Tuesday, March 26, 2013

Where Credit is Due

How is an economist like a fortune teller? They both get tired of being asked "Why didn't you see it coming?" when things go wrong.

Ok ok, it's not a very funny joke but economics is the dismal science after all.

Cyprus is the big news again this week, but honestly if you weren't already following that story you're unlikely to start now. So for those of you that are interested I'll just briefly mention that a bailout was pushed through despite the legislature's objections. The bailout obliterated Cyprus's second largest bank and along with it a large portion of the local economy, but preserved deposits below 100,000 euros. It's not a pretty picture and Cyprus is unlikely to recover any time soon.

But... why didn't economists see this coming? In retrospect all the signs were there. An oversize banking industry, exposure to toxic Greek assets, a fast and loose credit market. How could it have been missed? There should have been warnings! There should have been policy suggestions! Isn't economists' entire job to prevent these things!?

Yep. Here's one. And here.  Oh and here. Oh, and those are all just from one economist. He's not someone you're likely to have heard of (or will hear of again), but as early as four years ago Constantinos Stephanou was presenting papers which clearly outlined the risks Cyprus faced and how to mitigate them. Not only that, his papers were presented at the University of Cyprus. It's hard to imagine the message didn't make it from the campus to the capital (it's not a big country). Nor was Stephanou some lone wolf espousing strange and wild doctrine. Most economists who studied banking in the region knew something along these lines was coming. Many took the time to craft warnings backed by experience and data.  Unfortunately, most of them were also ignored.

This wasn't an unanticipated event.  It's unfortunate and poorly handled, but not unanticipated. The decisions that led to the current state of Cyprus were made years ago when a potential crises seemed unlikely. When Greece collapsed higher reserve and liquidity requirements started to seem like a prudent measure.  But by then such changes would have only exacerbated a problem that the banks already couldn't handle.  The banking sector which had been artificially inflated by the government in order to fuel economic growth was so over sized that the rest of the economy couldn't possibly prop it up for even a short time.  Which leads us to a nation dependent on failing banks that the rest of the EU must somehow try to save. 

So who's to blame? Economists did their job. Warnings were given.  The banks did their job. They kept the economy growing. The politicians did their job. They paved the way for the banks. Yet here we are with Cyrpus's economy decimated.

If there is anywhere to place blame it is with ourselves.  The idea of growth at all costs has become a political addiction. It seems any problem can be solved if we can just grow our economy fast enough to out race it. We pile risk upon risk in an effort to outrace our fiscal demons and eventually they catch up.  When that happens if you're not wealthy enough to pay them off you're just another Cyprus, or Greece, or Spain.

If you have any interest in Cyprus I encourage you to read the papers by Constantinos Stephanou linked above. They span several years and thus follow the progression of Cyprus's downfall nicely. In particular his point about how the euro transitioning into local currency played a part in the collapse was fascinating. 

Next week more economics. Until then stay safe and rational. 

Tuesday, March 19, 2013

The Cyprus Crisis

The big news in economics this week is the proposed bailout of Cyprus. In brief Cyprus is having difficulties paying it's debts and requires an influx of cash from the rest of the EU to prevent a collapse. Negotiators arranged a deal in which in exchange for a ten billion euro cash influx and debt reduction Cyprus would impose a one time tax on deposits held at Cyprus banks.

I've spoken with a number of my peers as well as searched extensively online for anyone willing to argue for the plan. Unfortunately, if anyone outside the creators of the deal are willing to support it they're doing it very quietly. Therefore although I do not believe the bailout package to be either well thought out or efficacious I will attempt to argue it's merits before discussing why it's ultimately foolhardy.

Undoubtedly one point of consideration during the construction of the bailout was that the EU (and Germany in particular) will not agree to pay for the spending of troubled nations indefinitely if those nations do not demonstrate some effort to pay first themselves. A deposit tax will clearly show the people of the more affluent nations that the citizens of Cyprus are paying their fair share as well.  There's a lot of merit to this idea. German taxpayers are likely to be less resentful that their taxes often are being used to refinance other nations debts if they can see those nations are suffering as well. After all no one wants to feel like they're the only ones suffering, especially if they feel like they're innocent of causing any of the current difficulties.

Additionally a deposit tax will hit the Russian affluent disproportionately harder than an average Cyprus citizen (in terms of raw euros lost). Cyprus is often used as a tax haven for wealthy Russians, who generally hold much larger accounts than an ordinary citizen. The deal called for these larger accounts to be taxed more heavily, whereas accounts under a hundred thousand euros were taxed at a lesser rate. To the elite of the European Union this must have seemed like free money. Take just a little from the people of Cyprus and get a lot from Russia (that isn't even an EU member). If you can take Russia's money to pay for your financial difficulties why not do it?

Finally, there must have been some rationalization that the money wasn't actually being stolen as depositors would be compensated with bank shares. The fact that these banks are on the verge of financial ruin clearly just slipped someones mind.

So there's the best case I can build for why such a plan was a good idea. Now here's the much easier case for why it would have been disastrous.

It wouldn't have worked and it would have (and did) instill additional uncertainty in an EU that is just starting on the road to recovery.

Let's imagine for a moment we're a depositor at a bank in Cyprus. Monday morning we wake up and find that the banks are unexpectedly closed. Further, when we check the news we learn that the government has a plan to take between 6% and 10% of our money without substantial compensation. The next day the bank opens and we're able to withdraw our funds if we so wish. What would your course of action be? I know I'm probably moving my money someplace where I can be sure I'm not going to have to tithe involuntarily. The only bright side is that when the inevitable run on the bank occurs we can be sure everyone will be able to get back 10% of what they deposited... since the banks took that from them the day before. Unfortunately the other 90% is probably gone forever. It's a pretty good plan to take a bank from the edge of collapse to actual collapse, but not a very good method for salvaging a failing economy.

What amazes me the most about the whole situation is the potential cost/benefit of the plan. Cyprus is a tiny tiny portion of the EU economy. Yet for some unknown reason negotiators drafted a plan that would spur doubt in the safety of bank deposits throughout the continent. Letting Cyprus collapse and withdraw from the Union would have been more damaging only in the sense that it would have cause an even larger media storm than this bailout package. In actual economic terms it would have been nearly unnoticeable. The scale of the problem is so small that it is amazing to me that the Troika didn't simply slap together a package, slip it to Cyprus under the table to keep them going for another year and then deal with it later when the European economies were under less scrutiny.

Politically it's a wonder anyone thought such a plan had a chance. Not a single legislator voted in support of the plan. A wise choice if they hoped to remain a legislator for very long. Unsurprisingly the bailout package is widely unpopular in Cyprus as well as many other nations which fear such a precedence.

I seriously question the wisdom of whoever constructed such a plan. However, undoubtedly it was the product of a bureaucracy which warped and twisted many good ideas into what was ultimately an ineffective and foolhardy result.  Luckily the bailout package has been rejected. Unfortunately that leaves Cyprus still on the verge of collapse and no closer to a solution.

More economics news next week be it political or academic. Until then stay safe and rational.

Wednesday, March 13, 2013

Investment Part 3: Stock Pricing

This is the final part of a three part series on understanding investment. The previous two postings can be found here and here. In this final posting I will attempt to explain the basics of how stock prices are established.

Stocks, like several other investments described in the previous sections, are a market investment. This means that fundamentally prices are dictated by supply and demand. When a stock becomes more desirable or more scarce the price will rise. When the converse occurs the stock will fall. Here is a brief example to illustrate this mechanism in action:

Tom is an apple seller along highway one. Every day he takes his apples from his apple orchard and stands next to the road selling apples to cars that pass use the highway. He sells apples for $5 each and makes quite a lot of money doing so.

On Monday Tom is startled to find that a dozen other apples sellers have set up along his road. They heard about his good fortune selling apples and now want a piece of the pie. All of them are imitating Tom's success and selling apples at $5. However, the demand for apples is unchanged and consumers pick which booth to stop at randomly (since each is the same) so Tom is making only 1/12th of what he made the previous week.  Tom, being an intelligent man, realizes that if he lowers his price to $4 he'll get all the business again. He'll only be making 4/5ths as much as he was previously but that's a lot more than 1/12th. So Tom lowers his price to $4 and drives the other apple sellers out of business. Here excess supply of apples has driven the price down to $4 instead of $5.

On Tuesday the local news reports that apples cause you to live forever. Tom's apple stand is flooded by consumers and he sells out of his day's supply before 9:00 am. He quickly runs back to fetch more apples but realizes he's got a golden opportunity. Everyone desperately wants apples. Whether he charges $5 or $10 he's still going to sell out and obviously $10 makes him a lot more money. So when he returns with his new batch of apples he doubles his price and makes a fortune. Here excess demand has caused the price of apples to increase.

The converse of both of the above examples is true as well. If nobody wants to buy apples (insufficient demand) Tom will lower his price in order to incentivize buyers. If Tom only has a few apples to sell (meaning it's easier to sell out) he'll raise the price and make fewer sales but get more money for each sale.

The key concept here is market equilibrium. Sellers have a range of prices at which they are willing to sell their stocks and buyers have a range of prices at which they are willing to buy.  When those values intersect an equilibrium is established and a stock price remains firm. When factors influence the demand for or supply of the stock the equilibrium shifts and a new price results.

Hopefully that has given at least a glimmer of how market investments work. Unfortunately, the above description is woefully inadequate. Markets are simply a summation of individual preferences. Thus to understand how stocks are priced you must also understand how individuals value stocks.

There are two primary methods by which individuals can value stocks. The first is a very mathematical, rigorous and sensible option. Unfortunately it also seems to be the more seldom used method.

Purchasing a stock is essentially buying a very small portion of a company, thus entitling the holder to a very small portion of profits. This distribution of profits to shareholders is generally known as a dividend. Most stocks do not pay dividends but for now we're going to pretend they all do. Suppose a firm earned $100 profit this year, has 100 outstanding shares and pays each share 1% of it's profits annually. It's easy to see that if nothing changes you'd earn $1 a year from each share of this stock. Essentially you would be purchasing an annuity of $1. It's easy to calculate the value of that dollar in perpetuity using the net present value method and thus arrive at a stock price that is sensible for an individual. However, the firm may also grow, retract, or even go completely bankrupt in the coming years. The likelihood and magnitude of these events must also be factored in to the individuals valuation. If the buyer thinks the firm is primed for massive growth in profits his annual return will growth quickly year after year so he'll be willing to pay more. As he projects further and further into the future however his expectations for the firm become more and more uncertain and thus he must rationally value expected gains further in the future to a lesser extent than more immediate gains. Still, even small expectation differences for the growth rate of a firm will result in large variations in valuation for a given stock.

As mentioned previously most stocks do not pay dividends and so this method may seem impractical. Most firms utilize what is known as retained earnings instead.  Essentially retained earnings are simply the dividends that would have been paid to the stock holders reinvested in the company.  This has a number of benefits. Firstly, earnings from stocks are taxed upon the sale of the stock while dividends are taxed constantly (since they are received frequently). Therefore when firms retain earnings rather than disbursing them stock holders can more easily regulate their tax liability. Assuming the retained earnings are not squandered foolishly (and if you believed that was the case why would you hold the stock in the first place) they will still increase the share price of the stock and thus not result in a loss of potential income to the stock holder. Secondly, if the money is utilized wisely by the company it will cause the companies stock price to increase even further. For example, suppose the $100 of dividends was instead used to buy a new factory which provided $130 of income after net present value calculations. This new income would be reflected in the stock price which would more than compensate stock holders for their foregone dividend payment.  Thus although dividend payers are a minority the NPV method of revenue stream calculation is still a sound approach to establishing individual stock valuations.

The second method of individual stock valuation is the "Greater Fool Theory".  This method of stock pricing seems to be the domain of pundits and editorialists both financially aligned and otherwise. Essentially the idea of the "Greater Fool Theory" is that if you buy "good" things someone will buy them from you later at a higher price. For example, if Applied Widgets has been doing well lately and is popular it's a good stock to buy. You can get it now and later when it's worth more you can gain some profit. This idea is a core concept of "momentum investing" and to be fair works quite often. Often times the market will become overly enthusiastic about a particular firm and many people make money by riding that wave of exuberance. However, attempting to time the market in such a fashion is essentially a guessing game. While it may work a significant portion of the time, when a buyer guesses wrong he'll often be stuck holding stock he over payed for and can't easily sell at a price he finds acceptable.

So, to briefly summarize, how are stocks priced? Individuals form personal valuations of stocks based on both rational and irrational methods. These individual valuations form a market which established a market equilibrium subject to market forces. This market equilibrium is the current price of a stock. There are a myriad of confounding factors that contribute to where that equilibrium is established but that is the essence of the system.

Next week I'll return to more academically interesting topics and leave this financial drudgery behind. Until then stay safe and rational.

Tuesday, March 5, 2013

Investment Part 2: Bond Pricing

Last week's post dealt with outlining the basic concept of investment and covering a few examples. If you haven't read that yet you can find it here. As a brief overview, investment primarily deals with using excess resources now to secure more resources in the future. Generally this amounts to expending money in order to obtain a revenue stream or payment in the future.

This posting and the next will deal primarily with how the two most infamous investment types, stocks and bonds, are priced.  Many of these principles can be applied to the other market investments (currencies, real estate and commodities) discussed in the previous posting, though often to a lesser extent.

Recall from the previous posting that annuities are payments over a future period in exchange for a payment now. A bond is a debt instrument, meaning you are lending your funds to another legal entity, which rewards the lender with an annuity plus the original payment back after a fixed period of time. For example, you might lend General Electric $1000 for ten years. In exchange they would return to you $20 annually plus $1000 at the end of the ten year period. This would award you $1200 overall or $200 more than your original investment.

There are two major factors that effect bond prices, risk and interest rates. Risk is generally expressed by bond ratings ranging from AAA (least risky) to D (most risky). Within a given credit rating there is an interest rate sufficient to incentive investors enough to lend their money to the firm.  As risk increases the interest rate required rises and thus return increases.  Correspondingly the risk of receiving no return (due to default) increases as well.

It's important to understand that the most important factor in terms of bond price changes is not the bonds rating at time of issue.  $1000 B rated bonds are issued at a cost of $1000 as are bonds of any other rating. The difference at the time of issue is the interest rate the bonds repay. So a B rated bond will pay a lesser interest rate due to being less risky than a C rated bond but both will cost $1000 dollars (or any other arbitrary amount) when issued. However, suppose Conglomerated Widgets was downgraded from B+ to B rating.  The interest rate of the bond can not change. Therefore it is still paying an interest rate appropriate for a B+ bond but merits the interest rate of a B bond.  Why would anyone accept a lesser interest rate for increased risk? In order to incentivize investors the bond must now be sold for less than other similar bonds. The interest (coupon) payments are the same, the bond will still return the $1000 dollars at maturity but because it has been deemed more risky than expected it is worth less.

Imagine someone asked you to buy our Conglomerated Widgets bond the day before maturity. Assuming the person was relatively trustworthy how much would you pay? It's very unlikely that the firm is going to default on it's debt before tomorrow so you'd probably pay slightly less than $1000. Suppose you were asked to make the purchase five years before maturity. Now the increased risk probably has a much larger impact on your decision and thus you're unwilling to pay as much. This is a fundamental principle of bonds. As bonds approach maturity their price also approaches their "par value" or the amount they will return to the investor upon maturity.  This is another example of how risk effects bond prices.  As maturity approaches there is less time for anything to go wrong (usually meaning default) with the bond. Thus as the risk abates the bond price tends towards it's par value.  Similarly if the firm's rating that issued the bond had been upgraded the upgrade would become less meaningful as maturity approached and the bond would decrease to par value.

Interest rates also have a profound effect on bond prices.  Understanding how interest rates are set is unimportant to understanding bond prices so for simplicity's sake imagine every year on January 1st the United States says they will use the final digit of the year (so 3% in 2013) to determine what interest rate they will repay ten year bonds at for that year. Further, suppose the United States is considered the absolute safest possible investment. If you were Conglomerated Widgets (CW) would you be able to get much funding if you issued bonds at the same interest rate as the United States? Probably not. You're going to have to provide an interest rate higher than the government in order to attract investors to your riskier debt. Let's imagine that CW has to have a coupon rate of 3% higher than the USA each year. Therefore in 2000 they issued ten year bonds at 3%, 4% in 2001, 5% in 2002 and so on and so on. Now it's 2013 and you have a number of options.

You can buy into the new bond issuance that will reward you $60 a year and $1000 in ten years.
You can buy last years bonds that reward you $50 a year and $1000 in nine years.
You can buy 2011's bonds that reward you $40 a year and $1000 in eight years.
You can buy 2010's bonds that reward you $30 a year and $1000 in seven years.
You can buy 2009's bonds that reward you $120 a year and $1000 in six years.
You can buy 2008's bonds that reward you $110 a year and $1000 in five years.
You can buy 2007's bonds that reward you $100 a year and $1000 in four years.
You can buy 2006's bonds that reward you $90 a year and $1000 in three years.
You can buy 2005's bonds that reward you $80 a year and $1000 in two years.
You can buy 2004's bonds that reward you $70 a year and $1000 in one year.
You can buy 2003's bonds that reward you $1000 now.

We already established that a bond close to maturity will cost approximately the par value so buying 2003's bond for $1000 in order to get $1000 is probably not the best plan. You'd make some money nearly guaranteed, but not very much.  How would you compare the debt between 2009 and 2010? Clearly the bonds issued in 2009 are a much better deal. You have to wait an additional year to collect your $1000 but you gain over $500 more while you wait for maturity. Thus 2009's bonds would sell at a premium because they're more desirable due to their higher than average yearly return.  2010's bonds however would sell at a discount because it's interest rate is lower than the current rate necessary for CW's investment class to attract funds. The key lesson behind the bond/interest rate relationship is that if the bond's interest rate is lower than the current prevailing interest rate for that class of investments the bond will sell for below par value. Conversely if the bonds rate is higher than the prevailing rate it will sell at a premium. Regardless of premium or discount as the bond approaches maturity it will trend towards it's par value.

All of the above examples are an effort in understanding the factors that cause changes in bond prices. If you were hoping for explanations regarding how to exactly price specific bonds you can find more information on that topic here.

So to summarize, how can you make money with bonds? Well, just holding a bond will generally pay money due to coupon payments and the par value.  However, if you believe interest rates will fall (thus making your existing bonds more attractive and valuable) bonds are a sound investment.  If you believe a certain company will receive a credit rating upgrade, their bonds would also be a wise purchase.  However, in general bonds are considered a relatively low risk, low reward investment. It's unlikely you'll make a fortune in the bond markets but it may be a reasonable way to preserve and slowly grow your wealth.

Next week I'll tackle stocks and how they're priced. Afterwards Bounded Rationality will return to it's usual impractical academic musings.