Author: sgstofka

Leverage And Risk

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In a 9/23/09 WSJ op-ed, Andy Kessler, a former hedge fund manager, argues against the current administrations proposal to curtail excess bonuses that reward employees of banks and investment firms for taking excessive risks.

Mr. Kessler writes “It wasn’t reckless schemes and excessive risk that sunk banks and Wall Street; it was excessive leverage.” Wall Street investment firms had used that excessive leverage to make what they thought were fairly low risk bets. The complexity of oversight and of rule making to control employee pay makes it difficult to manage.

Kessler’s proposal is a sound one. Instead of a cap on bonuses, Wall Street firms should be charged appropriately for the “insurance” that the Federal Reserve and the FDIC provide Wall Street. That risk adjusted insurance charge will reduce the profit for more leveraged trades, effectively squeezing an employee’s pay on the trade. Kessler argues “let the Fed and the FDIC use to market to protect the market.”

The Gap And The GAAP

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GAAP – it’s not the clothing store but an acronym for Generally Accepted Accounting Principles, or guidelines for companies to follow when figuring up their financials, including their earnings. It is those earnings that are usually the basis for how much a company’s stock sells for. Public companies report their earnings to the government each quarter according to GAAP principles, and are called net earnings. From these earnings companies pay out dividends to their shareholders.

There is another common form of earnings, called operating earnings, which are higher than net earnings. Naturally, company officers refer to those higher earnings in conference calls to investors each quarter. Operating earnings do give a better sense of the long term viability and profitably of a company. What’s the difference?

Operating earnings are what’s left after paying employees, material costs and operating expenses, lease or loan payments and depreciation on buildings and equipment and so on. There are two costs that it doesn’t account for: taxes and interest. Net earnings are lower because that’s what left after paying taxes and interest. Net earnings will also include adjustments for what are called extraordinary items: one-time expenses that should not be recurring.

In a 9/18/09 “Ahead of the Tape” WSJ column, Mark Gongloff reports that the gap has narrowed between these two measures, operating and net earnings. The gap was about 2% and that narrow gap signals stability – for now. Mark notes that the last time the gap was this narrow was in the quarter ending March 2000. What he doesn’t mention is that, shortly after that date, the stock market started a long swan dive. Over the past 15 years, the cumulative gap between these two earning figures has been increasing each quarter. From past experience, we know that the gap widens during a recession. I suspect that this long term trend shows that there have too many aggressive accounting tactics so that management could paint a rosier picture of a company’s future earning potential, thus driving up the price of the stock.

Lastly, these two measures play an important part in evaluating the price of a stock. The P/E ratio, a common yardstick to measure stock price, is the price of a stock divided by the earnings per share. There are two common P/E ratios: TTM, or stock price divided by earnings during the trailing, or past, twelve months; and forward P/E, which is the stock price divided by the estimated earnings for the next twelve months. However, the two P/E ratios are based on two different earnings. The TTM ratio is based on net earnings. Forward P/E is based on estimates of operating, not net, earnings. Even if estimates prove to be accurate (which is unlikely a year in advance), the net earnings will be lower when they actually happen. If a 2% gap in these two measures is unusual, then a cautious investor might add another 4% to a estimate of future P/E to get a more realistic estimate.

Cities In Crisis

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Many cities in the U.S. rely on sales tax for revenues and are facing budget shortfalls as consumers cut back their purchases and businesses reduce their inventories. In a 9/18/09 WSJ article, Leslie Eaton takes a deeper look into the financial woes of cities.

Big cities are having the greatest difficulty. The Pew Charitable Trust analyzed 13 major cities and found budget gaps averaging 5%. However, city payrolls have become bloated over the past 15 years. Technological improvements during that time have led to great productivity increases in the private sector but that efficiency has apparently escaped city governments. During that period city government employees, excluding teachers, have increased 13%.

Solutions to city budget woes have included layoffs and mandatory furloughs, sales tax increases, deferring pension obligations and closing libraries. Several years ago Chicago had privatized their parking meters, forgoing that continuing revenue stream for a one time payment of $1.15B. At least they had the prudence to put the money into a rainy day fund, which they raided this year to close their budget gap.

As unemployment rates stay high and consumers pay down debt, the budget problems of many cities will continue. Property taxes are a fairly stable source of revenue for many cities but reduced housing valuations will cut those revenues as well. For city officials this downturn has prompted a soul searching look at what are the core responsibilities and priorities of a city government.

Total Place

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Here’s an idea from Britain that American taxpayers might want to adopt. In a 9/2/09 Financial Times article, Nicholas Timmins, the public policy editor, summarizes a concept called Total Place, a comprehensive analysis that adds up all the public money spent in a region. In Britain, the results of two pilot studies has raised some eyebrows and led to the call for several more studies.

In the U.S., the Census Bureau maintains statistics on the amount of funds that state sends to and gets from the Federal Government. But there is no comprehensive analysis of total Federal, State and local public spending. Would we find the same disparities in per capita spending in regions of similar population density and how would we react if there were striking differences?

NHS vs US Health

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The good, bad and ugly of the American and British health care systems. In an 8/15/09 FT article, Nicholas Timmins gives a brief comparison of the two systems.

In a 9/15/09 PBS program, “Retirement Revolution”, host Paula Zahn spoke with a doctor who has worked in both systems. The doctor summed it up: The British NHS works well for most patients whose disease presents no particularly difficult or unusual complications. The American system, with much more emphasis on advanced technology and public funding for academic institutions, is better for those patients who do have unusual complications.

At town hall meetings this summer, some Americans touted the U.S. health care system as the best in the world, citing the estimated 400,000 people who come here each year to get medical care. An 8/24/09 AP article cites a 2007 estimate that almost twice that number, 750,000 U.S. citizens left the country to get medical care elsewhere. Estimates by the Medical Tourism Board for 2010 are that 1.6M patients will leave the U.S. for care outside the country.

Public Option

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Some people in this country have expressed concern that a “public option” in health care would drive out private insurance companies. The warning is repeated over and over again as though this prediction were fact. We have a history of a public option competing with private insurance companies – Workmen’s Compensation Insurance. Has it driven private companies out of the market? No.

In an 8/16/09 San Diego Union Tribune article, Dean Calbreath relates the early history of Workmen’s Comp insurance and the criticism that Pres. Woodrow Wilson endured from conservatives for initiating a public medical plan for workers. Dean recounts the century long struggle between private insurance companies and the California State Fund in this insurance market. The result? Private insurance companies in California dominate the Workmen’s Comp insurance market. Yet there are those clamoring that such a thing is impossible.

Were we to have a public option in health care insurance, a plan covering basic insurance needs, we might expect that private insurance companies would design insurance plans that filled the gaps left by such a public plan. Just as workmen’s comp insurers did in California, health insurance providers will offer competitive pricing to larger companies and command the majority of the market. Like the workmen’s comp example, the public health insurance option will appeal to small businesses and those individuals who have difficulty getting affordable insurance.

Had they been born a hundred years ago, those arguing against a public option today probably would have argued against Workmen’s Comp then. This debate is less about public insurance options and more about the role of government, a long and fierce argument that began before the founding of this country and continues to this day.

A hundred years ago, Andrew Carnegie was criticized by conservatives for his support for the use of public taxes for libraries. Public libraries did sometimes swallow up the collections of social libraries that charged a subscription fee to members. However, libraries whetted a desire for books, and private booksellers fluorished in larger cities to meet the demand for popular newly published books, a need that libraries were not designed to satisfy.

In smaller towns like Kankakee, Illinois, citizen-initiated drives for a public library were met with resounding support from their neighbors; private donations of books and land helped launch the library in 1896. Does President Obama hope that this kind of community spirit is still smoldering in the hearts of Americans?

How can any company possibly compete with a public entity as large as the Post Office? UPS, FedEx and other private mail and package delivery companies have met the challenges of this competition and fluorished. The once stodgy Post Office, in turn, has offered new services and products to compete with these private companies.

In the 1850s, conservatives protested loudly at the use of public dollars to fund free education for children. Has public education led to the demise of private schools? No.

The competition between a public option and private companies in insurance, libraries, mail delivery and education have promoted a vigorous environment which offers better choices to the public. To those who predict that a public option will kill the private insurance market, history replies, “You’re wrong.”

Consumer Debt

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Each quarter, the Federal Reserve calculates the average percentage of debt payments to income for households in the U.S. In 1980, credit card and automobile lease payments were about 11% of disposable, or after tax, income. By 1998, they had climbed to 12%. In 2006, that percentage broke 14%. During 2008, the American consumer has been whittling down that percentage to about 13.5% of disposable income.

Every 3 years, the Fed conducts a detailed survey of consumer finances. In its most recent released 2007 Survey of Consumer Finances, the Fed found that 2/3 of families had applied for credit in the past five years. 30% of those had been either turned down or been approved for less credit than they applied for (pg 45). 73% of families had credit cards but only 60% of those with credit cards had balances due, a healthy sign that families were paying off their credit card balances each month (pg 46). However, those holding credit card balances saw a 25% increase in their balance to about $3000. The median interest rate on a bank type credit card was 12.3% (pg 47).

Einstein said that compound interest was the most powerful force in the universe. When we owe debt, that power of compound interest is working for the other guy, the company we owe the money to. That 12% in interest we pay to a credit card company is in after tax dollars, meaning that it is more like 15% – 20%, depending on the tax bracket we are in. Translating that into hours, it means that we may work 1/2 day to a day each week just to pay the interest on the debt. We become someone else’s work slave.

Asset Allocation

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A portfolio analysis adds up your investments in various categories to determine your asset allocation, a measure of the anticipated risks and returns of a portfolio.

The historical returns of stocks are higher but so are the risks. Bonds have less risk and less return. More importantly, there is a historical inverse correlation between stocks and bonds so that bond prices usually rise when stock prices fall and vice versa.

These historical trends were broken during the past year as almost all asset classes fell. Since March 2009, both bond and stock prices have risen dramatically. The recent crash and credit crisis has made people more cautious and we can expect that money will continue to flood into the perceived safety of bonds. How long can both stocks and bonds rise? When will the inverse relationship reassert itself? Which is the more powerful emotion? Will fear continue to drive money into bonds or will greed goad investors into the more risky stock market?

Asset allocation can dampen the emotional driving forces behind your investment decisions.

In an October 1999 WSJ article, Jonathan Clements examined the finer points of asset allocation with some investment professors. Most people calculate their asset mix by adding up the value of their stocks, bonds and cash. An old maxim is that the percentage of bonds and cash in your portfolio should approximate your age. The truest maxim may be “Go with your gut.” If you can’t sleep at night worrying about your investment portfolio, then it’s time to ease up on the risk in your investments.

So what about your house? House prices historically rise 3 – 4% per year, a return that approximates the return on a bond. When calculating your asset mix, should you include the equity of your house in with the total of your bond investments? A real estate professor that Clements interviewed maintains that a house is not a conservative investment. Historical data shows that, over a period of three years, housing prices have sometime fallen 40%. Remember, this article was written in 1999. How many people heeded that advice and treated the equity in their house as though it were more like an investment in a stock fund?

An investments professor interviewed by Clements “suggests treating your mortgage as a negative position in bonds”, subtracting the amount of the mortgage from the total bonds in your portfolio.

The point of analyzing a portfolio is to assess the risks that your investments are exposed to and that you personally are comfortable with. In this past year, too many older Americans found out that they were exposed to a lot more risk that they thought.

Heirs Looking At You

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In a (undeterminate date) 2005 WSJ article, Jonathan Clements shares some retirement advice from a Pittsburgh accountant and estate-planning lawyer, James Lange, author of “Retire Secure” and a web site devoted to IRAs and other retirement strategies. “Spend your after-tax dollars first, and then your IRA dollars and then your Roth dollars.”

Children inheriting a regular or Roth IRA have to start taking minimum withdrawals based on their life expectancy. For a regular IRA, they will owe tax on the amount of the withdrawal. Withdrawals from a Roth IRA are income tax free.

Most people will not leave estates large enough to trigger an estate tax (in 2009 the threshold is $3.5M).

Many employer sponsored 401K accounts require beneficiaries other than a spouse to cash out the account. In this case, it may be wiser to convert the 401K to an IRA.

Health Reform Republican Plan

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Republican politicians and conservative talk show hosts have devoted plenty of time slinging arrows at Democratic health insurance reform proposals. Occasionally, I hear a talk show host or a Republican politician on a Sunday morning talk show mention the Republican health care plan but few or no details. Instead they continue to heap scorn on “Obamacare”.

When someone prefers to attack rather than explain their alternative, I get suspicious. Maybe the Republican plan sucks, I thought, and that’s why conservatives don’t offer summaries of the plan. If you, like me, would like to know what the Republican health care plan is, you can check out a Roll Call summary here on the Real Clear Politics website. It has some good features, notably the reduced government “footprint.”

As a small employer with several experiences with state insurance agencies, I am leery of government insurance solutions. In Colorado, Labor Dept employees seem to assume that the employer is at fault or lying, although a spokesman for the Labor Department would probably deny it.

An employee is taken at his or her word and it is up to the employer to prove that the employee is mistaken. Conversations with several other small employers in this state have confirmed this attitude on the part of state agency employees.

While there have been court decisions to clarify “reasonable grounds” or “reasonable suspicion” in criminal cases, there seems to be little precedent to stipulate what “reasonable grounds” are in civil and regulatory matters. If a state auditor feels they have reasonable grounds to believe that an employer is guilty of breaking one of the hundreds of state laws affecting employers, then, unlike criminal cases, the employer must prove their innocence.

I am afraid that this same attitude will prevail when the Federal government injects itself even deeper into health care and insurance in the U.S. Doctors and health care providers will be in the same position as employers, needing to prove their innocence. As patients, we might think that such a presumption of fault on health care providers is a good thing. Such a presumption will only cause more doctors and health care providers to leave the medical field. After all, who needs the aggravation?

Even without health care/insurance reform, there will not be enough doctors and health care providers for the juggernaut of the aging baby boomers. With or without reform, there will be delays in getting medical appointments with primary care physicians and specialists. We need reform and this is the time to do it. I can only hope that our politicans will use some care and sober judgment as they craft a reform bill.