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Top 10 Financial Reasons Blessings This Year
Nov 28th
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Yep, it’s been a tough year. There’s still much to lament, such as decades-high unemployment, rising budget deficits and shaky financial institutions, but considering the abyss we were staring squarely into at this time last year, we’ve also come a long way and made great strides toward a healthier economy. So, as we enter the traditional Thanksgiving period, let’s take a few moments to give thanks for the modest financial gifts we’ve received this year – and maybe more importantly, give thanks that in many cases, our worst financial fears failed to materialize.
1. Major Stock Indexes Rise
Good tidings! Major stock indexes are up 60% since their March lows. The rebound in our equity markets has been critical on several fronts. First, it has helped stem the losses seen in retirement accounts like 401(k)s and IRAs. These retirement accounts are increasingly the No.1 funding vehicle for retirees, so recouping any losses here is a big help, especially to the baby boomer demographic.
There’s also a confidence issue at play, and our stock markets – for better or worse – are a de facto barometer, an economic "feel-good" factor. Fortunately, stock markets look forward, not back. Right now, they’re telling us they anticipate better times down the road.
2. GDP Growth Returns
Gross domestic product growth is the engine that makes everything go in our economy. GDP growth leads to stock market growth contributes to job and wage growth, and increases tax revenues for state and local governments to help balance their budgets. We obviously need all of these things, and the GDP growth of 3.5% in the third quarter was a good start.
We still need consistent GDP growth over several quarters to claim economic victory, and we need it to be more organic, not artificially spurred by government stimulus and one-time fiscal measures. As we look forward to 2010, this will be the biggest catalyst to getting us out of this recession and bringing down our nosebleed unemployment level.
3. Banks Repay Their TARP Loans
Ten of the banks that received Troubled Asset Relief Program (TARP) funds were allowed to repay $68 billion to taxpayers in June, and most of the major recipients have committed to fully repaying their TARP loans over the next 24 months. Also, as the stock prices of major banks rise, the chances of the government earning a good return on its TARP loans and direct investments only increases.
Even the much-maligned auto makers are starting to make good on their promises to pay. General Motors even announced that it would start repaying its $15+ billion in federal loans.
4. Home Prices Are Stabilizing
While home prices are still down 30% from their peak, prices in many geographic areas ticked upward in August, September and October according to the benchmark Case-Shiller Index.
If home prices can stabilize and even (gasp!) begin to rise in 2010, the hundreds of billions in mortgage-backed securities (MBS) can begin to improve the balance sheets of our battered financial institutions rather than deteriorate them, as has happened for the past two years. There’s still much progress that needs to be made, however, as mortgage delinquencies are still on the rise, and the threat of higher interest rates looms on the horizon. But hey, it could be worse – a lot worse.
5. First-Time Homebuyer Tax Credit Is Extended
The $8,000 tax credit for first-time homebuyers was scheduled to end on December 1, but those who didn’t get on board in time have plenty of reason to be grateful. President Obama recently extended the credit until June 2010 in an effort to help to spur the housing market further. It was a smart move by Congress, as new housing starts remain at multi-decade lows, and inventory levels are still high across the housing market. The tax credit was also expanded to include income levels of up to $125,000 for individuals and $225,000 for joint filers.
6. Corporate Profitability Is Getting Stronger
Profit margins have been strong at corporations over the past few quarters as inventories have been depleted and costs wrung out of business models. We still need to see more demand in the form of revenue growth, but stabilization and earnings per share (EPS) growth is good and companies should come out of this whole mess stronger, smarter and looking to hire if conditions continue to improve. Higher EPS numbers also mean more tax revenues, which are sorely needed.
7. The Rest of the World Is Resilient and Growing
Another good sign: Many foreign markets are doing quite well. GDP growth in China and India is tracking above 7% for the year, Brazil is growing and will begin its mega infrastructure roll-out to prepare for the Olympics in 2016, and smaller emerging economies in South America and Asia are holding steady and/or growing.
The internal, domestic economic strength of these foreign markets will help U.S. exporters to sell more goods, which represent over half the earnings of S&P 500 companies.
8. Inflation Is at Bay
Inflation has yet to appear, which is keeping interest rates low. This is helping the U.S., as it must borrow heavily to fund its growing budget deficits. Most economists do agree that inflation is inevitable down the road given all the money being sloshed around Washington and Wall Street, but there seems to be enough slack in the economy that we may have a few more quarters before inflation creeps up on us. By then, hopefully the economy is on better footing, which will allow the Federal Reserve to raise rates slowly, without stifling the recovery.
9. Regulatory Scrutiny Has Increased
The Securities and Exchange Commission (SEC) has been near the top of a long list of entities that deserve a good finger-wagging for errors of submission or omission leading up to the financial crisis. But new measures are being put into place to protect investors from fraud and negligence by their financial advisors and corporate CEOs.
Whether the SEC is up to the task remains to be seen, but you can bet that they are embarrassed and bruised, and will be on the warpath to find the next problem before it blows up in their face. Any increased diligence by the SEC, or by groups like the credit ratings agencies (who are also quite red in the face) can only help investors in 2010 and beyond.
10. We’re Still Standing!
Last year at this time, many wondered if our financial system would even survive at all. It did (thank goodness), and that may be the best blessing of all.
8 Investing Lessons From John Paulson
Nov 23rd
Even as the financial system collapsed last year, and millions of investors lost billions of dollars, one unlikely investor was racking up historic profits: John Paulson, a hedge-fund manager in New York.
His firm made $20 billion between 2007 and early 2009 by betting against the housing market and big financial companies. Mr. Paulson’s personal cut would amount to nearly $4 billion, or more than $10 million a day. That was more than the 2007 earnings of J.K. Rowling, Oprah Winfrey and Tiger Woods combined.
How did he do it? Believing that a housing-market collapse was coming, Mr. Paulson spent over $1 billion in 2006 to buy insurance on what he then saw as risky mortgage investments. When the housing market cracked and the mortgages tumbled, the value of Mr. Paulson’s insurance soared. One of his funds rose more than 500% that year. Then in 2008, he shorted financial shares, or wagered that they would fall in price, profiting again when these companies collapsed.
And are there any investing skills that average investors can learn from his success? Yes. There are no guarantees, of course, but the success of Mr. Paulson and a few other underdog investors lends encouragement to individuals trying to compete with Wall Street’s pros.
Here are eight investing lessons of Mr. Paulson’s $20 billion gamble, the greatest trade in financial history:
1. Don’t Rely on the Experts
Many investors lost big in 2007 and 2008 as housing crumbled and the stock market tumbled. But no one lost more than commercial and investment banks caught with toxic mortgage-related securities. These bankers were the very same ones who created these investments, and Wall Street’s top analysts had vouched for their safety, even as Mr. Paulson and others bet against the investments.
Lesson: When Wall Street is wheeling out its latest can’t-miss product, be skeptical.
2. Bubble Trouble
Some academics argue that financial markets have become more efficient. But a rash of financial bubbles in recent years — including housing, energy, technology and Asian currencies — suggests that markets are becoming harder to navigate, and are more prone to overshooting. Today, investors of all sizes read the same articles, watch the same business-television programs and chase the same hot tips. They invariably head for the exits at the same time.
Lesson: Have an exit strategy — and cash to cushion any tumble.
3. Focus on Debt Markets
Most investors track the ups and downs of the stock market but have only a vague sense of moves in debt markets. That’s a mistake. Early signs of trouble were seen in sophisticated markets that don’t get much limelight, like the subprime-mortgage bond market. These problems eventually felled the housing and stock markets, and the overall economy, a set of falling dominos that Mr. Paulson and his team correctly anticipated.
Lesson: Debt markets can do a better job predicting problems than stock markets.
4. Master New Investments
Mr. Paulson scored huge profits by buying credit-default swaps, a derivative investment that serves as insurance on debt. When risky mortgage bonds tumbled in value, Mr. Paulson’s insurance soared. But many experts were flummoxed by CDS contracts or shied away from educating themselves about these relatively new investments.
Mr. Paulson and his team had no experience with CDS contracts. But they put the time into learning about them.
Lesson: Educate yourself about the range of exchange-traded funds being introduced, some of which can play a valuable role in a portfolio.
5. Insurance Pays
A number of investors worried about a bursting of the housing market, but few did much about it, even though insurance, such as CDS contracts, at the time were selling at dirt-cheap prices. Out-of-the-money put contracts — options that pay off only if the market tumbles — also were trading at reasonable levels. As cheap as this insurance was, many pros ignored it.
Lesson: Don’t underestimate the value of a safety net, such as put options.
6. Experience Counts
Some of the biggest winners in the meltdown were middle-aged investors dismissed by some as past their prime. But they had experienced past market downturns, while some of the bankers and analysts caught flat-footed knew only good times.
Lesson: A historical perspective can be a valuable tool.
7. Don’t Fall in Love
With an Investment. In early 2009, Mr. Paulson became more bullish about the banks and financial companies that he had wagered against in 2008, after determining that these companies had improved their balance sheets. The moves resulted in profits this year.
Lesson: Even the greatest trade doesn’t last forever.
8. Luck Helps
In early 2006, Mr. Paulson determined that housing was in trouble and set out to profit from the impending fall. But some housing experts already had determined that real estate was overpriced; others had wagered against housing but could no longer stomach their losses. Just months after Mr. Paulson placed his historic trade, U.S. housing prices began to fall.
Lesson: Don’t risk too much in any one trade, even one that seems like a sure thing.
Warren Buffett investments: businessman extraordinaire
Nov 18th
By Charlie Carter 11/04/09 – 17:32
Yesterday, American investor and business mogul Warren Buffett announced that his conglomerate holding company Berkshire Hathaway will pay $34 billion to buy out Burlington Northern Santa Fe Corp – his biggest-ever acquisition.
The move is based on a bet by Buffett that BNSF – the US’s largest rail company – will see massive benefits from a recovering US economy.
Meanwhile, reports are beginning to surface that the massive deal may lead Buffett to sell some of his prior investments, which include a number of insurance and financial firms – such as M&T Bank and American Express – as well as food and beverage giant the Coca-Cola Co. and newspaper publishing firms including the Washington Post.
Life at the top
The history of Warren Buffet investments are long and complex and to call Buffett a seasoned-investor is something of an understatement. As company chairman and CEO of Berkshire Hathaway, Buffett has long used the "float" provided by his firm’s insurance operations to finance his own investments.
In the early days of his career at Berkshire, Buffett tended to focus on long-term investments in publicly quoted stocks, but has more recently turned his attention to buying whole companies out – like BNSF – that have subsequently provided the elusive investor with a plethora business ventures, included outlets in candy production and jewelry sales.
Earlier this month, British economist and television presenter Evan Davis met with Buffett for a BBC television documentary, The World’s Greatest Money Maker. The honorary title is clearly warranted.
In short, Buffett manages to make more money than other investors by essentially being less ambitious. While Wall Street’s "Up-and-Coming" set their sights on high returns, using leverage, Buffett’s steady annual compounding of increases, avoiding debt, has always worked better.
Warren Buffett, one of the world’s best-known business people, is clearly different from the rest of the super-rich. At cut above, you could argue. As his biographer, Alice Schroeder, explains, Buffett’s method is "simple, but it’s not easy."
And, with yet another massive investment now under his belt, there is definitely more to this captivating financial services tycoon than meets the eye. Warren Buffett, we salute you!
6 Simple Steps to $1 Million
Nov 16th
Glenn Curtis
Monday, October 26, 2009
This article is part of a series related to being Financially Fit
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Let’s face it; we all don’t make millions of dollars a year, and the odds are that most of us won’t receive a large windfall inheritance either. However, that doesn’t mean that we can’t build sizeable wealth – it’ll just take some time. If you’re young, time is on your side and retiring a millionaire is achievable. Read on for some tips on how to increase your savings and work toward this goal.
Stop Senseless Spending
Unfortunately, people have a habit of spending their hard-earned cash on goods and services that they don’t need. Even relatively small expenses, such as indulging in a gourmet coffee from a premium coffee shop every morning, can really add up – and decrease the amount of money you can save. Larger expenses on luxury items also prevent many people from putting money into savings each month.
That said, it’s important to realize that it’s usually not just one item or one habit that must be cut out in order to accumulate sizable wealth (although it may be). Usually, in order to become wealthy one must adopt a disciplined lifestyle and budget. This means that people who are looking to build their nest eggs need to make sacrifices somewhere – this may mean eating out less frequently, using public transportation to get to work and/or cutting back on extra, unnecessary expenses.
This doesn’t mean that you shouldn’t go out and have fun, but you should try to do things in moderation – and set a budget if you hope to save money. Fortunately, particularly if you start saving young, saving up a sizeable nest egg only requires a few minor (and relatively painless) adjustments to your spending habits.
Fund Retirement Plans ASAP
When individuals earn money, their first responsibility is to pay current expenses such as the rent or mortgage expenses, food and other necessities. Once these expenses have been covered, the next step should be to fund a retirement plan or some other tax-advantaged vehicle.
Unfortunately, retirement planning is an afterthought for many young people. Here’s why it shouldn’t be: funding a IRA early on in life means you can contribute less money overall and actually end up with significantly more in the end than someone who put in much more money but started later.
How much difference will funding a vehicle such as a Roth IRA early on in life make?
If you’re 23 years old and deposit $3,000 per year (that’s only $250 each month!) in a Roth IRA earning and 8% average annual return, you will have saved $985,749 by the time you are 65 years old due to the power of compounding. If you make a few extra contributions, it’s clear that a $1 million goal is well within reach. Also keep in mind that this is mostly interest – your $3,000 contributions only add up to $126,000.
Now, suppose that you wait an additional 10 years to start contributing. You have a better job and you know you’ve lost some time, so you contribute $5,000 per year. You get the same 8% return and you aim to retire at 65. When you reach age 65, you will have saved $724,753. That’s still a sizeable fund, but you had to contribute $160,000 just to get there – and it’s no where near the $985,749 you could’ve had for paying much less.
Improve Tax Awareness
Sometimes, individuals think that doing their own taxes will save them money. In some cases, they might be right. However, in other cases it may actually end up costing them money because they fail to take advantage of the many deductions available to them.
Try to become more educated as far as what types of items are deductible. You should also understand when it makes sense to move away from the standard deduction and start itemizing your return.
However, if you’re not willing or able to become very well educated filing your own income tax, it may actually pay to hire some help, particularly if you are self employed, own a business or have other circumstances that complicate your tax return.
Own Your Home
At some point in our lives, many of us rent a home or an apartment because we cannot afford to purchase a home, or because we aren’t sure where we want to live for the longer term. And that’s fine. However, renting is often not a good long-term investment because buying a home is a good way to build equity.
Unless you intend to move in a short period of time, it generally makes sense to consider putting a down payment on a home. (At least you would likely build up some equity over time and the foundation for a nest egg.)
Avoid Luxury Wheels
There’s nothing wrong with purchasing a luxury vehicle. However, individuals who spend an inordinate amount of their incomes on a vehicle are doing themselves a disservice – especially since this asset depreciates in value so rapidly.
How rapidly does a car depreciate?
Obviously, this depends on the make, model, year and demand for the vehicle, but a general rule is that a new car loses 15-20% of its value per year. So, a two-year old car will be worth 80-85% of its purchase price; a three-year old car will be worth 80-85% of its two-year-old value.
In short, especially when you are young, consider buying something practical and dependable that has low monthly payments – or that you can pay for in cash. In the long run, this will mean you’ll have more money to put toward your savings – an asset that will appreciate, rather than depreciate like your car.
Don’t Sell Yourself Short
Some individuals are extremely loyal to their employers and will stay with them for years without seeing their incomes take a jump. This can be a mistake, as increasing your income is an excellent way to boost your rate of saving.
Always keep your eye out for other opportunities and try not to sell yourself short. Work hard and find an employer who will compensate you for your work ethic, skills and experience.
Bottom Line
You don’t have to win the lottery to see seven figures in your bank account. For most people, the only way to achieve this is to save it. You don’t have to live like a pauper to build an adequate nest egg and retire comfortably. If you start early, spend wisely and save diligently, your million-dollar dreams are well within reach.
10 investing basics from Buffett
Oct 25th
The Oracle of Omaha became one of the world’s richest people by adhering to simple but critical tenets. Here are his rules for smart living and savvy investing.
MSN Money
Last year’s market madness didn’t just flush away $7 trillion in wealth.
It also washed away a lot of investors’ confidence and left them stumped about the best position to take now. "Somewhere between cash and fetal," quips one pessimist.
In such downbeat times, let’s consider a dose of optimism, wisdom and insight: the basics as taught by that perennial investing Yoda, Warren Buffett.
For new investors or those now starting over, there’s good news here because Buffett’s investment success comes from some easy-to-grasp human qualities as much as sophisticated expertise in balance sheets.
Buffett would be the first to say his homespun and positive philosophy played a big role in his becoming the richest person in the world (before he gave most of his loot away).
Changing your basic psychology can be tough, so new investors may have a leg up here because they don’t have ingrained bad habits. But for anyone, a psychological makeover is worth the effort if you hope to recover your losses in the market’s next leg up — and then make the right moves for the rest of your life.
My tour of the essence of Buffett’s wisdom starts with the simple psychological lessons taught by the master, many of which are applicable in life outside investing.
Lesson No. 1: Be frugal
If the economic downturn is forcing you to live simply, look on the bright side: It’s making you more like Buffett.
Buffett lives in the same modest house in Omaha, Neb., that he bought more than five decades ago. He drives his own car.
How does this make him a better investor? First, it gives him more to invest.
Second, a frugal investor will demand this quality from managers. Buffett is leery of corporate waste. Excessive executive pay or silly perks are red flags. Buffett once quipped that companies stack pay committees with "sedated Chihuahuas."
Third, frugal people don’t need fast returns to support extravagant lifestyles. This leaves them free to think more clearly about when to buy and sell stocks, making them much better investors, believes Stephen Shueh, a Buffett expert and managing partner of Roundview Capital in Princeton, N.J.
Lesson No. 2: Wait for the ‘fat pitch’
Resist the itch to constantly buy or sell stocks.
"Lethargy bordering on sloth remains the cornerstone of our investment style," quipped Buffett in his 1990 annual report to Berkshire Hathaway (BRK.A, news, msgs) shareholders. Have the patience to wait a long time until some market turbulence brings the "fat pitch," as Buffett calls it, or stocks of great companies trading at really cheap valuations.
Lesson No. 3: Be a contrarian
A great way to make money is to go against the crowd. "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful," Buffett explained in a 1986 letter to shareholders.
So be skeptical of the conventional wisdom. Not because the crowd is always wrong but because the crowd’s wisdom is probably already reflected in market prices, says Todd Lowenstein, a portfolio co-manager of the HighMark Value Momentum Fund (HMVMX).
When the investing public is extremely negative, it’s usually a good time to buy stocks. When investors are confident, be careful.
Lesson No. 4: Stick with what you know
One of Buffett’s basic rules is: If you don’t understand a company’s product or how it makes money, avoid it. He calls this "staying within your circle of confidence."
This isn’t always easy. During the late 1990s boom, Buffett famously avoided tech companies, confessing that he could not understand what they did. He looked dumb until the bubble burst. "Ultimately, when it came full circle, he was proven right," Lowenstein says.
Lesson No. 5: Don’t depend on others to say you’re right
If you are in need of constant affirmation about your investment decisions, particularly from the stock market, you won’t be able to invest like Buffett, points out Legg Mason (LM, news, msgs) money manager Robert Hagstrom in his book "The Warren Buffett Way."
That’s because Buffett makes outsized returns by purchasing disliked value stocks that are so beaten down they’re often virtually ignored by the talking heads. They won’t be on TV every week telling you that you made the right choice.
Lesson No. 6: Buy companies cheap
This is the essence of being a value investor. The first step involves calculating what Buffett calls an "intrinsic value" for a business — either by examining what similar companies sell for or calculating the present value of all the cash that will be generated by a company in the future. For more details on how to do this, you’ll have to consult books such as "The Warren Buffett Way" or "The Market Gurus" by Validea’s John Reese.
Next, build in a "margin of safety" by purchasing a stock well below its intrinsic value.
Buffett doesn’t pay much attention to earnings per share, a common measure of value. Instead, he likes to see companies with good return on equity, solid operating margins and reasonable or no debt. He also likes to see that companies generate a lot of cash and that they invest it well or return it to shareholders in the form of dividends or buybacks.
The key throughout this analysis is to look back over five years or more. Buffett wants to see a consistent operating history; he’s not into startup companies. He also prefers to gauge how well a company does in different kinds of markets, not just the good times or the latest quarter.
Lesson No. 7: Look for companies with economic moats
A key characteristic supporting consistent operating history is a sustainable competitive advantage. In other words, a company should have a barrier to entry — or a kind of moat — that keeps potential competitors at bay.
This could be a patent protection on drugs, high costs to get into a business or simple brand power, fund manager Lowenstein says. "Franchise" businesses like these can do well because they have the power to raise prices. In contrast, companies in "commodity" businesses have to take whatever price is set by a competitive market — which can crush profits during hard times.
BNSF Railway is a great example of a "franchise" business. It’s pretty hard for anyone to lay enough track in North America to start a competing railroad. Coca-Cola (KO, news, msgs), another long-term Buffett holding, has barriers to entry in the form of a strong global brand and distribution system that is hard to replicate.
Lesson No. 8: Buy big, concentrated positions
Most professional money managers protect against risk by diversifying. Buffett goes against the crowd here, too. When he finds a company he likes, he piles into it big time.
This is crucial to his success. Money manager Hagstrom calculates that if you eliminate a dozen of Buffett’s best investment choices over his career, he’s only an average performer. Buffett thinks his risk protection comes from understanding a business better than the market does and then being patient enough to buy it at the right price.
Lesson No. 9: Hold for life
Buffett quips that his favorite holding period is "forever." Embedded in this concept are two key Buffett tenets I’ve already alluded to. First, it’s worth investing only in companies that are good enough to outperform for decades. Next, you have to think on your own and avoid the madness of the crowd.
"Buffett believes that unless you can watch your stock holdings decline by 50% without becoming panic-stricken, you should not be in the stock market," Hagstrom says.
This doesn’t mean buy and forget. Buffett tracks his investments closely and gets out when he thinks that they are fully valued or that trouble is on the way, points out Pat Dorsey, the director of stock analysis at Morningstar (MORN, news, msgs). A few years back, Buffett sold big positions in Fannie Mae (FNM, news, msgs) and Freddie Mac (FRE, news, msgs), the home mortgage companies that blew up last year.
Buffett is not infallible, however. He still owns big positions in Gannett (GCI, news, msgs) and Washington Post (WPO, news, msgs) even though he forecast at his 2004 annual meeting that the newspaper business would see nothing but trouble for decades.
The price of his company’s stock — always a major part of his wealth — dropped 31% in 2008 and continued to follow the market down early this year. Since, it and the market have rallied strongly.
Lesson No. 10: Believe in America
Unlike most investors, Buffett doesn’t tweak his portfolio depending on which party is coming into office or where we are in the economic cycle. This may make him seen naive. But it also has him putting money to work now, when many others have lost faith in the U.S. economic system. It’s a move that will likely make him a winner down the road yet again.
After all, the current fears about the long-term prosperity of U.S. companies make no sense, he wrote in an October op-ed column in The New York Times. That’s why he was buying stocks before the current rally began.
"These businesses will indeed suffer earnings hiccups, as they always have," he wrote. "But most major companies will be setting new profit records five, 10 and 20 years from now."
At the time of publication, Michael Brush did not own or control shares of any company mentioned in this column. This article was updated June 17 2009.
Government shareholding in banks: discontinue the medication, or complete the course?
Sep 22nd
There has been much debate about when the government’s investment in the banking industry should end. I told someone recently that this reminds me of a patient being prescribed a 5-day course of antibiotics. After two days, she feels better and wants to know if she can stop taking the medicine now? The answer of course is NO, you must complete the course. The government seems to be at the same stage with the banking industry – but do we really know what the best course is or should be and when does this phase end? While there is still uncertainty about the economy, it is becoming widely acknowledged that a divestiture plan needs to be put in place sooner than later, and is probably best executed over time to avoid negative market impact. Some progress appears to have been made in policy and practice reform; but the markets are not totally comfortable that proper risk management procedures have been implemented – I believe for example that stress testing could be dramatically improved with more robust scenario analysis; risk management organizations still appear to need some refurbishing; and not least, I am not sure we have done all the Training we need to do in the market across risk-takers and risk-managers, from Board Members to executives to analysts and everyone in between. It also seems counterintuitive for the government to pull out while various proposals for financial regulation are still pending. In many ways it seems continued Government investment makes the debate for reform easier – we need to protect the tax-payers. And would confidence not get totally destroyed if soon after a complete Government pull-out, there was need for them to come back in again. The counter argument of course is that from a risk perspective, the issue is of the Government as regulator. Ergo, the role of Government as owner is irrelevant; some may even argue the ownership stake is a needless conflict and distraction. And shouldn’t the Government and the taxpayer take the profits off the table? (note though that the large profit is on paper!). Regardless of its ownership stake, the Government retains full rights and responsibilities as regulator and we should all expect best risk practices and governance across the financial industry and at TARP companies specifically. And taxpayers are better served by keeping them out of risky businesses, and it is time to let private shareholders back fully into that area as voluntary risk-takers (of course, and unfortunately, we operated under that assumption long before the financial crisis took hold and look where we are now). It seems clear Government support of the financial industry at the height of the crisis instilled confidence in the markets and, perhaps, helped avert a greater economic downturn. The real question now seems to be can sustained economic growth be achieved when the major risk-taking enterprises operate in the shadow of Government ownership. What do you think?
Changes to the Disclosure of Corporate Risk Management Governance Practices
Sep 8th
Investors benefit from having access to meaningful information about the corporate governance practices of companies – including information related to risk management practices. Reflecting this, on July 10, 2009, the U.S. Securities and Exchange Commission published several proposals to amend existing corporate governance rules (S7-13-09.)
Some of the proposed amendments focus on the board’s involvement in the company’s risk management processes and apply to both financial and non-financial corporations. Through various forms of disclosure, corporate boards and corporations will have to provide important information to investors about the relationship between the board and senior management relating to managing those material risks that can impact the earnings and profitability of the corporation. These proposed disclosures touch upon many aspects of the overall structure of the board’s risk management function, including:
Before final adoption, the SEC has requested comments on specific areas that affect the risk governance of corporations. The first area relates to potential negative effects detailed risk management disclosures may have on the competitive and business position of individual companies. The second addresses the differences in risk management sophistication between corporations of different size. It is likely the small SEC reporting companies will be excluded from detailed disclosure. The final area relates to disseminating risk management related disclosures outside the proxy and in annual and quarterly reports to provide a wider reception and easier access to these policies and practices.
While much of the press has focused its attention on the amendments to executive compensation disclosures and on the increased proxy access afforded shareholders – both political hot button topics – there has been less attention and reporting on the impact these proposed rules could have on future corporate risk management practices (Sarah N. Lynch, SEC Plan Aims to Better Foretell Risks, July 2, 2009, The Wall Street Journal, page C3; Jeffrey McCracken and Kara Scannell, Fight Brews as Proxy Access Nears, The Wall Street Journal, page C1). If and when these proposals are enacted sometime in 2010, they will put increased focus on the importance of risk management in the evaluation of business risk, the different forms of corporate risk governance structures that exist, and the critical place of risk management at the board level.
For some time, the need for this increased focus has become evident to us from our conversations with investors, risk professionals, corporate executives, and board members. While we will remain agnostic on the need for additional regulation, we fully support the conceptual and practical importance of this information and recognize investors’ – and risk managers’ – need for it.
Stress-Testing
Sep 3rd
Earlier this year the Basel Committee on Banking Supervision issued the paper Principles for sound stress testing practices and supervision. For full text of May 2009 final paper, Click Here.
“Stress Testing” has obviously gotten a lot of press this year; but what does it really mean?
What is commonly known as “Stress testing” could also be defined in terms of:
Sensitivity analysis has historically been the methodology used to quantify portfolio risk. It is however, a limited approach that might best be described as one-dimensional.
Scenario analysis is a dynamic and systematic process for analyzing possible future events by considering various alternative outcomes. It is designed to allow improved decision-making, invoking consideration of negative outcomes and implications on business strategy, franchise, risks, and rewards.
Scenario Analysis is geared towards enabling decision making on risk appetite versus risk levels, asset allocation, client and product segmentation strategies, implicit and explicit diversification tactics, and insurance/hedge considerations; institutions can also compute scenario-weighted expected returns, and improve their knowledge of the unknown i.e. potential unexpected losses and economic/regulatory capital adequacy. Scenario analysis can also be used to illuminate wild cards and “black swans”.
Scenario based stress testing defines a scenario and uses specific algorithms (ideally full revaluations) to determine the expected impact on a portfolio’s return should such a scenario occur.
There are typically three types of scenarios:
A mathematical approach to scenario analysis looks to estimate expected cash flows under various situations. The expected cash flows used to value risky assets can represent a probability-weighted average of cash flows under all possible scenarios, or, they can simply be the cash flows under a single most likely scenario. In either case the scenario based cash flows will be different from expectations:
For example, instead of doing financial projections on a “best estimate” basis, a company may do Stress Testing, against, say, the following distinct scenarios
One good definition of ‘risk’ is the extent to which actual outcomes may be different from what is expected. The creation of a robust stress testing program that includes scenario analysis will go a long way towards minimizing future surprises.
Please keep the comments coming. I will look to summarize the discussion in my next post a week or so from now. I also want to address the use of stress-testing in the real world (not just running some numbers in a vacuum that nobody can relate to!)
To VaR or not to VaR
Aug 14th
Risk Measurement has become a whole new soul-search. In the late 1980s, financial markets began a transition into Risk Factor Sensitivities and Potential Loss Amount estimations, as alternatives to talking about Risk in notional amounts of exposure to one instrument or another. Senior management said well what does all that mean? How much could we lose?
And then came VaR!
And now a world with only two types of people – loud VaR-haters and very quiet and docile VaR lovers! Let me make my position crystal-clear: Some of my friends love VaR, some of my friends hate VaR. I agree with my friends.
Strengths of VaR
VaR Assumptions, weaknesses, and misunderstandings
Risk professionals will always use the caveats listed above, and warn against assuming VaR as the worst-case, or even the advisability of relying on a simple number that is statistically generated. With your continued involvement and comments, let us talk some more about VaR, Models, Stress-Tests…
Whither Risk Management?
Aug 12th
Recent crises have highlighted many failures in managing risk, including at the Board, senior management, regulator, and rating agency levels. But Risk Management failed too…
In measuring risk
- Risk models misused or specified incorrectly
- Lack of understanding or attention to issues of liquidity, correlation
- Ineffective use of stress testing
In mitigating risk
- Hedges viewed in isolation
- Concentrations of risk ignored, not understood
- What-if scenarios and stress-testing inadequate
(And almost above all) in communicating risk
- Not being proactive enough, just reactive
- Not ‘managing’ Risk as much as playing to some nebulous ‘support’ and ‘control’ roles
- Not ensuring an audience (exacerbated by the CRO not being truly in the C-suite)
As discussed under “The CRO of Tomorrow” the fundamental role of the risk manager is to oversee and continually test for “compatibilities” of a firm’s risk-taking with:
- Its risk appetite (contextualized for the legal-regulatory environment)
- Products and markets through which risk is taken
- Returns for taking such risks
As a primer, the fundamental questions for Risk Management should be:
- Do we know what bet/s we are making?
- Are our bets those that we can afford to make?
- Do limits reflect business strategy, risk-tolerance & appetite, our markets?
- Are positions within established limits?
- Is the risk/reward ratio appropriate?
- Is our risk-taking on purpose: do we know the unusual, the unintended, and the unacceptable?
- Do the right people discuss the risks…and watch over them?
The financial meltdown shows that among the many contributing failures, Risk Management didn’t sufficiently manage risk. Were Risk Managers constrained by the C-suite who wouldn’t hear the warnings, or were Risk Managers not answering (not able to answer) the Fundamental Questions? Either way, Risk Management has some soul-searching to do.
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