About that Apple Dividend/Buyback

So Apple has finally decided to pay a dividend and buy back some shares.  It’s about time. As a long-time Apple shareholder, I’ve been waiting quite some time for them to do something with their $100+ billion of cash lying around earning 1%.  I was never cynical enough to fully buy into Karl Smith’s hypothesis that Apple’s management was selfishly hoarding the cash at the expense of shareholders (a thesis which Smith admirably admits was proven wrong today–also, awesome graphic!).  Still, I also didn’t see the point of Apple holding onto all that cash earning an incredibly low rate of interest.  One of the most basic rules for management is that if your shareholders can earn a better rate of return on your firm’s excess capital than you can, you should return that capital to the shareholders.  That describes Apple’s situation perfectly–although in this case, it’s not because Apple doesn’t have any profitable investment opportunities but that Apple has such an incredible amount of cash that it has  run out of ways to use it.

Although I’m happy about Apple’s announcement, no, USA Today, shareholders will not get richer or make more money because of the announcement.  An otherwise fine article led with the fallacy that Apple’s shareholders will be making more money because they’re going to be receiving a quarterly dividend.  Nope–they owned the money as Apple’s shareholders before the dividend and they’re going to own the money after as well, albeit separately from their shares.  That’s why, in theory at least, after the dividend is paid out, the share price should decline by the amount of the dividend.  Now, after the dividend, if they invest the cash more profitably than Apple had been investing it, they will be making more money but there’s nothing about a dividend or a buyback that inherently makes a shareholder money.

Even with the dividend and buyback, though, Apple is still going to have a ton of cash.  I wouldn’t mind seeing Apple make an acquisition or two.  Barry Ritholtz makes a pretty convincing case here for Apple buying Twitter.  My roommate thinks that Netflix would be a good buy and relatively cheap for Apple–although this is true for most companies when  you’ve got the amount of cash that Apple has.

Lastly, although I agree with Felix Salmon’s favorable view of the dividend, I think he misses a few points when he’s critiquing people calling for Apple to issue debt at the end of his post.  He writes, “Having a cash pile and issuing debt is a bit like having a CD and running a balance on your credit card: idiotic.”  Try telling that to Google, which issued $3 billion in debt last May even when it had $35 billion in cash and marketable securities.  There are plenty of reasons why a company might issue debt even if it has cash.  If borrowing costs are really low and you have a way to use the money now (or in the future) that will earn a greater return than your interest payments, by all means issue debt.  Even if you have cash now, you may want to lock in low current borrowing costs in case you need the capital in the future.  In addition, when a company has a lot of cash on its balance sheet but that cash is being held abroad, it may make sense to issue debt in the U.S. to avoid the taxes which would be paid on repatriated profits.  (And I think that this actually applies to a fair amount of Apple’s cash).  I actually agree with Salmon that Apple shouldn’t issue debt, but that’s just because Apple has so much cash (did I mention how much cash Apple has?), not because companies with cash shouldn’t issue debt.

The Economist’s Ridiculous Complaints About Dodd-Frank

Photo courtesy Flickr user Shamigo, Creative Commons.

There are plenty of legitimate arguments to be made against the Dodd-Frank Act.  Unfortunately, in its anti-Dodd-Frank piece published last week, The Economist doesn’t make any of them. The article begins:

SECTIONS 404 and 406 of the Dodd-Frank law of July 2010 add up to just a couple of pages. On October 31st last year two of the agencies overseeing America’s financial system turned those few pages into a form to be filled out by hedge funds and some other firms; that form ran to 192 pages. The cost of filling it out, according to an informal survey of hedge-fund managers, will be $100,000-150,000 for each firm the first time it does it. After having done it once, those costs might drop to $40,000 in every later year.

Hedge funds command little pity these days. But their bureaucratic task is but one example of the demands for fees and paperwork with which Dodd-Frank will blanket a vast segment of America’s economy.

These rules require hedge funds, which for the most part exist in a regulatory blind spot, to report information related to their exposures, leverage, risk profile, and liquidity to the SEC and CFTC so that they can better monitor and reduce systemic risk. If regulators want to reduce systemic risk, they need to what’s going on in the financial system, so greater disclosure from hedge funds seems like a pretty reasonable thing to ask for. What’s more, there are two sets of reporting rules–one set for large funds and one set of significantly less onerous rules for smaller funds, so their burden is reduced.

It’s not really clear to me which part of this is objectionable. All The Economist says is that the forms are long–192 pages!!–and that hedge fund managers say they’re going to cost up to $150k the first year and $40k from then on. That doesn’t sound like an unreasonable amount for hedge funds with $1 billion or more assets under management to spend so regulators can have a basic idea of what they’re up to.

This is only one example among many that The Economist cites as evidence that Dodd-Frank is too long, too expensive and too complex.  The issue here isn’t that The Economist is criticizing Dodd-Frank–it’s that if you’re going to say the Act is too long and too expensive, you’ve got to do more than just stating that it’s long and expensive.  Even if Dodd-Frank is long and expensive, that’s not self-evidently a bad thing.  Financial reform which builds off our current regulatory system is going to be complex, because the current system is complex, and successful reform should be expensive and cause the financial sector to become less profitable.

Other examples of The Economist’s complaints about Dodd-Frank include: The act is so long it hasn’t been read by anyone outside Beijing. (What?) Independent funding through the Fed (because what’s a regulatory agency if Congress hasn’t been given the chance to starve it) and funding through new fees for banks are “exotic.” (Like the SEC?) Treasury’s Office of Financial Research is unnecessary because think tanks and academics already try to forecast financial crises (because that worked out so well in the past).  And so on.

After complaining about the CFPB, living wills and stress tests, The Economist writes, “But the befuddling form the act gives such ideas unintentionally opens a path to much more state interference.”  Well, yes. Regulators failed to prevent a crisis in 2008, so Dodd-Frank is meant to give them greater authority to regulate financial institutions so it doesn’t happen again. State interference is pretty much the idea. Maybe banks who want to be left alone by those pesky regulators don’t like this, but for the taxpayers who funded the bailout of the financial sector, it should sound pretty good.

As for the costs that Dodd-Frank’s going to impose on the financial sector, The Economist’s sources include an informal survey of hedge fund managers, the U.S. Chamber of Commerce, a risk factor from BB&T’s 10-K, Jamie Dimon and SIFMA. And surprise, they think the Act is going to be too expensive and not going to work. This is the equivalent of asking fifth graders if they think they have too much homework and using their response as evidence that they do.

If there was any doubt about where The Economist’s loyalties lie, they’re put to rest by a  correction at the end of the article:

Correction: The direct annual cost to JPMorgan Chase of these regulations is not going to be $400 billion-600 billion as we first wrote. A figure between $400m and $600m is rather closer to the mark.

On one hand, this could just be a typo, but I think the fact that the author of the article wrote this without thinking twice and that it also got through The Economist’s editing process tells you all you need to know about the point of view of the article.

Warren Buffett and the Laggards of Berkshire Hathaway

"Show some class and order a giant root beer float for dessert. Only sissies get the small one." Photo courtesy Flickr user Fortune Live Media, Creative Commons.

Warren Buffett’s annual letter to shareholders came out a few days ago, and it’s a delight to read. A lot of people have been picking out their favorite bits–see, for example, FT Alphaville on the value of gold vs. productive assets, Felix Salmon on Buffet’s acquisitions, Calculated Risk on Buffet’s view on housing, and Kid Dynamite on a whole bunch of topics. The whole letter’s worth a read, but one passage in particular stood out to me (emphasis added):

A few [of Berkshire’s companies], however, have very poor returns, a result of some serious mistakes I made in my job of capital allocation. These errors came about because I misjudged either the competitive strength of the business being purchased or the future economics of the industry in which it operated. I try to look out ten or twenty years when making an acquisition, but sometimes my eyesight has been poor. Charlie’s has been better; he voted no more than “present” on several of my errant purchases.

Berkshire’s newer shareholders may be puzzled over our decision to hold on to my mistakes. After all, their earnings can never be consequential to Berkshire’s valuation, and problem companies require more managerial time than winners. Any management consultant or Wall Street advisor would look at our laggards and say “dump them.”

That won’t happen. For 29 years, we have regularly laid out Berkshire’s economic principles in these reports (pages 93-98) and Number 11 describes our general reluctance to sell poor performers (which, in most cases, lag because of industry factors rather than managerial shortcomings). Our approach is far from Darwinian, and many of you may disapprove of it. I can understand your position. However, we have made – and continue to make – a commitment to the sellers of businesses we buy that we will retain those businesses through thick and thin. So far, the dollar cost of that commitment has not been substantial and may well be offset by the goodwill it builds among prospective sellers looking for the right permanent home for their treasured business and loyal associates. These owners know that what they get with us can’t be delivered by others and that our commitments will be good for many decades to come.

Please understand, however, that Charlie and I are neither masochists nor Pollyannas. If either of the failings we set forth in Rule 11 is present – if the business will likely be a cash drain over the longer term, or if labor strife is endemic – we will take prompt and decisive action. Such a situation has happened only a couple of times in our 47-year history, and none of the businesses we now own is in straits requiring us to consider disposing of it.

Buffett is admitting here that his decisions are motivated by more than his desire to make money for Berkshire Hathaway. In this case, the commitments that Buffett has made to the sellers of businesses that he’s purchased takes precedence over his duty to maximize value for shareholders. You could argue that the signaling value of this commitment to prospective sellers of businesses outweighs the lost profits of this strategy. What’s interesting, though, is that although Buffett acknowledges this possibility, it’s clear that the financial gains are a second-order effect for him and that simply upholding of commitments, whether he’s legally bound to or not, is what matters.

Of course, there are limits to the extent to which Buffett will hold onto a lagging business. The commitments that he makes to business are contingent on them not losing money in the long-term.  Moreover, as Buffett explains in Berkshire’s “Owner’s Manuel,” he’s not going to pour money into unprofitable businesses in the hopes of reversing their fortunes:

[W]e react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.)

Buffet’s stance is in stark contrast to the model of private equity proposed by Andrei Shleifer and Larry Summers in their 1988 paper entitled “Breach of Trust in Hostile Takeovers.” Shleifer and Summers make the argument that for the most part the profits made in hostile takeovers are due not to increased efficiency but to the breach of implicit contracts made between a target company’s shareholders and stakeholders which help “promote relationship specific capital investment by the stakeholders.”

For example, a company might underpay employees while they’re younger employees as they’re learning skills specific to their job. In return, the employees expect secure employment when they’re older as well as wages greater than their marginal product. This might be an efficient arrangement benefiting both the employees and the company, but a private equity firm can still profit by taking over the firm and firing the older employees. The end result is that the PE firm profits at the expense of stakeholders and destroys the increased efficiency that results from the firm’s ability to enter into implicit contracts with stakeholders.

Buffett operates in the exact opposite way. As his effusive praise for the managers of Berkshire’s subsidiaries throughout his letter makes clear, Buffett believes that value is created by upholding rather than destroying these implicit contracts, including those that he makes when he acquires a company. Morality aside, this actually fits with Shleifer and Summer’s hypothesis. The difference (one among many) between Buffett and private equity firms engaged in leveraged buyouts is that Buffett takes a long-term view of value creation while private equity firms often take a short-term view. Breaching these implicit contracts might be a good strategy for enriching shareholders in the short-term, but by eliminating the possibility of implicit contracts, this strategy can damage the long-term value of a company and therefore doesn’t make sense for a long-term shareholder like Buffett.

In Defense of Trills (and Bob Shiller)

So trill.

I love reading Felix Salmon’s blog, but today he goes off the rails a bit when discussing the prospect of GDP-linked bonds, as recently proposed by Bob Shiller.  The basic idea is that countries would issue a security where the coupon is linked to that country’s GDP.  GDP-bond supporters say that the bonds would help government issuers because they’d be counter-cyclical, helping countries in times of distress and lessening the probability of a default or a crisis.  Furthermore, the bonds would give investors the ability to gain diversified exposure to a country’s future prospects.  For a more in-depth look at GDP-bonds, I highly recommend checking out this 2006 paper by Stephany Griffith-Jones and Krishnan Sharma, which explains the benefits and challenges of GDP-linked bonds really well.  (I’d also recommend the commenters on Salmon’s post today, who make a lot of strong points.)

Salmon’s not a fan though, but after reading Salmon’s post today on GDP-linked bonds and his previous posts on the topic, I’m pretty confused about why.  In this post, for instance, it seems like he’s saying they’re a bad idea because they’ll be too expensive to issue:

Bond investors in general, and government bond investors in particular, are highly loss-averse — they’ll require much higher yields if there’s a real risk that they won’t be repaid their principal in full.

What’s more, bond investors valued those Argentine GDP warrants at zero when they were issued. If a detachable option with upside but no downside is valued at zero, then a built-in option with symmetrical upside and downside will clearly be valued at less than zero: the government is going to have to pay a big premium to complicate matters in this manner.

Yet yesterday he wrote that their value could be infinite:

If the coupons are steadily increasing, however, the math becomes very dangerous. The coupons will rise at the rate of nominal GDP growth, which in the US will probably be somewhere in the 4% to 5% range over the long term. As a result, if you’re a risk-averse person who wants a perpetual US government security and your discount rate is say 3%, then the expected value of a singe Trill is actually infinite. Of course, no security trades at a price of infinity. But the fact that valuations can get so high in a low-interest-rate environment is all you need to know about just how volatile Trill prices could get.

Well, yes, if you’re discounting future cash flows at a lower rate than their expected growth rate, then the security would have an infinite value.  That doesn’t mean their value is infinite–it just means your discount rate is wrong.  In this case, you shouldn’t use the risk-free rate to value the security just because it’s issued by the government.  You use the risk-free rate for a Treasury bond because the coupons are fixed and there’s (theoretically) no danger of the U.S. government defaulting.  For a trill, though, while there still might be no U.S.-default risk, your cash flows depend on GDP, which creates risk that needs to be incorporated into your discount rate.  An equity-like instrument like trills with exposure to the whole market should be discounted at something between the risk-free rate and the cost of equity.

Salmon tries to make the case that trills would be more volatile than the S&P 500, but I don’t think that can be true, simply because the S&P is a subcomponent of GDP, so exposure through trills is going to be more diversified than exposure through the S&P.  Salmon writes about the value of trills, “What really makes a big difference is the interest rate you use to calculate net present value. In other words, while Trills are designed to respond to news about the economy, in fact they would be an incredibly noisy and volatile instrument reacting mainly to changes in long-term interest rates.”  But the value of the S&P is theoretically calculated in precisely the same way–by discounting the value of future cash flows (dividends) that you get by owning the stock.  If the discount rate that you use to value trills is volatile, then the rate you use to value the S&P portfolio will be as well.  The only difference is that with trills, you’ll have more (or at least as) stable cash flows, so they should be less, not more, volatile.

The bottom line is that trills would cost more for countries to issue but would carry substantial benefits, which makes sense.  Equity costs more for companies to issue than debt because it’s riskier.  Trills would cost more than bonds for countries to issue, so countries should issue trills until the costs outweigh the benefits.

Lastly, I think Salmon takes a bit of a cheap (and unsubstantiated) shot at Shiller when he says that Shiller’s pushing trills because he’ll benefit financially through his firm, MacroMarkets.  It’s a bit absurd to suggest that Shiller feels the need to create business for his firm by convincing governments to issue trills.  Even if it were the case that it would be a boon for their business–which I don’t think would be true–there’s no basis for suggesting that Shiller is subverting his scholarly reputation and recommending a flawed idea just to make a few bucks.

What ISDA Got Right (and Wrong) About Greek CDS

In all the discussion about the Greek debt negotiations, one point that keeps coming up is the importance that the debt restructuring be voluntary so that the default clauses in credit default swaps (CDS) on Greek debt aren’t triggered.  I’ve never entirely understood this point, because the impact depends who the buyers and sellers of the CDS are.  If the debt restructuring is voluntary and there’s no technical default, there will be some winners and some losers, and vice versa if Greece is judged to have default, only the winners become the losers and the losers become winners.  There might be a case to be made that the shock to the system will be reduced if there’s no technical default, but I haven’t seen it.  (Maybe I’ve missed it.)

Regardless, what is true is that stakeholders in the Greek talks have a vested interest regarding the Greek default determination.  The question is, how much of an interest?  In one corner, we have Nobel laureate Joseph Stiglitz, who says that CDS exposure is a significant factor in the current negotiations:

There is, moreover, little evidence that a deep involuntary restructuring would be any more traumatic than a deep voluntary restructuring. By insisting on its voluntariness, the ECB may be trying to ensure that the restructuring is not deep; but, in that case, it is putting the banks’ interests before that of Greece, for which a deep restructuring is essential if it is to emerge from the crisis. In fact, the ECB may be putting the interests of the few banks that have written credit-default swaps before those of Greece, Europe’s taxpayers, and creditors who acted prudently and bought insurance.

Stiglitz also took a shot at the ISDA Determinations Committee, which will rules on what does and does not constitute a default, writing that “it seems unconscionable that the ECB would delegate to a secret committee of self-interested market participants the right to determine what is an acceptable debt restructuring.”  ISDA’s media.comment blog shot back:

As we have said many times and in many places, the $3.2 billion in net exposure of Greek sovereign CDS is relatively small. Plus: that $3.2 billion is the aggregate amount of all the individual net exposures, so the exposure of any one firm is less. Plus, plus: the exposures firms have to each other are marked-to-market and largely collateralized. Plus, plus, plus: the recovery value of a defaulted reference entity’s obligations further decreases the amount of cash that a protection seller would pay out to a protection buyer (so the aggregate cash payout following a credit event is less than $3.2 billion).

What does all of this mean? Simply that Greek sovereign CDS exposure is too small to be much of a factor in the Greek drama that is currently being played out.

We would have thought that Professor Stiglitz and his research staff surely know all of this? And that regulators have access to trade volumes and exposures through the CDS trade repository? And also that the EBA’s capital exercise, which detailed the CDS exposure of 65 European banks (including those from the UK, France and Germany) as of the end of the 2011 third quarter, showed that the total net CDS exposure of those firms was $545 million, all of which is already marked to market at approximately 30%?

ISDA says that the net notional amount of Greek CDS outstanding is $3.2 billion (which is to say, if Greece defaulted tomorrow, $3.2 billion would change hands between buyers and sellers of CDS on Greek debt).  The gross notional amount of Greek CDS is $69.5 billion, but due to the wonders of netting, the net amount is a fraction of that.  (These numbers are listed on the DTCC’s website here, in table 6 under “Hellenic Republic.”)

To put this into context, the total outstanding notional value of Greek debt held by private creditors is about 206 billion euros (US$270 billion).  So, on the broader point about the importance of CDS, it looks like ISDA’s right.  Greek debt worth $270 billion is going to matter a lot more than net CDS of $3.2 billion.  Score one for ISDA.

However…the fact that the net value of CDS is much smaller than the value of Greek debt doesn’t mean it that it doesn’t matter at all.  If creditors are basically resigned to a huge haircut but believe they have the power to affect whether or not Greece technically defaults, then they might care a whole lot about their CDS exposure.  And for stakeholders holding CDS but not Greek debt, the comparison between the two amounts is irrelevant.

I also have a small quibble with ISDA’s calculation of European banks’ net CDS exposure, which they calculate based on the EBA’s capital exercise.  It’s true that $545 million is the net exposure of the 65 banks included in the exercise, in that if you take the net positive exposure of all the banks and subtract it from their net negative exposure, you get $545 million.  But it would seem to me that a more important metric regarding the impact of the CDS on the banks would be their total net exposure, regardless of whether it’s positive or negative (i.e. the sum of the amounts that banks stand to gain or lose).   This amount is $1.7 billion (as of the end of the third quarter of 2011).  Again, not a huge amount relative to the value of Greek debt.

So for fun, let’s take a look at the individual net exposures of these European banks (all of the banks except for HSBC and RBS are net sellers of CDS):

The banks in red are on the ISDA Determinations Committee (again, at least as of 3Q 2011).  (RBS, in green, is a consultative dealer.)  To put this in context, BNP Paribas, which is shown here as being a net seller of US$91 million worth of CDS, wrote off 567 million euros related to Greek debt earlier this week.

In summary, when you look at the notional value of CDS, ISDA is right that it’s not as big a deal as everyone is making it out to be.  That doesn’t mean that we should ignore it entirely, but when trying to assess its impact on the negotiations, a little context helps.

PIMCO, Beating the Market, and Long-Term Capital Management

Photo courtesy Flickr user boxchain, Creative Commons

Noah Smith read Reuters’ article on the decline of PIMCO and wrote a great post about the challenges that successful funds face as they grow.  In short, the additional capital that flows into a fund that has been beating the market makes it more difficult for the fund to continue to beat the market.  Smith concludes:

Note that this is not Efficient Markets theory. This is just arithmetic. But the more “efficient” markets are, the quicker it will become impossible to beat the average as you grow in size, because the available mispricings that you can exploit to get excess returns will be more limited.

So here’s the lesson: if investors “expect” an asset management company to beat a comparable index fund by the same number of percentage points year in and year out, they will be disappointed, because the company will soon get so big that it is almost indistinguishable from an index fund (except that it will have higher fees). Such fixed expectations of excess returns are not rational. But if investors do have such expectations, asset managers will have an incentive to accept greater and greater risk in order to have a chance of holding onto their clients. This is exactly what that article says is happening with PIMCO.

Smith is talking about PIMCO here, but there’s another fund that even better illustrates this idea: Long-Term Capital Management.  LTCM started off in the early 90’s and initially made a killing in fixed income arbitrage, using innovative statistical models that no one else had.  As they became more and more successful, though, things started to go south.  As Roger Lowenstein explained in his book on LTCM, When Genius Failed:

Whether Long-Term wanted to admit it or not, the secret of bond arbitrage was out. By the late 1990s, almost every investment bank on Wall Street had, to some degree, gotten into the game. Most had separate arbitrage desks, with traders specifically assigned to look for opportunities in every nook and cranny of the business. Lured by the scent of the fantastic profits being earned in Greenwich; other banks were reaching for the same nickels as Long-Term. Inevitably, they whittled away the very spreads that had attracted them; thus do free markets punish success. Long-Term had always been dogged by imitators, but now the imitators were piling on faster than ever. No sooner did a spread open up than rival traders plugged it. “Everyone else was catching up to us,” Rosenfeld complained, “We’d go to put on a trade, but when we started to nibble, the opportunity would vanish.”

Characteristically, Meriwether encouraged the firm to explore new territory. Even at Salomon, the troops had always sought to extend their turf. Hadn’t they moved from swap spreads to mortgage-backed securities? Hadn’t they branched into junk bonds and European debt? In retrospect, such moves had been baby steps, not bold new departures. But the partners’ experience-to them, at least-seemed to belie the adage that it is dangerous to try to transport success to unfamiliar ground. Trusting their models, they simply rebooted their computers in virgin terrain.

LTCM ultimately failed for a number of reasons, but chief among them is the phenomenon explained above: their success in bond arbitrage spawned imitators, who made it more difficult to be successful in bond arbitrage.  While you might be able to invest $1 billion in profitable trades, investing $2 billion or $3 billion with the same rate of return that you achieved on your first billion is going to be very difficult, especially when everyone around is now trying to do the same thing.

LTCM responded to these pressures by applying their models to unfamiliar asset classes, jacking up their leverage, and trying their hand at investment strategies outside of their expertise, like merger arbitrage.  Risk management flew out the window, as LTCM began making large directional bets, rather than the arbitrage trades that were theoretically market-neutral, with dangerously high leverage.  The end result was that LTCM made the same investments it had in the past but in an even riskier manner and also made a whole series of new, riskier investments, all in an effort to maintain their high returns.  Rather than continuing to beat the market by a huge margin, as it had in its earlier years, LTCM imploded in spectacular fashion.

Of course, LTCM is an extreme example of this phenomenon.  The problems at PIMCO don’t seem to be anywhere near the same magnitude as at LTCM.  It sounds like some of the things that happened at LTCM are happening at PIMCO–new asset classes, new types of financial instruments, Gross doubling down on a bet as it turned against him.  But even last year when it was in the bottom 10% of its peer group, PIMCO’s Total Return Fund still returned 4.39%.  That’s pretty bad considering its peers’ average return of 6.39%, and even worse considering PIMCO’s sterling record, but it doesn’t suggest that PIMCO’s investment strategy, from Gross’s bearish bet on Treasuries to its reliance on derivatives, poses the level of risk seen in LTCM’s case.  Rather, the danger for PIMCO seems to be that it will start to achieve average returns on a regular basis, which is precisely what should happen in the long-run.

This is in part due to its increased size, as discussed by Smith and above.  But this is also true because it’s hard to get lucky again and again.  Even if you allow that the probability that a manager outperforms the market is 50% dependent on that manager’s skills—which I consider to be a generous estimate—that other 50% is still largely chance.  In order to consistently beat the market, a manager both has to be right about the market and lucky year after year.  Just as it’s unlikely that you’ll get 10 heads ten times in a row when flipping a coin, very few managers are going to be lucky over an extended period of time.  As for the manager’s alpha, even talented managers like Bill Gross are wrong in a big way every now and then, as his bearish Treasury bet shows.  In the end, most managers are going to achieve market returns—and that’s before you deduct fees.  And this is why you should invest in low-cost index funds.

What’s Missing From Bloomberg’s Dodd-Frank Graph

Photo via Flickr user World Economic Forum, Creative Commons

Bloomberg Businessweek published a fun graphic today trying to illustrate what’s in Dodd-Frank.  Overall, it’s not bad.  Because Congress decided to build off of the existing regulatory structure instead of tearing it down and building a new one, Dodd-Frank is tremendously complicated and almost impossible to understand for anyone who’s not a banker or Wall Street lawyer (and nearly impossible for many of those people too).  Explaining it isn’t easy, and this chart hits most of Dodd-Frank’s main features while being is as accurate as you can hope when explaining an 800 page bill on financial regulatory reform to a lay audience.  That said, there are a couple things that it gets wrong and a few pretty major provisions of Dodd-Frank left out that are definitely worth a mention.

Starting off with what the chart gets wrong, in the top right corner, it says, “A ‘living will’ provision requires you to spell out how you’d wind down if you go bust.  That way customers won’t be left in the lurch.”  The first part is right, but the purpose of living wills isn’t really to protect customers.  (I’m not even sure who “customers” is supposed to refer to.  A bank’s clients?  Shareholders?  Counterparties?)  Living wills are designed so that if another Lehman fails, everyone’s not running around like chickens with their heads cut off because they have no idea what’s going on.  That will benefit the failing bank itself (it will be better prepared to react to a crisis), regulators (they’ll be able to wind the bank down in as orderly a fashion as possible), other financial institutions (greater transparency for the market reduces the feared “domino effect” of the 2008 crisis), and, last but not least, taxpayers (who won’t be forced to bail out failing banks).

I should note that all of this assumes the best case scenario.  The living will process is still very much ongoing, so all of these benefits are conditional on regulators getting the rules right and financial institutions implementing them properly, which will probably take some time.

There are two more little nits that I’d point out.  The “Are you filthy rich?” circle points to a box which reads, “Starting in February, you’ll no longer be allowed to count the value of the house you live in to prove you’re rich enough to invest in hedge funds.”  This is true (shout out to Sec. 413, “Adjusting the Accredited Investor Standard”!) but this isn’t meant to apply to the filthy rich.  Rather, it’s supposed to stop those who aren’t filthy rich from investing in risky private funds.  The threshold is now a net worth of $1,000,000, not counting the value of the person’s primary residence.  Having a million dollar net worth isn’t poor by any means, but to qualify as “filthy rich” you’ve got to do a little better than that.

Lastly, the “too big to fail” box underneath the “Are you a big bank?” box, which I think is referring to all the new heightened regulatory requirements for systemically important financial institutions (SIFIs), doesn’t really have anything to do with derivatives.  The increased capital standards for major swap dealers and the like are a whole different ball game (and actually have their own box on the chart).

With all that out of the way, there are a few things I’d add to the chart.  The biggest one that’s missing is the FDIC’s shiny, brand-new Orderly Liquidation Authority.  When a small, regional bank fails, the FDIC swoops in, packages it up, and sells it off to a nearby bank over the course of a weekend.  Orderly Liquidation Authority is like that, except for Bank of America or Goldman Sachs or Citi.  Needless to say, this is immensely more complicated because of the size and complexity of these institutions, as well as the international issues involved.  No one really knows how this is going to work, but the FDIC and Fed are trying to figure it out right now.  Let’s hope they get it right.

A couple other smaller things that aren’t as important but still worth mentioning:

• The chart mentions Legal Entity Identifiers, “a global corporate ID system,” but doesn’t name the agency charged with implementing this: the Treasury’s Office of Financial Research!  The OFR’s job is to collect more data on what’s going on in the financial system, analyze the data, and provide it to regulators.  To anti-Dodd-Frankers, this threatens the privacy of sensitive financial data while expanding government and wasting money, but to me it sounds like a great way to use data to help regulators do their job better.

• Dodd-Frank sets up whistleblower offices in both the CFTC and SEC.  The SEC is apparently already overloaded with tips, probably by potential whistleblowers enticed by the promise of an award equal to between 10 and 30% of the resulting sanctions.

• There are a bunch of other regulations designed to prevent municipalities from getting their faces ripped off, like, for example, Jefferson County, Alabama.

• If I had to mention one mining-related provision of Dodd-Frank, I’d go with the section on Conflict Minerals Originating in the Democratic Republic of the Congo.  Bloomberg chooses the next section on mining safety, but then I guess they’ve never seen Blood Diamond.

Aside from listing specific provisions of Dodd-Frank, there are a few broader points that I think are equally important in understanding what’s happening with the bill.  First, financial regulatory reform is by no means a done deal.  Republicans may not have been able to stop it from being passed, but they are making sure that agencies like the CFTC and SEC are underfunded so that they can’t properly implement the bill.  And they’re also gumming up the CFPB as best they can.

Secondly, although a fair amount has been written about the cooperation and coordination that Dodd-Frank necessitates between different U.S. regulatory agencies, the more difficult challenge will be the coordination between U.S. regulators and foreign regulators that’s required for Dodd-Frank to be effective.  This cooperation is vitally important for proper implementation of huge sections of the bill, from derivatives regulations to orderly liquidation authority.  Like just about everything Dodd-Frank-related, this won’t be easy.

Lastly, it will be years before we’re truly able to gauge the effectiveness of Dodd-Frank.  Unsurprisingly, many people have strong opinions about the bill, imperfect as it is, but we’ll only be able to judge how it works as we see the financial sector and financial regulation evolve–and inevitably fail again–in the coming years.

Why Tie to Gold? Why Not 1982 Bordeaux?

Photo via Flickr user hto2008, Creative Commons.

The University of Chicago IGM Economic Experts Panel, a group of economists spanning the ideological spectrum, was asked this week whether they agreed with a statement regarding the gold standard:

If the US replaced its discretionary monetary policy regime with a gold standard, defining a “dollar” as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American.

Hilarity ensues.

Austan Goolsbee: “eesh. Has it come to this?”

Richard Thaler: “Why tie to gold? why not 1982 Bordeaux?”

Of the 37 economists, 57% strongly disagreed with the statement and 43% disagreed.  William Nordhaus and Anil Kashyap chose to use their answers to drop some truth on all the Ron Paulistas out there.

Nordhaus: “This proposal makes no sense in the modern world. Just look at the Eurozone to see the consequences.”

Kashyap: “A gold standard regime would be a disaster for any large advanced economy. Love of the G.S. implies macroeconomic illiteracy.”

On a more serious note, Pete Klenow linked to a short, interesting 1982 paper by Robert Hall on the implications of a gold standard and, more broadly, a commodity standard.  Hall dismisses the possibility of a gold standard (“unacceptable as a basis for stabilizing the dollar because variations in the relation between the world price of gold and the United States cost of living are much too large”) but goes on to contemplate a commodity standard for the dollar based on certain quantities of aluminum, copper, plywood and ammonium nitrate.  It’s an interesting hypothetical, although problematic for any number of reasons, some of which Hall points out.  In the end, Hall concludes that the quality of monetary policy is the determining factor under both a fiat currency and a commodity standard system.  That’s one thing that people who love the gold standard don’t seem to grasp–under the gold standard, the government’s ability to influence monetary policy doesn’t go away.  The government just influences policy in a different way, by determining what quantity of gold is equal to a dollar, rather than directly regulating the quantity of money.   So even if you think government/Fed control is the problem, the gold standard still isn’t the answer.

h/t Ideas Market

Why America Losing Out on iPhone Work Isn’t That Big a Deal

Photo via Flickr user Yutaka Tsutano, Creative Commons.

Today’s must-read article in the New York Times is Charles Duhigg and Keith Bradsher’s piece on why the iPhone isn’t manufactured in America.   The article starts off lamenting the relatively few jobs that Apple has created in America compared to, for example, the 400,000 employed by GM in the 50’s, especially when Apple’s employing hundreds of thousands in China.  I don’t want to downplay the weaknesses with America’s workforce, factories and manufacturing clusters that the article highlights, but there are a lot of reasons why Apple’s reliance on China rather than America isn’t as big a deal as it seems.

To state the obvious, a lot of China’s advantage lies in its relatively lax regulations related to workers’ rights, and the ineffective enforcement of these regulations–a weakness which in this article becomes a strength.  Factories in China have dormitories so that workers are “available 24 hours a day,” Duhigg and Bradsher write, so that when last-minute new iPhone screens arrived at one factory in the middle of the night, the factory woke up thousands of its workers to begin producing the new iPhones immediately.  It’s hard to imagine that happening in the US; indeed, it’s even illegal in China, though that didn’t seem to make much of a difference.

According to Apple’s 2012 Supplier Responsibility Progress Report (pdf), only 38% of the factories it audited were in compliance with working hours regulation.  Only 69% of its factories were in compliance with wages and benefits regulations.  And, most shockingly to me, only 78% were in compliance with “prevention of involuntary labor” regulations, which makes it sound like a fifth of Apple’s factories rely on something akin to slavery.  In short, this isn’t really an area in which America should be competing with China.  The difference in regulations and enforcement of regulations between China and the US is the reason why, contra Ygelsias, even if Apple’s Chinese workers came to America, they wouldn’t be as efficient and productive as they are in China.

Duhigg and Bradsher write that, if America had the same manufacturing capabilities as China, “paying American wages would add up to $65 to each iPhone’s expense. Since Apple’s profits are often hundreds of dollars per phone, building domestically, in theory, would still give the company a healthy reward.”  I’m not sure what constitutes a “healthy reward,” but regardless, Apple’s goal is to maximize profits for its shareholders, not the number of Americans it employs.  $65 per iPhone works out to about $4.7 billion in 2011, over 15% of Apple’s annual profits.  The article seems to imply that this wouldn’t be that bad an outcome, which sounds reasonable when you’re focusing on how America benefits from the jobs Apple creates rather than the shareholder value it creates.  But that’s not a great metric to judge a corporation by.  Here’s what the article has to say about Apple’s stock:

Since 2005, when the company’s stock split, share prices have risen from about $45 to more than $427.

Some of that wealth has gone to shareholders. Apple is among the most widely held stocks, and the rising share price has benefited millions of individual investors, 401(k)’s and pension plans. The bounty has also enriched Apple workers. Last fiscal year, in addition to their salaries, Apple’s employees and directors received stock worth $2 billion and exercised or vested stock and options worth an added $1.4 billion.

The biggest rewards, however, have often gone to Apple’s top employees.

Say what you will about Tim Cook’s compensation–and there’s a pretty strong case to be made that it’s excessive–but it’s certainly not larger than the tens of billions of dollars in wealth that Apple has created for its shareholders in the past decade.  Certainly, that money has disproportionately gone to the upper class in America, to the extent that wealthier people are more likely to own stocks than the less wealthy.  And it’s not a good thing when that wealth is a result of human rights abuses, although Apple seems to be making a strong effort to promote sound practices in its factories.  Overall, though, we shouldn’t downplay the extent to which Apple has created an incredible amount of wealth for this country even if it’s been in the form of capital gains rather than jobs for the middle class.

Does Dylan Ratigan Want to End the Fed?

Photo via Flickr user Fibonacci Blue, Creative Commons.

Noam Scheiber wrote about what sounded like a pretty crazy idea in Dylan Ratigan’s new book on Tuesday: derivatives should be classified as online gaming and naked derivatives should be “deemed null and void.”  I wasn’t even really sure what that meant, but Felix Salmon helpfully quoted the full page of Ratigan’s book Scheiber is referring to:

We must require not only that banks retain more capital but also that when they place bad bets, they pay the price for their losing bets themselves. Otherwise we are stuck with the worst of two economic systems: like a capitalist country, we have private banks that keep their profits. But like a communist country, we have a system where banking losses are charged to the government. Only when we end this corporate communism will we realign the interests of the banks with the investors they serve. The way to do this is debt reduction or cancelation. If the system is so out of control that we can use a computer to fabricate trillions in new money by simply adding some zeros, then surely we can find a way to delete some zeros as well. By definition, if you can print it, you can cancel it.

As we have already seen, a swap can either be an insurance policy that helps to lower long-term costs for a business or a bet by an outsider on whether a given company or country will succeed or fail. Putting swaps on a public exchange would create the visibility for all to see the difference between commodity insurance that is critical to the economy and speculative bets that are not much different from gambling.

Salmon does a great job pointing out what’s so ridiculous and incoherent about this passage.  Although I haven’t read Ratigan’s book in its entirety, I had much the same reaction and wanted to both expand on one section in particular that Salmon quotes:

The way to do this is debt reduction or cancelation. If the system is so out of control that we can use a computer to fabricate trillions in new money by simply adding some zeros, then surely we can find a way to delete some zeros as well.

Ratigan seems to confusingly conflate debt cancellation with the creation of money.  But more significantly, Ratigan takes our ability to “use a computer to fabricate trillions in new money” as evidence that “our system is so out of control.”  Nevermind that “deleting some zeros” is what happens when the Fed reduces the monetary base.  In Ratigan’s eyes, the Federal Reserve’s ability to enlarge of the monetary base to stabilize the economy and, in the present case, stop a recession from becoming a depression is a bad thing.  It’s possible  Ratigan doesn’t realize the implication of what he’s saying here and doesn’t actually believe this.  Or maybe he does want to take away the Fed’s power to set monetary policy and put the US back on the gold standard.  I haven’t read his book and haven’t watched much of his show, so I don’t really know.  Either way though, these are ideas that I’d expect to find in a book by Ron Paul or Glenn Beck, not an MSNBC host purporting to write a serious book on policy.

I don’t want to be entirely negative though, and there are sentences in the passage that, on their own, are quite sensible and which the Dodd-Frank Act is trying (in some cases more successfully than others) to address.  It’s true that the banks shouldn’t be able to keep their profits in good times and pass off their losses on the government in bad times.  Dodd-Frank’s answer was Orderly Liquidation Authority, which in theory would make it so large financial institutions can be resolved in an orderly manner rather than having to be bailed out by the government.  There should be greater transparency for swaps and derivatives–that’s why Dodd-Frank created Swap Execution Facilities and Swap Data Repositories.  Clearinghouses don’t really function the way Grasso talks about them, but Dodd-Frank has provisions for those too, which the CFTC and SEC are in the process of implementing and should go a long way towards making the swap and security-based swap markets less dangerous.  In short, the zany parts of Ratigan and Grasso’s argument are, well, really, really zany, and the bits that are non-zany are already being worked on.  Maybe not in the most effective way, but give credit where credit’s due.