individual consumer would normally need. For instance, the standard contract size for gasoline futures is 42,000 gallons, quite a bit more than you’ll need, even if you own the largest SUV. At $3 a gallon or so, on paper this is a $126,000 investment that few individuals would be able to make. So doesn’t this discourage participation in the market? Not really, because commodities traders can borrow on margin (see #86) to finance most of the purchase. In the case of gasoline futures, a $6,000 upfront cash payment gets you in. As you can see, the leverage is high—a 10 percent increase in the price of gas ($12,600 on the contract) would almost triple the initial investment. However, if the price goes down, your $6,000 disappears quickly; when gone, your position is liquidated. That affords some downside protection.
Futures contracts are bought and sold by producers and consumers of the commodities involved. Producers like farmers or energy companies are looking to hedge, or protect, against future price decreases, while consumers like manufacturing companies are hedging against price increases. But there aren’t that many producing or consuming businesses in the market at any given time for, say, copper. The markets are made complete by speculators, short-term investors trying to make a profit by guessing the future direction of the price of a commodity. While many speculators rarely see the actual cotton, they do play an important role in the determination of the price of cotton.
In many cases, the underlying assets to a futures contract may not be traditional commodities at all. For financial futures, the underlying assets or items can be currencies, securities, or financial instruments and intangible assets or referenced items such as stock indexes and interest rates. The “future” is the future price of the instrument, not the physical commodity.
Futures are traded on special markets set up to trade them, the most important of which are the Chicago Board of Trade (CBOT), the Chicago Mercantile Exchange (CME), and the New York Mercantile Exchange (NYMEX).
Commodities markets serve the economy as an important way to set prices on key materials that the economy depends on, both now and in the future. Ultimately, the price of the coffee you drink or the gas you buy is determined by what happens in the commodities markets. Commodity futures also provide a way—albeit not the only way—to invest in the perceived future scarcity of materials like oil, and in the performance of the economy in general.
Commodity traders like to point out that there is less “headline risk” in commodities—that is, there’s no CEO or CFO to be caught fudging the books, for instance. Many of the human factors that add risk to stocks, bonds, and other investments are not present in commodities; investors consider commodities to be more of a “pure” investment.
The exchange of national currency is vital in the course of national trade, and thus in the course of international economics. We cannot buy Japanese cars (produced in Japan, anyway) without first buying Japanese yen, and the Japanese can’t buy U.S. rice without first buying U.S. dollars. So that need to support trade has given rise to foreign currency exchange markets to allow market participants to exchange currency, and in many cases to set the price, or rate, of that currency exchange.
The dynamics of currency exchange and exchange rates are complex and covered in more depth in Chapter 8. Here, we’ll talk about the foreign exchange markets themselves (known as “FOREX” or simply “FX”), and how they work.
Like commodity futures (see #80 Commodities, Futures, and Futures Markets), foreign exchange is a bigger market and plays a greater role than simply as a place for buyers and sellers of foreign goods to acquire the needed currency. Banks, large businesses, central banks, and governments use the FOREX markets to hedge positions, and even to implement policy, buying or selling currencies to achieve an exchange rate objective. And also like commodities, a considerable number of speculators and short-term traders “bet” on moves in currencies with relation to each other, adding market volume and liquidity to make exchange rates truly reflect the supply and demand of the moment.
Foreign exchange markets have grown enormously with the increase in international trade and the tendency since the early 1970s for countries to let their currencies “float”—that is, trade freely with a market-determined exchange rate. The average daily volume of FOREX transactions in 2013 was about $3 trillion, up from $2 trillion at the end of 2011 and $761 billion in 2008—phenomenal numbers. More than half of that volume is represented by dollar-euro and dollar-yen trades, according to the Foreign Exchange Committee’s Survey of North American Foreign Exchange Volume.
Foreign currencies can be traded outright as “spot” trades, or as futures, forwards, or swaps. FX markets are more like bond markets than stock markets—a loosely connected confederation of electronically connected, over-the-counter dealers, rather than a centralized market or exchange. By nature the markets work across borders, and thus aren’t subject to much regulation from any single country. There really isn’t any one single exchange rate; it is more a matter of the last trade that shows up “on the tape”—the electronic record from actual trades, and of the current dealer quotes being offered. Although these markets are set up more for large institutions and full-time players, most “retail” investors access these markets through specialized brokers set up for currency trading. Most retail investors play these markets through futures, which employ margin to expand the size of the transaction. More recently, regulators have moved toward allowing ordinary retail brokers to handle FX trading for their clients.
The exchange of currency is vital to the function of the growing global economy. While outright currency trading is complex and best left to specialists or dedicated individuals, the outcome of FOREX trading can have a big effect on what you pay for foreign goods, and on the greater health of the economy.
Your good friend John Smith, a registered investment adviser, wants your business. He wants to help you by investing your savings and managing those investments.
Your good friend Mary Jones, a broker working for YouNameIt Securities, a registered broker-dealer, also wants your business. She also wants to help you manage your investments.
What should you do? What do these people do, and what is their premise and promise in the management of your assets? Broker-dealers and registered investment advisers perform an important role in helping individuals (and corporations and institutions) manage their money, since perhaps they don’t have the time, expertise, and interest in doing so. It’s a service like any other service. But it’s good to know a few things about what these folks do, how they’re regulated, and what the pitfalls are before you pick one, if you decide that the “do it yourself” choice isn’t an option.
A broker-dealer is a company set up and in business to trade securities—stocks, bonds, and commodities—for its customers (as “broker”) or on its own account (as “dealer”). Most broker-dealers participate in the markets to make money for their own benefit. A broker-dealer is a corporation or some other business form, not an individual. Many broker-dealers are actually subsidiaries of larger firms—banks or other financial services companies.
Broker-dealers are regulated under the Securities Exchange Act of 1934 by the SEC (see #43 and #44). They are also self-regulated to a degree through a familiar trade industry group known as the Financial Industry Regulatory Authority (FINRA), formerly known as the more familiar National Association of Securities Dealers (NASD).
Registered investment advisers (RIAs), on the other hand, can be individuals or firms registered with the SEC or a state regulatory body to manage the investments of others. RIAs can work independently, for RIA firms, for broker-dealers, or for other non-RIA firms.
An RIA must pass an exam (FINRA’s Series 65 Uniform Registered Investment Adviser Law Exam) or show equivalent professional competence, fill out forms, and pay filing fees, but there is no required curriculum or technical standard of performance. The standards are more centered on customer care, including the commitment to act in a “fiduciary capacity” by always placing the interest of a client in front of personal interest. There are also standards for disclosure and avoiding conflicts of interest. These legal responsibilities are well known but can be difficult to enforce in practice; RIAs must keep accurate records and file periodic reports. RIAs are usually paid on a fee-for-service basis, while broker-dealers are typically compensated by per-transaction commissions.
The key difference between broker-dealers and RIAs in practice is liability: RIAs can be liable for the advice they give, while broker-dealers as firms are not. Further, there is no clear regulation of the conflict of interest in a broker dealing in the same securities for its own account while advising you to buy or sell them; it’s a bit like doctors making money from the drugs they prescribe for you. Not that this conflict comes into play continually, but it happens, and it’s something to be aware of.
Obviously, not all broker-dealers are bad, and not all RIAs are good. Read the disclosure documents and discuss them carefully to know who or what you’re working with, and keep the fiduciary standard in mind as you observe your adviser’s behavior and actions.
Let’s suppose you need not only investment advice, but also advice on handling your overall finances. You need the right insurance. You need to plan for college and retirement. You need to figure out how much money you need now and in the future, and how to provide for yourself, your family, and the eventual financial legacy you leave to your loved ones.
Unless you’re the strong, silent, do-it-yourself type (and there are a lot of you out there), you need a financial adviser.
Financial advisers are paid professionals who learn your financial situation, develop financial plans for you and your family, and help you find the tools—investments, savings plans, insurance, legal advice—to execute the plan. A good financial adviser looks at your personal and family goals, translates them to short- and long-term financial needs, and then develops, documents, and reviews a complete plan to meet the goals and needs.
Depending on the adviser, some may implement all or part of the plan—if they are registered investment advisers (see #82 Brokers, Broker Dealers, and Registered Investment Advisers) too, they may buy and sell securities on your behalf. If they are licensed insurance salespeople, they can sell insurance. If they are CPAs, they can do your taxes. If they are attorneys, they can execute trusts and estate plans. You get the idea.
There are two primary types of financial advisers, distinguished by the way they are paid. Fee-based advisers typically charge a mix of flat fees and per-transaction fees. The flat fees are tied to your asset base for general services; the per-transaction fees may be collected from you or from the providers of the securities they sell as commissions. Some criticize fee-based advisers for having an inherent conflict of interest, making money for selling XYZ family of mutual funds while supposedly also acting in your interest. Fee-only advisers don’t collect commissions, which reduces the risk of a conflict of interest between the adviser and the client if the adviser is beholden to another financial institution.
Financial advisers can come with a large assortment of credentials, some of which are more impressive than others. The Certified Financial Planner (CFP) is considered the highest in the food chain, with requirements for education, examination, and experience before practicing in the profession, and a strong fiduciary commitment to act in your interest besides. You’ll also see credentials like CLU (Chartered Life Underwriter) that point to a specialty in insurance, but many of these credentials also cover other elements of the financial planning process. For more on financial advisers and the financial planning process, the Financial Planning Association (www.fpanet.org) is a good resource.
As with most services, you should shop carefully for a financial adviser. Checking references, getting examples of what they’ve done for others, and checking credentials, experience, attitude, and personality all can play a part. They work for you, and their purpose, as well as their best interest, is to serve your needs.
Few industries have been revolutionized as much by technology as the trading of securities—stocks, bonds, futures, and the like. Electronic trading has speeded the function of the markets to the point where trades can be executed on a global basis almost instantaneously. That has in turn speeded up the pace of change and increased the need for quick decision making at all levels of business and government—and has spurred a whole new approach to securities trading, where algorithms and computer models can replace a considerable amount if not all human thinking and decision making. The effects are huge. We got a hint as we witnessed the 2008 market meltdown; there was scarcely any time to react as global markets swooned on even the slightest news. We got another big hint—really, a kick in the side of the head—during the so-called “flash crash” of May 2010, where computerized trading froze up due to a relatively simple set of triggering events, and the market plunged—for a few minutes. So while electronic trading only affects those traders in a given securities markets on the surface, the global impacts can be a lot larger.
For most of history, stock and other securities markets were physical markets like the NYSE, where people actually met face-to-face and traded stocks and securities (see #78 Stocks, Stock Markets, and Stock Exchanges). Communications like telephones and teletype machines connected those humans with other humans at exchanges, at securities dealers around the country, and in a few cases, around the globe. Those communications were rapid, but were only point-to-point—that is, one sender to one receiver—and the entire process was only as fast as the interaction of the humans at the end of the communication chain.
Improvements in communications and technology, notably networked computers, made it less important for buyers and sellers to work face-to-face. The NASDAQ automated quote system allowed market participants—dealers—to come together by posting quotes electronically; the entire market was visible to market players with the right level of access. This advance greatly superseded point-to-point communications; the markets could handle the actions of many participants at once. Personal technology allowed individuals to work in markets once restricted to big trading firms with large computer installations. Beyond the actual execution of electronic markets, all market players also had real-time access to information, including quotes, news releases, and company information.
Today’s trading is becoming more electronic, with buyers and sellers coming together on electronic quote boards known as electronic communications networks (ECNs). Some ECNs like Arca have been absorbed as part of the major exchanges (the NYSE in Arca’s case), providing an electronic trading platform within the exchange. The rapidly growing (and combining) BATS, Direct Edge, and other electronic markets noted in #78 have provided another major trading venue. Sophisticated “client” algorithms and triggers automate the entry of orders when certain price conditions have been met, and have enabled one computer to trade with another computer through the electronic network; humans barely need to be involved, except to set the conditions of order entry.
So-called “high-frequency trading,” where orders are triggered by algorithms and executed in milliseconds, even nanoseconds, accounts for some 50 percent of all stock market volume. High-frequency traders are attempting to capture tiny gains, over and over, by getting information “first,” and by capturing small differences in prices among markets, often less than a penny per share. High-frequency trading, while providing “liquidity”—volume and execution speed—to the markets, has also been described as unfair, as direct connects to exchange computers and newswire services give large firms involved in the game an unfair advantage. A recent ruling denied the release of University of Michigan’s Index of Consumer Sentiment indicators to certain traders (who paid extra) two seconds before the broadcast release, on the grounds that it was “insider information” giving advantage to those traders (see #85 Insider Trading).
If you’re a stock or other securities trader, it’s important to understand how the different trading platforms and markets work. If you’re not an active trader, it’s still good to be familiar with the forces behind today’s markets, and to be aware of how fast things can change, and why.
Suppose you wanted to buy into the corner ice cream store. It looks like a great investment, and the “fringe benefits” of being an owner seem appealing too. So the founder and majority owner offers to let you buy shares. You’re happy about your investment, and ready to cash in (and eat) the proceeds. Everything goes well; your investment rises in value, and you get a nice discount on two-scoop helpings of chocolate peanut butter ice cream besides. Eventually you need the money for something else, and sell for a reasonable profit.
Shortly afterward, you find out that a major operator of ice cream parlors wants to add that store to its chain, and is willing to pay a handsome price for it. Then, in a casual conversation with your neighbor across the fence, you find out that she bought a boatload of stock at a ridiculously low price because the founder/owner gave her a tip that this might happen. She got a tip; you didn’t. She bought; you sold. Is that fair? Should you, also an owner—and other owners—have been privy to the same news before you sold?
Although we’re dealing with a small business, not a big, publicly traded corporation, you’ve been a victim of insider trading. An insider got information you weren’t privy to, and made money on it. What happened here isn’t technically illegal because the ice cream parlor wasn’t “public,” but it gives you an idea of what could happen when owners, directors, key managers, or employees disclose certain private information to privileged investors and not to everyone.
Insider trading is the illegal trading of a public company’s stock or other securities based on “insider information”—information acquired as, by, or from someone who creates or has access to privileged information about a company not available to the general public. “Insiders” include company officers, directors, or beneficial owners (more than 10 percent) of a company’s stock. The general rule is that employees, by virtue of employment, put shareholder interests ahead of their own—all shareholders’ interests—so disclosing inside information to certain shareholders violates this principle.
That said, especially in today’s teleconnected world, you can see how easy it would be, say, for a large hedge fund manager or individual investor to get—or even buy—the “inside scoop” from even a fairly low-level employee and trade big on the tip. Think of what someone in a financial reporting, sales, or even a shipping department might know about a company’s products and prospects. Think of what professional securities analysts, who make their living talking to companies and following their fortunes, might know, act on, and disseminate illegally before the general public finds out. Think of what politicians and government officials, who might know what contracts are coming up or what purchases are about to be made, could do.
Several high-profile insider-trading cases have come up in recent years, and recent rulings have strengthened the hand of regulators to go after the perpetrators. Former hedge fund manager Raj Rajaratnam was sentenced to eleven years for his role in an insider-trading ring, where he set up at least four different insiders, three of whom were Harvard classmates, to pass information his way. This high-profile case has led to a greater crackdown on the activity, but it remains difficult to enforce, and especially to gain convictions. Still, the prospects of greater enforcement and jail terms have sent a powerful signal to corporate executives about disclosing anything that might be considered sensitive information.
First, if you’re an investor, know that you’re putting a lot of pressure on your friends and colleagues if you ask them to tell you what’s going on in the companies they work for. And if you work for a public company, be careful about what you tell others around you. Aside from that, insider trading has led to untold millions in profits for the perpetrators, at least indirectly at your expense. On the flip side, many feel that the recent crackdown has led to faster disclosure of information to the general public (once available to everyone, it isn’t “insider” any more), a good thing for all investors.
Buying on margin refers to borrowing from your broker to buy a security, usually a stock, a bond, or a futures contract. The security, or other securities in your portfolio, is used as collateral. When you borrow to buy on margin, you pay margin interest rates set by the broker, usually a fairly high rate, but not as high as a credit card. Margin buyers are trying to buy larger positions than they can afford out of pocket in order to get more exposure—leverage—from their investments.
To buy on margin, you must set up a margin account with your broker. Typically that means depositing a certain amount and signing several forms indicating you understand the terms and conditions. This can be done online with online brokers. And not all securities are marginable; some low-price or risky stocks, for instance, do not qualify for margin buying.
When you buy a security on margin, you must have enough collateral to make the purchase. This test comes in the form of a margin requirement, 50 percent for stocks, set by the Federal Reserve in the wake of the 1929 stock market crash. That means you must have at least 50 percent of the entire purchase available in your account as cash or equity. This is, of course, to prohibit you from borrowing too much, as many did in 1929 and before, when they borrowed up to 90 percent of their securities purchases.
That 50 percent requirement only applies to the initial purchase. After that, rules set by your broker apply. There is a minimum maintenance requirement below which your equity portion will trigger a sale or a request for more equity (cash) to be whole—this is a margin call. A typical minimum maintenance requirement is 35 percent, meaning that once your equity falls below 35 percent of the entire stock position, you get the call. So if you buy 100 shares of a $10 stock for $1,000, you can borrow $500 of the $1,000. If the stock drops below the point where the equity portion of the investment is 35 percent, you’ll trigger the call.
What is that price? The formula is: Borrowed Amount/(1−Maintenance Requirement). Got that? So if the maintenance requirement is 0.35 and you borrowed $500, the formula would give you the total securities value to match 35 percent, in this case $500/(0.65), or $769.23. That means that if your $10 stock goes down to $7.69, you will get a margin call.
Margin positions are evaluated each night for sufficient equity. The calculation of margin sufficiency is more complex with multiple securities in an account. Also, this example applies to stocks; the initial and maintenance margin requirements are different for commodities.
Margin can add power to your investment portfolio, but like any other borrowing, it can be dangerous, and should be treated accordingly. Margin interest rates, while moderately high, can be lower than some other forms of short-term borrowing, so it might make sense to use margin to get some cash from your investment account for certain purposes. On a larger scale, when stock margin borrowing levels increase in aggregate, it’s a sign that too many people are speculating on stocks and that a bubble might be forming, leading to a bust later on.
Short selling in financial markets is the practice of borrowing a security, usually a stock, and selling it in the market. The idea is to borrow and sell with the hopes of buying the security back, or covering, later at a lower price. It is done when you think the price of the security is too high. Note that short selling means something different in real estate (see #90 Foreclosure/Short Sale).
Short selling made the front pages during the height of the 2008–2009 market meltdown, when large hedge funds and short sellers drove down the prices of certain stocks, mostly in the financial sector. It was felt that short sellers “ganged up” on some of these stocks, creating an unnatural downward momentum. During that time the SEC initiated some short selling curbs on certain financial stocks, but many feel that such artificial curbs don’t have much real effect on the markets—a “sick” stock will go down anyway, with or without the curbs.
In stock market parlance, “going long” means you are buying the security; by “going short” you effectively own a negative quantity of a security. You owe the security and will pay margin rates (see #86) to borrow it, with many of the same margin rules in effect. In normal practice, you borrow the security from a real lender, arranged behind the scenes through the broker network. The lender is entitled to receive any dividends that may accrue during the borrowing period, and of course, to receive the shares back once the short sale is covered.
Short selling is inherently risky. Why? Because a stock can only go to zero on the downside, but rise, theoretically, to infinity on the upside. If it rises “to infinity and beyond,” you’re liable for the entire amount of that rise from the price you shorted it at.
Most short sellers are knowledgeable and seasoned professionals who employ good risk-management techniques to control potential large losses. In recent years there has been a rash of “naked” shorting, where sellers sell shares they don’t borrow or have (sometimes such shares can be in short supply). Naked shorting probably exaggerated the slide during the financial crisis.
If a stock or other security is being sold short, that isn’t always a bad thing for investors in that stock. Active short selling does mean that some investors—probably pretty good ones—are betting against the stock. It also adds supply to the market, driving prices down. But all shares sold short must be bought back, or covered, eventually, so assuming your company isn’t going bankrupt, that demand will all come back to market sooner or later.
Short selling serves a useful purpose in allowing individual investors to bet against a stock or company. It also adds liquidity to the market, and prevents the market from rising beyond reality—it is sort of a check and balance on the markets.
Unless you’re a fairly active and knowledgeable investor, short selling probably won’t be in your bag of tricks. If you do sell short, you must choose wisely and be prepared to follow closely. When short selling becomes rampant in a market (not always easy to tell, for so-called short interest statistics are published only monthly), it’s a sign of a “bear,” or down, market. The reversal of a short selling pattern can be quite sharp to the upside, as short sellers rush to cover; this phenomenon is called a short squeeze. In sum, short selling isn’t for the faint of heart; neither is owning stocks that are short seller favorites.
If you’ve been reading along, we’ve covered about every financial and financial market topic except real estate. For this and the next three tips, real estate assumes center stage.
Real estate is both a commodity and an investment. As a commodity it serves a useful purpose, and its price reflects the laws of supply and demand. As an investment, it requires an upfront purchase to generate cash returns later, either as income or as a capital gain upon selling the property. If you own your own home, those “cash returns” come in the form of rent you don’t have to pay.
Real estate markets operate quite differently from other financial markets. As the saying goes, “all real estate markets are local.” Aside from real estate investment trusts (REITs) and other investment vehicles, each piece of property is unique, and its price is determined by the supply and demand in that local market, as those of you who have tried to buy beachfront property or a home in the most expensive neighborhood in town already know.
Still, like all markets, we need some kind of pricing benchmark—like a market index, a commodity futures price, or an exchange rate—to know where that market stands compared to its past, and to determine how affordable a certain property is. That’s where median home price enters the picture.
Median home price is a statistics-based figure used to measure pricing in a given area. That area can be nationwide, regional, by state, by city, or even by neighborhood. For that geographic segment, the median home price means that half of the homes in a given area sold for more than the median price, and half of them sold for less.
If the national median price for single-family homes was $199,000 in mid-2013, that means that half of all of the single-family homes sold for more than $199,000 (think of those fancy mansions on the beach in Malibu), and half of them sold for less than $199,000 (think of the large numbers of modest homes in, say, St. Louis). That figure was over $230,000 in 2005 but dropped to $169,000 in 2009, so you can see how much the real estate market has fluctuated in recent years—and in many markets like Las Vegas and Phoenix it has fluctuated quite a bit more than that.
Median home prices are calculated by several agencies, the most prominent of which is the National Association of Realtors (NAR). The NAR publishes a quarterly list of Median Sales Price of Existing Single-Family Homes for Metropolitan Areas, with data stretching back to 1979. See www.realtor.org/topics/metropolitan-median-area-prices-and-affordability/data and other resources on that site.
Median home prices affect you as a homebuyer on a few levels. Of course, it is a quick read on the real estate market, and whether your home is worth more or less than it was, say, this time last year. Since medians are just that—medians—it’s important to look at median prices in your city, and better yet, in your neighborhood, to get an idea of your home’s worth.
You might also consider the varying regional median prices as a litmus test for where you can actually afford to live. While the national average as of mid-2013 is $199,000, you can look at prices, and the inventory and sales figures, which affect prices, in your city at the National Association of Realtors databank mentioned above. You can get median prices at your neighborhood level on Zillow (www.zillow.com).
Can you, or anyone else, afford a home in your area or in another area you might be hoping to live in? Clearly that’s not an easy thing to figure out. Equally clearly, your ability to afford a home in a certain area is a function of your income, and the average incomes of those in that area. So to determine affordability, economists and real estate professionals take the median home price for any given area and compare it to the median income for the same area to determine whether or not the housing stock is actually affordable. Can the people who live and work there actually afford to buy what’s on the market?
The measurement of home prices was covered in the previous entry. But these home prices don’t exist in a bubble; they exist in real communities that have real people with real jobs and incomes, and affordability actually lies in whether the average Joe in any given place can afford to buy at the median home price. If the median price for an existing single-family home in the West is at present $247,800, how many of the folks in that area make enough money to be able to comfortably afford that price?
In addition to median home prices, the NAR publishes the Housing Affordability Index. This index takes into account several factors, and gives you an idea of what it takes to afford a house in any given region.
The index, which is calculated over time and by region and is available at www.realtor.org/topics/metropolitan-median-area-prices-and-affordability/data under “Affordability Data,” compares median home prices to median income and determines whether the median income affords exactly the median home (index=100), affords more than the median home (>100), or affords less than the median home (<100). Factors included in the affordability calculation include the median price, the average mortgage rate, monthly principal and interest payment (P&I), payment as a percentage of income, the median family income, and the qualifying income. The calculation assumes a down payment of 20 percent and a total P&I payment not exceeding 25 percent of median income.
Here’s how the calculations work. Suppose we want a snapshot of housing affordability in the Midwest for example. Assuming a standard 20 percent down payment on a single-family house with the current median price of $143,100 at a mortgage rate of 3.66 percent and a thirty-year, fixed-rate mortgage (360 payments), the monthly P&I would be $526. This would be 10.1 percent of the $62,359 median family income in that area. In order to qualify for that loan you would have to have an income of $29,088, giving an affordability index of 206. So, is Midwest housing affordable based on this measure? You bet.
Housing affordability, like the median home prices, can help you determine whether a certain area or region can provide the kind of lifestyle you want at a reasonable price. Of course, beyond median family incomes, whether you can afford an area depends on what you earn, not the averages, and it depends on the home you choose. Still, housing affordability helps you make important lifestyle choices, and it also helps indicate whether real estate prices in a locale are in line with reality.
Not too long ago, the words “appreciation” and “opportunity” were the first to come to mind when the topic of real estate came up. Then came the bubble and the bust, and the words “foreclosure” and “short sale” dominated the listings and the conversation. Since then, the number of foreclosures has dropped significantly, but they still stubbornly remain an important part of the market, at least for the time being.
Foreclosure is a formal process that occurs when an owner cannot pay the mortgage on a property, and ultimately transfers title on the property from the borrower to the lender. A short sale is designed to “short circuit” that process; it’s an arranged distress sale to avoid the foreclosure. Both processes serve to get distressed owners out of an untenable situation, typically with both the lender and the borrower losing some in the deal.
Foreclosure is a lengthy and costly process that typically starts with a notice of default, which goes out when a payment is 60–90 days overdue. At that point, as an owner/borrower, you still have time to cover the obligation or arrange an alternative. After 90–120 days, the notice of default turns into a notice of sale where a court determines that a lender can start sale proceedings and evict the owner. When the title is transferred to the lender, it is known as real estate owned (REO), especially if the lender is a bank. Banks and other lenders, as a result of the huge numbers of foreclosures that occurred in 2008–2010, ended up owning far more property than they knew what to do with (see #88 Median Home Price). Just as bad, the foreclosure process is estimated to cost the lender some $50,000 to $60,000 to carry out.
Because of the glut of REO and the cost of fully pursuing foreclosure, many lenders opted to accept proposed short sales. A short sale is a negotiated deal between the borrower/owner and lender to accept a lower price on a sale to a third party, and in turn the lender is willing to accept less than the full amount owed for a property on which they hold the mortgage. Often the seller has little or no equity and might even owe more than the property is currently worth, and the seller usually must convince the lender that the situation is due to financial hardship. Regardless, it can be a win-win, for the borrower/owner gets out of the home and doesn’t take the hit of a foreclosure on the credit record, while the lender doesn’t take on any more REO, saves fees, and doesn’t have to worry about property deterioration while held as REO.
A borrower/owner must approach the lender for the short sale; the lender will not propose it. The owner must also show effort in trying to sell the property for market price for some period of time.
You don’t want to go through foreclosure, if at all possible. Not only do you lose your home and any equity you might have built up in it, but your credit rating can be blemished for as long as ten years. If you’re in trouble, you should evaluate all options, including short sales, deed in lieu of foreclosure (where you simply hand the keys back to the bank), and an assortment of government programs that continue to be in force, although they tend to have fairly strict qualification guidelines.
It’s also worth learning the mechanics of foreclosure if you’re a buyer. Foreclosures and short sales signal opportunity, and if you play the game right, you can still get a bargain. Most local realtors have developed the skills and knowledge (by necessity!) to deal in foreclosed homes.