In Defense of Repricing Stock Options

This is actually news from last week, but Google announced that they are repricing their employee stock options.

John Batelle has fairly representative coverage on his blog.  His post cites coverage from Adam Lashinsky at Fortune (a personal favorite as a journalist) with a fairly typical dig on the issue.  Here’s the actual quote:

One last item of note. Google is offering employees the opportunity to exchange underwater stock options for newly priced options due to the stock price having been hammered. (The only catch in the exchange is that employees will have to wait an additional 12 months before selling re-priced options.) The stock price is  currently around $300, compared with $700 in late 2007. The number of shares eligible for exchange is about 3% of the shares outstanding, and the exchange will result in a charge to earnings of $460 million over a five-year period.

One must re-phrase this last bit in English: Google is transferring almost half a billion dollars in wealth from shareholders to employees, and for what ….? Motivation and retention, says Google. This a well known farce, as old as the Valley, which tells itself first that it offers generous stock options as a form of incentive and then, when share prices plummet, moves the ball so its employees, whose incentives apparently didn’t work (as if the stock price were under their control) can be re-incentivized. Retention? Would someone please tell me where the average Google employee is going to go right now?

To be clear, there have always been people who have a significant problem with employee stock option repricing, and with good reason.  Theoretically, options are supposed to align employee interests with shareholders.  In an ideal world, the employee wins if the shareholders win.   Repricing, therefore, breaks this model, because, after all, no one reprices the shares purchased by outside shareholders when the stock tanks.

Somewhere in the post-2000 bubble hangover, this criticism went from being a common argument to conventional wisdom.  Accounting standards were changed to require the expensing of employee stock options, and stock option repricing became largely verboten.

I rarely see anyone in the financial press explaining anymore why, in fact, there are very good arguments for stock option repricing.  So, I’m going to take a quick crack at it here.  Even if you disagree, it does a disservice to not reflect both sides of the argument fairly.

First, and foremost, it’s important to note that, while options are intended to help align employee interests with shareholders, stock options, in fact, do not do this in all situations.  The problem is the inflection point in the curve.


This is a simple chart that shows the intrinsic value to an employee of a stock option with a strike price of 50 at different stock prices.  Notice the blue line, which is stock, actually reflects a 1:1 ratio of value.  If the stock is worth $10, the employee gets $10, etc.  For the stock option, however, there is a “break” in the line.  Below $50, the employee gets $0.  Above $50, the employee gets $1 for every $1 of stock price increase.

In general, employee stock options are granted at the strike price of the stock roughly on the date that they join.  So, the assumption is, this aligns the employee with gains after they join.  In theory, it’s even better than stock, because if the stock drops, they get no value for gains made before the date of their join.

This sounds good in theory, but we know that it has real problems, on both the upside and the downside.

On the upside, most stocks go up every year.  (Yes, I know.  In 2009, it’s hard to remember that.)  If the stock market itself goes up 7% every year, then an employee will see real returns on their stock options for just “matching the average”.  In fact, they can actually see real material gains over long periods even by underperforming their benchmark index.

However, since shareholders also enjoy that benefit, it tends to only get complaints when you see incredible gains by executives with huge option packages.   No one likes to see an outsized pay package for undersized performance.

On the downside, however, the problem is much more severe.  Let’s say our stock example from above drops to $25, a price that the company hasn’t been at for 3 years.  The good news is that shareholder alignment works, to a point, as advertised.  Not only are shareholder gains for the last 3 years wiped out, but so are the option grants for employees who joined in the last 3 years, and even any other employees who received grants in the past 3 years.

That part seems fine… at first.

Where does the company go from here?  Now we need to talk about the principle of sunk cost.  Sunk costs are costs that cannot be recovered, and therefore should be ignored when making future investment decisions.  (More rigorous explanation on Wikipedia).  For stocks, it’s important to remember the stock market does not care what you paid for a stock.  It has no memory.  The question for a shareholder (barring external effects like taxes, etc) is purely where you think the stock will go from here.

But now we see that the employee is no longer aligned with the shareholder!  From $25, most shareholders would love to see a gain of 20%, which would take the stock to $30.  But for employees, a $30 share price and a $25 share price mean the same thing:  $0.

Worse, if employees leave the company, and get a job at a new company, they will get option prices at today’s stock price.  In fact, if the employee quits the company, and then is rehired back, they would actually get their options priced at today’s stock price.

In a world of at-will employment, this is a big problem.  True, as Adam Lashinsky pokes at, most employees won’t be able to find a new job so fast.  But many of the good ones can.  And they will.  Because your competitor can actually come in with in a simple, fair market offer for the employee, and beat your implicit offer of zero.  Even if they don’t do it today, these problems tend to persist for long periods of time, and employees have long memories.  You may find that your best talent starts leaving, and then you get snowball effects because great talent is hyper-aware when other talent leaves.

So what is a company to do?

In a perfect world, the company would have a very tight and accurate evaluation of their best talent, and would target “retention compensation” proportionally to their people based on their value.  This would both minimize the risk of flight, and would also help “re-align incentives” for the gains going forward.

Unfortunately, the mechanics and accounting of repricing makes this fairly prohibitive.   As a result, it tends to be an all-or-nothing option.

The truth is, repricing stock options can be one of the best things to realign employee incentives going forward.  It resets the vesting period, basically treating employees like new employees.  The employees do not get to go back in time and recover their equity compensation for the past three years.  The new vesting period basically wipes out the history.  They literally no longer own the rights to the shares – they have to re-earn them.  In fact, if the employee quits the next day, they will take no stock with them, even if they worked for the company for three years.

As a result, stock option repricing actually re-aligns employees more closely with shareholders than nay-sayers give credit for.

Last thoughts

While I am explaining the reasons why repricing stock options makes sense, there is still the significant problem of “repeat abuse”.  If employees believe all options will be repriced for all drops, then you end up with a moral hazard, where you might actually want to drive down the price, get your options repriced, and then recover easy gains.  True, the market is fairly hostile to repricing due to the accounting charge, so it’s unlikely this would happen, but it’s still a real concern.

As a result, my recommendation would actually be that companies faced with this situation actually use the opportunity to not reprice stock options, but move to actual stock-based compensation.  Both have an accounting charge, but actual stock-based compensation serves three purposes:

  • The new stock grants can be better targeted to employees based on performance and value
  • The new stock grants have immediate value, serving as a kind of retention bonus
  • The new stock grants align the employee with shareholders going forward in both up and down markets

So while I do believe that repricing stock options gets a “bum wrap” in the financial media, I also believe that there may be potentially better compensation alternatives, particularly for public companies.

Bernie Madoff: YouTube Justice

I haven’t posted here to date on the Bernie Madoff scandal.  No sense writing a huge amount on the topic at this point – it’s been well covered elsewhere.  Let’s just summarize my feelings as:

  • We will never see an end to Ponzi schemes, because they work.
  • This exposes some of the flaws in the fund of fund approach to hedge funds.  Picking a manager is almost impossible, adding a level indirection truly is. (courtesy Dave Swensen)
  • The level of scandal for absconding with billions is historic.  The number of charity dollars, particularly from the Jewish community, is truly shocking, and likely deserves its own, new circle of hell (for those Dante fans).
  • There is no punishment that can fit this crime.  The impact will literally be felt by millions.
  • This failure will likely be used as a scapegoat and excuse to permanently damage the hedge fund industry in ways that may materially harm our markets for decades. (knee-jerk, political grandstanding regulation)
  • We still haven’t heard the worst of it.

Now, among friends, I’ve joked that while I’ve heard the expression “death by a thousand cuts”, this situation seems to be a good opportunity to actually test that theory out.  (yes, dark humor)

For my birthday, my brother actually forwarded me this Youtube video, and I couldn’t stop laughing.  So I’m posting it here, since it seems to have a shockingly low view count.


The Benefits and Pitfalls of Inverse & Double/Triple ETFs

Caught this article on Seeking Alpha on Wednesday on the problems with using inverse ETFs.  It reminded me of a topic that I’ve debated quite a bit with Elliot Shmukler over the past two years, and have been meaning to write about here on the blog.

Since I haven’t commented much on personal finance topics lately, this seemed like an opportune time.  🙂

Quick set of definitions, if you aren’t familiar with the topic:

  • ETF:  Exchange Traded Fund.  These are funds that are similar to mutual funds, except that they are traded like stocks.  For the most part, they are index funds with extremely low expenses.  In the last five years, there has been an explosion of index-based ETF funds, ranging from the plain vanilla US Stock Market to indexes only for water companies.
  • Inverse ETF:  This is a fund that makes money based on the opposite direction of an index.  Example: An S&P 500 bear ETF, or inverse index, would attempt to give you a positive 20% return in the case that the S&P 500 dropped 20%.
  • Double/Triple ETFs:  A double (or triple) ETF attempts to give you double (or triple) the returns of a given index.  For example, a double oil fund would attempt to give you a 20% return in the case that oil rose in price 10%.

The original discussion Elliot & I had was back in 2007, when we were comparing two hypothetical portfolios:

  • Portfolio 1:  100% invested in the S&P 500
  • Portfolio 2: 50% invested in cash, 50% invested in double S&P 500 ETF

At first blush, it might seem like Portfolio 2 is the winner.  After all, with Portfolio 2, it would seem that if the stock market were to drop more than 50%, Portfolio 2 would allow you to keep 50% in cash safe and sound.  If the stock market returns more than negative 50%, then the portfolio seems to offer exactly the same return as Portfolio 1.

The trick, however, is the nature of the double ETF itself.  Double ETFs are not perfect instruments – because they simulate returns using derivative contracts, they try to match their promised returns on a daily basis.  (I’m assuming here, by the way, that the simulation of returns is perfect.  In real life, these funds have an additional problem of tracking error due to the nature of the way they are implemented.)

So if on Day 1 the S&P 500 goes up 1%, the double ETF tries to return 2%.  I say “tries” because it’s rarely perfect.  If the next day the S&P 500 drops 2%, the double ETF should drop 4%.

Unfortunately, it turns out that the math for doubling daily returns does not necessarily lead to a long term result that matches the long term double of the index.

An easy example of where this breaks is to take a huge increase followed by a huge drop.

Let’s say you put $1000 into the S&P 500, and $1000 into the double S&P 500 ETF.

On Day 1, the index goes up 40%.  Great news!  Your $1000 in the S&P 500 is worth $1400.  Your $1000 in the double S&P 500 ETF is now $1800, expected, for a 80% gain.  Everything is as expected on Day 1.

On Day 2, the index goes down 40%.  Bummer.  Your $1400 in the S&P 500 is now $840.  Your $2000 in the double S&P 500 ETF is now $360.  Wow.  That’s bad news.

You can see the problem.  Technically, over two days, the S&P 500 dropped 16%.   But the double S&P 500 ETF dropped 64%.  Most people assume it would have dropped 32%, which is double the two-day return.  This is the issue with percentages – the product of a series of percentage changes will not equal the product of a series of 2x those same percentage changes.  (Covered in Calculus D at most schools, for those in a nostalgic mood).

If you are skeptical, you might be thinking: “Well, Adam just picked the extreme example.  Of course a one day 40% move wipes you out. Most stock market moves are small, so the error is small.”

Unfortunately, this isn’t the case either.  A long series of small moves can lead to large errors as well.

Let’s assume a stock market where every day is either up 2% or down 2%.  In this case, we’ll go up twice for every down.

Let’s say you put $1000 into the S&P 500, and $1000 into the double S&P 500 ETF.

After thirty days of +2%, +2%, -2% (10 times), here is what you are left with:

You’ll have $1214 in the S&P 500, for a 21.4% gain.  But you’ll have $1457 in the double S&P 500 ETF for a 45.7% gain.  In just thirty days, you’re off by 6.6% (in gains).  In this case, it’s a good thing, but obviously in a market like the one we’ve been having over the past six months, it can be a very bad thing.

In fact, over the long term, the errors can be fairly extreme, and whether they are to your benefit or not is based purely on the size and ordering of the volatile movements.  The only way to get ride of the errors is to have an absolutely equally distributed, linear progression of the market in one direction.  And let me be the first to say that we will never actually see that happen.

So, what’s the takeaway here?  Simple.

The errors in inverse and double/triple ETFs grow rapidly based on volatility.  In low volatility markets, they can be used for a short period with expected results.  Like options and other derivatives, however, their tracking errors make them poor choices for long term allocation or investment.

They do make interesting options for speculative bets in the short term, especially in situations where:

  • You want to keep liquidity (ie, cash available)
  • You want to limit your downside to 50%

But watch out for those error rates…

Refinancing? Try Pentagon Federal Credit Union (PFCU)

With rates plummeting these days, many people are choosing to refinance.  My family falls into that bucket, as we refinanced our home almost five years ago (2004) at the low, low rate of 4.5% for a 5/1 mortgage.  (In case you are curious, we ended up getting a 5/1 because while 30-year rates were also low, we felt it unlikely that we’d be staying in our current house more than 7 years.)  At the time, I remember looking at historical rates and saying:

When will we ever be able to refinance at 40-year lows again?

Silly me, the answer turned out to be about five years later, in late 2008.  Since our rates were about to float, and not trusting the bank to keep the rate reasonable, we decided to lock in rates for at least another five years.  In the process, we evaluated almost every web-based pricing agent, several internet deals, and one professional mortgage broker.

The winner: Pentagon Federal Credit Union

To get a mortgage, you must join the credit union.   You can do this for free if you or a family member served in the armed forces and has proof.  Otherwise, you can sign up to join the National Military Family Association for $20.  Yes, that’s right.  $20.

I’ve been extremely happy with the service.  In fact, when we originally engaged with them, the rates on a jumbo 5/5 mortgage (a unique mortgage they offer that resets every 5 years based on US Treasury rates) were at 5.375%.  They have dropped twice since then, and they allowed us to reset at their current price of 4.625%.

Yes, I know there is probably a better deal out there.  But I also know that most are worse.

In any case, they are worth checking out.  Their rates are updated daily.  Low closing costs.  They depend on Fannie Mae for securitization, so it’s really a good deal if you have a good credit score and fit within guidelines.  No points for loans under 70% LTV.  0.50 points for loans between 0.70% and 0.80% LTV.

If you find a better deal out there… don’t tell me.  I’m happy enough as is.  I may ask for you help again in 2014.

Or, at the rate we’re going, if rates plummet to 100 year lows in 2009, we might refinance again.

3% mortgages?  That’s the magic of deflation

Understanding Deflation: Bonds Paying 0%

There wsa a good article in today’s WSJ (requires subscription) describing the unique point we hit today in the bond market.  Some durations of US Treasury bonds are now actually paying negative interest, -0.01% in some cases.

Investors around the world are stuffing their money into a mattress — otherwise known as the U.S. Treasury-bond market.

Fund managers, corporate treasurers, hedge funds, banks and central banks want to show their constituents, or bosses, their portfolios are bulletproof as year end approaches. Even with all the government’s steps to shore up the credit markets, investors aren’t taking any risks. Instead, they are willing to pay a premium, rather than collect one, to ensure they have in 2009 what they have now.

That means that someone is paying $100.00 for the priviledge of  getting back $99.99 at the end of the term.

This may sound ridiculous, unless you think of it in plain English:

“I’m willing to pay the US Government one penny to keep my $100.00 safe and sound for this duration.”

In a world of fear and deflation, this statement starts to make sense.  Hell, you might even pay more than $0.01 for that security in some cases.

Deflation is a very weird financial state.  For most people, it’s completely counter-intuitive. It’s a world where cash today is worth less than cash tomorrow.  It’s a world where commodities (like gold, silver, oil, food) get cheaper over time nominally, not more expensive.  It’s a world where you don’t buy today, because tomorrow the same product will be cheaper.

In fact, the only large segment of the population at this point who likely have an instinctive feel for deflation are people tied to high technology, primarily hardware like hard drives and semiconductors.  They’ve spent 30 years dealing with the fact that their products will be cheaper tomorrow than today.  They’ve even created high return businesses in effectively a deflationary environment.

I’m not going to go into detail about all aspects of deflation in this post.  But I did think it was worth explaining why 0% bonds might make sense.

Think about the dangers for keeping cash:

  • Someone could steal it.  So you have to secure it.
  • It can get physically destroyed (fire, pets, small children)
  • You can invest it, but those investments may lose money (stocks, bonds, commodities, you-name-it)
  • You can put it in a bank, but they may go bankrupt.  (you are protected up to $250K, but you may not get it immediately)

When people are afraid, and liquidity is rushing out of the system, 0% guaranteed by the ultimate “too big to fail” institution in the world can sound pretty good.

Now, I doubt this makes sense for individuals with dollars measured in thousands.  With those numbers, you can get 3+% on a CD, guaranteed by the FDIC.  But for institutions with millions or billions, how do you protect your cash?  Seriously.  It’s not a trivial problem when you think about it.

And no, you can’t just “go to gold”.  Even gold drops in nominal value during deflation.

Mathematically, if a country is undergoing 5% deflation per year, that means that $1000 of gold will only cost $950 in a year.   From that point of view, 0% percent interest + 5% deflation = a 5% real return on your capital, adjusted for inflation.

Yes, it seems like a monetary phenomenon from Bizzaro’s home planet, a square world where people say “goodbye” when they come and “hello” when they go.

But that’s what we’re flirting with right now, as it seems like literally $20 Trillion in nominal value may have disappeared off the planet.

The silver lining, however, is that you can make money in a deflationary market, if you re-orient your thinking.  Sell your products quickly, for cash.  Money now is worth more than money later.  Prioritize products that buyers cannot postpone.  Inventory turnover is key.

Intel has made billions turning over products that drop in value 1% a week in some cases.  It can be done.

Why the Price of Gold is Sinking Fast

The price of gold has dropped below $700 an ounce, and that has a lot of people in the precious metals community puzzled.

After all, isn’t gold supposed to be a safe haven in times of financial depression and panic?  And if these aren’t times of financial depression and panic, what are?

After all, every country in the world is busy running their printing presses to fund bailouts and fight deflationary forces.  Gold should be on its way up, not down.

If you want to see a good article on the topic, there is some nice coverage here on Marketwatch

Gold futures hit a historic high above $1,000 an ounce a few days after Bear Stearns was taken over by J.P. Morgan Chase & Co. on March 14. But in the recent round of crises triggered by the collapse of Lehman Brothers Holdings Inc. gold has fallen to below $700 for the first time in 13 months. The metal has so far lost nearly $170 this month.
The reason, according to analysts at the World Gold Council, is that the latest bout of the credit crisis has been deeper and more far reaching. Funds were forced to sell desired assets such as gold to meet margin calls, while weakness in European economies lifted the U.S. dollar, which then pushed dollar-denominated gold prices lower.
One of my readers commented today on a blog post I wrote back in August 2007, “The Lessons of Long Term Capital Management (LTCM) & The Volatility of August 2007”.  That article is actually some of my better commentary to date on why historical diversification of assets isn’t helping very much in this downturn.  Here’s a snippet:

This decade has seen an amazing boom in investment tolerance for non-traditonal asset classes.  People freely talk about how different new investment assets have a “low correlation” to the stock market.  Real estate, commodities, rare coins, art, collectibles, long/short funds, you name it.   As a result, across the world, trillions of dollars are now factored into different asset classes, prudently distributed to minimize risk and maximize reward.

This would all be fine except for one thing.  And it’s the one thing that more than anything led to LTCM’s demise.

That one thing is that all of these great measures of risk are based on historical records.  And as all mutual fund prospectus readers know, “past history is not necessarily indicative of future performance.”

You see, you can take two things that historically have not been correlated.  Asset A & Asset B.  But the minute that an investor owns both A & B, there is now a correlation that didn’t exist historically.  The investor is that correlation.

If Asset A goes down, and the investor needs to sell something, they may now turn to Asset B for liquidity.  And that means selling pressure for Asset B, based on nothing but the asset price of Asset A.  Voila, correlation.

Gold didn’t used to trade like a stock in an ETF that anyone could buy.  It was expensive, hard to store, and was distributed through inefficient, clumsy channels.  It was diversified from other investment classes because it couldn’t be bought & sold easily like stocks or bonds.

Now, buying a Gold ETF is trivial, and can be done for less that $10 a trade with very little spread.  In fact, many commodities can.

All of a sudden, in this market, people are realizing that the investors are the correlation.  And that correlation is much stronger than historical analysis would suggest.

Not to get to gloomy, but re-reading my August 2007 post, I caught this somber realization:

What’s worse, those historical models lead investors to believe that they have less risk on their books than they do have, which leads rational investors to introduce leverage into their portfolios.  That means when the risk shows it’s ugly head, the results get magnified by the leverage of loans.

That’s what happened to LTCM.  Their models were excellent, but they were based on historical correlation.  The minute some of their investments turned the wrong way, their incredible leverage forced pressure in previously uncorrelated investments.  What’s worse, other investors, smelling the “blood in the water”, discovered this new-found correlation, and pressed trades against them.

So, this scares me a lot, at least intellectually.  There are very good reasons why major investors like hedge funds and other asset managers can’t share their up-to-the-minute holdings.  That means, however, that no one really understands this type of “co-investment risk” that is building in mass across the markets.  Unfortunately, the only way I can imagine to properly handle this risk would be to have a universal monitoring set up to accurately reflect this new type of correlation from mass “co-investment” across assets.


Personal Finance: The Best Advice is from Saturday Night Live

I have a special attachment to Saturday Night Live, since it debuted the same year I was born.  This skit is genius, and summarizes the best financial advice you are going to get this year.

You can watch it here on

Don’t Buy Stuff You Cannot Afford


Scene: a typical American kitchen. A husband (Steve Martin) and wife (Amy Poehler) are puzzling over their finances.

Wife: Oh, I just can’t get these numbers to add up
Husband: Like we’re never going to get out of this hole.
Wife: Credit card debt, does it ever end?
Salesman: [entering from who-knows-where] Maybe I can help.
Husband: We sure could use it.
Wife: We’ve tried debt consolidation companies.
Husband: We’ve even taken out loans to help make payments.
Salesman: Well, you’re not the only one. Did you know that millions of Americans live with debt they can not control? That’s why I developed this unique new program for managing your debt. [Holds up book] It’s called, “Don’t Buy Stuff You Cannot Afford”
Wife: Let me see that. [Reading from book] If you don’t have any money, you should not buy anything. Hmmm … sounds interesting.
Husband: Sounds confusing.
Wife: I don’t know honey, this makes a lot of sense. There’s a whole section here on how to buy expensive things using money you’ve “saved”.
Husband: Give me that. And where do you get this “saved” money?
Salesman: I tell you where and how in Chapter 3.
Wife: OK, what if I want something but I don’t have any money?
Salesman: You don’t buy it.
Husband: Let’s say, I don’t have enough money to buy something. Should I buy it anyway?
Salesman: No.
Husband: Now I’m really confused.
Salesman: It’s a little confusing at first.
Wife: What if you have the money, can you buy something?
Salesman: Yes.
Wife: Now, take the money away. Same story?
Salesman: Nope. You shouldn’t buy stuff when you don’t have the money.
Husband: I think I’ve got it. I buy something I want, then hope that I can pay for it. Right?
Salesman: No. You make sure you have money, then you buy it.
Husband: Oh, then you buy it! But shouldn’t you buy it before you have the money?
Salesman: No.
Wife: Why not?
Salesman: It’s in the book. It’s only one page long. The advice is priceless and the book is free.
Wife: Wow. I like the sound of that.
Husband: Yeah, we can put it on our credit card.
Announcer: So, get out of debt now. Write for your free copy of “Don’t Buy Stuff You Cannot Afford”. And, if you order now, you’ll also receive, “Seriously, If You Don’t Have the Money, Don’t Buy It” along with a twelve month subscription to “Stop Buying Stuff” Magazine. Order today.

Genius.  Pure Genius.  I feel like I’ve actually had this conversation with people before.

How to Create Your Life Plan

Interesting timing on a post from Lifehacker today:

LifeHacker: How to Create Your Life Plan

The article points to a blog post by Michael Hyatt, CEO of Thomas Nelson Publishers.  The post from Michael is extremely detailed about the system he’s used for the past five years to guide his life (not just career, but life) on a quarterly basis with the help of his executive coach.

Here is the intro:

I have met very few people who have a plan for their lives. Most are passive spectators, watching their lives unfold a day at a time. They may plan their careers, the building of a new home, or even a vacation. But it never occurs to them to plan their life. As a result, many end up discouraged and disillusioned, wondering where they went wrong.

But it doesn’t have to be this way. You can live your life on purpose. It begins by creating a “Life Plan.” This won’t insulate you from life’s many adversities and unexpected twists and turns, but it will help you become an active participant in your life, intentionally shaping your own future.

I remember some of these exercises from the management and leadership curriculum in the IEEM (now MS&E) track at Stanford, but never with this much richness or detail.   It’s a fairly personal and exposed post in many ways – impressive in some regards to see this kind of transparency from an executive. I used to not have a plan about my life what so ever, I remember how I would always be regretting how I was not able to rent the beach house from twiddy how I always wanted, until I decided it was time to take control and suddenly everything changed.

On the surface, it feels a little strange to see this type of micro-management of your entire life.  Of course, I’m not sure it makes sense to expect your goals to be fulfilled without both a clear definition of your goals, and a strategy & execution to get there.  After all, it’s what I hold Product Managers accountable for, right?

Can you manage your life the way you manage a product?

Definitely worth a read and at least 15 minutes of consideration…

Vanguard Is Splitting 3 ETFs… But Why?

Vanguard had a funny announcement today that I had to comment on (from

Vanguard announces share split for three exchange-traded funds

June 04, 2008 – Vanguard announced today a two-for-one split of shares of Vanguard® Total Stock Market ETF (VTI), Vanguard Emerging Markets ETF (VWO), and Vanguard Extended Market ETF (VXF). The conventional shares of the funds are not affected by this split.

The share split entitles each shareholder of record at the close of business on June 13, 2008 to receive one additional share for every share of the ETF held on that date. The additional shares are expected to be distributed to shareholders on June 17. The shares will trade at the new split-adjusted prices beginning June 18.

I need someone to explain this one to me.  After all, splitting a stock does absolutely nothing for the fundamentals of the stock.  You might argue there is some emotional, momentum-based advantage when go-go growth stocks do it, but this is an index fund.  And a Vanguard fund to boot!  I just can’t imagine the Vanguard trustees chasing momentum money, or expecting momentum money to flow to an index fund just because it’s splitting.

There is that old argument that you want to keep share prices low so “small investors” can buy a “round lot” of 100 shares… but that logic went out the door with odd lots and discount brokers about 30 years ago.

So why did they do it?  Are they trying to capture small investments under $100 with the ETF?  Brokers like E*Trade already offer free dividend reinvestment on ETFs, which allows you to buy partial shares.

Anyway, if you own any of these funds, note it in your calendar, Quicken, etc.


The Problem With Raising the Capital Gains Tax Now

OK, normally I stay away from posts that could be perceived as political.  But it’s hard to comment on economic issues in the heat of this intense primary season without venturing into those dangerous waters.

I’m going to try to be careful here not be too specific about any candidate or their plans.  I felt, however, that this topic was non-obvious enough that it was worth commenting on, despite the danger.  I can only hope that these comments might reach the ears of all three of the currently viable candidates…

Please don’t raise capital gains taxes in this environment

Or at least, please don’t raise them without also indexing gains to inflation.  It’s not a serious problem when inflation is extremely low for long periods of time, but it could be very very bad if we are, in fact, heading into an environment with a weak dollar and higher prices.

Why?  Because the capital gains tax today is based on nominal gains, not real gains.

Not clear on why this is a problem?  Here is an example:

Let’s say you bought a stock in 2009.  It’s a good stock, but not a great one, and it returns roughly 10% per year for the next 7 years.  In fact, by 2016 the stock has doubled, exactly, from $10 per share to $20 per share.  Since you bought 1000 shares, you’ve just turned $10,000 into $20,000, for a $10,000 gain.

That sounds good, and you might be thinking, “Well, with a $10,000, why should I begrudge the government $2,000 or even $2,800 of that gain?  After all, it’s this great country that has made that type of gain possible.”

Here’s the problem.  Let’s say inflation over the next 7 years is higher than it has been.  5% instead of 3%.  Well, then actually $10,000 in 2016 doesn’t buy what it did in 2009.  In fact, it takes over $14,000 2016 dollars to buy the same car that $10,000 did in 2009.

But the tax man doesn’t care.  The IRS still calculates your gain as $10,000, not $6,000.  So $2,800 might be 28% of your nominal gain, but it’s 47% of your real return, after inflation.


It gets worse.  If inflation manages to soar to around 8%, which it did in the 1970s, then actually that $2,800 tax becomes more than your entire real return.  At 8.1%, in fact, your real return becomes negative – you end up paying a real tax of over 100% of your inflation-adjusted gains.


That’s pretty much what happened to people in the 1970s.  And it really did have a drastically negative effect on capital investment and tax collection, because rich people basically decided to either avoid capital investments, or they decided to postpone taking gains.  (Little known fact, but capital gain tax revenue has increased since we lowered the rate to 15%… a combination of better market performance and likely some acceleration of people taking gains.)

Now, in the 1980s and 1990s, this wasn’t such a big deal, because we both lowered capital gains tax rates and we killed inflation.  Or, at least, we wounded it.  When inflation is low, and the holding periods are relatively short (under 10 years), you could argue that the inflation “tax” automatically adjusts the 15% up to something higher, but manageable.

So, I think that leaves us in a policy bind, since it’s very likely we’re headed for higher inflation in the next 10 years.  In fact, you could argue that cutting the capital gains tax commensurate with the increase in inflation and the average holding period might make sense, if the goal was economic neutrality.

One solution would be to index capital gains for inflation.  It’s a sticky problem, because it means that taxpayers would have to have a table of “multipliers” to apply to any investment, based on the year of investment.  You would also likely have to exclude shorter holding periods to avoid trading scams, and have some sort of wash-sale like rule.  But this is all doable.

If you see another path around this problem, I’d love to hear it.  Right now, it feels like inflation is going to take a serious whack at capital investment if we’re not careful.

Parting Ways with Paul Krugman on Social Security

Thank goodness, I was getting worried there.

For a while, Paul Krugman was making more and more sense to me.  It had me worried, because I remember distinctly feeling more and more alienated by his commentary in the past 5+ years.  But since I don’t follow him that closely, the reasons why were fading from memory.

This article snapped them back into clarity.  Oh boy, is this column off-base.

I think the point of his column here was to effectively claim that there is no social security crisis, that social security is doing just fine, and that the arguments against it are contradictory and specious.  I’m not really sure, though, because the point of the column kind of wanders.

In any case, he is right about one thing: the arguments against the stability of social security do contradict each other.  Unfortunately, what is good for the goose is good for the gander… Krugman’s arguments seem to also contradict themselves.

The fundamental argument that is correct, unfortunately, is that Social Security is going to start doing some serious damage to the Federal Budget, starting around 2018.

Krugman is correct that there is, in fact, a Social Security surplus, engineered as part of the Federal tax changes made in 1986.  This surplus, however, is not saved in any sort of marketable assets.  Instead, these trillions of fictional dollars have already been spent as part of the regular annual budget (yes, even after that we still run a deficit), leaving in their place special US Treasuries, redeemable in the future by the US Government.

What Krugman misses here is that US Treasuries are just an IOU that the US Government is writing to itself.  US Treasuries are in fact a great asset to invest in for every single entity other than the US Government. It’s as if you decided to buy a car today by lending yourself the money.  Yes, it is that silly.  Guess what happens when the right hand goes back to the left hand to get payment on that loan?

Allan Sloan sums the argument up well in the March 2008 issue of Fortune Magazine:

How can I say that, given Social Security’s $2.3 trillion (and growing) trust fund? It’s because the fund owns nothing but Treasury securities. Normally, of course, Treasury securities are the safest thing you can hold in a retirement account. But Social Security’s Treasuries won’t help cover the program’s cash shortfall, because Social Security is part of the federal government. Having one arm of the government (Social Security) own IOUs from another arm (the Treasury) doesn’t help the government as a whole cover its bills.

Here’s why the trust fund has no financial value. Say that Social Security calls the Treasury sometime in 2017 and says it needs to cash in $20 billion of securities to cover benefit checks. The only way for the Treasury to get that money is for the rest of the government to spend $20 billion less than it otherwise would (fat chance!), collect more in taxes (ditto), or borrow $20 billion more (which is what would happen). The spend-less, collect-more, and borrow-more options are exactly what they would be if there were no trust fund. Thus, the trust fund doesn’t make it any easier for the government to cover Social Security’s cash shortfalls than if there were no trust fund.

I think Krugman does a real disservice here by pretending that this fact is some sort of charade cooked up by people who want to privatize social security.  The fact is that social security, in its current structure, is part of the general budget.  It has no marketable assets beyond those US Treasuries, which the US issues at its discretion anyway.  The US has no sovereign wealth fund in marketable assets.  That means in 2016/2017 or so, we’re going to start having to pay the piper.  According to the Social Security Administration, the tab will be $96B in the red in 2020.

Sure, we can fund it with higher taxes.  Or lower spending.  Or both.  But it’s going to start hurting as soon as it goes negative.

There are a lot of potential solutions here – but none are easy, and none erase the fact that we effectively spent our $2.3 Trillion surplus before we were supposed to.  We’re going to have to pay it back, one way or another, or we’re going to have to radically rethink Social Security.

So, my apologies Mr. Krugman, but we do, in fact, have a Social Security crisis and a general budget crisis in the making.  And it’s going to be in the next decade, not in 2042.  My generation is going to end up paying a lot more for a lot less, assuming we even have a claim on assets at all when it’s all said and done.

Where No Fed Has Gone Before

There has been a lot of sensationalist talk in the past two weeks since the Bear Stearns acquisition by JP Morgan Chase.  I’ve seen editorials slamming the Fed for doing too little, for doing too much, for not acting soon enough, and for acting at all.

However, I’ve seen pitifully few articles that actually explain the details of what the Federal Reserve did, and why it was so revolutionary for the almost 100-year old institution.  Sure, I’ve seen commentators refer to a “$30 Billion Bailout” of Bear Stearns, especially in the context of populist rhetoric that this somehow would justify spending $30 Billion to bail out homeowners who are under-water on their mortgages.  But this isn’t really a bailout.

Well, the April 7th issue of Business Week actually has a decent article on the topic, and I recommend it to those who are seeking to understand what, exactly, the Fed did.  (Hard not to like the cartoon, also):

A few facts to glean from the article:

First, the Federal Reserve action, although structured like a loan, actually seems to behave mathematically more like equity:

So far, few people have focused on what exactly the Fed is getting in exchange for supplying $29 billion to JPMorgan Chase. That’s a bit surprising because whatever the deal is, it’s far from a standard loan. The strangest twist is that even though the money goes to JPMorgan, that firm isn’t the borrower. So the Fed can’t demand repayment from JPMorgan if the Bear assets turn out to be worth less than promised.

What’s also odd is that if there’s money left after loans are paid off, the Fed gets to keep the residual value for itself. That’s what one would expect if the Fed were buying the assets, not just treating them as collateral for a loan. Vincent R. Reinhart, a former director of the Fed’s Division of Monetary Affairs and now a resident scholar at the American Enterprise Institute, said in an interview on Mar. 26: “The New York Fed is the residual claimant. That doesn’t look to me like a loan. That looks like equity.”

More detail follows down the page:

Here’s how it works: A Delaware-based limited liability company will be set up to receive, upon completion of the merger, $30 billion in various Bear holdings, such as mortgage-backed securities. The Fed will lend $29 billion to that company, which will pass all the money along to JPMorgan, Bear’s new owner. JPMorgan itself will lend $1 billion to the Delaware company. The company, managed by BlackRock ­Financial Management, will pay back the loans by gradually liquidating the assets. As a protection for the Fed, it gets paid back fully before JPMorgan gets back anything on its loan. The other sweetener for the Fed is that if there’s money left over even after ­JPMorgan gets repaid, the Fed gets it all.

From an economic perspective, this complex arrangement is functionally identical to a purchase of the Bear portfolio by the Fed—one that’s financed in small part by the subordinated $1 billion loan from JPMorgan. But the Federal Reserve Act doesn’t seem to provide for the Fed to make such equity investments. That doesn’t trouble the Fed because it argues that the $29 billion is indeed a loan—or, to use the antiquated language of the Fed’s founding legislation, a “discount” of a “note.”

This is an important point, because if the history of liquidity-impacted portfolios like LTCM are any indication, it’s very likely that an orderly disposal of the Bear Stearns assets could actually net gains in the long term.  More importantly, since JP Morgan takes the first $1B in losses, the Fed actually gets a bye on the first 3.3% of net loss on the portfolio, if it exists.

Now, you could argue that the Fed has put $29B of taxpayer dollars at risk, and that is true in a sense.  But the value of that risk is not the $29B number thrown around, but a complex calculation of the actual expected gain/loss here.  As I mentioned, historically, these type of crunch-induced crisis portfolios actually net out positively when given the time to unwind outside of a panic situation.

The fairest criticism I’ve seen of this action to date is the result of the raised offer from $2/share to $10/share by JP Morgan, which will not only keep Bear Stearns credit holders whole, but will also net common shareholders something of a windfall.  You could argue that shareholders should have received nothing, and that credit holders should have born the first risk traunche of the portfolio.

The problem with this argument is that it assumes that any other deal could have been workable and accepted in the limited timeframe caused by the run on Bear assets & liquidity.  These situations always seem calmer from hindsight, and beg for Monday-morning quarterbacking, but the truth is, they are negotiated in the heat of panic, and the almost audible sound of an approaching, falling knife.

New ETN to Track Chinese Renminbi & Indian Rupee

Caught this in yesterday’s news:

Morgan Stanley has teamed up with Van Eck Global to launch currency exchange-traded notes offering exposure to the Chinese renminbi and the Indian rupee. The Market Vectors – Chinese Renminbi/USD ETN (NYSE Arca: CNY) and Market Vectors – Indian Rupee/USD ETN (NYSE Arca: INR) are the first exchange-traded products to offer exposure to those two currencies. They launched today on NYSE Arca.

The notes are designed to go up in value when the named currency appreciates against the U.S. dollar, and down when the dollar strengthens. The ETNs are underwritten by Morgan Stanley, and Van Eck is the marketing agent. The notes charge 0.55% in annual fees.

Full details are on Yahoo Finance.

The securities are already live and trading.  Here is a quote for the Market Vectors – Chinese Renminbi ETN (CNY), here is a quote for the Market Vectors – Indian Rupee ETN (INR).

There are a few details that are worth noting.  ETNs, or Exchange Traded Notes, are a relatively new innovation in indexes, and as a result, there are some grey areas around their long-term tax treatment.  Both notes do not actually own the currency.  Instead, you are buying a promise, from Morgan Stanley, that they will pay off a return on investment that matches the return on investment of an index that is tied to the currency.  Got it?  Yes, it’s two levels of indirection… almost like a HANDLE to the currency.  (Bonus points to old-school Mac developers who get the reference.)

Here are three caveats from the article:

First, unlike most currency products, they earn interest based on the U.S. Federal Funds interest rate … not local interest rates.�(Although they are currently similar.)

Second, these ETNs do not pay out interest income – instead, it is added to the share value of the note.�That creates a problem for investors, as the IRS has said that investors must pay taxes each year on this notional interest … even though they won’t realize the gains until they sell the note.

Finally, ETNs are debt instruments, which means investors are exposed to the credit risk of the underlying bank. Morgan Stanley seems sound, but the current market environment could give people pause.

This is an interesting option, but likely only appropriate for tax-protected accounts.  Personally, I still have a soft spot for Everbank, and it’s currency-based bank notes, CDs, and money market funds in different world currencies.

Investor Presentation for JPMorgan/Bear Stearns Deal @$270M

I love the web.  I can’t believe we live in a time where a guy like me can actually review the presentation behind something this momentus, in close to real time.

Credit to Paul Kedrosky’s Blog.

Slice the $270m JPMorgan just agreed to pay for Bear Stearns any way you want to and still it’s a horrible end for a storied brokerage firm. To end up paying $0.25 on the dollar for the company’s $1 in headquarters real estate, in effect, and to do it in equity, no less, is an embarrassment beyond embarrassment for people collectively incapable, at least until now, of being embarrassed.

Tragic, tragic stuff, and, we can only hope, a bottom, even if one we bounce along for some time,  to one of the worst periods in modern financial markets. But trust me, there is nothing in it for anything to be proud of, other than removing much of the Bear-specific counterparty risk that would have taken everyone in the financial market out in a major way during trading tomorrow.

Here is the NYT piece, from tomorrow’s newspaper, tonight, online.

Here is the PDF of the investor presentation.

Don’t Count Out the Fed

Still digesting the news from the Fed yesterday on the new $200B Term Securities Lending Facility.  This type of arrangement has been discussed for some time as a possibility, but its still dramatic to see it unveiled like this.  This is a big deal for a couple reasons – first, it allows for 28-day loans, not just overnight, and second, it allows a much broader range of bonds as collateral, including mortgage-backed securities.  Combined with the other two $100B initiatives, the Fed has opened up over half of its $700B+ balance sheet to stabilize the credit markets.


It’s becoming fashionable in circles to doubt the Fed.  I’ll be posting a book review of “Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve” soon, and I’ve seen a lot of commentary doubting Mr. Bernanke.  All I can say at this point is that it is way too soon to be counting out the Fed.

They can’t work miracles, of course, but the power of almost unlimited resources is significant, if wielded properly.

The most fascinating aspect about central banking is it’s amazing foundation on the irrational and the immeasurable.  In the end, it’s more about confidence than anything else.  By convincing the markets that you will solve the problem, you create the confidence that increases liquidity and solves the problems.  You can’t be predictable, because, like in warfare, predictability leads to people thinking steps ahead and countering your actions.  Like a great General, you have to be unpredictable enough to instill fear and uncertainty in those who would fight against you, and through that uncertainty, ironically you win.

So you want uncertainty, but only the type that destabilizes those that would bet against you.  You want to reduce uncertainty around the likelihood of Fed success.

Got it?

If the juxtuposition sounds funny, blame it on the fact that I read the Greenspan book and a biography of George Washington all within a two week period.

Anyway, at times like this, it’s good to remember that the guy we have at the helm, at this time, is someone whose fundamental academic expertise is the mistakes made in the 1930s Great Depression, and the mistakes made in Japan in 1990s.  A quick reference from Paul Krugman:

What you probably should know is that Ben Bernanke, in his capacity as a professional economist, spent a lot of time worrying about Japan’s experience in the 1990s. (So did I.) What was so disturbing about Japan was the way monetary policy became ineffective; by the later 1990s the short-term interest rate was up against the ZLB — the “zero lower bound.” This is alternatively known as the “liquidity trap.” And once you’re there, conventional monetary policy can do no more, because interest rates can’t go below zero.

Krugman also points out that today’s TED spread indicates a mixed message – confidence seems better slightly, but not significantly.  That could be an indicator that the weight of uncertainty.  Still, in his own words, yesterday’s move was a big slap in the face for the credit markets.

I can’t wait until the weekend when I have time to dig into all of this further.