A couple weeks ago Warren Buffet wrote an opinion piece that was subsequently syndicated across many different news outlets, a link follows below. The basic guise of the article is to thank government for stepping in to avert the financial meltdown that was occurring in 2008 and still is occurring and will continue to occur for at least the next couple years when no one else would or could have. Although the government is wasteful at times and often messes things up it did pull through in a big way during the crisis.
http://www.cnbc.com/id/40229527/Warren_Buffett_s_Letter_to_Uncle_Sam
Tuesday, November 30, 2010
Friday, November 12, 2010
Income Statement Basics - FS - #2
This is going to be long, its going to be painful but sometimes that's what you have to do to learn something, in this case the "Income Statement." Everything takes effort, just like efficient markets hypothesis says in regard to people that spend their entire life looking for outsize returns - they get those returns, but at the expense of all the time spent looking for them. So if you want outsize returns you are going to have to put in your time, so get comfortable and stay alert for this one. Ohh, and by the way, we are starting simple to make sure no one misses anything, but pay attention things will get more difficult.
We've already discussed in brief that there are three main financial statements: 1) Income Statement, 2) Balance Sheet, and 3) Statement of Cash Flows - there is a forth 4) Statement of Stockholder's Equity but it is used much less in financial statement analysis. At some point in the future I'm sure I will discuss it, but for today we will do a quick run through the income statement.
Below is an extremely simplified "Income Statement," but it demonstrates the flow of how the statement operates (remember in finance the parenthesis mean minus/subtract/negative).
So the basic "Income Statement" just has us taking sales and subtracting costs to get us to net income. We have some amount of sales that generates a swath of money, then we take away all the costs that it took to generate those sales, if anything is left over, we have a profitable business and will hopefully stay in business.
The tricky part is that this process involves accruals (to be discussed), and in reality there are many different costs within the statement. Of that myriad of costs some that matter a lot for our analysis and some are not as important. Some of those costs can be tips that a company may be engaging in some not so conventional activities which could scare us away while others may not give us much information at all.
Below I have set up a slightly more complex "Income Statement" that we can go through line by line. There are major sections to the statement that each contain many costs under them. There are multiple lines in an it that are breaks to create stopping points before taking out additional costs (italics). At each of these steps we can understand certain aspects about a company that may give us key insight into where a company excels and where their profits are getting eaten up.
As you look at the monster below which we will refer to multiple times, do not get worried, I will explain step by step what we are looking at, take a general look for a minute but do not try to understand everything - that's why I'm here! And remember, all "Income Statements" are different, I can prepare you for a lot but at the end of the day there is a reason you can't automate financial statement analysis: all financial statements are different and all have multiple moving parts that taken singularly may mean little but taken together can paint a striking picture of a company.
Yes, it appears daunting but lets first look at the main sections and see what each of them contain.
The first section is listed as "Operating Expenses," it by far paints the most important picture of the nuts and bolts of whether a company is working well or not. But there is one step before that, after our sales line we take out something called "Cost of Goods Sold" or "COGS" in short. This is just what it sounds like, and includes the materials, labor, and manufacturing overhead (all costs included in making the actual good sold). You won't see this in a service company. After you take away "COGS," you end up with "Gross Profit," or the profit you make on the items you have sold before taking away any other corporate expenses, selling expenses, financing costs or taxes. This shows how profitable your actual products are before other costs.
Anyways, back to "Operating Expenses." These are all the "normal" costs of a company (after COGS of course), they include any "Administrative" or "Selling" expenses (which you can think of as subsections of "Operating Expenses." There are a few examples of "Administrative" and "Selling" expenses under each heading that should be self explanatory.
By now you should be noting that company's have many different costs, costs that eat away at that dollar that you dropped in the top of the IS (income statement) when you initially made your sale. That is why you often hear about cost cutting as a way to increase profitability, that is one of only two ways to increase net income - the other method is to increase sales.
Increasing sales helps profitability because some costs are fixed and some are variable, as sales increase the cost of goods sold is spread over fixed costs which makes each additional dollar in sales more profitable than the last. This is something we will also hit more on later.
At this point in time before discussing our next category of costs it is important to note that the further we move down the income statement the more infrequent each cost becomes. Most company's will always have the costs we've talked about above; however, some of the costs we discuss that are further down the "Income Statement" are less common and may not occur every quarter. This is something that many people don't understand.
A simple check here is to be sure that some of the costs at the bottom of the IS that we discuss below shouldn't be occurring every quarter. Executives know that many analysts ignore these costs and thus may try to hide normal costs in them knowing that analysts will focus more on top of the income statement costs (remember executives are always trying to move around costs so always be skeptical). If you are still with me we will continue on...
We just got down to our "Operating Income" line. We have taken out some basic costs of what everyone knows it takes to run a company (well in general at least). Now we are going to take out some "Other" stuff, literally. Next we take out out the category "Other Expenses/Losses," and add in "Other Revenue/Gains." Here we would be removing expenses or losses that aren't related to our core business and adding in additional revenue of the same nature (not core revenue).
Think of it like this, Walmart does not exist to invest in other companies and get dividends; however, from time to time it may strategically purchase shares and receive dividends, this isn't related to Walmarts core retail operations but is still added to get to net income. In addition, Walmart may have debt outstanding that it pays interest on, interest isn't related to the core selling or "Operating" business of Walmart but does have to be deducted before getting to net income. If you are quick reader you will also recall that we have moved further down the income statement and these costs may not occur every quarter; however, companies very frequently own shares in other companies and have debt issued to finance operations, so most large companies will have these items.
After taking out all of the expenses to this point we have arrived at "Income From Continuing Operations," which is again pretty much what it sounds, all these costs are common and frequent and should occur on a continual basis. Now will now look at a couple "weird" costs before getting to our goal, "Net Income."
Next we deduct "Losses from Discontinued Operations." When a company decides to get out of a certain business or close a store that isn't profitable this is where the costs of that series of events ends up. "Losses from Discontinued Operations" is a hodgepodge of costs related to moving merchandise out of stores that are closing, literally nailing the doors shut, selling the property and so on. Frequently these are estimated and the cash actually moves through the "Statement of Cash Flows" at different times, but at this point you just need to know these are expenses from closing certain stores, segments or divisions of a company.
With large companies, like Walmart, expenses from discontinuing operations will pretty much be a perennial occurrence - so seeing them over than over doesn't have to spook you. Very large companies are always engaging in new ideas, some that work and some that don't, when one doesn't work it gets cut after a period of time and this is where the costs of that "cutting" end up. Do your homework though, look for large spikes in these expenses or continued growth in the size of this expense account, this could be a sign that a company is trying to hide other expenses here or is engaging in lots of projects that are not panning out.
We are now left at the line "Losses Before Extraordinary Items." In accounting lingo, "Extraordinary Expenses" are any expenses that are infrequent and unpredictable, or something like that. In my example "Income Statement" I put "Earthquake Expenses." This would include expenses related to damage caused by an earthquake. However, these may not even always qualify if your stores are based in earthquake prone zones, then the expense may just be put in "Other Expenses," after all, earthquakes on the San Andreas fault are not that rare. To drive the point home "Extraordinary Expenses" are so rare that accountants are thinking of phasing the section out of "Income Statements" in general. In other words, you shouldn't see stuff here, EVER!
Folks we are almost at our destination! We have sliced out all sorts of costs but there is still one cost that hits all companies, "TAXES." In the next step we take out taxes, which sounds straightforward but isn't at all in reality (again for later), and end with "Net Income." Now for some important caveats.
An important thing to remember is that the "Income Statement" does not necessarily represent money that was collected and paid out. The income statement is showing expenses that occurred over a period of time, a quarter, half or year. The income and expenses are shown on the "Income Statement" because the transaction that created them occurred during that period, even though the cash collected or paid may not occur until much later. Sounds odd but it isn't that complex, although it creates many complexities for accountants.
A company may make a large sale on credit during the first quarter and the entire sale would be listed in the sales number for that period; however, the cash collected may not show up in the "Statement of Cash Flows" until the second quarter. A company could also prepay a years rent and it would show up in the "Statement of Cash Flows" when paid, but again if the rent was only for the first quarter only a portion of that rent would show up in the "Income Statement."
This makes the important point of why we must review the financial statements as a unit and not base decisions on information garnered from just one financial statement. A company may be generating stupendous sales numbers but they can still run out of cash if they are extending credit out in the future to make those sales.
Once we get through the "Statement of Cash Flows" and the "Balance Sheet" it will all make sense. We haven't really performed too much analysis here but at least when you look at an income statement you can start understanding how it is organized. In addition, it is important to remember that all "Income Statements" are slightly different. With GAAP (Generally Accepted Accounting Principals [the system used within the United States]), there is some leeway as to how financial statements are presented and thus we get differences which I can't prepare you for, but you now have the structure to be able to gauge where they go and whether they are important or not.
One more point is to start simple in your analysis and DO NOT start with an insurance or financial company. Banks do accounting in very different ways and the "Income Statement" will not make sense based on what I have just told you. As usual I would recommend starting with something like a manufacturer or a retail company to wet your teeth.
In the future we will discuss our other financial statements, following that we will do some ratio analysis on our statements and then look at red flags that may show something undesirable is going on within the company - finally we will tie it all together by looking at how the statements interact with each other and flow together.
As always, feel free to email me with any questions you may have on any of this...sorry for the monster post but hopefully you were able to learn something.
We've already discussed in brief that there are three main financial statements: 1) Income Statement, 2) Balance Sheet, and 3) Statement of Cash Flows - there is a forth 4) Statement of Stockholder's Equity but it is used much less in financial statement analysis. At some point in the future I'm sure I will discuss it, but for today we will do a quick run through the income statement.
Below is an extremely simplified "Income Statement," but it demonstrates the flow of how the statement operates (remember in finance the parenthesis mean minus/subtract/negative).
So the basic "Income Statement" just has us taking sales and subtracting costs to get us to net income. We have some amount of sales that generates a swath of money, then we take away all the costs that it took to generate those sales, if anything is left over, we have a profitable business and will hopefully stay in business.
The tricky part is that this process involves accruals (to be discussed), and in reality there are many different costs within the statement. Of that myriad of costs some that matter a lot for our analysis and some are not as important. Some of those costs can be tips that a company may be engaging in some not so conventional activities which could scare us away while others may not give us much information at all.
Below I have set up a slightly more complex "Income Statement" that we can go through line by line. There are major sections to the statement that each contain many costs under them. There are multiple lines in an it that are breaks to create stopping points before taking out additional costs (italics). At each of these steps we can understand certain aspects about a company that may give us key insight into where a company excels and where their profits are getting eaten up.
As you look at the monster below which we will refer to multiple times, do not get worried, I will explain step by step what we are looking at, take a general look for a minute but do not try to understand everything - that's why I'm here! And remember, all "Income Statements" are different, I can prepare you for a lot but at the end of the day there is a reason you can't automate financial statement analysis: all financial statements are different and all have multiple moving parts that taken singularly may mean little but taken together can paint a striking picture of a company.
Yes, it appears daunting but lets first look at the main sections and see what each of them contain.
The first section is listed as "Operating Expenses," it by far paints the most important picture of the nuts and bolts of whether a company is working well or not. But there is one step before that, after our sales line we take out something called "Cost of Goods Sold" or "COGS" in short. This is just what it sounds like, and includes the materials, labor, and manufacturing overhead (all costs included in making the actual good sold). You won't see this in a service company. After you take away "COGS," you end up with "Gross Profit," or the profit you make on the items you have sold before taking away any other corporate expenses, selling expenses, financing costs or taxes. This shows how profitable your actual products are before other costs.
Anyways, back to "Operating Expenses." These are all the "normal" costs of a company (after COGS of course), they include any "Administrative" or "Selling" expenses (which you can think of as subsections of "Operating Expenses." There are a few examples of "Administrative" and "Selling" expenses under each heading that should be self explanatory.
By now you should be noting that company's have many different costs, costs that eat away at that dollar that you dropped in the top of the IS (income statement) when you initially made your sale. That is why you often hear about cost cutting as a way to increase profitability, that is one of only two ways to increase net income - the other method is to increase sales.
Increasing sales helps profitability because some costs are fixed and some are variable, as sales increase the cost of goods sold is spread over fixed costs which makes each additional dollar in sales more profitable than the last. This is something we will also hit more on later.
At this point in time before discussing our next category of costs it is important to note that the further we move down the income statement the more infrequent each cost becomes. Most company's will always have the costs we've talked about above; however, some of the costs we discuss that are further down the "Income Statement" are less common and may not occur every quarter. This is something that many people don't understand.
A simple check here is to be sure that some of the costs at the bottom of the IS that we discuss below shouldn't be occurring every quarter. Executives know that many analysts ignore these costs and thus may try to hide normal costs in them knowing that analysts will focus more on top of the income statement costs (remember executives are always trying to move around costs so always be skeptical). If you are still with me we will continue on...
We just got down to our "Operating Income" line. We have taken out some basic costs of what everyone knows it takes to run a company (well in general at least). Now we are going to take out some "Other" stuff, literally. Next we take out out the category "Other Expenses/Losses," and add in "Other Revenue/Gains." Here we would be removing expenses or losses that aren't related to our core business and adding in additional revenue of the same nature (not core revenue).
Think of it like this, Walmart does not exist to invest in other companies and get dividends; however, from time to time it may strategically purchase shares and receive dividends, this isn't related to Walmarts core retail operations but is still added to get to net income. In addition, Walmart may have debt outstanding that it pays interest on, interest isn't related to the core selling or "Operating" business of Walmart but does have to be deducted before getting to net income. If you are quick reader you will also recall that we have moved further down the income statement and these costs may not occur every quarter; however, companies very frequently own shares in other companies and have debt issued to finance operations, so most large companies will have these items.
After taking out all of the expenses to this point we have arrived at "Income From Continuing Operations," which is again pretty much what it sounds, all these costs are common and frequent and should occur on a continual basis. Now will now look at a couple "weird" costs before getting to our goal, "Net Income."
Next we deduct "Losses from Discontinued Operations." When a company decides to get out of a certain business or close a store that isn't profitable this is where the costs of that series of events ends up. "Losses from Discontinued Operations" is a hodgepodge of costs related to moving merchandise out of stores that are closing, literally nailing the doors shut, selling the property and so on. Frequently these are estimated and the cash actually moves through the "Statement of Cash Flows" at different times, but at this point you just need to know these are expenses from closing certain stores, segments or divisions of a company.
With large companies, like Walmart, expenses from discontinuing operations will pretty much be a perennial occurrence - so seeing them over than over doesn't have to spook you. Very large companies are always engaging in new ideas, some that work and some that don't, when one doesn't work it gets cut after a period of time and this is where the costs of that "cutting" end up. Do your homework though, look for large spikes in these expenses or continued growth in the size of this expense account, this could be a sign that a company is trying to hide other expenses here or is engaging in lots of projects that are not panning out.
We are now left at the line "Losses Before Extraordinary Items." In accounting lingo, "Extraordinary Expenses" are any expenses that are infrequent and unpredictable, or something like that. In my example "Income Statement" I put "Earthquake Expenses." This would include expenses related to damage caused by an earthquake. However, these may not even always qualify if your stores are based in earthquake prone zones, then the expense may just be put in "Other Expenses," after all, earthquakes on the San Andreas fault are not that rare. To drive the point home "Extraordinary Expenses" are so rare that accountants are thinking of phasing the section out of "Income Statements" in general. In other words, you shouldn't see stuff here, EVER!
Folks we are almost at our destination! We have sliced out all sorts of costs but there is still one cost that hits all companies, "TAXES." In the next step we take out taxes, which sounds straightforward but isn't at all in reality (again for later), and end with "Net Income." Now for some important caveats.
An important thing to remember is that the "Income Statement" does not necessarily represent money that was collected and paid out. The income statement is showing expenses that occurred over a period of time, a quarter, half or year. The income and expenses are shown on the "Income Statement" because the transaction that created them occurred during that period, even though the cash collected or paid may not occur until much later. Sounds odd but it isn't that complex, although it creates many complexities for accountants.
A company may make a large sale on credit during the first quarter and the entire sale would be listed in the sales number for that period; however, the cash collected may not show up in the "Statement of Cash Flows" until the second quarter. A company could also prepay a years rent and it would show up in the "Statement of Cash Flows" when paid, but again if the rent was only for the first quarter only a portion of that rent would show up in the "Income Statement."
This makes the important point of why we must review the financial statements as a unit and not base decisions on information garnered from just one financial statement. A company may be generating stupendous sales numbers but they can still run out of cash if they are extending credit out in the future to make those sales.
Once we get through the "Statement of Cash Flows" and the "Balance Sheet" it will all make sense. We haven't really performed too much analysis here but at least when you look at an income statement you can start understanding how it is organized. In addition, it is important to remember that all "Income Statements" are slightly different. With GAAP (Generally Accepted Accounting Principals [the system used within the United States]), there is some leeway as to how financial statements are presented and thus we get differences which I can't prepare you for, but you now have the structure to be able to gauge where they go and whether they are important or not.
One more point is to start simple in your analysis and DO NOT start with an insurance or financial company. Banks do accounting in very different ways and the "Income Statement" will not make sense based on what I have just told you. As usual I would recommend starting with something like a manufacturer or a retail company to wet your teeth.
In the future we will discuss our other financial statements, following that we will do some ratio analysis on our statements and then look at red flags that may show something undesirable is going on within the company - finally we will tie it all together by looking at how the statements interact with each other and flow together.
As always, feel free to email me with any questions you may have on any of this...sorry for the monster post but hopefully you were able to learn something.
Wednesday, November 10, 2010
Den of Thieves
From now and then as I finish a good book. Quite often I like to discuss small parts of it and recommend it to others, today I finished "Den of Thieves," a book by James Stewart. The book came out in the 1992 and chronicled the rise of high yield bonds (or the artist formerly known as junk bonds) and the art of the leveraged by out.
The main character is Michael Milken - the man who pioneered to leverage buyout through junk bonds while dominating his firm Drexel Burnham Lambert. Milken basically takes over the firm through the sale of junk bonds. As we know from past articles, at an investment bank the man who runs the bank is not the CEO but the guy that brings in fees - that man was Milken. To give you a taste of his earning power, he took home over half a billion dollars in payment (mostly bonus) in 1986.
"Den of Thieves" also discusses many arbitrage traders that along with Milken eventually were prosecuted for various insider trading and tax shelter schemes. Much of Wall Street including the likes of Kidder Peabody, Goldman Sachs, Drexel Burnham Lambert and various law firms were involved in the schemes.
One of the themes I noticed that by far isn't the main theme doesn't come in until the second half of the book. While members of the Manhattan attorneys office and SEC are trying to put together a case against different investment bankers you realize what they are up against. The various banks half millions of dollars to throw at lawyers and the number of law firms involved in the defense is mind blowing....the public side that is doing the prosecuting pales in comparison.
Many meetings are held at hotels where law firms would buy out entire floors to set up shop. In one scene from "Den of Thieves," as lawyers from the attorneys office are discussing arrangements with private lawyers the private lawyers order lunch. Looking at the prices including a $12 hamburger the members from the attorneys office decide not to eat, although they are very hungry. They also are forced to stay in sub-par hotels that fit their government stipend and their victory celebration at the end of the trials is held at a small inexpensive restaurant.
My point is that the book paints the picture of how hard it is to regulate Wall Street. This was during the 1980's and the junk bond fiasco very well mirrors the housing crisis, the products were just further down the food chain in our more recent case. Public regulators will always have trouble regulating Wall Street, the incentives aren't commensurate on the public side compared to the private side and the resources at ones disposal are nothing compared to the private sector. The question I would pose to you that is not discussed in "Den of Thieves," is how does one fix that?
The main character is Michael Milken - the man who pioneered to leverage buyout through junk bonds while dominating his firm Drexel Burnham Lambert. Milken basically takes over the firm through the sale of junk bonds. As we know from past articles, at an investment bank the man who runs the bank is not the CEO but the guy that brings in fees - that man was Milken. To give you a taste of his earning power, he took home over half a billion dollars in payment (mostly bonus) in 1986.
"Den of Thieves" also discusses many arbitrage traders that along with Milken eventually were prosecuted for various insider trading and tax shelter schemes. Much of Wall Street including the likes of Kidder Peabody, Goldman Sachs, Drexel Burnham Lambert and various law firms were involved in the schemes.
One of the themes I noticed that by far isn't the main theme doesn't come in until the second half of the book. While members of the Manhattan attorneys office and SEC are trying to put together a case against different investment bankers you realize what they are up against. The various banks half millions of dollars to throw at lawyers and the number of law firms involved in the defense is mind blowing....the public side that is doing the prosecuting pales in comparison.
Many meetings are held at hotels where law firms would buy out entire floors to set up shop. In one scene from "Den of Thieves," as lawyers from the attorneys office are discussing arrangements with private lawyers the private lawyers order lunch. Looking at the prices including a $12 hamburger the members from the attorneys office decide not to eat, although they are very hungry. They also are forced to stay in sub-par hotels that fit their government stipend and their victory celebration at the end of the trials is held at a small inexpensive restaurant.
My point is that the book paints the picture of how hard it is to regulate Wall Street. This was during the 1980's and the junk bond fiasco very well mirrors the housing crisis, the products were just further down the food chain in our more recent case. Public regulators will always have trouble regulating Wall Street, the incentives aren't commensurate on the public side compared to the private side and the resources at ones disposal are nothing compared to the private sector. The question I would pose to you that is not discussed in "Den of Thieves," is how does one fix that?
Tuesday, November 9, 2010
How to Start an Investment Bank
I don't understand how it happens so frequently but I often find myself in conversations on How to Start and Investment Bank when talking with friends, not that I have any that are capable of it including myself. However, from my viewpoint it seems pretty simple, most of it is similar to starting any company except for one thing, you need a senior banker that has contacts!
Yes, contacts - someone needs to have client exposure and their Rolodex in order that you can grab a few clients to Start Your Investment Bank. When rainmakers leave an investment bank they often take many of their clients with them, clients like certain investment banks but more importantly they want to deal with someone they know and have continuity with that person.
The senior banker with the Rolodex is the key; however, if you can find one of these people you have your ticket to start a bank. There are numerous examples of this including, Perella Weinburg, Cowen Group as well as Moelis. All these were started by bankers that defected with their contact list and took those customers with them.
Other than that you need some capital as well and you should probably have some interaction with a lawyer. On top of that add a few secretaries and some analysts and start working the phones. And there you go, How to Start an Investment Bank 101, I haven't done it yet but I think that would be the correct approach.
Yes, contacts - someone needs to have client exposure and their Rolodex in order that you can grab a few clients to Start Your Investment Bank. When rainmakers leave an investment bank they often take many of their clients with them, clients like certain investment banks but more importantly they want to deal with someone they know and have continuity with that person.
The senior banker with the Rolodex is the key; however, if you can find one of these people you have your ticket to start a bank. There are numerous examples of this including, Perella Weinburg, Cowen Group as well as Moelis. All these were started by bankers that defected with their contact list and took those customers with them.
Other than that you need some capital as well and you should probably have some interaction with a lawyer. On top of that add a few secretaries and some analysts and start working the phones. And there you go, How to Start an Investment Bank 101, I haven't done it yet but I think that would be the correct approach.
Monday, November 8, 2010
Citi Debt Funds Probed by SEC
Every now and then I have to comment on something that is just so incredibly ridiculous and completely destroys my faith in multiple tenants of finance, economics, statistics, rich people and life in general. In this case it is Citi Debts Probed by the SEC.
There is a new article in the Wall Street Journal which can be seen here Citi Debt Funds Probed by SEC. The gist of the article is that people invested in a leveraged fund that invested in municipal bonds and MBS.
This is the statement that shocked me:
"Standard & Poor's Corp. gave the Falcon funds a rating of "low to moderate sensitivity to changing market conditions," equivalent to safe, medium-term government bonds, a rating that sales materials highlighted. S&P declined to comment.".
Shattered Faith:
1) Finance/Economics - In no way shape or form does any municipal bond or MBS have the same risk profile as a U.S. Treasury bill....unless it is guaranteed by the U.S....like a lot of stuff right now - but not the Falcon issue.
2) Statistics - Once again I'm sure volatility was used to make similar risk projections, once again Wall Street manages to use a historical measure to predict future risk to a precise point. Don't even get me started on VAR (Value at Risk)...
and
3) Rich People - I keep thinking they're smart, but they frequently are not, many are just gamblers on a good run.
Ahh life is interesting....Citi Debt Funds Probed by SEC, no it isn't personal finance but it is good to think about these items.
There is a new article in the Wall Street Journal which can be seen here Citi Debt Funds Probed by SEC. The gist of the article is that people invested in a leveraged fund that invested in municipal bonds and MBS.
This is the statement that shocked me:
"Standard & Poor's Corp. gave the Falcon funds a rating of "low to moderate sensitivity to changing market conditions," equivalent to safe, medium-term government bonds, a rating that sales materials highlighted. S&P declined to comment.".
Shattered Faith:
1) Finance/Economics - In no way shape or form does any municipal bond or MBS have the same risk profile as a U.S. Treasury bill....unless it is guaranteed by the U.S....like a lot of stuff right now - but not the Falcon issue.
2) Statistics - Once again I'm sure volatility was used to make similar risk projections, once again Wall Street manages to use a historical measure to predict future risk to a precise point. Don't even get me started on VAR (Value at Risk)...
and
3) Rich People - I keep thinking they're smart, but they frequently are not, many are just gamblers on a good run.
Ahh life is interesting....Citi Debt Funds Probed by SEC, no it isn't personal finance but it is good to think about these items.
Sunday, November 7, 2010
Boutique Investment Banking Firms
First of all - sorry for the onslaught of investment banking posts, but people have been asking me for a list of boutique investment banking firms as opposed to the bulge brackets so I thought I would comply as it is interview season. So I pulled out the old job search folder with each of my saved cover letters and pulled out a few firms, there are many more than whats listed.
So first off what is the difference between boutique and bulge. Bulge bracket firms are the big guys that usually dominate multiple league tables in the top ten. League tables are just how banks rank themselves in things such as Mergers and Acquisitions, Equity IPO's, Debt Raised Capital etc. Boutiques are usually smaller outfits (that don't have thousands of employees) although they can get big - that specialize in something or just don't have as many workers as the bulge brackets. In short they aren't as well known, anyways here are some boutiques.
1) Moelis
2) Blackstone
3) Centerview
4) Cowen
5) Evercore
6) Greenhill
7) Houlihan Lokey
8) Jefferies
9) Lazard
10) Perella Weinburg
In no particular order of anything.
So there is a list to get you started, do some research on the firms if you are applying, and remember - if you can connect with one person at any of these boutique investment banking firms it will greatly help your chances at landing a job.
So first off what is the difference between boutique and bulge. Bulge bracket firms are the big guys that usually dominate multiple league tables in the top ten. League tables are just how banks rank themselves in things such as Mergers and Acquisitions, Equity IPO's, Debt Raised Capital etc. Boutiques are usually smaller outfits (that don't have thousands of employees) although they can get big - that specialize in something or just don't have as many workers as the bulge brackets. In short they aren't as well known, anyways here are some boutiques.
1) Moelis
2) Blackstone
3) Centerview
4) Cowen
5) Evercore
6) Greenhill
7) Houlihan Lokey
8) Jefferies
9) Lazard
10) Perella Weinburg
In no particular order of anything.
So there is a list to get you started, do some research on the firms if you are applying, and remember - if you can connect with one person at any of these boutique investment banking firms it will greatly help your chances at landing a job.
Investment Banking Analyst Jobs
This will probably be similar to my post Ahh!?! WTF Do Investment Bankers DO!?! but I wanted to supply a short quick post on investment banking analyst jobs, what they are and what they entail.
For starters, I am directing this post at traditional investment banking (this is not sales and trading related). Before many people get deep into job searching for Wall Street jobs they often say they want to be an investment banker.....after they search around they figure out whether they want to be in sales and trading or investment banking. Sales and trading is pretty much what it sounds like while investment banking is a little more confusing. If you don't know what investment banking entails check the aforementioned post.
As an investment banking analyst you are at the bottom of the totem pole and serve as a corporate clients banker. The job is tough (on the basis of hours) and you can expect to work 80-100 hour weeks for the most part. Anything under 60 hours would be considered a vacation. Although the hours are long, a lot of time is spent sitting around waiting for deals. As an analyst your main job is to do whatever the associate above you asks of you. Usually this means putting together pitch books (also mentioned in the link above), monitoring at the printer, getting coffee, running errands - and if you want to survive - never asking for more work. Building pitch books is very boring.
A good investment banking analyst has expert command of excel and can navigate it solely by using the keyboard. The majority of your time related to pitchbook making will be spent using excel for models and powerpoint for the actual book pages. You will get very good at both if you aren't already. Most of the material will be recycled from a previous pitch.
The hours are long and the work is repetitive but there is one bonus, you get paid a lot. If you get placed in New York you will get a salary of $70,000 and your bonus will be at least 40% of that (if you are bad), in a good year it could be one and a half times your salary. Other areas will have slightly smaller pay-outs. So you can decide if it is worth it to you.
On another note, if you aren't coming from an Ivy League school, investment banking analyst jobs are very tough to get. Email me if you need help in your search, but remember I will ask you why you want to be on Wall Street.
For starters, I am directing this post at traditional investment banking (this is not sales and trading related). Before many people get deep into job searching for Wall Street jobs they often say they want to be an investment banker.....after they search around they figure out whether they want to be in sales and trading or investment banking. Sales and trading is pretty much what it sounds like while investment banking is a little more confusing. If you don't know what investment banking entails check the aforementioned post.
As an investment banking analyst you are at the bottom of the totem pole and serve as a corporate clients banker. The job is tough (on the basis of hours) and you can expect to work 80-100 hour weeks for the most part. Anything under 60 hours would be considered a vacation. Although the hours are long, a lot of time is spent sitting around waiting for deals. As an analyst your main job is to do whatever the associate above you asks of you. Usually this means putting together pitch books (also mentioned in the link above), monitoring at the printer, getting coffee, running errands - and if you want to survive - never asking for more work. Building pitch books is very boring.
A good investment banking analyst has expert command of excel and can navigate it solely by using the keyboard. The majority of your time related to pitchbook making will be spent using excel for models and powerpoint for the actual book pages. You will get very good at both if you aren't already. Most of the material will be recycled from a previous pitch.
The hours are long and the work is repetitive but there is one bonus, you get paid a lot. If you get placed in New York you will get a salary of $70,000 and your bonus will be at least 40% of that (if you are bad), in a good year it could be one and a half times your salary. Other areas will have slightly smaller pay-outs. So you can decide if it is worth it to you.
On another note, if you aren't coming from an Ivy League school, investment banking analyst jobs are very tough to get. Email me if you need help in your search, but remember I will ask you why you want to be on Wall Street.
Saturday, November 6, 2010
Time Warping Money (or present valuing it)
When this blockbuster got dropped on me my sophomore year in college I was floored. I highly doubt it will have the same effect on you but hopefully it will add something to your arsenal. After I learned it happily pounded away on my HP-10C for hours figuring out how much money that was saved at different rates was worth at different times. I also enjoy casually reading annual reports.....sorry. Anyways...."Time Warping Money" is a concept called "Present Value" but that does not accurately portray it's level of coolness.
The concept of "Present Value and Future Value" or "PV and FV" as any financial calculator would say is very simple. They are pretty much one concept that once understood really opens your horizons for valuing any cash flows. The idea is to be able to compare a dollar today to a dollar in the future or vice-versa, which come to think of it would be the same thing. This is important because dollars at different points in time are worth different amounts - our economist out there will know that the opportunity cost of a dollar is of course the forgone interest you could have earned.
Suppose we have a dollar today and someone offers to pay us five dollars in eight years if he can borrow our one dollar. Also suppose that if we invest that dollar today we can get a 12% return. Should we keep the dollar or lend it out for five future or eight year dollars. Present value concepts allow to see how much that five dollar bill received eight years from now is worth today with some quick math as shown below.
$5.00/(1+.12)^8=$2.02 - this is our equation used to turn that future five dollars into today's money
or
FV/(1+r)^t=PV (explained below)
So what are we doing, we are taking our interest rate, known as "i," and raising it to our time factor of eight or "n." We then take our future amount of cash and divide it by that number and have the value of that five dollars but in today's money. We can now compare that to our dollar today. It turns out we should loan out our dollar because $2.02 (our five dollars in today's money) is more than we can get investing our $1.00 at 12% for five years....but how to we know that. Above we just future valued, now lets present value. You heard me right, get excited.
$1.00*(1.12)^8=$2.48
or
PV*(1+r)^t=FV
So if we move around our equation a little we can find out what one dollar invested at 12% for eight years will grow to $2.48, which is far less than our five dollars. So again, this means that we should lend out our dollar for five future dollars because it is going to earn us more money than simply investing our dollar at 12% rates for eight years.
And that little equation is how we compare money in different time frames. Later I will teach you all how to derive that (among other things such as annuities). In the real world there are other factors, the main one being risk but for now this should be a good starting point and check for different investments you are considering. Think on this as you finish this article - we could make keeping the dollar a better deal than lending it out for five future dollars, but only if we increased our interest rate past 12% or increased our time frame.
The concept of "Present Value and Future Value" or "PV and FV" as any financial calculator would say is very simple. They are pretty much one concept that once understood really opens your horizons for valuing any cash flows. The idea is to be able to compare a dollar today to a dollar in the future or vice-versa, which come to think of it would be the same thing. This is important because dollars at different points in time are worth different amounts - our economist out there will know that the opportunity cost of a dollar is of course the forgone interest you could have earned.
Suppose we have a dollar today and someone offers to pay us five dollars in eight years if he can borrow our one dollar. Also suppose that if we invest that dollar today we can get a 12% return. Should we keep the dollar or lend it out for five future or eight year dollars. Present value concepts allow to see how much that five dollar bill received eight years from now is worth today with some quick math as shown below.
$5.00/(1+.12)^8=$2.02 - this is our equation used to turn that future five dollars into today's money
or
FV/(1+r)^t=PV (explained below)
So what are we doing, we are taking our interest rate, known as "i," and raising it to our time factor of eight or "n." We then take our future amount of cash and divide it by that number and have the value of that five dollars but in today's money. We can now compare that to our dollar today. It turns out we should loan out our dollar because $2.02 (our five dollars in today's money) is more than we can get investing our $1.00 at 12% for five years....but how to we know that. Above we just future valued, now lets present value. You heard me right, get excited.
$1.00*(1.12)^8=$2.48
or
PV*(1+r)^t=FV
So if we move around our equation a little we can find out what one dollar invested at 12% for eight years will grow to $2.48, which is far less than our five dollars. So again, this means that we should lend out our dollar for five future dollars because it is going to earn us more money than simply investing our dollar at 12% rates for eight years.
And that little equation is how we compare money in different time frames. Later I will teach you all how to derive that (among other things such as annuities). In the real world there are other factors, the main one being risk but for now this should be a good starting point and check for different investments you are considering. Think on this as you finish this article - we could make keeping the dollar a better deal than lending it out for five future dollars, but only if we increased our interest rate past 12% or increased our time frame.
Thursday, November 4, 2010
Why our Financial System Destroys Value
When I was a student in college, I went through a two to three year period where my goal was to work on Wall Street at a large bank. The particular field I wanted to enter was the traditional side, known simply as investment banking (I did not want to be a trader). This is the part where I tell you, "To get to the tidbits of good financial information on this blog you also have to endure my rants." If you are unsure how an investment bank works or what I mean by not being a trader, click here What Happens in an Investment Bank.
I was not from a target school, so at the time I literally had to BREAK INTO Wall Street, or at least carefully slip through the backdoor as to not wreck the Ivy League party. The process was not particularly pleasant. It first involved calling any alumni I knew (at my non-target school) that had somehow made it into the field and beyond that cold-calling people I could look up on my school Bloomberg Terminal.
Sidenote: You know all those pictures you see of large trading rooms at banks with the multi-colored screens. Well in the early 1980's most of those were probably Quotron screens but what you see now 90% of the time are Bloomberg Terminals. Ohh, and each one runs about $20,000 a year.
Side Sidenote: Yes - the company was started by the Mayor Bloomberg of New York.
Anyways, after getting rejected '86' times (this means I sent in '86' applications and received rejection letters from almost all of them), I got hits at three large bulge bracket banks in NY and went up for second round interviews. At this point I had practiced interviewing with numerous friends in the same boat as well as new, recently hired, analysts I knew that were a year ahead of me and gotten through first round phone interviews. In another semi-sidenote, one has to understand that analysts are the key to interviews because they know all the flavor of the day questions, and in a world of quick bucks interview standards change rapidly.
What I failed to mention in the preceding paragraph was that during that application process, and the preceding six months, I had started to develop a fear of investment banking. It wasn't the '100' hour weeks or the horror stories of forgetting a pitch-book for a critical meeting, nor the insane practical (or not so practical jokes often played) - the problem was, I found myself struggling to figure out if investment bankers really added to the economy and created value. My bottom line was I couldn't figure out if the bankers did anything productive.
Now to grasp this you need to understand what I expected to be doing. My goal was to enter what is called the Investment Banking Mergers and Acquisitions space. This basically means I would be doing valuations for companies that would be considering purchasing other companies in order to discover a price, or doing valuations for companies being bid for, what is called a "Fairness Opinion." A Fairness Opinion means get the highest price possible.
So I thought about my place in the world and asked myself some of the following questions:
1) Does my job need to exist for the economy to function; rephrased does it make sense for companies to purchase other companies?
Any business major could answer this question with one word, SYNERGIES! Of course it was good, a company buys another and reaps economies of scale which cuts cost and saves money (obviously this was one of my first questions and the answer is pretty obvious). Some readers are probably thinking this is a bad answer but trust me, I will address your concerns below.
2) Do mergers create value for companies, rephrased, do those synergies work?
This was slightly tougher, but I was able to weasel my way into an answer that I could accept. The answer is yes, mergers do create value.....sometimes. Most mergers actually result in overpayment by the company making the purchase and end in some degree of failure. However, I was content in my naïveté thinking that any deal I participated on would have to look good or I would simply move to another team (not only was this naive but it would probably have gotten me fired; however, at the time it did the trick).
3) As an economist I had to ask, are the incentives aligned between the company and the banker representing the company? In other word, is what’s good for one good for the other. My post on Why The World Sucks Because We Don't Understand Incentives may be helpful for you at this point.
This was the curve ball. An investment banker of course wants to make money, to make money they earn fees, and their fees are directly and positively correlated to the size of the deals they participate in and the number of those deals. While a company may purchase another at a few critical points during its life when it sees a good opportunity, a banker wants companies to buy each other as much as frequently as possible! Wouldn't you, if you get 1% in fees of the dollar size of every transaction, the more buying and the bigger the better. A good four man banking team consisting of an analyst, associate, VP (Vice-President) and MD (Managing Director), can clean-up on over a million dollars in a few busy days.
And that was my problem. The more I thought about it the more I realized why barely any of those mergers or buy-outs worked out for either company. Most merger ideas were the product of overworked, just out of business school associates slaving away putting together pitch books at the discretion of a VP. A VP who is desperately trying to make a pitch stick, so they can pad their bonus and make MD in a few years. The banker could care less of the terms of the acquisition (except for the fee schedule) and would have no qualms with bilking companies on a bad purchase. And that is why I couldn't stomach becoming an investment banker.
Now I recognize that someone has to exist to shepherd companies through the few acquisitions that actually do create value; however, the incentives governing the game at this moment in time are terribly misaligned and I think that the bad by far outweighs the good.
Now this is only referring to traditional investment bankers (I will save traders for later) - but if I have convinced one future engineer to stay that career track and not move to banking this post was worth it, for the other problem with Wall Street is it sucks away good honest talent. For another post...
I was not from a target school, so at the time I literally had to BREAK INTO Wall Street, or at least carefully slip through the backdoor as to not wreck the Ivy League party. The process was not particularly pleasant. It first involved calling any alumni I knew (at my non-target school) that had somehow made it into the field and beyond that cold-calling people I could look up on my school Bloomberg Terminal.
Sidenote: You know all those pictures you see of large trading rooms at banks with the multi-colored screens. Well in the early 1980's most of those were probably Quotron screens but what you see now 90% of the time are Bloomberg Terminals. Ohh, and each one runs about $20,000 a year.
Side Sidenote: Yes - the company was started by the Mayor Bloomberg of New York.
Anyways, after getting rejected '86' times (this means I sent in '86' applications and received rejection letters from almost all of them), I got hits at three large bulge bracket banks in NY and went up for second round interviews. At this point I had practiced interviewing with numerous friends in the same boat as well as new, recently hired, analysts I knew that were a year ahead of me and gotten through first round phone interviews. In another semi-sidenote, one has to understand that analysts are the key to interviews because they know all the flavor of the day questions, and in a world of quick bucks interview standards change rapidly.
What I failed to mention in the preceding paragraph was that during that application process, and the preceding six months, I had started to develop a fear of investment banking. It wasn't the '100' hour weeks or the horror stories of forgetting a pitch-book for a critical meeting, nor the insane practical (or not so practical jokes often played) - the problem was, I found myself struggling to figure out if investment bankers really added to the economy and created value. My bottom line was I couldn't figure out if the bankers did anything productive.
Now to grasp this you need to understand what I expected to be doing. My goal was to enter what is called the Investment Banking Mergers and Acquisitions space. This basically means I would be doing valuations for companies that would be considering purchasing other companies in order to discover a price, or doing valuations for companies being bid for, what is called a "Fairness Opinion." A Fairness Opinion means get the highest price possible.
So I thought about my place in the world and asked myself some of the following questions:
1) Does my job need to exist for the economy to function; rephrased does it make sense for companies to purchase other companies?
Any business major could answer this question with one word, SYNERGIES! Of course it was good, a company buys another and reaps economies of scale which cuts cost and saves money (obviously this was one of my first questions and the answer is pretty obvious). Some readers are probably thinking this is a bad answer but trust me, I will address your concerns below.
2) Do mergers create value for companies, rephrased, do those synergies work?
This was slightly tougher, but I was able to weasel my way into an answer that I could accept. The answer is yes, mergers do create value.....sometimes. Most mergers actually result in overpayment by the company making the purchase and end in some degree of failure. However, I was content in my naïveté thinking that any deal I participated on would have to look good or I would simply move to another team (not only was this naive but it would probably have gotten me fired; however, at the time it did the trick).
3) As an economist I had to ask, are the incentives aligned between the company and the banker representing the company? In other word, is what’s good for one good for the other. My post on Why The World Sucks Because We Don't Understand Incentives may be helpful for you at this point.
This was the curve ball. An investment banker of course wants to make money, to make money they earn fees, and their fees are directly and positively correlated to the size of the deals they participate in and the number of those deals. While a company may purchase another at a few critical points during its life when it sees a good opportunity, a banker wants companies to buy each other as much as frequently as possible! Wouldn't you, if you get 1% in fees of the dollar size of every transaction, the more buying and the bigger the better. A good four man banking team consisting of an analyst, associate, VP (Vice-President) and MD (Managing Director), can clean-up on over a million dollars in a few busy days.
And that was my problem. The more I thought about it the more I realized why barely any of those mergers or buy-outs worked out for either company. Most merger ideas were the product of overworked, just out of business school associates slaving away putting together pitch books at the discretion of a VP. A VP who is desperately trying to make a pitch stick, so they can pad their bonus and make MD in a few years. The banker could care less of the terms of the acquisition (except for the fee schedule) and would have no qualms with bilking companies on a bad purchase. And that is why I couldn't stomach becoming an investment banker.
Now I recognize that someone has to exist to shepherd companies through the few acquisitions that actually do create value; however, the incentives governing the game at this moment in time are terribly misaligned and I think that the bad by far outweighs the good.
Now this is only referring to traditional investment bankers (I will save traders for later) - but if I have convinced one future engineer to stay that career track and not move to banking this post was worth it, for the other problem with Wall Street is it sucks away good honest talent. For another post...
Wednesday, November 3, 2010
Seeing Yourself as a Business
This post is for the most part a mental stretch to try to prepare yourself for looking at businesses properly. One of the fun parts about analyzing companies is trying to parallel what you are reading in say an Annual Report or say a news article to what it would be like if you were the business. Today we will looking at your life and what you own in the form of a balance sheet
A balance sheet is one of the three main financial statements. The balance sheet shows a snapshot of what a company is worth in time. The image below shows the standard formula for a balance sheet.
The first point is the organization (yes this is an equation that must be satisfied). On the left side we have Assets (a house, car, guitar etc.) - on the right side we have Liabilities (what we owe) as well as Equity; the share we have in the worth of our assets (or in this case what we have already paid).
With the balance sheet the main rule we have to recognize (which will be slightly simplified at this point) is that our assets are stated at "Book Value." Book Value in our case is what we paid for the assets, if we posted the assets at what they were worth (real-estate usually appreciates), it would be called "Fair Market Value." So lets work through an example.
Below we have information concerning some of the most expensive things a person might own. For this exercise we also need to know what the person owes on each item, this is so we can list our Liabilities. So below are four things that someone might own in their life along with what they still owe on them.
If we took this personal information and put it into the format of a balance sheet we would have the image below:
And with that we have created a balance sheet. The Assets and Liabilities part are usually pretty clear for everyone, it is the Equity that is somewhat confusing. For the Equity we have taken the asset value for each item and subtracted the debt that is still owed. This leaves us with the portion you own of the item free and clear.
You could also take this one more step and say although this person has assets of $632,000 - they are only worth $400,000 (their equity value) because they still owe $232,000. This is similar to only paying $10,000 for a $20,000 car that still has $10,000 owed on it. Remember, relieving someone of debt is the same as paying them cash.
Be careful though when using a balance sheet to determine your "Net Worth." You can use a balance sheet to easily determine your "Book Worth," but any increases in real estate values could increase your net worth to higher than your Book Value balance sheet would reflect.
Hopefully this was helpful!
A balance sheet is one of the three main financial statements. The balance sheet shows a snapshot of what a company is worth in time. The image below shows the standard formula for a balance sheet.
The first point is the organization (yes this is an equation that must be satisfied). On the left side we have Assets (a house, car, guitar etc.) - on the right side we have Liabilities (what we owe) as well as Equity; the share we have in the worth of our assets (or in this case what we have already paid).
With the balance sheet the main rule we have to recognize (which will be slightly simplified at this point) is that our assets are stated at "Book Value." Book Value in our case is what we paid for the assets, if we posted the assets at what they were worth (real-estate usually appreciates), it would be called "Fair Market Value." So lets work through an example.
Below we have information concerning some of the most expensive things a person might own. For this exercise we also need to know what the person owes on each item, this is so we can list our Liabilities. So below are four things that someone might own in their life along with what they still owe on them.
If we took this personal information and put it into the format of a balance sheet we would have the image below:
And with that we have created a balance sheet. The Assets and Liabilities part are usually pretty clear for everyone, it is the Equity that is somewhat confusing. For the Equity we have taken the asset value for each item and subtracted the debt that is still owed. This leaves us with the portion you own of the item free and clear.
You could also take this one more step and say although this person has assets of $632,000 - they are only worth $400,000 (their equity value) because they still owe $232,000. This is similar to only paying $10,000 for a $20,000 car that still has $10,000 owed on it. Remember, relieving someone of debt is the same as paying them cash.
Be careful though when using a balance sheet to determine your "Net Worth." You can use a balance sheet to easily determine your "Book Worth," but any increases in real estate values could increase your net worth to higher than your Book Value balance sheet would reflect.
Hopefully this was helpful!
Tuesday, November 2, 2010
Rockefeller - The Petroleum Pimp
F' you money, loaded, stacked or just plain rich - there are many different words used to describe someone who has a lot of money. Today people look to likes of Bill Gates, Warren Buffet and various Wall Street CEO's when contemplating those rich, fortunate (word choice intentional) individuals. The problem is, people neglect to realize how f***ing rich Rockefeller was.
To put the guys cash stacks in perspective, lets look at people we have mentioned and their estimated net worth - of course before Gates and Buffet carved out their fortunes to charity:
1) Bill Gates - $54 billion
2) Warren Buffet - $62 billion
3) Rockefeller in today's money, $400-$600 billion easy
SPAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAANKED!!!
Bill Gates and Warren Buffet are constantly trading spots for the richest person in the world - but Rockefeller was leagues ahead of them with the oil empire he built, not even the same f***ing ball-park. Rockefeller ran house, controlling 1.5% of the American economy in his day. With today's GDP (that's Gross Domestic Product - or the value of all goods produced in the U.S. in a year) levels, Gates sits at a paltry .38% of United States GDP and Buffet at a meager .45%. Rockefeller was 3x buffet easy.
Rockefeller was the petroleum pimp. If Rockefeller offered a competitor a buy-out, they'd best respect or Rockefeller would undercut and clean house. When they finally broke up Standard Oil (aka Rockefeller's House) it was broken up into the predecessors of Exxon, Amoco, Chevron, Shell, CononoPhilips - little pimpets compared to Rockefeller.
So regardless of how bad Rockefeller may have been to competitors and employees, in the end, no one can argue the fact that Rockefeller definitely was F***ing loaded and dominated the oil industry. He may have been tough on people but can you blame the Petroleum Pimp for wanting to crush bills!
To put the guys cash stacks in perspective, lets look at people we have mentioned and their estimated net worth - of course before Gates and Buffet carved out their fortunes to charity:
1) Bill Gates - $54 billion
2) Warren Buffet - $62 billion
3) Rockefeller in today's money, $400-$600 billion easy
SPAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAANKED!!!
Bill Gates and Warren Buffet are constantly trading spots for the richest person in the world - but Rockefeller was leagues ahead of them with the oil empire he built, not even the same f***ing ball-park. Rockefeller ran house, controlling 1.5% of the American economy in his day. With today's GDP (that's Gross Domestic Product - or the value of all goods produced in the U.S. in a year) levels, Gates sits at a paltry .38% of United States GDP and Buffet at a meager .45%. Rockefeller was 3x buffet easy.
Rockefeller was the petroleum pimp. If Rockefeller offered a competitor a buy-out, they'd best respect or Rockefeller would undercut and clean house. When they finally broke up Standard Oil (aka Rockefeller's House) it was broken up into the predecessors of Exxon, Amoco, Chevron, Shell, CononoPhilips - little pimpets compared to Rockefeller.
So regardless of how bad Rockefeller may have been to competitors and employees, in the end, no one can argue the fact that Rockefeller definitely was F***ing loaded and dominated the oil industry. He may have been tough on people but can you blame the Petroleum Pimp for wanting to crush bills!
Monday, November 1, 2010
The World Sucks Because We Don't Understand Incentive Systems
To start off simple, take a baseball player that is taking steroids to enhance his performance in an attempt to break the standing home-run record. The benefit (or as traders say "upside") of taking steroids is that he has a better chance of attaining a new home-run record, achieving great fame, and living the non libation related high life.
If the punishment (or as traders say "downside") of getting caught doing illicit drugs is a $50 fine, the the baseball player will most likely brush it off as a cost of doing business and achieving fame, in other words let the juice flow! However, if the penalty is getting kicked out of the National Baseball League - yes this blog is based in the United States - the player may think twice about juicing. So, if the NBA really wants to put their foot down on steroid use, they would increase the penalties to create an incentive system geared towards discouraging steroid usage.
This logic can be extended to businesses as well. Take the example of a business CEO (Chief Executive Officer) who is granted a bonus that gives him an extra $50,000 for every .1% that he increases net income over the year. If he increases sales by a full percentage point he gets an extra $500,000 - not a bad bonus.
The problem with this incentive system is that it is rather short-term. There are any number of ways the CEO can juice net income in the short-term to help his bonus. He can sell inferior products and lower costs, this may work for a year but over the long-term will cause customers to purchase from other businesses. He could also create deep discounts and encourage customers to buy lots of product and stock up before the end of year. This will increase net income but will significantly drop sales because the customers will purchase less the following year.
This is a poor incentive system because it only focuses on the short-term needs for the business. Many businesses have tried to get around this by granting stock as bonuses and finally stock options that CEO's could not cash in on for a certain amount of years (say five) in order that they keep the stock price up for at least that long.
We can also look at the financial crisis. In the past when a bank loaned money to someone to purchase a house they then held that mortgage on their books as an asset (yes an asset - for banks loans are assets because they are entitled to a future cash flow). When securitization became popular banks could sell those mortgages in a package to a firm that pooled them and then issued bonds to individual investors that purchased a share in that cash flow.
This skewed incentives for the bank making the loans. In the past a bank that would only make loans if they knew they were to be paid on those loans, after securitization became popular they had "no skin in the game" because if they made a bad loan they got fees for it but did not have to suffer consequences if the mortgage holder didn't pay their mortgages. This was a main contributor to the housing crises as people with poor credit quality and an inability to pay their mortgage were extended loans. Now regulators are trying to make banks retain a portion of those mortgages to expose them to the "downside" risk, not just the "upside" benefits.
Or take politics....I don't need to get to the incentives lobbyist provide to individual politicians in Washington D.C. but you get my drift. A lack of understanding of the incentives we establish within society is what creates most of our problems. We can all help this issue by just thinking about the "upside" and "downside" to any decision we make. As far as your investing, are you purchasing shares in companies that align their executives incentives with what is best for the company long-term - if not you may want to start!
Sunday, October 31, 2010
Getting Started Understanding A Company - FS - #1
To make organizationi easier, if you do not wish to read anything other than my financial statement analysis posts I will numnber that as shown above so you can be sure you haven't missed one...moving on....
A lot of people don't know where to start when they want to start investing. A finance degree gives you a lot of the tools that you can use to analyze companies, but still many finance majors and investors everywhere forget the one basic tenant of long-term stock investing. Do your homework!
You can run all sorts of analysis and do all sorts of different types of investing but in the most general sense you want to invest in a company that you understand and believe in. The best way to understand a company is by sitting down and reading an annual report (aka the 10k, a 10q is a quarterly filing). You can get an annual report online from the website of any public company (usually through the "About" or "Investor Relations" section of their website) or if you like holding paper in your hands order them for free here Annual Reports. They deliver the report if they have it in stock, if they don't have it in stock they will have the company mail it to you.
Now in the future I will detail more specific ways of analyzing a companies prospects but the big one is actually working your own way and mucking through an annual report. The more you read finance the more you realize, understanding a good company is mostly common sense:
General Motors had trouble because it paid too much in health benefits through years of union concessions and had too large a product line which lead to added costs, other companies that didn't have these issues could easily undercut General Motors with better quality cars at lower prices. It doesn't take a finance whiz to come to that conclusion. General motors cost per car number was through the roof compared to its rivals - I recall working through analysis and attributing an extra $2000+ costs in health benefits to each GM car that was made over its foreign competitors (a conclusion many others also came to). In addition, the quality of their cars started to deteriorate and management began to get complacent.
On another note a lot of time Wall Street analysts also get caught up in companies and issue positive ratings or "buy" recommendations because that makes the companies happy. They also may nix an analyst that issues unfavorable ratings. In the case of Enron, nobody understood how they made their money, they were what industry folks call a "black box," it was too good to be true - and subsequently it wasn't true. Again, common sense, if now one can understand the company, something strange is going on.
Like anything else it will take a while to get through your first 40-50 annual reports and you will not understand much at first, but google your questions and continue to try - there are learning curves to everything and it does take time. I would recommend that you start with a simple company though, steer clear of any finance and high-tech companies as they engage in complex activities, a manufacturer or a retailer would work well for starters. Lastly, once you find a company you like trust your analysis - you will have looked at many different ones and know more about them than most investors. It may take a while to reap your benefits, but over the long time if the company is solid and it is not overpriced it will show in your returns (later we will see how to spot overpriced stocks).
A lot of people don't know where to start when they want to start investing. A finance degree gives you a lot of the tools that you can use to analyze companies, but still many finance majors and investors everywhere forget the one basic tenant of long-term stock investing. Do your homework!
You can run all sorts of analysis and do all sorts of different types of investing but in the most general sense you want to invest in a company that you understand and believe in. The best way to understand a company is by sitting down and reading an annual report (aka the 10k, a 10q is a quarterly filing). You can get an annual report online from the website of any public company (usually through the "About" or "Investor Relations" section of their website) or if you like holding paper in your hands order them for free here Annual Reports. They deliver the report if they have it in stock, if they don't have it in stock they will have the company mail it to you.
Now in the future I will detail more specific ways of analyzing a companies prospects but the big one is actually working your own way and mucking through an annual report. The more you read finance the more you realize, understanding a good company is mostly common sense:
General Motors had trouble because it paid too much in health benefits through years of union concessions and had too large a product line which lead to added costs, other companies that didn't have these issues could easily undercut General Motors with better quality cars at lower prices. It doesn't take a finance whiz to come to that conclusion. General motors cost per car number was through the roof compared to its rivals - I recall working through analysis and attributing an extra $2000+ costs in health benefits to each GM car that was made over its foreign competitors (a conclusion many others also came to). In addition, the quality of their cars started to deteriorate and management began to get complacent.
On another note a lot of time Wall Street analysts also get caught up in companies and issue positive ratings or "buy" recommendations because that makes the companies happy. They also may nix an analyst that issues unfavorable ratings. In the case of Enron, nobody understood how they made their money, they were what industry folks call a "black box," it was too good to be true - and subsequently it wasn't true. Again, common sense, if now one can understand the company, something strange is going on.Like anything else it will take a while to get through your first 40-50 annual reports and you will not understand much at first, but google your questions and continue to try - there are learning curves to everything and it does take time. I would recommend that you start with a simple company though, steer clear of any finance and high-tech companies as they engage in complex activities, a manufacturer or a retailer would work well for starters. Lastly, once you find a company you like trust your analysis - you will have looked at many different ones and know more about them than most investors. It may take a while to reap your benefits, but over the long time if the company is solid and it is not overpriced it will show in your returns (later we will see how to spot overpriced stocks).
Ahhh! WTF Happens Inside an Investment Bank!?!
So they had a huge hand in the financial crisis, they have most of Washington in their pockets, they are really confusing and everyone that works at one seems to be a millionaire. They have names like Morgan Stanley, Goldman Sachs, Lazard and in the recent past Lehman Brothers, Merrill Lynch and Bear Stearns. It takes about '100' years to make a good one and they are the envy of ivy league business majors and MBA's all over the world. They are investment banks, not to be confused with your mom and pop banks and below is what they look like inside.
So lets talk about what we are looking at, hopefully in a way that won't make you cringe. At first glance we have four main sections in our picture:
1) Investment Banking
2) Sales and Trading
3) Operations
4) Capital Markets
*In reality you will see many other functions such a prime brokerage, asset management etc. but the big players are above.
Lets discuss what they do and to make it more interesting we can also discuss their personalities and how much money they make!
Our first stop will be the investment banker, the investment banker usually specializes in an industry and may specialize or fall into another group such as Mergers & Acquisitions. These are like financial advisors for companies. They help companies raise capital (through debt/equity offerings), tell companies to buy other companies and bring private companies public; and they do not do this for free, they charge hefty fees. The general character of an investment banker is calm and reserved. Unlike traders (who we will discuss later) they don't use brash words and never unbutton a shirt collar.
Because the investment bankers only make money when a business moves money around, either to purchase a company or raise money - they constantly want corporations to move money. To do this they have to give the companies ideas of what they should do at all times in the form of neat little presentations called pitch-books (in industry terms PIBS). Many of these ideas never see the light of day but because the bankers have to think up 100's of pitches for every one that comes to fruition they never sleep and are at the beck and call of a company that is processing a deal - the lower you are on the totem pole the less you sleep. You start as an analyst, then become an associate, if you are good the following step is vice president and if you can make it rain a Director or even Managing Director.
In 2010 as a starting analyst you can expect to get a $70,000 salary and get a bonus of about 80% and up of that, you can also expect to work 90-120 hour weeks during deals. After two years of being an analyst you go back to get your MBA and become an Associate. Now you have a salary of about $100,000 and your bonus structure remains the same. If you are good you make VP and are crushing half a million bucks a year and a good Managing Director that can really make it rain could be making eight, nine or ten million a year (there are those poor suckers who only make a couple million). Ohh and what about that little red line in the picture, that is called "The Chinese Wall." Because bankers have access to private client information (they need it for their pitches) they aren't allowed to be around other people in the bank who could profit from that information. Hence all banks have two big escalators and two big elevator banks that never mix.
Traders are a whole other entity not to be confused with bankers or salesman. Traders and salesman work together on a trading floor but that is the only thing they have in common. Traders for the most part specialize in a certain product or region and trade for either clients (flow trading/market making) or for the bank itself (proprietary traders) although these are a dying breed thanks to the Dodd-Frank bill and the Volcker Rule.
Because Frank Partnoy already described the difference between a trader and a salesman in his book "FIASCO," I can just steal his work!
"The traders are the men with rolled up sleeves and loosened ties who hold several phones each and periodically smash one phone against a desk, a computer or a trading assistant, and then grab another donut out of a monstrous box."
"In contrast the salesman calmly adjust their cuff links while they hold one phone to each ear and, by alternatively squeezing hidden mute buttons in their handsets, carry on several composed conversations at once. A good salesman can simultaneously schmooze a client, discuss tonight's Knicks game with his bookie, order his assistant to steal a donut from the traders, and explain to his wife where he had been last night until 4:00am - and none will be aware of the other conversations or the nearby pandemonium." (of the trading floor).
Folks in sales and trading get similar salaries to their counterparts in banking but their bonuses are based on the number of clients and how much they trade or how their trades fair in the market. This allows them to be ridiculously profitable. A good proprietary trader can make more than the CEO of a large bank in a good year and the guy that controls the money is the one that really runs the bank. Think Michael Milken of Soloman Brothers in the 1980's. Best of all for proprietary traders (the high-flying jocks of the traders), you are gambling with the firms money!
Capital markets guys are there to help feel out the markets when the bankers need to raise debt. An investment banker will say something like "Johnson & Johnson wants to raise $10 billion in debt, they want something that has a pretty short maturity. How much will it cost them?" Capital markets will work with a group called "Syndicate" to price the security in the market for the bankers. Of course this is after the investment banker has pitched to '100' different companies that they need to raise debt and one has finally listened. A good capital markets guy keeps his pulse on the market and knows how much everything costs at the time. A capital market workers salary is slightly below a bankers mainly because they lie further from the clients.
Then there are the Operations guys. This is everything that the bank has that slightly resembles a normal company. This is management, legal and administration. Most banks have huge seperate buildings to house the real gritty operations people that actually work out their trades as well as clear their accounts and make sure everything goes through. These buildings aren't nearly as glamorous as to the buildings for the bankers and traders (ie. Goldman Sachs shuffles all of its operations people off to a large building in New Jersey) and the pay is a fraction of every other position.
So those are the basics of an investment bank, it can be as complicated as you make it but the knowledge above will put you leagues ahead of the average person!
So lets talk about what we are looking at, hopefully in a way that won't make you cringe. At first glance we have four main sections in our picture:
1) Investment Banking
2) Sales and Trading
3) Operations
4) Capital Markets
*In reality you will see many other functions such a prime brokerage, asset management etc. but the big players are above.
Lets discuss what they do and to make it more interesting we can also discuss their personalities and how much money they make!
Our first stop will be the investment banker, the investment banker usually specializes in an industry and may specialize or fall into another group such as Mergers & Acquisitions. These are like financial advisors for companies. They help companies raise capital (through debt/equity offerings), tell companies to buy other companies and bring private companies public; and they do not do this for free, they charge hefty fees. The general character of an investment banker is calm and reserved. Unlike traders (who we will discuss later) they don't use brash words and never unbutton a shirt collar.
Because the investment bankers only make money when a business moves money around, either to purchase a company or raise money - they constantly want corporations to move money. To do this they have to give the companies ideas of what they should do at all times in the form of neat little presentations called pitch-books (in industry terms PIBS). Many of these ideas never see the light of day but because the bankers have to think up 100's of pitches for every one that comes to fruition they never sleep and are at the beck and call of a company that is processing a deal - the lower you are on the totem pole the less you sleep. You start as an analyst, then become an associate, if you are good the following step is vice president and if you can make it rain a Director or even Managing Director.
In 2010 as a starting analyst you can expect to get a $70,000 salary and get a bonus of about 80% and up of that, you can also expect to work 90-120 hour weeks during deals. After two years of being an analyst you go back to get your MBA and become an Associate. Now you have a salary of about $100,000 and your bonus structure remains the same. If you are good you make VP and are crushing half a million bucks a year and a good Managing Director that can really make it rain could be making eight, nine or ten million a year (there are those poor suckers who only make a couple million). Ohh and what about that little red line in the picture, that is called "The Chinese Wall." Because bankers have access to private client information (they need it for their pitches) they aren't allowed to be around other people in the bank who could profit from that information. Hence all banks have two big escalators and two big elevator banks that never mix.
Traders are a whole other entity not to be confused with bankers or salesman. Traders and salesman work together on a trading floor but that is the only thing they have in common. Traders for the most part specialize in a certain product or region and trade for either clients (flow trading/market making) or for the bank itself (proprietary traders) although these are a dying breed thanks to the Dodd-Frank bill and the Volcker Rule.
Because Frank Partnoy already described the difference between a trader and a salesman in his book "FIASCO," I can just steal his work!
"The traders are the men with rolled up sleeves and loosened ties who hold several phones each and periodically smash one phone against a desk, a computer or a trading assistant, and then grab another donut out of a monstrous box."
"In contrast the salesman calmly adjust their cuff links while they hold one phone to each ear and, by alternatively squeezing hidden mute buttons in their handsets, carry on several composed conversations at once. A good salesman can simultaneously schmooze a client, discuss tonight's Knicks game with his bookie, order his assistant to steal a donut from the traders, and explain to his wife where he had been last night until 4:00am - and none will be aware of the other conversations or the nearby pandemonium." (of the trading floor).
Folks in sales and trading get similar salaries to their counterparts in banking but their bonuses are based on the number of clients and how much they trade or how their trades fair in the market. This allows them to be ridiculously profitable. A good proprietary trader can make more than the CEO of a large bank in a good year and the guy that controls the money is the one that really runs the bank. Think Michael Milken of Soloman Brothers in the 1980's. Best of all for proprietary traders (the high-flying jocks of the traders), you are gambling with the firms money!
Capital markets guys are there to help feel out the markets when the bankers need to raise debt. An investment banker will say something like "Johnson & Johnson wants to raise $10 billion in debt, they want something that has a pretty short maturity. How much will it cost them?" Capital markets will work with a group called "Syndicate" to price the security in the market for the bankers. Of course this is after the investment banker has pitched to '100' different companies that they need to raise debt and one has finally listened. A good capital markets guy keeps his pulse on the market and knows how much everything costs at the time. A capital market workers salary is slightly below a bankers mainly because they lie further from the clients.
Then there are the Operations guys. This is everything that the bank has that slightly resembles a normal company. This is management, legal and administration. Most banks have huge seperate buildings to house the real gritty operations people that actually work out their trades as well as clear their accounts and make sure everything goes through. These buildings aren't nearly as glamorous as to the buildings for the bankers and traders (ie. Goldman Sachs shuffles all of its operations people off to a large building in New Jersey) and the pay is a fraction of every other position.
So those are the basics of an investment bank, it can be as complicated as you make it but the knowledge above will put you leagues ahead of the average person!
Saturday, October 30, 2010
How Does a Bank Make Money?
Often times I find myself wanting to write articles that are not necessarily directly related to personal investing but I feel help to round out the skill set that every investor should have such as How Does a Bank Make Money. Having knowledge of how what I call a "normal bank" but what we can also call a "retail bank" (a bank that takes deposits from people like you and I and makes loans to small businesses as well as individuals) helps one better understand how the economy operates.
The idea of a simple retail bank centers on a couple big concepts; many people probably use different names to describe the functions that allow a bank to make money without getting too technical.
1) Credit Knowledge - banks gather together employees that are knowledgeable of the credit quality of the clients they lend to and thus are better able than the average person to price and make a loan based on the loan customers credit quality. Logically, if a bank made bad loans all the time to businesses and individuals that could not repay them the bank would ultimately go bankrupt.
2) Banks take deposits from individuals, aggregate them and lend those deposits out to customers at different maturities to profit from an upward sloping yield curve (this should be sound confusing right now).
The first concept allows banks to operate in a manner which allows them to be profitable in engaging in the second concept. Lets now focus on breaking down the second topic.
We all understand the concept of a bank taking deposits, we all have some form of a bank account (checking, savings etc.) and we all put our paychecks into a bank or at least cash them at the bank. What this does is leave the bank with a significant amount of cash that they can then lend out.
I will now introduce a second concept that will be detailed in a later post, it is something called the yield curve. There are many other names for this curve and there are many other similar sounding curves but the yield curve for United States Treasury Securities (what 99% of people mean when they reference the "yield curve"), is the most important. The yield curve is just what it sounds like, a listing of different debt that the United States government has outstanding for different maturities and what the yield rate (or interest rate) on each of those securities is. Usually the it is upward sloping because longer maturity debt almost always carries a premium (higher interest rate) because the longer the term of a loan, the greater the risk that an investor will fail to collect on it. Below is am image of what the yield curve may look like at any given time.
So we see from above that as the maturity of United States' debt increases, so does the yield. In short, if Japan purchases a 30-year United States Federal Government bond, they demand more yield than if they purchase a 5-year bond because a lot more can happen over the 30-year period (more uncertainty) than over the five year period. I'll introduce the concept of spread later (not all of us can borrow at the same rate as the U.S. government due to credit quality) but in general longer loans have higher interest rates.
So back to how does a bank make money. We give them our deposits - because we can pretty much demand our money from the bank at any point in time, they are short term deposits and thus offer very little interest. Everyone can recall that putting your money in a CD (Certificate of Deposit) for a lock-up period of a year or more will usually result in higher interest than a regular deposit account. Many savings accounts yield less than half a percentage point.
The bank takes all those small deposits, bundles them together and makes a large long-term loan to a business in the area. Because the loan is long-term it demands a higher rate. The difference in what the bank pays on deposits and what they lend at is called the "Net Interest Margin" and is a key metric in analyzing a banks profitability. Below is an example illustrating the importance of a bank's "Net Interest Margin."
Suppose a bank pays interest to consumers on their deposits at an average annual rate of say .35% and lends out those deposits at an annual rate of 3.4% they have a NIM (Net Interest Margin) of 3.05%. Assume their total loans outstanding are two billion dollars. A little math ($2,000,000,000 * .0305% = $70,000,000) nets the bank a cool $70,000,000 over the course of a year, and two billion dollars in deposits may sound like a lot but in reality that is a rather small bank. To put it in perspective J.P. Morgan has over two trillion in assets.
So what have we learned? First off, a bank makes money by borrowing short-term and lending long-term. In addition, the steeper the yield curve the better for a bank because that means they can get a wider Net Interest Margin. Lastly, a bank has to be able to analyze credit because if too many customers default on loans, the bank will go bankrupt. In the future we will discuss more of the inner-workings of more complex banks. In short, we have now figured out how a bank makes money!
The idea of a simple retail bank centers on a couple big concepts; many people probably use different names to describe the functions that allow a bank to make money without getting too technical.
1) Credit Knowledge - banks gather together employees that are knowledgeable of the credit quality of the clients they lend to and thus are better able than the average person to price and make a loan based on the loan customers credit quality. Logically, if a bank made bad loans all the time to businesses and individuals that could not repay them the bank would ultimately go bankrupt.
2) Banks take deposits from individuals, aggregate them and lend those deposits out to customers at different maturities to profit from an upward sloping yield curve (this should be sound confusing right now).
The first concept allows banks to operate in a manner which allows them to be profitable in engaging in the second concept. Lets now focus on breaking down the second topic.
We all understand the concept of a bank taking deposits, we all have some form of a bank account (checking, savings etc.) and we all put our paychecks into a bank or at least cash them at the bank. What this does is leave the bank with a significant amount of cash that they can then lend out.
I will now introduce a second concept that will be detailed in a later post, it is something called the yield curve. There are many other names for this curve and there are many other similar sounding curves but the yield curve for United States Treasury Securities (what 99% of people mean when they reference the "yield curve"), is the most important. The yield curve is just what it sounds like, a listing of different debt that the United States government has outstanding for different maturities and what the yield rate (or interest rate) on each of those securities is. Usually the it is upward sloping because longer maturity debt almost always carries a premium (higher interest rate) because the longer the term of a loan, the greater the risk that an investor will fail to collect on it. Below is am image of what the yield curve may look like at any given time.
 |
| For a current yield curve navigate to the "Rates" section of http://www.bloomberg.com |
So we see from above that as the maturity of United States' debt increases, so does the yield. In short, if Japan purchases a 30-year United States Federal Government bond, they demand more yield than if they purchase a 5-year bond because a lot more can happen over the 30-year period (more uncertainty) than over the five year period. I'll introduce the concept of spread later (not all of us can borrow at the same rate as the U.S. government due to credit quality) but in general longer loans have higher interest rates.
So back to how does a bank make money. We give them our deposits - because we can pretty much demand our money from the bank at any point in time, they are short term deposits and thus offer very little interest. Everyone can recall that putting your money in a CD (Certificate of Deposit) for a lock-up period of a year or more will usually result in higher interest than a regular deposit account. Many savings accounts yield less than half a percentage point.
The bank takes all those small deposits, bundles them together and makes a large long-term loan to a business in the area. Because the loan is long-term it demands a higher rate. The difference in what the bank pays on deposits and what they lend at is called the "Net Interest Margin" and is a key metric in analyzing a banks profitability. Below is an example illustrating the importance of a bank's "Net Interest Margin."
Suppose a bank pays interest to consumers on their deposits at an average annual rate of say .35% and lends out those deposits at an annual rate of 3.4% they have a NIM (Net Interest Margin) of 3.05%. Assume their total loans outstanding are two billion dollars. A little math ($2,000,000,000 * .0305% = $70,000,000) nets the bank a cool $70,000,000 over the course of a year, and two billion dollars in deposits may sound like a lot but in reality that is a rather small bank. To put it in perspective J.P. Morgan has over two trillion in assets.
So what have we learned? First off, a bank makes money by borrowing short-term and lending long-term. In addition, the steeper the yield curve the better for a bank because that means they can get a wider Net Interest Margin. Lastly, a bank has to be able to analyze credit because if too many customers default on loans, the bank will go bankrupt. In the future we will discuss more of the inner-workings of more complex banks. In short, we have now figured out how a bank makes money!
Friday, October 29, 2010
The Rule of 70
Quick post just to give everyone a quick estimation method for figuring out how long it takes money to double. It is called the "Rule of 70" and this is how it works.
1) Take an interest rate (say 5%)
2) Divide that into 70 (70/5=14)
3) The number you receive is roughly how long it will take in years for your money to double at that interest rate or rate of return.
In this case at an interest rate of 5% your money will double in about '14' years. This is a quick, often impressive, method that can be used to ballpark how many years it will take your investment to double.
For our math nerds the method comes by taking the natural logarithm of two. This gives you '.7' which is where the '70' integer is derived from. In other words if you wanted to see how long it would take your money to triple simply take the natural logarithm of three and multiply by ten. Then you have the "Rule of 110," to divide your interest rate into and find how long it will take your money to triple!
1) Take an interest rate (say 5%)
2) Divide that into 70 (70/5=14)
3) The number you receive is roughly how long it will take in years for your money to double at that interest rate or rate of return.
In this case at an interest rate of 5% your money will double in about '14' years. This is a quick, often impressive, method that can be used to ballpark how many years it will take your investment to double.
For our math nerds the method comes by taking the natural logarithm of two. This gives you '.7' which is where the '70' integer is derived from. In other words if you wanted to see how long it would take your money to triple simply take the natural logarithm of three and multiply by ten. Then you have the "Rule of 110," to divide your interest rate into and find how long it will take your money to triple!
Why You Should Refinance
A big mistake that I often see, is people that are not taking advantage of the opportunity to refinance there homes. I decided to work out some numbers for fixed rate mortgages that could prove how much interest can be saved over the life of the loan (technically you should present value the future interest to get a better gauge but we won't worry about it at this point). Remember this only applies to fixed rate mortgages (not I/O interest only teaser loans, Option-ARMS adjustable rate mortgage or Reverse-ams which actually grow principal over time).
Most people realize the notion that when you get a 30-year fixed mortgage (the Cadillac of mortgages) you will be paying a lot of interest over the course of the loan - but how much interest? Below is an image to show on a yearly basis roughly how much of your payments are interest over each year of a 10-year fixed mortgage (with an interest rate of around 8%), a thirty year would be even worse in interest!
You can see from the image above that during your first year of payments you are almost paying entirely interest and barely any principal on your loan. Most people know not to run up credit card debt inter-monthly because you end up paying dear in interest but look what your house is costing you if you pay the minimum mortgage payment. This should be a red light to pay off your house as fast as possible (after you have settled any debt with higher interest rates). Below I've worked through some numbers that compare the interest paid over the life of a loan of different maturities over a couple different interest rates.
Suppose you got a $200,000 thirty year fixed mortgage with a 7.5% monthly interest rate. Your monthly payments would be $1,400 and over the course of the loan you would pay a whopping $300,000 in interest, what a waste! Lowering that to a 20 year increases payments to $1,600 but lowers lifetime interest to $184,000. A ten year increases payments to $2,400 but reduces lifetime interest to $83,000. Remember, extra interest doesn't get you anything extra.
I had talked about refinancing so lets take a look at the benefits of refinancing to a 5% loan at each of these maturities from that 7.5% interest loan. Remember, mortgage refinancing requires paperwork and does cost money, usually $3,000-$5,000 which is worth some attention. Many people are refinancing right now, if you go to bloomberg.com, bankrate.com or any real-estate website you could probably see 30-year averages below 5% (historically this is extremely low). In the future I will discuss what changes this rate (entities such as Fannie Mae, Freddie Mac and United States Federal Reserve), but at this point assume you get that $200,000 30yr-fixed mortgage at 5% as opposed to 7.5%.
This new loan results in $1,100 payments per month (a savings of $300 per month) and lifetime interest of $184,000 (a savings of $116,000 over the life of a loan). If you had started with a 20 year 7.5% loan on that $200,000 and converted to a 5% loan you would pay$1,300 a month (a savings of $300 again) and lifetime interest of $115,000 (a savings of $69,000 in lifetime interest). If you had the ten year your monthly payments would be $2,100 and over the life of the loan you would save $30,000 and only pay $53,000 total.
This should show you that if you can afford the payments, your best bet is to go for a shorter term loan. If you can refinance, work through some numbers and taking to cost into consideration figure out if the lower payments and interest savings are worth it to you, feel free to email me if you want a spreadsheet to compare different rates a loan terms. Don't forget to keep that credit rate up, you still have to get approved at your lower rate! Feel free to email me with any questions - unmaskingfinance@yahoo.com
Most people realize the notion that when you get a 30-year fixed mortgage (the Cadillac of mortgages) you will be paying a lot of interest over the course of the loan - but how much interest? Below is an image to show on a yearly basis roughly how much of your payments are interest over each year of a 10-year fixed mortgage (with an interest rate of around 8%), a thirty year would be even worse in interest!
 |
| Email me for a spreadsheet that can work out different rates and maturities! |
You can see from the image above that during your first year of payments you are almost paying entirely interest and barely any principal on your loan. Most people know not to run up credit card debt inter-monthly because you end up paying dear in interest but look what your house is costing you if you pay the minimum mortgage payment. This should be a red light to pay off your house as fast as possible (after you have settled any debt with higher interest rates). Below I've worked through some numbers that compare the interest paid over the life of a loan of different maturities over a couple different interest rates.
Suppose you got a $200,000 thirty year fixed mortgage with a 7.5% monthly interest rate. Your monthly payments would be $1,400 and over the course of the loan you would pay a whopping $300,000 in interest, what a waste! Lowering that to a 20 year increases payments to $1,600 but lowers lifetime interest to $184,000. A ten year increases payments to $2,400 but reduces lifetime interest to $83,000. Remember, extra interest doesn't get you anything extra.
I had talked about refinancing so lets take a look at the benefits of refinancing to a 5% loan at each of these maturities from that 7.5% interest loan. Remember, mortgage refinancing requires paperwork and does cost money, usually $3,000-$5,000 which is worth some attention. Many people are refinancing right now, if you go to bloomberg.com, bankrate.com or any real-estate website you could probably see 30-year averages below 5% (historically this is extremely low). In the future I will discuss what changes this rate (entities such as Fannie Mae, Freddie Mac and United States Federal Reserve), but at this point assume you get that $200,000 30yr-fixed mortgage at 5% as opposed to 7.5%.
This new loan results in $1,100 payments per month (a savings of $300 per month) and lifetime interest of $184,000 (a savings of $116,000 over the life of a loan). If you had started with a 20 year 7.5% loan on that $200,000 and converted to a 5% loan you would pay$1,300 a month (a savings of $300 again) and lifetime interest of $115,000 (a savings of $69,000 in lifetime interest). If you had the ten year your monthly payments would be $2,100 and over the life of the loan you would save $30,000 and only pay $53,000 total.
This should show you that if you can afford the payments, your best bet is to go for a shorter term loan. If you can refinance, work through some numbers and taking to cost into consideration figure out if the lower payments and interest savings are worth it to you, feel free to email me if you want a spreadsheet to compare different rates a loan terms. Don't forget to keep that credit rate up, you still have to get approved at your lower rate! Feel free to email me with any questions - unmaskingfinance@yahoo.com
Thursday, October 28, 2010
A Holistic View
The reason I initially decided to make this website was because I realized many of my friends coming out of college didn't have an overall view of how they should be planning their finances. Many people were missing simple concepts that were making their financial future extremely risky for minuscule additional returns in investing.
Examples of problems I saw included people that were thinking about playing the stock market before they had sufficient health care benefits, people that were thinking they needed life insurance before they were married, as well as people who were putting all their money in investments without a sufficient cash cushion for emergencies.
In the future I will surely discuss stock, bond, mutual fund, etc. investing but I think before that people need to understand some risk basics and evaluate whether they are in a position to invest.
I would like to make it clear as well, if someone would like a specific question answered just comment or sent me an email and I will be happy to either answer it or if it is a common question make an entire post about it.
Examples of problems I saw included people that were thinking about playing the stock market before they had sufficient health care benefits, people that were thinking they needed life insurance before they were married, as well as people who were putting all their money in investments without a sufficient cash cushion for emergencies.
In the future I will surely discuss stock, bond, mutual fund, etc. investing but I think before that people need to understand some risk basics and evaluate whether they are in a position to invest.
I would like to make it clear as well, if someone would like a specific question answered just comment or sent me an email and I will be happy to either answer it or if it is a common question make an entire post about it.
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