The Float

Monday Reading

Regulatory reform edition...

• Paulson spoke this morning, but Yves Smith went to work on the Treasury proposal over the weekend.
• Paul Krugman gives it a name: "The Dilbert Strategy," heavy on flowchart shuffling, light on teeth.
• And as parts of official Washington turn to the question of What To Do Next, John Hussman isn't quite over What Was Done in the Bear Stearns deal...and he doesn't much like it.
• More on the policy front: Barry Ritholtz isn't impressed with a recent opinion letter from the SEC, which, Barry writes, is "nothing short of an invitation to commit fraud."
• And wrapping it all up: Minyanville's Mr. Practical wants everyone to "Let the Market Be."

Friday Reading

Go get 'em, Bucky...

• Worth thinking about, but not at all straightforward: The New York Fed's Tim Geithner on policymakers acting "to prevent excesses" in financial markets and asset prices.
• And some more Fedspeak: Mishkin on the desirability of just a little inflation (via Calculated Risk).
• Interesting rumination on those Q4 GDP numbers from the WSJ's Real Time Economics.
• Here's a long-ish profile of prophet of non-Gaussian randomness Nassim Nicholas Taleb from Bloomberg's Stephanie Baker-Said.
• From yesterday's New York Times, Vikas Baraj on Americans' $1.1 trillion in borrowing against their home equity.

Variable Annuities: A Common Misperception

This space has featured several arguments against variable annuities. For what we think is the most interesting of those arguments, click here. Last Thursday, we ran across another entry in the ongoing annuity debate, this one from Investors Business Daily.

Here's the opening stanza of Trang Ho's story:

The basic idea of an annuity is simple: You give an insurance or investment firm a wad of money. In return, it promises to pay you a set amount of money, every year, for the rest of your life.

The fear of running out of money in old age grows as traditional pensions dwindle and Social Security leads to insecurity.

Americans reacted to that concern by pouring $134.4 billion into variable annuities in the first nine months of 2007, says the Association of Insured Retirement Solutions. That was a 15% increase in sales over the year-before period.

Assets invested in variable annuities total $1.5 trillion.

What follows, from an industry representative, reflects one of the worst--and most harmful--misconceptions in the business: the idea that the moment of retirement represents the finish line.

"It's all about protection," said Robert DeChellis, president and CEO of Allianz Life Financial Services. "No one has control over the market the day they're retiring."

That's true, of course, but it's not nearly as relevant as the annuity sales force would like people to believe. Now, it clearly is the case that weak market returns in the early years of an investor's distribution phase can inflict disproportionate damage on a portfolio's staying power. But investors can and should manage their short-term risk without locking in depressed returns by paying far too much for market exposure. Here's IBD again (emphasis added in bold):

Annuity policies, fees, charges, investment options and tax treatments are complex. Tony Bahu, a former independent insurance agent who sold annuities, says agents don't really know what they're selling or don't fully disclose all the costs.

"They made these things sound like they're a cure for cancer," said Bahu. "The agent goes out and maybe doesn't do his research and just believes what the insurance company is stating (and sells) this thing without proper knowledge or with bad information."

So what are the charges that can eat away at your returns?

Start with mortality and expense, or M&E. According to the Securities and Exchange Commission, M&E typically costs 1.25% of the total account every year. This is for taking on the insurance risk of the annuity contract. It helps cover the company's costs, such as paying the insurance agent's commission.

Administrative fees cover such items as record keeping. This can be a flat fee of $40 a year or 0.15% of the total account, the SEC says.

Surrender or withdrawal fees are the penalty for taking money out early or canceling contracts. Fees start at 8% for as long as the first 10 years of contracts, then decrease.

Variable annuities, which hold mutual funds, bonds or money markets, also charge sales loads and management fees for the underlying investments. And switching investment options can bring a transfer-fee bill.

Guess what else? A fee exists for each additional perk such as a stepped-up death benefit, long-term care insurance or protection against market declines. Some states and cities levy a premium tax--sometimes as high as 3.5%--on an annuity's value when it's sold.

Given widespread--and, we think, entirely justified--expectations of subdued market returns, these expenses could fully wipe out several years' gains. But the sales force remains undaunted:

Allianz's DeChellis defends annuities, arguing that record annuity sales show that Americans put a high premium on steady and secure retirement payments.

Actually, we think it shows that too-slick-by-half sales tactics and glossy brochures can exploit investor naïveté--to the detriment of most.

Source

Trang Ho, "Annuities: Plus Or Too Many Minuses?" Investors Business Daily, March 20, 2008

Stubborn Credit Markets

Good piece in this morning's Journal on stubborn credit markets. This isn't exactly breaking news, but the story makes an important Big Point, and provides a couple nice graphics, which we've included below:

The Federal Reserve's efforts to heal broken credit markets have diminished worries about a big financial failure, but wariness about lending remains in bond and loan markets.

This wariness shows up in the movements of many interest rates and in a commonly watched measure of risk known as a spread. A bond's spread is the difference between its interest rate and the interest rate on a relatively risk-free investment, like a Treasury bond or a Federal Reserve loan. When spreads get bigger, as they have in recent months, it shows that investors are reluctant to own anything but the safest investments.

In many markets, ranging from short-term money markets, to mortgage markets to junk-bond markets, spreads have improved since the Fed's actions of last week. But they remain elevated compared with a few months ago.

Bankers and Federal Reserve officials are watching carefully to see if these spreads come down as a sign of a return to normalcy.

Other measures of risk in credit markets, such as the cost of insuring bonds against default, have improved, particularly for bonds issued by financial institutions, but they aren't out of the woods yet.

Source

Liz Rappaport, "Bond, Loan Markets Remain Wary," Wall Street Journal, March 27, 2008 (subscription required)

The "Lost Decade"

Amid all the chatter about E.S. Browning's big think piece in this morning's Wall Street Journal on the last 10 years in the financial markets, we'd like to make a few simple points. Let's begin with the opening passages from Browning:

Over the past 200 years, the stock market's steady upward march occasionally has been disrupted for long stretches, most recently during the Great Depression and the inflation-plagued 1970s. The current market turmoil suggests that we may be in another lost decade.

The stock market is trading right where it was nine years ago. Stocks, long touted as the best investment for the long term, have been one of the worst investments over the nine-year period, trounced even by lowly Treasury bonds.

The Standard & Poor's 500-stock index, the basis for about half of the $1 trillion invested in U.S. index funds, finished at 1352.99 on Tuesday, below the 1362.80 it hit in April 1999. When dividends and inflation are factored into returns, the S&P 500 has risen an average of just 1.3% a year over the past 10 years, well below the historical norm, according to Morningstar Inc. For the past nine years, it has fallen 0.37% a year, and for the past eight, it is off 1.4% a year. In light of the current wobbly market, some economists and market analysts worry that the era of disappointing returns may not be over.

First, notwithstanding the protestations of a few CNBCers* that Browning's story has them "depressed" today, this isn't news to anyone who's been paying even the slightest attention. As we noted on March 3rd in a piece on Warren Buffett's annual letter, back in the Summer of 2004, the Financial Times ran "Buy-and-hold on permanent hold," a piece that compared the experience of the early 2000s to the equity plateaus of the 1930s and 1960s/70s. (To compare these episodes, check out this slick trio of charts from the WSJ.)

Second, we think the primary headline on the Browning piece--"Stocks Tarnished by 'Lost Decade'"--is backward. For investors looking forward from this point, stocks have actually regained some of their luster...because the multiple compression of the last several years has improved their expected future returns. Which isn't to say that the process of multiple compression has run its course. We think more of the same lies ahead. But relative to where equities were valued in 1999 and early 2000...the last few years have made big-cap U.S. stocks more compelling in the medium term (i.e., a full market cycle) relative to certain asset classes that have clearly outperformed S&P 500-style securities. For a comparison of several major asset classes, see the adjacent WSJ graphic. Again, this does not constitute a near-term prediction about asset class performance. It's a bigger-picture argument about relative valuations and reversion-to-the-mean.

Third, as the adjacent table shows, and as any responsible participant in the capital markets knows, large-cap U.S. equities are just one asset class. So yes, if someone owned only an S&P 500 index fund (or only actively managed funds benchmarked to the S&P 500), the last nine years would have amounted to very little indeed. But prudent investors weren't so wildly over-allocated to big-cap domestic stocks, and intelligent rebalancing, let alone (as Browning points out) an ongoing process of dollar-cost-averaging, would have delivered substantial benefits over the last several years, both in terms of risk management and improved returns.

Fourth, John Bogle was exactly right this afternoon in his interview with Erin Burnett: Periods of muted returns make the management of expenses--and of investor behavior--more important than ever.

~~~~~~~~~~~~~~~~

*Overheard: Kneale and Burnett. We suspect more such claims were made while we weren't listening.

Sources

E. S. Browning, "Stocks Tarnished by 'Lost Decade'," Wall Street Journal, March 26, 2008 (subscription required)

Elizabeth Wine, "Buy-and-hold on permanent hold," Financial Times, August 30, 2004

Update: Things We Don't Like About CNBC

With Dennis Kneale back from vacation, we thought this would be a good time to add to our CNBC list. Alas, this one isn't Kneale's fault.

New Item

• The little clock in the upper-right corner of the network's charts rushing past in hundredths of seconds. As if the general tone of the whole production weren't short-term jumpy enough.

Old Items

• Those Pat Boone gold ads. The leathery face is bad enough, but the overweening hucksterism has earned these spots a place in this particular hall of shame.
• Cramer's Fed-Begging. Part schtick, part sincere, entirely over the top.
• Rick Santelli not getting enough love. Chicago's own is a rare (if not "lone") voice of reason in the wilderness.
• Erin Burnett insisting that her guests say something positive. We like positive stuff ourselves--where it's justified. But scraping around for a "silver lining" for its own sake strikes us as something other than disinterested.
• Dennis Kneale. We don't understand Kneale's relentless, damn-the-evidence optimism on the economy and the markets. But the real problem with Kneale is that no one on CNBC's air gets more immediate corrections, curious looks, and dismissive headshakes. It's the willful cluelessness, not the opinions themselves, that make Kneale CNBC's most mutable voice. We simply do not understand why the network has made him such a fixture. Perhaps it's because no one with a fuller sense of reality could muster Kneale's spin--a kind of spin CNBC's decision-makers think they need to sustain their audience.
• "It's four o'clock on Wall Street. Do you know where your money is?" What in the world is that supposed to mean? Why do Maria Bartiromo and her understudies insist on saying it every day? This is a daily must-mute moment.
• The sound effects used to transition between images during Bartiromo's 4:00 summary schtick. Too loud. Too grating. Utterly unnecessary. Sort of like most of the fake noise made in NBA arenas these days: sound and fury signifying nothing.
• Inane questions about why the market is doing what it's doing at a given moment. Bill Griffeth on February 27th, when the S&P 500 was 0.73 points above the previous day's close: "Why are we higher today?" Good grief.

As always, we'll add more as necessary, so feel free to send us your nominations.

Wednesday Reading

March madness edition...

• At MarketBeat, David Gaffen collects a few observations on 10 years of treading water in large-cap U.S. equities.
• From The Economist's big package on Wall Street's woes: A pithy comparison of banking crises past and present, which includes this point concerning the interdependence we noted on Monday: "The growing complexity of links between banks is the reason why Bear Stearns, an investment bank that may not have worried regulators had it failed 15 years ago, could not be left to collapse today."
• Via Yves Smith: The FT's Martin Wolf pronounces March 14th to be "the day the dream of global free-market capitalism died."
• A new regulatory framework is on its way.
• This is Ritholtz at his best: Calling out the National Association of Realtors, and various media enablers, for their horrific spin.

One Year In

Today marks the passage of one year since we posted the first humble item in this space. In those 12 months, we've seen a powerful cyclical bull run its course, a tremendous spike in market volatility, the rise, demise, and dubious debuts of high-powered players from the worlds of private equity and investment banking. We've seen incredible events--and a wide range of truly unbelievable claims.

Today we'll look forward to The Float's second year by taking a look back at its first, through a collection of our 10 favorite items, offered here in chronological order, starting in the Spring of 2007...

1. "Slay the Right Dragon," May 17, 2007
2. "It Pays To Do the Math," June 18, 2007
3. "If the Fed Acts, Will It Matter?" September 10, 2007
4. "Wring Out the Excess," September 14, 2007
5. "A Short Note on Liquidity," October 12, 2007
6. "Wasik on 401(k) Plans: Half Right," November 8, 2007
7. "Real Participants, Real Problems," November 9, 2007
8. "Hubris," January 7, 2008
9. "Target-Date Funds Revisited," February 11, 2008
10. "Faster Markets," February 14, 2008

We'll kick off our second year of blogging with new material tomorrow morning.

Monday Reading

Animal spirits edition...

• Two great items from Barry Ritholtz: "Investing in a Post-Fact Society" and, from the Department of Don't-Believe-the-Hype, the closely related "February Existing Home Sales Fell 23.8%."
• More on those existing home sales numbers from Calculated Risk.
• With this morning's news, John Hussman's prediction of $0 per share for Bear Stearns looks relatively unlikely, but his latest market comment delivers your weekly dose of righteous indignation at the Fed's deal with JP Morgan.
• From BusinessWeek's Aaron Pressman: Commodities can be (i.e., will be) turbulent, but they play an important if modest role in a diversified portfolio.
• We don't do politics here, but purely on the economic merits, this strikes us as an exceptionally bad idea.
• Whatever Wall Street's short-term prospects, there's still plenty of foreboding stuff on Main Street. From Reuters, "'Pay day' loans exacerbate housing crisis." And from Workforce Management, "More Employees Borrowing Against 401(k) Plans."

Dilution Was No Solution

Reflecting on the last few years--and especially the last few months--in the financial markets, one of the more remarkable subplots was just how convinced many participant-observers were that what started in subprime would stay there. The notion of "containment" never struck us as particularly plausible, but it sustained a furious bull run through mid-July, 2007.

Though his Harper's piece isn't exactly news anymore (it appeared in the February issue), Eric Janszen captured the essence of the problem as well as anyone. Here's our favorite passage from a very good essay (emphasis added in bold):

The U.S. mortgage crisis has been labeled a "subprime mortgage crisis," but subprime mortgages were only a sideshow that appeared late, as the housing-bubble credit machine ran out of creditworthy borrowers. The main event was the hyperinflation of home prices. Risks are embedded in price and lurk as defaults. Even after the faith that supported a bubble recedes, false beliefs continue to obscure cause and effect as the crisis unfolds.

Consider the chemical industry of forty years ago, back when such pollutants as PCBs were dumped into the air and water with little or no regulation. For years, the mantra of the industry was "the solution to pollution is dilution." Mixing toxins with vast quantities of air and water was supposed to neutralize them. Many decades later, with our plagues of hermaphrodite frogs, poisoned ground water, and mysterious cancers, the mistake in that logic is plain. Modern bankers, however, have carried this mistake into the world of finance. As more and more loans with a high risk of default were made from the late 1990s to the summer of 2007, the shared level of credit risk increased throughout the global financial system.

Think of that enormous risk as economic poison. In theory, those risk pollutants have been diluted in the oceanic vastness of the world's debt markets; thanks to the magic of securitization, they are made nontoxic and so pose no systemic risk. In reality, credit pollutants pose the same kind of threat to our economy as chemical toxins do to our environment. Like their chemical counterparts, they tend to concentrate in the weakest and most vulnerable parts of the financial system, and that's where the toxic effects show up first: the subprime mortgage market collapse is essentially the Love Canal of our ongoing risk-pollution disaster.

The point here is interdependence, awareness of which never should have deserted investors. But it did. And some very high prices have been paid for such willful ignorance of the defining characteristic of modern life.

Source

Eric Janszen, "The next bubble: Priming the markets for tomorrow's big crash," Harper's, February, 2008