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January 30, 2006
Flattening Banks
The current flat yield curve in U.S. interest rates is causing trouble for banks, according to today’s edition of The Wall Street Journal Europe. Banks are generally in the position of “riding the yield curve,” when they borrow, or accept deposits, at low short term rates and lend for longer terms, normally at higher rates.
Normally the yield curve is upward sloping, so that banks have a built-in margin, but with short term and long term rates both at about 4.5% now, this built in margin has disappeared. The Wall Street Journal Europe quoted Brad Setser of Roubini Global Economics Monitor as saying, “I really don’t see where the easy money is. No matter how sophisticated you are, you can’t get away from the basics of banking: Borrow short, lend long.”
The Investor’s Business Daily reported on January 20 how the earnings or stock prices of many banks were being hurt by this situation. Specific banks mentioned were Citigroup, Washington Mutual, Wells Fargo, National City Corp., Commerce Bancorp and First Niagara Financial.
The problem is bigger than making new loans at these rates. If interest rates rise further, the old long term loans that banks have on their books will decrease in value faster than the value of their short term liabilities. The sensitivity of these values to the interest rate is known as “duration” with long term debt having a higher duration than short term debt. Banks monitor their risk due to interest rate changes by looking at their “duration gap,” the difference between the durations of their assets and liabilities.
A further complication is that many other currencies have flat or flattening yield curves, making the problem global, rather than just an American problem.
Sources:
“Flat Yield Curve Stymies Banks,” Clint Riley, The Wall Street Journal Europe, 1/30/06, p. 22 “Citigroup, Other Banks Miss Forecasts As Flat Yield Curve Shrinks Profit Margin,” Marilyn Alva, Investor's Business Daily, 1/20/2006, http://www.investors.com/editorial/IBDArticles.asp?artsec=5&issue=20060120 “The World Isn't Flat, but Its Yield Curve May Be,” Daniel Gross, New York Times, 1/8/06, www.nytimes.com/2006/01/08/business/yourmoney/08view.html?ex=1294376400&en=f318c1d016561a54&ei=5090&partner=rssuserland&emc=rss Subscribe Now $9.99 for 4 months or $14.99 for a full year. View detailed contents October 26, 2005 Home-made What is the value of getting dividends rather than capital gains on a stock? Modigliani-Miller’s Nobel prize winning work on this subject gives a surprisingly simple answer: under standard perfect market assumptions, there is no difference in value between dividends and capital gains. Cash is cash no matter what form it is received in. Investors can create their own "home-made dividends" simply by selling off part of their share holdings, or their own "home-made capital gains" simply by reinvesting their dividends into the shares. Since this can be done at no cost (under their assumptions), there is no reason for investors to pay more or less far a company that pays more or less in the forms of dividends or capital gains. Mark Rubinstein reviews the history of the MM theorems at http://www.in-the-money.com/artandpap/II%20Modigliani-Miller%20Theorem.doc. An extended example and spreadsheet showing dividend policy irrelevance is given in Disk Lectures on Finance in lecture 8, “Stock Pricing and Discounted Dividends.” See www.DiskLectures.com/members.php . Today’s Wall Street Journal shows an example of “home-made dividends” in its story “The High Cost of High Dividends” (p C15). The story shows how mutual fund managers can convert a portfolio of low dividend paying stocks into a high dividend paying mutual fund – just by selling some of the shares to pay the dividends. The WSJ sagely advises that this method may result in a capital loss and shows mutual fund results to prove it. The article is a wonderful demonstration of how Modigliani-Miller should work, but it does add in one more level. Even if investors don’t want to go to the trouble of making home-made dividends themselves, they don’t need firm managers to “correctly” decide on the dividend level – mutual funds can make the “home-made” dividends for the investors. Modigliani-Miller can be one of the most challenging topics in a corporate finance course. I’ve always loved to use the following limerick in explaining it. A young farmer by name of Caruthers had cows with miraculous udders. He said “Isn’t this neat. I get cream from one teat and skim milk from each of the others!” Note: to my knowledge this limerick first appeared in an early edition of the Brealey and Myers textbook, but has since been removed. I believe (but can’t prove) that the original author is Merton Miller himself. Subscribe Now $9.99 for 4 months or $14.99 for a full year. September 21, 2005 Punishment to Fit the Crime Dennis Kozlowski, former CEO of Tyco, Inc., was sentenced on Monday to 8-25 years in jail, and fines and restitution of $167 million for stealing from Tyco. Mark Swartz, former Tyco CFO, was also sentenced to at least 8 years and payment of $72 million. Other well-known former executives have also recently received stiff sentences for similar crimes, including WorldCom CEO Bernard Ebbers (25 years), Adelphia Communications CEO John Rigas (15 years) and his son and CFO Timothy Rigas (20 years). Time Magazine’s website (http://www.time.com/time/business/article/0,8599,1106932,00.html) suggests that these sentences are too harsh, asking “Are white-collar criminals due for a sympathy vote? … Defense lawyers and, increasingly, many others are wondering if white-collar criminals are being treated too harshly. …. A chorus of dissent from business leaders, investors and even some regulators is rising." I’m always skeptical when journalists editorialize about rising choruses of dissent or rising tides of public opinion, but the question Time raises is fair – What is the appropriate punishment for executives who steal hundreds of millions of dollars?
The only argument, as I see it, for leniency for white-collar criminals is that the crime is not violent. Nobody is usually beaten or has a gun stuck in his face. But clearly, a CEO who steals hundreds of millions should receive a much stiffer sentence than somebody who only steals $1 million, and that person should be punished more harshly than somebody who only steals $10,000, and that person should be punished more harshly than somebody who steals $1,000. Sentencing guidelines for white-collar crimes, which take these types of factors into account, were the subject of a Senate hearing in 2002 (see http://judiciary.senate.gov/testimony.cfm?id=310). The testimony of John Coffee, the Berle Professor of Law at Columbia University, is perhaps the most informative on the current state of thinking on these matters. Coffee points out that deterring crime depends not so much on the harshness of the sentence, but on the probability of getting caught, which seems to argue for lighter sentences. I’ll point out that this argument only makes sense if we take steps to increase the probability of getting caught. White-collar crimes are notoriously difficult to discover and to prosecute. White-collar crime is quite common. The website http://frauddigest.com/news.php reports on the latest high profile court cases. Over the 5 days ending September 20, the site reports 20 cases including 5 cases on public corruption, 3 on embezzlement, 2 on charity fraud involving Hurricane Katrina, 2 on securities and investment fraud, a $1.9 million health care “rent-a-patient” fraud, and frauds involving government contracting, insurance, the internet, mortgage lending, newspaper circulation figures, and a Ponzi scheme involving phone-sex, as well as the Tyco sentencing. The former COO of Hollinger, Inc. (the world’s third largest publisher of English-language newspapers) pled guilty to one count of fraud in a $32 million fraud case. He is expected to cooperate in a federal investigation of his former boss, Conrad Black which may involve payments of $85 million. Hollinger, Inc. is now suing Black, its founder and former CEO for $425 million. The trial of former Illinois Governor George Ryan began. Ryan is accused of racketeering, mail fraud, tax fraud, and lying to federal agents in connection with the award of several large state contracts. A former Prudential broker pled guilty to defrauding mutual fund investors via improper trading practices. All of the jail sentences reported were less than Kozlowski’s 96 months, but two involving government corruption were 80 and 87 months. These may actually turn out to be stricter sentences because they will be served in federal prisons, whereas Kozlowski’s New York State sentence is more likely to be reduced by parole. White-collar crime is indeed wide spread. Sociologists report (see e.g. http://www.delmar.edu/socsci/rlong/intro/wc-crime.htm) that the monetary loss from white-collar crime is larger than the loss from all other types of crime. Nevertheless, white-collar suspects are much less likely to be convicted (5% in one study) and convicted white-collar criminals are much less likely to go to jail (17% in one study). Even white-collar criminals who go to jail sometimes emerge as millionaires: Kozlowski will likely be such a case. One similar case is Mike Milken, who pled guilty to 6 felonies involving securities violations in the 1980’s and according to news accounts at that time paid a “billion dollar fine.” Mike served less than 2 years in jail, and likely is still worth over a billion dollars. His website http://www.mikemilken.com/biography.taf now claims his conviction was the result of a conspiracy of his business enemies and that his fine was only about $200 million (he may be closely parsing the legal difference between the words “fine” and “restitution”). Indeed, after reading his website you may be tempted to call him “St. Mike.” Ultimately, the proper punishment for future corporate criminals is up to the people, voters and legislators, to decide. White-collar crime is clearly wide-spread and results in large monetary losses. It is difficult to prosecute, and punishment cannot be highly probable, simply by the nature of the crime. All this points toward stiff legal penalties, when they can be enforced. I’ll add one other suggestion – since the crimes are essentially monetary – much of the punishment should also be monetary. Payment of triple damages would ensure that very few white-collar criminals would remain millionaires. Sources: Christopher Bowe “Tyco’s Kozlowski to spend up to 25 years in jail,” Financial Times, September 19 2005. http://news.ft.com/cms/s/b014235e-2914-11da-8a5e-00000e2511c8.html Fraud Digest, September 20, 2005. http://frauddigest.com/news.php Daniel Kadlec “Does Kozlowski's Sentence Fit the Crime?” Time Magazine Web Exclusive, September 20, 2005. http://www.time.com/time/business/article/0,8599,1106932,00.html Russ Long, White-Collar Crime (lecture notes), August 23, 2005. http://www.delmar.edu/socsci/rlong/intro/wc-crime.htm Micheal Milken, “Micheal Milken, Philanthropist, Financier, Medical Research Innovator,” accessed September 20, 2005. http://www.mikemilken.com/biography.taf Senate Judiciary Committee, Subcommittee on Crime, Corrections and Victims’ Rights, "Penalties For White Collar Crime: Are We Really Getting Tough on Crime?" July 1, 2002. http://judiciary.senate.gov/hearing.cfm?id=310 John Coffee’s testimony, http://judiciary.senate.gov/testimony.cfm?id=310&wit_id=711 Subscribe Now $9.99 for 4 months or $14.99 for a full year. August 30, 2005 How Much Should Directors be Paid? Corporate governance – how the corporation should be run – is an issue that has received intense scrutiny since the Enron scandal and the resultant Sarbanes-Oxley Act of 2002. Ultimately, the corporate board of directors is the key institution designed to prevent abuse of corporate and managerial power. For example, the compensation committee of the board decides how key managers should be paid. But how much should the directors themselves be paid, and who should decide this question? The short answer to this question is that directors decide their own pay, usually based on surveys of director compensation, which are conducted by management consultants or by industry organizations such as the Conference Board. The Wall Street Journal reported yesterday on a Mercer Human Resources survey of 350 U.S. companies with revenue over $1 billion. The median pay of these directors rose 18% in 2004 to $155,000, including a record $85,000 coming from stock awards. Cash payments were up 10%, which include annual retainers, board meeting fees, and committee meeting fees. Annual retainers increased 25% to $50,000, board meeting fees stayed the same at $1,500, and committee meeting fees increased 25% to $1,500 on average. Only 64% of the firms pay board meeting fees, decreasing from 75% in 2000. The full report is available only to paying customers, but complete out-dated reports are available on the internet including the Conference Board’s 2003 report, which surveys a larger range of firms and breaks down results by firm size and industry (see http://www.heidrick.com/NR/rdonlyres/768BF3A0-AB04-4269-9A97-BEC765FC7206/0/TCB_DirCompBrdPractices.pdf). This report states that board members typically meet 4-16 times per year, with 6 meetings being the median. Board meetings last from 4 to 10 hours. Data on smaller firms are available in SEC filings, and may be reported in the local business press, such as this article from the Business Journal in North Carolina (http://triad.bizjournals.com/triad/stories/2005/04/11/story1.html?page=1). Many large firms now report director compensation policies as part of their overall corporate governance policies on their websites. Sites for IBM, McDonalds, and Microsoft are listed below. Chester Spatt, Chief Economist at the SEC, discusses several issues related to director pay in a speech given at Carnegie-Mellon University this summer. In passing, he questions the role of compensation surveys in determining director compensation, and explores what should be the underlying factors in their pay. One preliminary conclusion he suggests – if we want directors to be more independent of management – is that they should be paid more, relative to CEO’s compensation. Sources: Davis, Paul, “Triad firms raising pay for directors,” The Business Journal, April 11, 2005. http://triad.bizjournals.com/triad/stories/2005/04/11/story1.html?page=1 Plitch, Phyllis, “Director Pay Rose 18% in 2004, Largely Due to Rising Stock Prices,” The Wall Street Journal, August 29, 2005. p. C3. Spatt, Chester, “Governance, the Board and Compensation.” http://www.sec.gov/news/speech/spch060905css.htm IBM Corporate Goverance, http://www.ibm.com/investor/corpgovernance/index.phtml McDonald’s Corporate Governance, http://www.mcdonalds.com/corp/invest/gov.html Microsoft Corporate Governance, http://www.microsoft.com/mscorp/governance/guidelines.mspx The Conference Board, Directors’ Compensation and Board Practices in 2003. http://www.heidrick.com/NR/rdonlyres/768BF3A0-AB04-4269-9A97-BEC765FC7206/0/TCB_DirCompBrdPractices.pdf Subscribe Now $9.99 for 4 months or $14.99 for a full year. August 23, 2005 College and Textbook Costs Peter D. Ekman College tuition costs about three times as much as it did in the 1970’s after adjusting for inflation, writes Richard Vedder, an economics professor at Ohio University, in today’s Wall Street Journal. How did this happen? What accounts for the price increase? Vedder suggests 6 reasons: 1) rising demand fuelled by federal loans and grants, 2) the lack of market discipline in the mainly non-profit education sector; 3) the de-emphasis on undergraduate education; 4) price discrimination; 5) stagnant productivity; and 6) rent seeking behavior. All of these factors contribute, but – putting my two cents in - I’ll emphasize the effects of easily available federal loans on the market. Colleges and universities do not just sell education. They sell prestige and the contacts and job prospects that come with that prestige. The market for prestige is something like the market for diamond engagement rings – the more you spend the better. Actually, it doesn’t matter how much you spend, just as long as it’s more than what your neighbor spent. If you get your fiancée a $100 engagement ring, all you’ve bought is a load of trouble. A $1,000 ring might keep you up with the Joneses in some circles. Other suitors might need to spend $10,000 on a ring to keep up with their neighbors, even though a diamond ring might be considered intrinsically worthless. (I should emphasize that these are my opinions – not my wife’s.) Now imagine what would happen to the price of rings if the federal government started giving out easily available loans to buy diamonds. Everybody would have to buy a bigger diamond ring. Fiancées would not be happier, because their relative standing – their prestige - would be the same. Couples would start their married lives with larger debt, the government would hold a lot of risky loans , and the diamond cartel would get a lot richer. The word “cartel” is crucial in applying this analysis to the market for college education. Are colleges and universities a cartel that fixes prices to enrich themselves? That’s probably going too far, but it’s clear that university administrators are not very good at keeping costs low, and they do not compete on the basis of price. A generation ago, state universities and less prestigious colleges would emphasize their affordable prices, but now they seem to compete on how fast they can get applicants to the financial aid office. Some of the same forces may be driving the large price increases in textbooks. A Government Accounting Office report released in July reports that “enhanced offerings appear to drive recent price increases.” In other words, all the extra CDs, websites and workbooks publishers now include with texts cost so much to produce that they force prices upward at almost twice the rate of inflation. I don’t think so. College textbook prices are not determined by the costs of production, but rather by the market power of the relatively few publishers who dominate most subject markets. For example, the trade paperback “Finance” by Groppelli and Nikbakht is not sold as a textbook, but is widely available for less than $15. In its 600 pages, it covers essentially the same material as more prestigious textbooks, and does a good job at it. The standard MBA finance texts are slightly better – for example Brealey, Myers, and Allen certainly know how to turn a humorous phrase, and some of their examples are not only elegant in form, but also deserve a big belly laugh. Amazon.com sells the BMA text for $132.19 which includes all the bells and whistles. Bodie and Merton’s text has a higher list price, but sells at only $118.53, with all the bells and whistles. Ross, Westerfield, and Jaffe’s text has a similar list price, but looks like a bargain at $92.15. The main difference between these textbooks and the trade paperback is prestige. The textbooks have much more prestigious authors. Is this prestige really worth the 7-fold price difference? If students decided on textbooks rather than instructors, who rarely even know the price of the text, the decision would often be quite different. The argument that all the hi-tech extras - CDs and websites and such – are pushing textbook costs up should raise red flags with anybody who has studied the economics of information technology. Information technology drives down costs in most industries. My impression of textbook hi-tech extras is that most teachers don’t know what to do with them, the products don’t make very good use of the technology, and that they haven’t yet risen above the level of a marketing gimmick. I can’t tell students how to completely get around the high prestige – high cost – modern versions of higher education and college textbooks, but there is one factor that seems to have been left out by some schools and texts: education. If you know more than somebody who has gone to a more prestigious school, you might just occasionally get the jump on him. The only advice that I can give to students is to make sure that you learn – do everything possible to learn on your own – and isn’t that what higher education is supposed to be all about? I’ll end with a plug for my product – Disk Lectures in Finance – which gives you a complete set of MBA-level finance lectures including PowerPoint slides, audio, exercises with immediate feedback, dynamic graphics, web links, etc.– that can be downloaded for a total of $9.99 over a 4-month subscription period. 100% satisfaction guaranteed, or your full payment will be cheerfully refunded at any time during the subscription period. Let’s see if one of the major textbook companies will give you a similar guarantee! Sources: Richard Vedder “Why Does College Cost So Much?” The Wall Street Journal, p.A10, August 23, 2005. GAO Report “College Textbooks,” July 2005. http://www.gao.gov/new.items/d05806.pdf Associated Press “College textbook increases far outpace inflation. GAO report blames supplements, software for rapid rise in costs,” August 16, 2005. http://www.msnbc.msn.com/id/8963920/#storyContinued Inside Higher Education, “Taking Both Sides on Textbook Prices.” August 16, 2005. http://insidehighered.com/news/2005/08/16/textbooks Association of American Publishers, News release, August 16, 2005. http://www.publishers.org/press/releases.cfm?PressReleaseArticleID=276 Subscribe Now $9.99 for 4 months or $14.99 for a full year. August 8, 2005 Why Do People Trade Options? When you can buy or sell stock, why would you want to trade options instead? The standard answer to this question is that a small initial investment can result in very large returns, very quickly with options trading. (See the “Options 1” lecture at www.DiskLectures.com/freebies.php ) Sonja Anticevic, a 63 year old retired tailor from Omis, Croatia found this out the hard way. Mrs. Anticevic, who lives on a pension of about $263 a month and who occasionally works as a cleaning lady, is accused by the U.S. Securities and Exchange Commission of buying $130,000 of Reebok call options in the 2 days before Reebok was taken over by Adidas-Salomon AG. On the day the take-over was announced, she allegedly sold the call options for a $2 million profit. She told the Associated Press that she "never bought a stock and I have no idea how that works." Her nephew, who is reportedly a stock broker in New York, will likely be questioned in the affair. Other trades in Reebok options made on August 1-2 will also be investigated, according to The Wall Street Journal. 8,675 Reebok options were traded on those two days, more that 50 times the usual amount. Mrs. Anticevic is accused of trading 38% of the call options on those two days, even though she had never traded Reebok shares or options before, according to the SEC. The SEC investigation was prompted by the timing of the unusual volume. Of course, it is not illegal to make a profit trading options. Presumably, the SEC believes that Mrs. Anticevic traded on inside information, though it is not clear how she might have obtained the inside information. Sources:
Forbes.com. 8/08/05, http://www.forbes.com/home/feeds/ap/2005/08/08/ap2175419.html The Wall Street Journal, 8/08/05, p. C3, “SEC Wins Court Order in Case Prompted by Reebok Call Trades.” Securities Litigation Watch 8/05/05, http://slw.issproxy.com/../the_formula_sti.html Our Guarantee 100% satisfaction guaranteed, or your full payment will cheerfully be refunded, at any time during the subscription period. Subscribe Now $9.99 for 4 months or $14.99 for a full year. View detailed contents
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