To Infinity... And Beyond!

Here's an interesting aside, Paul Krugman, an economist and columnist for the New York Times, recently posted on his blog an old thesis he penned when he as an assistant professor at Yale. The title "The Theory of Interstellar Trade." You can find it here.

Here's the abstract:

This paper extends interplanetary trade theory to an interstellar setting. It is chiefly concerned with the following question: how should interest charges on goods in transit be computed when the goods travel at close to the speed of light? This is a problem because the time taken in transit will appear less to an observer travelling with the goods than to a stationary observer. A solutoin is derived from economic theory, and two useless but true theorems are proved.

Krugman is, of course, referencing Einsteins special theory of relativity, which describes how time slows down as you approach the speed of light, from a stationary observer's perspective.

Yes I am going to read this. And yes I am going to waste your time with a post on it (after I get back from Spring Break).

What can you learn from that post? Not much. Certainly not anything relevant to what is going on right now in our economy. Thankfully, it is not my intention to educate you about anything timely in this post. Krugman's paper is a concerted appreciation of economic theory (all "publish or perish" arguments aside), as transposed into another interest in the author's life: science.

A paper like this is simply play, and to some extent, that is what this blog is. While I can really only speak for myself, I believe that the authors of this blog spend their time writing because economics and finance truly interests us enough to think and write about in our free time. Of course, a powerful incentive is educating you, but in all honesty, that would have only produced a few posts a month if that were our only motivation.

We hope you develop similar intellectual appreciations, as you learn more in your respective collegiate pursuits. But please don't restrain yourself to any one practice, or academic microcosm. I tip my hat to both the non business/economics majors who read this blog, as well as the business/economics majors who look elsewhere for intellectual stimulation. I personally wish I could have written about when scientists recently mathematically observed the elusive Hawking radiation, as found through a Bose Einstein Condensate (please ask me about any of these things, if you are so interested), or how we recently FINALLY found dark matter. But this blog is not the proper vehicle to express those passions.

So keep reading, and keep learning.

One more Bear on our endangered species list....

So Bear Sterns is in trouble again. They had big problems last year, when two of its hedge funds blew up, but it looks like this could ultimately be a killing blow for them.

What happened? According to the WSJ (this article's citation is available at the bottom of this post, in case you can't get to it), Bear's management hasn't been doing a good enough job at reassuring their investors and other stakeholders (e.g. customers and business partners) that the company is financially stable. Well, BSC's investors got nervous, and there was an enormous deflation of their market cap ( 5 day price chart, 1 year, 1 year compared to another ibank, Goldman Sachs), as everyone scrambled to get out. It looks like the S&P is feeding the fire, downgrading Bear's credit rating to BBB, and suggesting that further downgrades are likely. Forbes.com reports their market cap, as of 3:45 today, to be around $5bln, about half that of their book value.

Losing all of that money is a death knell for an investment bank, which depends on the capital provided by equity investments in them for the liquidity necessary for daily operations.

So what is being done? Well, when commercial banks have liquidity issues, our government's central banks offer them emergency funds, in the form of secured fed loans, in order to keep afloat. In this case, JP Morgan Chase & Co, a commercial bank (among other things) is serving as a conduit through which the Federal Reserve Bank of New York can offer Bear Sterns emergency funding. In case you are wondering why they are a part of the deal, JP Morgan is on a very short list of commercial banks, which doesn't include Bear Sterns, allowed to borrow through the Fed's discount window.

The WSJ discusses in a different article how the Fed and not JP Morgan, is bearing the risk of the loan. This decision, which invokes an ancient ordinance from the 1930s, is potentially exposing the Fed to more risk at the moment than they normally have, lending through their discount window to their usual staple of banks during regular money market operations.
This is decision is quite unusual, and is probably more indicative of our government's larger concern about the state of America's financial sector than their concern over saving one (albeit very big) investment bank.

This is only a short-term solution for larger financial problems that probably beleaguer Bear Sterns, which explains the S&P's downgrade decision. Bear Sterns is now forced to consider all of its strategic options, which includes being bought out.

A side note: As this WSJ article suggests, JP Morgan is incurring costs of its own by helping the fed in this way. Obviously, those costs don't include bearing any risk on their behalf, the fed is shouldering that burden. But the work involved is consuming JP Morgan's employee's valuable time, which apparently has a real affect on their stock price.

*In case you can't reach the Wall Street journal article, the title is "Bear Sterns to Get Backing From J.P. Morgan, N.Y. Fed" and was written by Kevin Kingsbury, Andrew Dowell, and Serena Ng.

Market Summary: Thurs. March 13, 2008

Things didn’t look pretty this morning as the selling pressures from yesterday spilled over to today. We got awfully close to testing Monday’s lows (lowest prices before Fed’s $200B announcement), but never broke through them. There were three major causes of the early morning selling: 1) talk of Carlyle Capital going under because creditors were making claims on their assets, 2) liquidity concerns at Bear Stearns, and 3) weak retail sales data.

Carlyle Capital failed to meet $400M+ worth of margin calls related to mortgage-backed securities and its investors began to claim their assets while they still have some value. The company also announced it defaulted yesterday on $16.6B worth of debt. As stock and home prices continue to decline, Carlyle said they expect an additional $97.5M worth of margin calls (Source: Bloomberg.com).

Bear Stearns (BSC) fell 7.5% to $57.00 because investors are uncertain the company has enough capital to remain solvent. Massive amounts of put options (bets that the stock price will decrease) with a $25 and $30 strike price were traded today, basically signaling traders believe the stock price will be cut in half by next Friday (when these options expire). If one of these companies is having problems like this, who knows how many other companies are experiencing the same thing (Source: Bloomberg.com)?

February retail sales declined 0.6%, and excluding autos sales declined 0.2%. Last week, many retailers reported monthly same-store sales and the numbers were not too great, so this number reported today is not too big of a surprise.

Stocks made an abrupt reversal at 10am after S&P announced they see write-downs related to sub-prime mortgages coming to an end soon. The company increased its write-down forecast to $285B from its previously estimated $265B, but the end is “now in sight” (Source: Bloomberg.com). The company also said “the positive news is that, in our opinion, the global financial sector appears to have already disclosed the majority of valuation write-downs of sub-prime” related securities” (Source: Fortune.com, CNBC.com).

In my opinion, this statement doesn’t mean too much. S&P missed the beginning of this whole sub-prime mess and they have been behind the curve ever since. I don’t see how they can estimate write-downs will come to an end given that the credit ratings of the mortgage and bond insurers are still uncertain. When housing prices bottom, then I’ll believe the write-downs will come to an end.

In other news, the Dollar sunk to new all-time lows and gold futures briefly traded above $1000. Everyone knew gold was going to trade at $1000, now it will be important to see where we go from here. You have to realize we didn’t “break through” $1000, rather we just “touched” it. This is something that happened to oil late last year and it traded sideways for some time before recently “breaking out.” Oil futures hit $111 as the Dollar continued its slide.

- Morgan Stanley downgraded GM and Ford and predicted weak sales in 2009

- Morgan Stanley also downgraded AIG to “equal weight”

- February foreclosures were up 60%

- Chrysler is shutting down production for 2 months this summer

- According to Bloomberg.com, futures show that there is an 86% chance the Fed will cut rates by 75 basis points next Tuesday

- Initial jobless claims remained steady at 353K

Tomorrow, the CPI data will be reported. Everyone knows the number is going to be bad and it is already priced in to stocks. So, if we get an unexpectedly tame number, I foresee a big rally. If the number is really bad, we’ll probably just drift lower throughout the day into the close just like we have the past few Fridays.

DJIA 12,145.74 +35.50 (+0.29%)
Nasdaq 2,263.61 +19.74 (+0.88%)
S&P 500 1,315.48 +6.71 (+0.51%)
NYSE Volume 5,083,948,000

2-Yr Bond 1.63% unch
10-Yr Bond 3.56% +0.07
30-Yr Bond 4.47% +0.07

Dollar Index 72.072 -0.332
Crude Oil (Apr) 110.33 +0.41
Nat Gas (Apr) 10.230 +0.219
Gold (Apr) 993.80 +13.30

Market Summary: Wed. March 12, 2008

After yesterday’s rally, I wasn’t too surprised the markets took kind of a breather. Tomorrow will be a very important day, even more so given today’s lackluster performance. Everyone always talks about “follow-through” and we didn’t have that today. Basically, a one-day rally doesn’t mean much, especially in this kind of volatile market.

The main reason we were down today was because some of the big banks came out and said the Fed’s $200B plan might not help them that much (Source: CNBC.com). This news sparked selling in the financials and the market followed. Bonds had a huge rally as the Dollar hit another all-time low. Many people are worried this Fed plan won’t work and investors continued to pour their money into safer investments than stocks – right now, one of them is crude oil. Today, crude oil passed $110 and there seems to be no end in sight. As long as the Dollar continues to lose ground everyday, a barrel of oil will looker cheaper and cheaper to foreign investors. Today’s inventory report showed a larger than expected build, but prices did not seem to be affected by this usually-bearish news. I’m getting a little cautious at these levels because a lot of this move is due to speculation and oil is not trading on its fundamentals anymore – supply and demand. Many, though, will argue that oil hasn’t been trading on its fundaments for the last year (Source: Bloomberg.com).

In other news, Caterpillar reaffirmed their earnings estimates for 2008, but they did not raise guidance for 2008 (Source). The stock was up 3.64% on the day. The airline stocks have been getting crushed lately because of high oil prices, and it was no different today. On CNBC, an analyst reported that regardless of how the economy does over the next year, the airlines will not record a profit. JPMorgan also lowered its earnings estimates for many of the companies. Southwest (LUV) was forced to ground 41 plans because of inspections (Source: Marketplace).

The healthcare group was under lots of pressure again today. Yesterday, WellPoint got crushed after lowering its guidance, and today, Humana cut its FY2008 profit by about 25%. HUM finished the day down almost 14% (Source: CNNMoney.com).

Tomorrow is jam-packed with economic news. February import and export prices will be announced (today, the Treasury Budget deficit was reported at $175.6B), initial jobless claims and retail sales will also be reported.

There are no big earnings reports tomorrow – just a bunch of smaller companies like Jamba Juice, Aeropostale, and Eddie Bauer.

DJIA 12,110.24 -46.57 (-0.38%)
Nasdaq 2,243.87 -11.89 (-0.53%)
S&P 500 1,308.77 -11.88 (-0.90%)
NYSE Volume 4,399,095,000

2-Yr Bond 1.63% -0.11
10-Yr Bond 3.49% -0.11
30-Yr Bond 4.40% -0.13

Dollar Index 72.404 -0.873
Crude Oil (Apr) 109.92 +1.17
Nat Gas (Apr) 10.011 +0.011
Gold (Apr) 980.50 +4.50

Margin Calls 101

A combo post by Bellz and DLight:

Here, I'll do my best to explain margin calls and how they are affecting the markets and stock prices. Some of the biggest funds (the one's that determine market prices) borrow money from their brokers because they can borrow at a lower rate compared to the rate of return they expect to receive from their investments. Everyday investors like you and me can set up a margin account where we can borrow up to 50% of our portfolio's total equity (usually). If I had a $50,000 portfolio, I could borrow up to $25,000 making my portfolio's value $75,000. Some of the big funds, though, can borrow up to 15-25x the amount of cash (or cash equivalents) in their portfolio. Carlyle Capital, the company that has been in the news lately because of margin calls, is rumored to be levered 30x, i.e. they were borrowing 30x the value of deposits that had been given to them by investors.

Now, why do funds borrow money? It allows you to make much more money if you can play the game correctly. For example, a hedge fund will borrow cash at an 8% interest rate, but the fund expects to earn 15% on its investments, so it makes 7% extra because of borrowing. Sounds great, right? That's assuming they are making a greater return on their investments compared to the interest they are paying on their borrowed funds. It also helps when the market is good and trending upward. This is a very risky strategy with the potential for fabulous returns, but only the biggest funds are allowed to be highly levered. You call this fund "levered" because they are using borrowed money to increase their purchasing power so they can invest in more stocks – by borrowing they create power, or leverage, over the returns they are capable of generating.

However, we are running into a problem with the current financial markets because prices are declining. Funds have to maintain a minimum "maintenance" balance, i.e. they have to have enough equity to use as collateral to support their borrowing. So, let's set up an imaginary hedge fund to show what happens when a portfolio's value declines and a fund is faced with a margin call.

In July 2007, the company has $1B in equity (cash from its investors tied up in stock) and $1B in borrowed funds (cash from its creditors tied up in stock). Like I said before, big funds can be much more "levered," but for simplicity sake, we'll use a 1 to 1 ratio. When you borrow funds you need to put up collateral, and these funds use their equity (stock purchased using their investors’ money) to borrow more money (which will be used to buy more stock). A brokerage house loans $1B to this hedge fund and according to the borrowing contract the fund cannot let debt exceed 60% of the total value of their portfolio – this is their "maintenance" balance. If the value of the equity in the portfolio dips below 40%, the fund will be forced to liquidate (sell) some of its assets or come up with more cash to give to the banks. These maintenance (or margin) requirements are how the banks try to protect themselves.

Now it's January 2008 and stock prices have declined significantly since July. The portfolio's value has declined by 10% so its total value is now worth $1.8B. But how does this break down? Well, they still have a $1B loan outstanding that they have to pay back, so their total stakeholder equity is now $800 million, a 20% loss. This is why borrowing to invest is so risky. When a fund is 1x levered, the equity portion of the portfolio increases or decreases 2x the amount of the portfolio's performance. Gains or losses are exaggerated based on how much the fund is borrowing. There is no margin call just yet.

Now it's March 2008 and stock prices have gone down even further. The portfolio's value has declined by 20% so it is now worth $1.6B. They still have the $1B loan so equity is worth $600M. The equity portion has actually declined by 40% because the fund still owes the lender $1B. Debt now makes up 62.5% (1,000/1,600) of the portfolio, so the fund will be forced to sell (sometimes the broker will liquidate assets without letting the fund know, the broker will always do that for you and me) or "de-lever" in order to get back to the contractual agreements of the loan. Everything they sell goes to pay off the loan. The fund currently has a total portfolio value of $1.6B. To get back to the maximum 60% debt threshold they have to sell at least $100M of their holdings leaving them with $600M of investor capital and a $900M loan (900/1,500).

So you've seen how taking on leverage creates power. It can substantially boost your returns both up and down (remember, a portfolio levered 1x sees actual appreciation/depreciation of 2x their equity value), but too much leverage can also cause forced selling of securities. Forced selling then forces lower prices, which may cause a margin call on someone else, which would cause more forced selling, which would cause lower prices...are you seeing the vicious cycle? That's why when you start hearing about major mortgage calls, it's a real risk.

Why did agriculture and energy stocks struggle at the end of last week? We were getting margin calls. Ag and energy have had a huge run, so they're the easiest to sell, so you saw them get beat down a little bit because of redemptions to give funds more liquidity.

Stocks post biggest gain in 5 years; Google buys DoubleClick

Well, Google (GOOG) didn't buy Digg, but was approved to purchase DoubleClick for 3.1 Billion dollars. You may have not heard about this deal because it was announced 11 months ago. The reason it took this long is that it needed to be approved by United States regulators (which happened in December) and the European Union, which just happened today. What will DoubleClick do to help Google? According to Google Chief Executive Eric Schmidt, "combining with DoubleClick would allow Google to more quickly bring to market advances in technology and infrastructure that would dramatically improve digital media and better target advertising to users" (AP). In simpler words, it will provide better features for those who use Google Ad's to make profit. However, there is some bad news for DoubleClick employers. Reuters reported that Google will make an unspecified number of job cuts from the 1,500 current DoubleClick employers (Reuters).

So what should you do with Google now? Well, my plan for shorting Google for the rest of the week backfired. I looked like a genius after Monday, but with DoubleClick under Google's belt, Google would have skyrocketed even without the Fed's Credit plan. What I think you should do is buy Google now, or just get rid of Google. They needed something to rebound from their tumble. Google's high was 741.79 on November 6th 2007. It has been falling ever since- its low of 413.84 was yesterday (March 10th, 2008). Google reports earnings April 17th, 2008. I think Google will beat earnings, as do analysts according to Yahoo. Its hard to say what Google is going to do between now and April 17th. If you are a relatively young investor, I would buy now. If you are older, say over the age of 30, wait until the 2nd week of April to buy Google.

In another news, Stocks posted their biggest gain in 5 years. The reason is mostly due to the Feds credit plan. The Federal Reserve plans to pump $200 billion into the financial markets to help ease the strain from the credit crisis (AP). The Dow Jones industrial average went up 416.66 points at the 12,156.81 level. That's the index's biggest one-day point gain since July 24, 2002 (AP).

Market Summary: Tues. March 11, 2008

Well, well, well…the Fed finally got creative. If you missed it, the Fed announced they will provide $200B worth of Treasuries to primary dealers (investment banks) for a term of 28 days in return for AAA-rated mortgage backed securities. This new tool, called the Term Securities Lending Facility (TSFL), is different than the Term Auction Facility (TAF) which was only targeted at commercial banks. This move is just what the financial markets needed. This unique intervention pretty much replaces an inter-meeting rate cut (which everyone was calling for) and targets the exact problem in the credit markets – liquidity issues.

Basically, the government said they will accept banks' mortgage-backed securities (MBS) in exchange for a safer investment – government Treasuries. Some of the banks' MBS are at risk of defaulting and many have declined significantly in value over the last few years as home prices have fallen drastically. This move caused lots of short covering and many of the stocks that have been knocked down the most over the last few months (financials, mortgage/bond insurers, homebuilders) got the biggest pop today.

Now, we have to start thinking about what the Fed will do at their next meeting March 18^th. Before today’s move the market had at least a 75 bp cut priced in, but now the Fed won’t need to cut that much. Today’s move prevents inflation from spiraling out of control and prevents the Dollar from continuing its precipitous decline. My hat goes off to Bernanke and his team for their creative approach to solve this worldwide crisis.

We probably saw at least another short term bottom in many of the financial stocks until some more bad news surfaces. What we have to remember is this move does not immediately fix our problems. Investors are very optimistic right now and look for this rally to continue for a few days. There was no “sell the rally” like we have been seeing for the past few months – on any good news, investors were selling. The write-downs by the banks will still happen, they just might not be as big anymore.

Something very important to note is that this plan is being coordinated with the European Central Bank, the Bank of England, and several other banks. Foreign banks are expected to provide up to $45B in funds (Source: Bloomberg.com). This is a worldwide crisis and now there is a worldwide effort to try and fix the problem.

Bonds sold off on this news and the dollar rebounded slightly. Many of the emerging market ETFs were up huge. Bear Stearns was down huge in early trading because an analyst cuts its price target in half and warned of more write-downs. Oil almost hit $110 during trading and settle at about $109.

Also, Google popped “after European Union regulators cleared the Internet company's $3.1B bid for online ad tracker DoubleClick” (Source: Finance.yahoo.com). GOOG was up $26.

The January trade deficit was slightly greater than the December deficit.

Sprint Nextel was down huge after it had its earnings estimates cut (Source: MSN.com).

Here are the results from yesterday’s $50B Term Auction Facility.

There were 82 bidders that submitted $92.595B worth of bids. The going rate was 2.80%.

DJIA 12,156.81 +416.66 (+3.55%)
Nasdaq 2,255.76 +86.42 (+3.98%)
S&P 500 1,320.65 +47.28 (+3.71%)
NYSE Volume 5,309,577,000

2-Yr Bond 1.74% +0.27
10-Yr Bond 3.60% +0.14
30-Yr Bond 4.53% +0.08

Dollar Index 73.277 +0.284
Crude Oil (Apr) 108.75 +0.85
Nat Gas (Apr) 10.000 -0.024
Gold (Apr) 976.00 +4.20

Latest Poll Results

Something to keep an eye on...

Will shares of Google (GOOG) trade below $400 this month?

Yes - 7 (50%)
No - 7 (50%)

Blindsided...

This morning we got blindsided by the Fed. Over the past 6 months this would be undoubtedly bad news, but today they got it right. They got creative. Their solution involves allowing banks (mainly investment banks) to borrow money for 28 days using their mortgage-backed securities as collateral. This solution will help bring liquidity back to the system more than a rate cut would have. A rate cut is like blanket bombing, it affects the whole economy. Further rate cuts could create a serious inflation problem just months down the road. The Fed's new program is much more precise, which is exactly what we need. It helps to fix the mortgage-bond market. However, don't feel like were out of the woods. As long as house price depreciation continues... we'll be in big trouble.

For today, the Fed did phenomenally to address our problems at their core by using a much more creative and precise solution than they have previously.

Market Summary: Mon. March 10, 2008

The financials, as well as Eliot Spitzer (NY Governor), stole the day’s headlines as more credit and liquidity problems surfaced.

Morgan Stanley cut earnings estimates for the major U.S. banks by $8.8B because of “severe” deterioration in the credit markets (Source: Bloomberg.com). There was also talk of job cuts at Citi (30,000) and Lehman Brothers (up to 5% = 1,430). Citi also announced they expect up to $9B more in write-downs.

Bear Stearns was the main laggard (down 11% on 4x the normal trading volume) because of rumors that the company was out of cash and might be insolvent. Bear Stearn’s CEO said “there is absolutely no truth to the rumors” and that their “balance sheet, liquidity and capital remain strong” (Sources: CNNMoney.com, Bloomberg.com).

Many of the mortgage and sub-prime lending companies got hammered because they are under an FBI investigation. Countrywide Financial, Ambac, MBIA, Freddie Mac, and Fannie Mae were the big losers.

Also, Fitch Ratings downgraded Washington Mutual’s long-term default to BBB from A-. Shares of WM closed at $10. The stock was trading as high as $45 in July 2007.

Not all of the day’s news was bad. McDonald’s reported that same store sales for February increased 11.7%. Also, the January Wholesale Inventory report came in at 0.8% when analysts were only looking for a 0.5% increase.

Something very important to note that was discussed on Fast Money. People are investing in crude oil futures almost as a safe-haven investment – just like the flight to quality in Treasuries. Many speculators are jumping back in because this is the only area of the market that seems to be going up in price. The upward and downward moves are going to be exaggerated, so if you can stomach the volatility and find a nice entry point, the energy complex might be a good place to put some money.

Some other important news…

- Thornburg Mortgage was down 55% after it was downgraded to “underperform.”

- Gasoline hits $3.19/gallon (national average)

- Crude oil rallies to $108/barrel à airlines very weak

- Goldman Sachs expects oil to reach $200/barrel

- NY Governor Eliot Spitzer is believed to be involved with a prostitution ring

- After the bell, Texas Instruments lowered its Q1 earnings and revenue forecasts

- China’s inflation rate hits 8.7%, higher than expected (Source: Bloomberg.com)

- The Blackstone Group, a huge private equity firm, announced earnings that were well below analysts’ expectations

- Well Point, a healthcare benefits company, lowered its Q1 guidance and the stock is down 20% in after-hours trading

DJIA 11,740.15 -153.54 (-1.29%)
Nasdaq 2,169.34 -43.15 (-1.95%)
S&P 500 1,273.37 -20.00 (-1.55%)
NYSE Volume 4,226,324,000

2-Yr Bond 1.47% -0.06
10-Yr Bond 3.46% -0.10
30-Yr Bond 4.45% -0.10

Dollar Index 72.993 -0.034
Crude Oil (Apr) 107.90 +2.75
Gold (Apr) 971.80 -2.40

The Earnings Game

All public firms have the opportunity to "game" or mess with, distort, misrepresent, lie about or in any way alter the earnings they report each quarter. Why can companies game their earnings? Well, lets face it, our accounting system isn't perfect... to say the least. But none is. There are multiple ways to report various items, companies can use these options to change their expense structure in order to give earnings a boost when they need it, or even when things are great, to create a reserve that they can draw on when they do need a boost to earnings. Why would companies go through all this trouble for an extra couple cents of EPS? Well because remember those earnings estimates that analysts have are priced into stocks, and not meeting those expectations, or exceeding those expectations has a huge effect on the stock price.

I was planning on writing a long article on this for a while but then today I was reading Buffett's annual letter to shareholders (in class of course) which went out a couple weeks ago. Besides from hearing what the richest man in Amerca's company is up to, and gaining a true genius' insights to the economy, there are a couple pages of borderline academic education that is laced with his unique and hilarious (in a nerdy way) sense of humor... it's classic. In this year's he talks about just this topic, gaming earnings. He addresses it from two ways managers can achieve this: stock option expensing and manipulating pension funds. Of course there are more, but instead of me rambling, below is what Buffett has to say.

Bottom line: watch out for gaming earnings, it's one reason why going through a company's footnotes to their financials is so crucial.


Below is the option expense manipulation part from Warren Buffett's 2007 Annual Letter to shareholders, I encourage you to go here and read it in its entirety... as well as the one from each year.

Fanciful Figures – How Public Companies Juice Earnings
Former Senator Alan Simpson famously said: “Those who travel the high road in Washington
need not fear heavy traffic.” If he had sought truly deserted streets, however, the Senator should have looked to Corporate America’s accounting.

An important referendum on which road businesses prefer occurred in 1994. America’s CEOs had just strong-armed the U.S. Senate into ordering the Financial Accounting Standards Board to shut up, by a vote that was 88-9. Before that rebuke the FASB had shown the audacity – by unanimous agreement, no less – to tell corporate chieftains that the stock options they were being awarded represented a form of compensation and that their value should be recorded as an expense.

After the senators voted, the FASB – now educated on accounting principles by the Senate’s 88 closet CPAs – decreed that companies could choose between two methods of reporting on options. The preferred treatment would be to expense their value, but it would also be allowable for companies to ignore the expense as long as their options were issued at market value.

A moment of truth had now arrived for America’s CEOs, and their reaction was not a pretty sight. During the next six years, exactly two of the 500 companies in the S&P chose the preferred route. CEOs of the rest opted for the low road, thereby ignoring a large and obvious expense in order to report higher “earnings.” I’m sure some of them also felt that if they opted for expensing, their directors might in future years think twice before approving the mega-grants the managers longed for.

It turned out that for many CEOs even the low road wasn’t good enough. Under the weakened rule, there remained earnings consequences if options were issued with a strike price below market value. No problem. To avoid that bothersome rule, a number of companies surreptitiously backdated options to falsely indicate that they were granted at current market prices, when in fact they were dished out at prices well below market.

Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved.

Our deeper, more liquid, planet

Once again, I refer to the collective genius that is McKinsey's Quarterly publication to discuss the big picture of everything we are talking about. This report will come from two articles, the first being a Mckinsey Quarterly study entitled "Mapping the Global Capital Markets." The authors were Diana Farrell, Aneta Marcheva Key, and Tim Shavers.


This blog discusses financials and economics, mostly around the US equities market. Well the truth is less than 30% of the world's capital is in equity, the rest being in corporate or government debt, or bank deposits. And then in the US, only about 33% of capital is in equities market. Still, it is a sizable portion - around $15 trillion, according to McKinsey. How much capital is there in the world? Currently ~$118 trillion, up from $53 trillion in 1993 and only $12 trillion in 1980. Damn! And if trends carry on, we should be looking at passing $200 trillion by 2010! Along with that growth is a shift in where the money is going. In 1980, 45% of all capital was held in bank deposits, this has dropped down to 30% today, as the proportion shifted to debt and equity securities. Clearly, this has increased liquidity, as the money was freed from bank vaults into trade-able contracts offering higher returns.

Now, don't confuse this with global GDP. The amount of capital in a country is supposed to be larger than the country's GDP. Like DLight and Dyer will tell you, financial assets are meant to reflect the expectation of future value, while GDP ain't. This means that capital markets should be many times greater in value, or, in economics terms, deeper, than a country's GDP.

The article goes on to explain:

Financial depth alone, however, doesn't indicate the strength of an economy or its financial system. The financial depth of the United States is nearly twice that of Norway, for example, though both countries have similar GDPs per capita. Germany and Thailand, by contrast, have similar financial depth at greatly different income levels. Financial depth also doesn't necessarily mean that an economy's financial system is in relatively good health. Japan, for instance, has great financial depth but struggles with nonperforming bank loans and with shrinking corporate-bond and equity markets. Asset price bubbles and the issuance of excessive government debt can lead to an unhealthy financial deepening—and painful corrections.

Interestingly, the depth of an individual country is becoming less and less relevant as globalization continues. McKizzle notes:

Today, for example, foreigners hold 12 percent of US equities, 25 percent of US corporate bonds, and 44 percent of Treasury securities, up from 4, 1, and 20 percent, respectively, in 1975. Since 1995, cross-border capital flows have more than tripled, and they now total upward of $4 trillion annually, including foreign purchases of equity and debt securities, foreign direct investment by corporations, and cross-border bank lending.

Unfortunately, this can hurt markets as much as it can help them, due to the increased competition between financial markets. We've already discussed the importance of depth in a market - shallower regions may attract less investment attention. A more direct concern is low turnover (the rate at which shared are traded). This, along with dated infrastructure and technology, results in each trade costing more. This is also known was the cost of liquidity, and is a closely watched measure of financial health. Globalization can allow for a trader in Kuala Lumpur to focus on trading on the NYSE instead on his own native Bursa Malaysia.

According to the the McKinsey Quarterly report "Why ASEAN's stock markets must work together," written by Emmanuel V. Pitsilis, Andrew Sheng, and James Twiss, this could be a big problem for, say, Malaysia.

ASEAN may be in trouble, due to these concerns. There are no immediate threats, but in the long run, as the global markets evolve, we may see a drain in the liquidity of the exchanges in ASEAN. This could be disastrous for their economies, as economic complacency settles in. What are possible solutions? Well, the exchange could simply be purchased by one of the larger ones (e.g. NYSE Euronext), or they could try to bond together.

As the report describes, this hasn't been very successful, historically. Combining and compromising on all the different regulations , national agendas, and stakeholders (i.e. shareholders) have made actual mergers a huge headache. Furthermore, building alliances or creating cross listings hasn't brought the desired results either. McKinsey instead suggests a merger of what is an actual area of synergy: operations and technology. This has apparently worked well for NYSE Euronext as well as OMX.