Riffing On Tuna

As this post will reveal, my recipes aren't really recipes at all - I don't follow recipes well, and find the concept of baking to be absolutely petrifying. (What do you mean, I have to use an exact quantity of ingredients?) Rather I work with themes of inter-relating ingredients that play well together, screwing around with them for my own amusement, hopefully in a way that won't result in a trip to McDonalds at the end of the night.

With that in mind, what can you do with Tuna steaks?

• Cook them as little as you can stand. If you can get sushi-grade tuna, not cooking them at all would be perfectly acceptable. If you do have to cook them, coat each side with black pepper and maybe some salt or seseme seeds, then cook each side with a very small amount of peanut oil on a hot stainless steel pan. This is sort of a poor-man's tuna equivalent of pan-searing a steak. Cook time varies by how much you trust the tuna, but we're talking minutes, and a small number of them. If the fish is good, I want pink in the center!

• You can chop up and serve the tuna over vegetables - avocado and cucumber are what I usually go to. Anything that is good in Sushi will do here.

• For rice, you can simply prepare a small amount of rice, or make sushi rice (that is, pre-rinse the starch off short-grain rice and coat it in a rice-vinegar/sugar solution at the end). See also risotto below.

• For sauce, I usually make some spicy mayonnaise, which is just regular mayonnaise mixed with Sriracha hot sauce and a small amount of cayenne pepper. (You don't have Sriracha? We must never speak to each other again.) Here my inability to measure things is going to cripple the recipe. Basically you want to use a tiny amount of cayenne pepper - it adds a ton of heat and will make the sauce unmanageable very quickly. Add the Sriracha to taste - it brings spice but also a nice tomato flavor.

  For sauce you can also reduce rice vinegar and soy sauce (perhaps with some stock) into the pan after cooking the tuna. This doesn't quite work like a traditional fond in that the tuna isn't fatty enough to leave the rich drippings you get off of steak. Still, this can bring a salty flavor to the party that isn't as lethally hot as the spicy mayonnaise.

• I usually serve this mess by doing something silly, like piling the tuna on top of the rice with the vegetables all around, e.g. you can play "New york chef" in the comfort of your own kitchen. The taller you stack it, the more points you get. Duct tape is cheating. The sauce can be poured right on or left on the side or safety. (If I've had a few beers before I start cooking and have been liberal with the cayenne pepper I leave the spicy mayo on the side for safety.)

Sushi Risotto

One of the weirder experiments I have done with this recipe was to make sushi risotto - that is, a risotto flavored with sushi-rice flavors (rice vineger, saki, sugar, although I probably ignored the Saki due to it not being on hand). I'm going to have to make the recipe again to remember what went into it, but the trickiest part is to get the two sets of flavors to play nice together. It can be done. I use Alton Brown's recipe as a starting point for Risotto, but in this case I backed off the white wine a lot (perhaps half a cup at most) to avoid clashing with the sushi-related flavors.

(The recipe was quite dreadful mid-preparation, and I thought we'd be ordering take-out, but as the alcohol cooked off the white wine, the whole thing mellowed.)

Anyway, if you can get a "sushi risotto" going, it can serve as a nice base to the tuna, bringing in some contrary flavors and making the rice more interesting.

Pie in the Sky

There are two other ideas for this recipe that I haven't gotten around to cooking yet:

• Wasabi cream sauce. I'll have to figure out how to engineer this but the idea is to make a light cream sauce with a bit of wasabi flavor to pour over the rice. (This is a continuation of the whole "sush-like flavors" theme.) Probably this can't be done without using real cream.

• Tangy sauce. Hell, I don't even know what this is. Basically at the Elephant Walk over a decade ago I had a raw tuna and vegetable appetizer, with some kind of tangy salty sauce that was just astoundingly good. If I had to speculate, there was fish sauce or oyster sauce in there, but cut with something to make it not lethal.

Bob Vila Needs Shrimp!

Lori and I found a good Chinese restaurant, just in the nick of time for xmas: Red Pepper, on route 9 in Framingham.

Disclaimer: Lori and I have become Chinese food snots - we like food that is more like what you'd have in China, rather than Americanized recipes. With that in mind, Red Pepper totally delivers!

Bob Vila Needs to Make More Than the Mortgage

Lori and I have entered a new phase of owning a home: we have rented it out. Lori began vet school this month, so we needed to relocate to Massachusetts). Rather than sell the home and buy a new one (or not), we rented the house and are renting a condo near school.

We ended up using a property management company. I spent almost two months in DC trying to rent the house myself and eventually gave up. Given the work that the management company did on the house, it is possible that we could have rented it ourselves. But the quality of applicants I screened on my own was...well...it wasn't good. What I've been told (and my experience bears it out) is that financially problematic tenants look for owner-landlords, thinking they won't be strict on financial criteria and/or won't do their homework. I did my homework, and what I saw was not pretty.

This is my game theory rationale for why a management company can pull better tenants. The agency cost is born by the landlord, who pays as much as first months rent in finders fees. The tenant pays nothing. High quality landlords and tenants are trying to find each other (or rather, if you are a high quality landlord, you want a high quality tenant, and vice versa). The agency cost acts as a selection signal - that is, if I am willing to burn my first month's rent on agency costs, I must believe that I will be able to sustain a high quality tenant in the long term, because my house isn't falling apart. High quality tenants know I am serious from this.

Since the finder's fee is real money, it's not a signal that can be faked easily by a landlord with a problematic house. But...why should the landlord pay the fee and not the tenant?

My answer is: asymmetric risk. As a tenant in a blue state, my landlord can't do much to me. His business is heavily regulated, the courts are sympathetic, and best of all, since he's sitting on property, he's a sitting duck for lawsuits. (That is, if he won't pay, I can get a judge to put his lien on his house.) I didn't realize how much leverage tenants had until I read the law as a landlord.

The landlord, however, is not in a great position. Give me a bottle of scotch and let me loose in your bathtub, and I can do damages to your house that will cost a full year's rent to repair. Against damage to an insanely expensive asset, a landlord has a few thousand dollars security deposit. And in terms of practical collections on damages, the tenant can skip town.

So it doesn't surprise me that the landlord pays for agency. It's worth a lot more to me financially as a landlord to have a good tenant than it is for me as a tenant to have a good landlord.

(As a tenant in Boston in 1998 I did use a broker, and it was structured where the tenant paid. Perhaps this is consistent with the brutally tight Boston housing market, where landlords can do pretty much whatever they want?)

So, Did You Make the Mortgage

The most common question I get asked when people here we're renting out our house is: do the rental payments cover your mortgage?

The short answer: yes.
The long answer: it's still definitely the lesser of two crappy housing options.

The problem is that the total cost of renting a house goes well beyond the mortgage. Besides the mortgage (which gives you a deduction against income tax on rental payments), you have property tax (a surprisingly big fixed cost), agency fees (in our case), repair and maintenance costs, and return on equity.

To focus on that last one: if you have positive equity on your home, it is not enough to get $1 more in after-tax rent than you spend per month in mortgage, maintenance, property tax, and any landlord-paid utilities. You are also losing the interest income on the money "tied up" in the house - your equity. If you would get cash out by selling, that cash could be sitting in a bank account returning...um...okay, so it wouldn't be returning squat right now, but in theory there is such a thing as interest.

I don't know what the long term outcome of renting the house will be. I do know that in the very short term, we're still in the red due to one-time costs to get the house ready to rent. (A lot of that stuff is repairs we could have done but put off as owner-occupiers.)

I will describe the trade-offs of selling vs. renting out in a future post.

Bob Vila Would Not Spend This Much Time On Green Bean Casserole

My mother is a very systematic person - she keeps notes on how much food everyone eats during Thanksgiving. So when I called her to find out how many pounds of green beans we needed to serve ten people (1.5 pounds is on the safe side) she had historical data on the Supnik family green bean consumption dating back several years.

My original thought was to file this under "things that makes Mom unique"...that is, until I realized that I do the same thing. The Apple doesn't fall far from the tree.

I started logging my recipes several years ago when I was teaching myself to cook French sauces. The problem with French sauces is that if you make them frequently enough to really get good at them, you'll die of congestive heart failure before you finish your training period. So I started keeping notes on my recipes to avoid going back to square one every time.

So while normally the purpose of blogging is to rant about things I am unqualified to rant about (in an attempt to build a resume for Fox News), I'm going to start archiving my recipes^H^H^H^H^H^H^Hexperiments here for next year.

Green Bean Casserole the Hard Way

Lori and I were charged with Green Bean Casserole this Thanksgiving...you can find the "classic" recipe here. We made this recipe with two changes:

1. We used fresh green beans. We microwaved them for, um, a while, to soften them, as they won't cook fully in the casserole.
2. We made the condensed mushroom soup from scratch. It seemed like a good idea at the time.

(I did give serious thought to frying my own onions, but Thanksgiving involves cooking food, taking it in a car, having it sit, then it gets reheated. I'm not convinced home-fried food would be terribly appealing after such a long wait.)

So about the condensed cream of mushroom soup. Basically we used this recipe, but without any of the chicken stock. We started without the corn starch and water, but when it became clear that we needed thickening power, we added it. We also added some cheese to the casserole because, well, we could.

The results were reasonable I think. The main change I would consider for next time is making the soup even thicker, which could reduce casserole cooking time, either via longer cooking, more corn starch, or both.

Essence of Mushroomy Goodness

As a side note, the creamed mushrooms (that is, mushrooms sauteed with shallots in cream) is astoundingly tasty, and not unrelated to a number of other mushroom, wine and cream potions. I have a strange compulsion to make ice cubes out of anything that is concentrated and tasty, e.g. home made chicken stock, pesto, leftover pizza (you do have to put it in the blender first) and concentrated creamed mushrooms falls in that category.

Poking at the recipe:

• Don't be lazy about the shallots - they bring a lot of flavor to the party.
• If making a sauce, you might be able to get away with less cream - judge by consistency. I am definitely of a mind-set that while "mouth feel" can be luxurious and delicious, it's useful to know what recipes are using extra fat for feel and not for flavor. This is one of them.
• You can probably deglaze in white wine, also a mix of white wine and vinegar (preferably a white wine vinegar - if you only have distilled, be careful) would be good.
• Extra credit if you use tarragon with the shallots - it plays well with mushrooms.

If you have left-over tarragon and shallots, you can reduce a saute of tarragon and shallots in vinegar and white wine, then combine it with (a relatively unflavored/unspiced ) hollandaise sauce and you end up with Béarnaise sauce, which is absurdly good and can be dumped on, well, pretty much anything. (Allegedly you need chervil to make a Béarnaise correctly, but I have used up leftover tarragon and shallots and it's still very good.)

Innovation and Commodification

There are fights going on in the banking industry right now that I want to rant^H^H^H^H call attention to. They are issues that most people probably don't know or care about, and yet they will affect our collective quality of life directly.

What do credit cards, mortgages, and over-the-counter (OTC) derivatives have in common? They are all products that are non-uniform - that is, each bank gets to make each product individually.

Defenders of deregulation would argue that the freedom to innovate in any way the banks can imagine is good for all of us, because the innovation leads to efficiency.

Despite having been raised by liberal socialists, I am sympathetic to this argument. I work in a highly deregulated industry (IT/computer tech) and would be at best grumpy if anyone told me how I could go about writing X-Plane.

But is that really the right analogy? I submit that banks don't fear the end of innovation - they fear the beginning of commodification, and we have a perfect analogy in the PC industry.

The computer hardware industry is, to put it bluntly, brutally competitive. It's not an easy part of the industry to make money in. Every year a PC sells for less money, but does more. Poor companies like Dell and HP are caught in the middle of that.

Okay - who are we kidding? No one is crying a river for HP or Dell, but being able to buy a laptop for under $500 is pretty awesome. There is no question that, from a price performance standpoint, whatever economic force is holding HP and Dell (and all of the other manufacturers) feet to the fire is yielding real dividends to consumers.

I believe that the force driving the price of PC hardware down is: commodification. Simply put, all PC hardware is like all other PC hardware. For any given product category, the ways a manufacturer can "innovate" is limited by the implicit rules of the PC ecosystem.

• RAM & Hard Drive: you can increase capacity, decrease latency. But you can't go changing around how the part fits onto the motherboard.
• CPU: you can increase the number of cores, you can increase speed. But you can't change what types of computer programs it runs.
• Graphics card: you can increase how many triangles you can draw. You can increase how much detail you can draw per pixel. But you have to do this via a standard interface.

When the specifications of a product become limited, it can be commodified - produced the same way by multiple manufacturers. Purchasers can easily change between suppliers, which puts intense competitive pressure on manufacturers to compete on the "commodified" axes (that is, the official ways commodities are measured).*

So let's take this back to banking. Look at things the banking lobby hates:

• "Plain vanilla" pre-approved consumer products. This would be direct commodification of anything in the consumer market. When the only thing banks can compete on is interest rate, interest rates are going to get driven down about as low as they can go. (The loss will come out of the banks margin on the product.) It's understandable why they don't like that.

• OTC vs. Exchange Traded Derivatives. This is complicated enough to warrant another blog post, but basically a derivative sold on an exchange is a standardized, commodified derivative, and the companies "manufacturing" the derivatives for trade make only the thinnest margin on large volume.

  By comparison an OTC derivative (a custom derivative made by a big bank for a company - think of it as getting a car designed from scratch instead of just going out and buying a Honda) is sold by one bank . There aren't any comparable derivatives to even check the price against! Which product do you think is more profitable?

Commodification is appropriate when we can quantify exactly how we want to select our products. Commodified memory works because we can standardize all but two variables: size and price. For a given class of memory, we can then buy the cheapest chips.

Could we do that for financial products? Yes! I reject the claim that exotic mortgages are useful for some class of buyers with special needs. If this were true, they would not have become the standard financing vehicle for several years. I think we know what most people want from a mortgage:

• Low up front costs
• Low monthly payment
• Low interest rate

In other words, when it comes to a mortgage, there is really only one variable: price. If that isn't a product waiting to be commoditized, I don't know what is.

If there is a single idea I want to leave you with, it's this: different kinds of innovation are good for different parties, and commodification channels that innovation into avenues that are good for the purchasers of a product. There is nothing anti-competitive about commodification. In fact, I would argue that it is anti-competitive not to have commodification.

Banks like the current system because they can offer products just different enough, just confusing enough, just opaque enough that consumers can't direct purchasing power toward the competitor who provides the best deal. Commodification would make these products transparent, and would make the market more efficient.

In a commodified world, banks would have to innovate, but they'd have to innovate on how to get us the best price on a mortgage, not on how to hide the fees in the hardest-to-find places.

* I would be remiss if I were to pretend that this always works out well. Five years ago, the commodity for CPUs was clock speed, rather than throughput, and the result was the market producing CPUs that ran very fast, but got very little done as they ran.

Is It My Turn Yet?

NAR wants us all to beg congress for an extension to the first time home-buyer's tax credit. That sounds good to me, but I wanted to punch up the text a little bit. Here's my version of the letter.

Dear ________,
I am writing to express my strong support for Congress to extend the $8,000 first-time homebuyer tax credit through 2010.

Throughout this financial crisis, there has been one consistent, clear, and very American policy: if you did something really stupid in the last decade, whether it involved making non-competitive cars that no one wants or designing financial instruments that would lose most of their value while paying hefty bonuses to bankers, congress will bail you out, and the tax payer will fund it. Should housing be any different?

Reports show that home sales to first-time homebuyers increased by 25% in 2009 and now account for 50% of all sales. In addition, the tax credit is reducing the inventory of foreclosures that are sitting on the market, helping our neighborhoods and communities recover. Like the big banks, us home buyers did some really, really dumb things over the last few years, and this government-provided bail-out is helping us "recover" from our mistakes by making future, similar mistakes cheaper.

While I believe the market has improved, I do not think it has fully corrected itself. In order for that to happen, we will have to reach similar levels of bad lending policies (NINJA anyone?) and delusional optimism that housing prices only go up. While this level of psychotic optimism has been hard to find in today's difficult economy, the best way to assure continued housing activity is to extend and expand the credit and to do that NOW. Nothing says "do whatever you want, we'll pay for your mistakes" quite like a government back-stop on bad investments.

We can't wait until late in the year to see what happens. It might turn out that houses aren't worth as much as we paid for them in 2006.
Sincerely,
_______

Now where's the bail-out for grumpy-coffee-drinking-work-at-home-computer-programmers-whose-pets-are-running-around-the-house-like-animals?

Bob Vila would not eat meat by-products (but your dog should!)

I went to a talk by a veterinary nutritionist yesterday at Tufts Vet for Obesity Awareness Day. Her talk was really educational. For instance, I learned that the body that regulates pet food nutrition, content, etc. is called AAFCO (Association of American Feed Control Officials). They seem to be a lot less stringent than FDA regulating human food. Anybody can make a pet food and put it on the market, regardless of whether it meets your pet’s nutritional needs. Moreover, pet food does NOT have to be tested in feeding trials to go on the market. Why does this matter? Well, our pets generally have only one or two sources of food – whatever we feed them on a daily basis (compared to people, who eat a variety of different foods and obtain different nutrients from each one). Our pets cannot synthesize certain vitamins and amino acids, so it is important that their food provide these.

The label will tell you whether or not it’s been tested. Definitely buy one that has been tested. How will you know? Read the labels. Here is how to interpret:

TESTED wording (example): “Animal feeding tests according to AAFCO procedures substantiate that…”

NON-TESTED wording (example): This food has been formulated to meet AAFCO standards…”

Key point here: “formulated to meet” = “HAS NOT BEEN TESTED”

When buying a pet food you also need to look for the words “complete and balanced” on the label. That means the food meets all your pet’s nutritional needs.

Wording (example): “Animal feeding tests according to AAFCO procedures substantiate that XYZ food provides complete and balanced nutrition…”

If the food is appropriate for puppies/kittens, it will say, “provides nutrition for growth of puppies/kittens,” and for adults it will say, “for maintenance of adult dogs/cats.” Foods can be appropriate for both youth and adult stages. But some foods are only for one or the other.

Wording (example): “Animal feeding tests according to AAFCO procedures substantiate that XYZ food provides complete and balanced nutrition for growth of puppies and maintenance of adult dogs…”

The only marketing claim word that means anything on a pet food label is “natural.” So “organic” is just a marketing term. Which is of course the opposite of people food, where “natural” is meaningless and “organic” has to be backed up.

Don’t worry about buying the fanciest food for Fido. More expensive or prettier packaging does not necessarily equal better nutrition. Just make sure the food has undergone AAFCO feeding trials and provides for all your pet’s nutritional needs: “Complete and balanced” – just like FOX News!

Leaving DC

Lori has already relocated to Boston - once W was gone, there was just no reason for her to stay.

Well, after watching this I realized that I have to get out of DC too. Actually, Canada's looking pretty nice.

Edit: this will help wash away the icky feeling you get from watching Glenn Beck fans.

Houses and Finance

You might have thought that my mad rants on finance were totally unrelated to a housing blog. But...it turns out that housing and finance do intersect, in some ways that have turned out to be pretty unfortunate for home-owners.

There are a few financial bloggers who I really like - Mike Konczal is one of them. He wrote a series of guest posts on the The baseline Scenario (another really good finance blog) that are of interest to home-owners who might be asking the question: "how did Wall-Street-style price-insanity infect my local neighborhood?"

The Limits of Arbitrage. This is an idea that has also been explored for stocks, but the basic idea is that if enough people lose their minds and start buying up the price of an asset, it may be impossible for sane, well-informed people to bet against them, making money while forcing the price down. There can be two reasons why people can't "bet against" the bubble:

1. There is no good way to make the bet. For example, if I believe houses are going up, I buy a house. But if I think houses are going to crash, it's a lot harder. If I don't already own a home, I can't sell a house.

   Since I can buy 2, 3, or 4 houses if I want, but I can only sell what I already own (1 house for most home owners) it's a lot easier to make the bet that houses are going up than going down.

2. If you borrow money to bet against an asset, you can go very, very broke. The problem is this: if you bet against asset X, you lose money every time asset X gains money. Your lender isn't going to lend you money once you've lost more than your own share. Put it together and a large enough rise in asset X means you're broke.

   For example: Google is at $100 and I think it's going down. I have $1000 and I borrow another $1000 and short (bet against the stock). I now am short 20 shares. If Google doubles in price to $200 then my initial $1000 only covers half of those shares. At about this time the bank is going to ask me to unwind the trade and give them back their money, because if things get any more out of hands, I won't be able to pay the bank back at all.

   Of course, this sucks for me - if Google later crashes down to $10, I'll never see my money - the bank forced me to sell at the worst time because I ran out of credit! Why does this matter? It matters because people can use credit to bet that an asset will go up. If they can't use credit to bet that an asset will go down (without risking the bank pulling the rug out from under them) then the amount of money betting on a rise (amplified by borrowing) will dwarf the bets on a fall, and the people betting on the price going down won't be able to "hold down" the price.

Phew. So what does this mean for houses and stocks? It means that even if smart, clever people could have predicted the bubble (some did, it remain arguable if enough did to make a difference) those smart people might not be able to keep prices sane because of structural problems with the markets. The only thing you can do is get out of the asset class entirely while the bubble goes by and wait for things to calm down. This is possible for stocks but more difficult for houses.

Prepayment. Mike is a financial engineer, so his articles can get technical, but I think prepayment is worth looking at. Cynics like me might accuse the banks of speculating on rising housing prices when they wrote all of these lame loans, but how do you make the link?

In The Giant Pool of Money NPR financial reporters explore the idea that with low interest rates and a lot of international capital, there was a huge desire for mortgage debt. In Infectious Greed Partnoy argues that often derivatives were sold to clients who didn't know what the hell they were doing.

So you can put together an argument and say "oh - the banks made subprime loans because hedge funds, insurance companies, pension funds, and other pools of money wanted the derivatives that come from subprime loans, and were too stupid to see the risk." But this doesn't explain a strange market inversion, where sub-prime mortgages were in higher demand than prime mortgages, creating incentives for brokers to push them. (A broker might make a higher fee on a subprime loan, but only because the originator set things up that way - e.g. the broker gets paid more for subprime if the originating bank wants that loan...why does the bank want a subprime mortgage?)

Here Mike suggests an answer: the prepayment penalty in a sub-prime mortage changes the very nature of what a mortgage is. One of the weird features of prime (normal) mortgages is prepayment. Owners pre-pay when interest rates fall (making a re-fi a good idea). This really sucks for the lender. If I offered you a CD that has a 5 year term but will drop to a 1 year term only if interest rates fall, would you accept it? Heck no!

(If I understand my financial engineering, mortgages have "negative convexity". Basically the longer a loan, the more its value changes with interest rates. But a mortgage's time span goes down when interest rates fall due to prepayment. So a mortgage is a loan whose duration is longer when interest rates are going up. Since a loan's value (to the lender) is inversely proportional to interest rates, this is about as bad as it gets: a loan that changes its value a lot when its value falls but only a little bit when its value goes up. If this seems totally one-sided, it is...this one-sided lender-is-hosed pricing comes directly out of the one-sided nature of pre-payment. Prepayment is heads-I-win-tails-you-lose, with the winnings for the borrower and losses to the lender.)

But if you can soak your borrower with a 4% penalty every time they prepay and encourage the borrower not to run the mortgage to its full 30 year duration (by having horribly high floating interest rates after the first few years) well....now we have something. We have a mortgage without this "negative convexity".

There's only one problem: it's a subprime mortgage - we might not get our money back. And now we can connect the dots. To the lender, a subprime mortgage has less interest rate risk but higher credit risk. And the credit risk of a mortgage has everything to do with housing prices. Ergo: the subprime mortgage as a speculative instrument exposing banks to rising real-estate prices.

(Of course we can see the problem now: as a way to speculate on housing increases, a subprime mortgage is a bit like selling a put option - you make a little money when you win but lose a lot when you lose. In the case of the mortgage, the most you make is the higher interest and prepayment penalties. The most you lose is a huge chunk of the mortgage. Which is exactly what has happened.)

More Brain-Melting Pet Photos

In "The Truth About Dogs", Steven Budiansky makes the case that dogs are essentially a successful parasite. Harsh? Perhaps, but his argument provides a lot of insight into the human-pet relationship.

A successful parasite is one that takes advantage of a mechanism in the host that the host cannot live without. (If the host could live without the mechanism, the selection pressure from the cost of the parasite would slowly extinguish the required mechanism.)

Pets fit this criteria - they get us 30-somethings with our ticking biological clocks that have been snoozed for year after a year to devote our important resources (read: food) to pets instead of our own offspring. Fortunately pet food is pretty cheap. It's a good thing the pets don't have a taste for filet mignon.

I think Lori and I may be infected: we can spend hours babbling about how good the pets are and how sleepy they get. Perhaps the parasitic infection is melting our brains?

Anyway, what follows can be thought of as a chronic condition.

I am in your office paying your billz! Can haz stamps?

Corporate-espionage-kitteh is stealin your secretz.

(Without our kodez u is 2 yearz behind us. With our kodez u is 4 yearz behind us!)

Warning: absurdly cute.

I can haz kitteh?

Apartment-kat sez: upstairz neighbor is makin too much noize!

O hai...big sister, you is good pillow.

Mixed Messages About Flying Under the Influence

When we bought the house 3 years ago it came with this totally awesome biplane made entirely out of Coors Light beer cans. I find it simultaneously wonderful and revolting.

I am very tempted to send it to Austin as a house warming gift...

Rent This House

We spent the last two days preparing pictures for our home web page. You can see the end result here.

As usual, the pets were immensely helpful!

We're ready for our close-up.



I don't want to go in the toaster!



After a big day on set...we get soooooo sleepy!

CC Is Tired


I am ready to help if you need me!

Ch-Ch-Ch-Changes

3 months without a post? 4 months? Quiet blogs sometimes indicate significant "stuff" in the lives of the posters. That's definitely true of my work blog (less posts = more code) and is true here too.

Here's the short of it:

• Lori got into Tufts vet school! She starts "real soon".
• We're moving to Westborough, MA.
• We'll be renting out our house here in Maryland.

So we're going a bit crazy right now getting the house ready to rent, getting the move organized, etc.

The of whether to sell or rent is a complex one, and it ties together the two themes of this blog (housing rants and financial rants) into one, um, über-rant. Comparing life as a tenant, landlord and home-owner is eye-opening too.

More to come soon - we're working on our showing pictures today, and I think they're coming out pretty good...it's nice to see that the house can look good when we get all of our junk out of the way. (Then we ask: why don't we always leave the house like this? Answer: we have too much stuff!)

ETF Warnings

My previous post outlined two reasons why ETFs might be more attractive than traditional low-cost indexed mutual funds.  Here are some down-side risks to check for.

Does This ETF Suck?

This isn't a risk unique to ETFs - there are lots and lots of lousy mutual funds too.  But suffice it to say, the biggest risk with an ETF is that it isn't a very good one.  Check the expense ratio, and make sure the index makes sense for your investment goals.  There are actively managed ETFs, custom-indexed ETFs, high expense ratio ETFs - lots of weird stuff.

Brokerage Fees

ETFs are "more fair" (IMHO) than mutual funds because the cost of buying and selling the shares is out front where everyone can see it: you pay a commission to buy or sell an ETF, just like you would a stock.

But this means you have a fixed cost per transaction, and this changes things compared to a mutual fund.  For example, if your 401k normally buys a small amount of 4 mutual funds every pay period, that's 104 transactions a year.  At $12.50 a transaction, you've paid $1300 in brokerage fees.  If you contribute the IRS maximum ($16,500) that's a 7% commission!  Ouch!

Simply put, heavy dollar-cost averaging over a wide number of funds isn't going to be cost-effective with ETFs.  To use ETFs, you need to make contributions in fairly large chunks.

It should be noted that mutual fund buys are not really cost-free; the mutual funds that you can buy through your broker without a sales fee are subsidized by the mutual fund itself.  Example: I can buy any Fidelity mutual fund for free via my Fidelity account because Fidelity's mutual funds have an agreement with Fidelity's brokerage.  If I buy a Van Guard mutual fund I pay $75 - way worse than a trading commission.

Typically mutual funds that are free to buy will have a higher expense ratio - part of the expense ratio will go back to "mutual fund supermarket" brokers (like Fidelity, Charles Schwab, etc.) to offset buying costs.  There is no free lunch.  (One possible exception: Fidelity heavily subsidizes its own Spartan index funds to keep the expense ratios competitive with Van Guard.  So there may be some loss leader mutual funds.)

The bottom line is: your buying pattern may have to change to use ETFs, and there is a cost to not dollar-cost averaging, so look at the big picture and the details.

The Bid-Ask Spread

Since ETFs are traded, there is a bid-ask spread - that is, the price you sell at will always be a tiny bit lower than the price you buy at on the exchange.  That spread is the profit that market makers get for providing liquidity (that is, buying and selling whenever people want to keep the market working).

A healthy ETF should have high liquidity and thus a very narrow bid-ask spread.  For example, IVV (an iShares S&P 500 ETF) has a 1 penny bid-ask spread on an $85.51 share price - that is, the spread is really, really tiny.  If the ETF is less liquid, traded less often, has fewer shares, etc. you might see wider spreads.

If the bid-ask spread is too wide, treat this like an expense; you will lose the spread each time you buy/sell.  If an ETF were to have a 1% bid-ask spread, you'd lose 1% when you buy and sell.

(A one-time loss is not as bad as recurring fee like expense ratios, but it does warrant examination.)

Arbitrage Failure/Tracking Error

When you buy some shares of an open-ended mutual fund (most mutual funds are open-ended), the mutual fund manager goes out and buys some stock (or bonds or stuff) - in other words, crunch all you want; when you buy, the manager makes more.  To understand the problem of arbitrage failure in ETFs, we have to first ask: where to ETF shares come from.

When you buy and sell shares of an ETF, you are simply buying or selling existing shares on an exchange.  But...what if everyone wants shares of IVV (an S&P 500 index ETF) at once and there just aren't enough? What keeps the price of IVV from skyrocketing above the S&P index that it should track due to the outsized demand?

The answer is in the way ETF shares are born: in-kind creation and redemption.  ETF shares are created by someone coming to the ETF with the underlying stock or bind and saying "convert these stocks that make up the S&P into ETF shares".  The ETF takes the stock and holds onto it (that's what the ETF does) and issues brand new shares.  There are now more ETF shares in existence but the ETF now has more underlying stock to back them up.

Now when someone does an in-kind creation or redemption, he or she will make a profit or loss based on the difference between the ETF share price (as traded on the market) and the price of the underlying stocks and bonds that make up the ETF.  This is what keeps an ETF's price so close to its underlying value ("net asset value" or NAV).  

If the ETF share prices were ever selling for a lot more than the underlying stocks, some clever investor could buy the stocks and sell the ETF at the same time (making a profit).  To then recover the sold ETF shares, the investor simply converts the bought stock to ETF shares.  In other words, if the ETF trading price diverges from the NAV price, there is an arbitrage opportunity.  Arbitrage keeps ETF trading and NAV prices in sync, and that's why your ETF shares are always worth the value of the underlying assets.

Well, almost always.  During the recent market crisis, some ETF shares were trading at less than the value of their underlying assets.  How did this happen?  Vanguard explains here.

Basically if the NAV of an ETF share is below the trading price you don't want to buy (you'd be over-paying) and if the NAV of an ETF share is above the trading price you don't want to sell (because theoretically you should be able to get a better price).  In practice, you're most likely to see this with bond funds, where the market for selling the underlying assets (bonds) is (a) not very fast/transparent like a stock exchange and (b) tends to seize up periodically these days.

PEBKAC

ETFs introduce one last potential risk: you.  If you are the kind of person who might be tempted to day-trade your index funds, if  given the tools to do so, you might not want an ETF. Mutual funds are fairly clunky to buy & sell - they're terrible for day trading and speculating. ETFs don't have this weakness - you can short them, trade them every 3 minutes, and probably even buy them on margin.  If the temptation is too much, an ETF might not be a good idea.

Two Reasons to Consider ETFs

I am assuming that you already use low-cost indexed mutual funds, and assuming retirement planning (e.g. ignoring taxes).  Here are two reasons to use low-cost index-based exchanged traded funds (ETFs).  I am not arguing in favor of high cost ETFs (they do exist!) or some of the weirder indices (people make up indices and build ETFs around them all the time) - this is just a comparison of mutual funds vs. ETFs for things like the S&P 500.

WTF is an ETF?

Here are two articles explaining (or trying to explain ETFs).  But the basic idea is this: an ETF is like a public company whose business is to simply own the stocks (or bonds) in the index it tracks.  Since the company doesn't really have a business plan other than holding these stocks or bonds, the share value of the company is pretty much equal to the assets inside it.  Thus you can trade a single "stock" (the ETF shares) on an exchange instead of trading the 500 stocks that make up the S&P.  In other words, ETFs are sort of "meta-stocks".

How is this different from a mutual fund?

• In a mutual fund, when you buy & sell shares in the mutual fund, the mutual fund buys and sells the underlying "stuff" inside the fund to raise the cash to give you your proceeds when you sell, and then buys more stuff when you give them cash to buy.
  
• In an ETF, you actually buy and sell the ETF shares itself - the stocks inside the ETF don't have to be unbundled, sold separately, then rebundled each time a share of the ETF is sold.
  

This structure turns out to be good in two ways...

ETFs Often Have Lower Expense Ratios

When I went looking for a broad bond-index mutual fund a few years ago, I couldn't find anything cheaper than an expense ratio of 0.45.  For a bond fund, that's not very good - if I am only going to earn 3%, I don't want 15% (!) of my profits going to the managers.  You can find bond ETFs with expense ratios a lot lower - more like 0.11%.

There are a number of reasons why ETFs might have cheaper costs:

• The market is very competitive and very hot.
• The structure may actually be cheaper to work with.  When ETF shares change hands, only the ETF shares get sold, not the underlying instruments.*  So it is possible that ETFs are less costly to run.
• Mutual funds have this ugly property: if I sell all my shares and get out of Fidelity's Super-Actively-Managed-Wicked-Indexed-Cool-Kids-Fund (SAMWICK?!?) and you have shares, the fund pays the brokerage fee for the sale out of the fund.  But wait ... you own the fund and I don't.  You just paid my brokerage fees.  Sucker!
• By comparison, if I sell my ETF shares, I pay a brokerage fee to sell (like I would a stock). I pay my own costs.

On this last point, I would say the cost structures of ETFs are more fair - but it also means that the expense ratio of an ETF doesn't tell the whole story.  (Nor does the expense ratio of a mutual fund - more on that in the next post.)

The bottom line here is that if you are shopping for cheap indices to hold, the best deals seem to be in ETFs.  Van Guard has a nice set of low-cost ETFs wrapped around a number of indices -they are liquid (mostly), well funded, and have very low expense ratios.

More Control Over Buying and Selling

The way the two-step buying process of a mutual fund (step 1 - buy the fund; step 2 - the fund buys more "stuff") is implemented in the US is really lousy: I put a buy order in during the day, then the market closes, then they recalculate the fund price, and then they buy for me at the new price.*  In other words, there is a huge delay in order execution.

That didn't bother me three years ago, but times have changed, and the market jumps up and down several percentage points in a single day.  And that's where another feature of ETFs is handy: the ability to execute trades faster and place limit orders.

Since an ETF is traded like a stock, all of the things you can do with a stock are available on the ETF - in particular, you can place a limit order, saying "I would like to buy 1000 shares of this ETF when and only when the price dips below $50 a share".  You set the limit order and walk away, knowing that if the ETF falls in value (altering the balance of your portfolio) the limit order will (hopefully) kick in and change your asset allocation back to where it should be.

(In my experience limit orders don't work as perfectly as you might hope - I don't know what kind of mechanism is behind the execution process, but exchanges aren't perfectly continuous - there will be a limit to the precision of order execution.)

Similarly, if you place a market order on an ETF, it's going to go through pretty fast.  So in volatile times, with an ETF at least you know what you're buying.

ETFs also have some potentially negative features, and they're a bit more subtle than an ETF's features.  I will cover them next.

* The mutual fund situation is worse - since the NAV is calculated after hours, you only know the NAV if you buy after hours - but if you do that, they wait an entire market cycle.  So you basically never know what you're getting unless you calculate NAV yourself right before the close of market.

Isolating the Wrist

Plenty of people have written plenty of blog entries about Ultimate Frisbee, and, being a typical perennial rec-leaguer (read: not that good) I'm not really qualified to write squat about Ultimate frisbee.

But - I did manage to "fix" my back-hand throws over the last year (more or less) and, being a big nerd with no coordination who doesn't "get" any sporting activity naturally, I can write about how I did it, because the process was deliberate, intentional, and took a while.

I think you could identify a number of important elements to throwing a frisbee - spin is always at the top of the list, as well as the relationship between the disc and its flight path, how the disc is oriented at release, etc.  In my case what I was missing most was wrist isolation.

When you throw a frisbee, the wrist has a special role: many muscle groups are providing forward velocity, which will make the disc go faster (and thus farther before it falls out of the sky).  For a short throw, the elbow and shoulder might be involved; for a longer throw the whole body might rotate.

But the wrist is the only part of the body that can make the disc spin.  Why is that?  Well, the bigger the muscle group, the slower the rotational speed it produces.  I can snap my wrist almost instantly, but I can't rotate my hips 90 degrees that fast.

Thus the key to a frisbee throw is to "save" the wrist snap until the very last instant possible.  If you snap your wrist too early one of two things happens:

• Your wrist has rotated as far as it goes and the throw isn't over.  Or more likely...
• Your wrist rotates more slowly than it can so as to rotate at the same speed as bigger muscle groups.

I suspect that many attempts at "big" throws go wrong because the thrower synchronizes the wrist and another muscle group.

For my forehand, snapping my wrist at the last second just sort of happens - I don't know why. But for my back-hand, one of the keys to rehabilitating it was to learn to delay the wrist snap until the last minute - it was an issue of coordination.

What finally got my head in the game was to think of the arm movement and wrist snap as two distinct steps.  The exercise I do is to first step across to 10 o clock with the arm swinging as part of the movement, and then, only once my arm actually gets to the throwing position, snap my wrist to throw, as if throwing without any arm movement at all.

(A number of websites suggest first throwing wrist-only to isolate muscle groups - I think this is a good suggestion.  The next step then is to be able to move the arm and not lose the independent wrist control.)

Yet Another Way to Fund Housing

In a previous post I suggested that housing could be funded via equity instead of debt, an idea inspired from other economists and twisted slightly.  It's a somewhat impractical idea - at best the equity stake in a house owned by those other than the occupant would be split into tiny pieces and combined to make a "housing equity index"-style investment.  (The goal of slice and dice here is to emulate stock index funds and insulate passive investors from the occasional idiot home owner who destroys his own equity.  The goal is not to create tranches to change the risk curve like a CDO.)

The problem with this scheme is that the equity holders of the house would either have a say in how the house is managed (an annoying intrusion on home owners) or have no say (which means their capital is at risk).  This new scheme tries to work around this by keeping ownership with the occupant.

Derivatives As Insurance

Derivatives are like the force - they can be used for good or evil.  A legitimate use of derivatives is to offset one risk with the exact opposite risk.  For example, an airline (which is hurt by rising fuel prices) can use derivatives to cheaply set up an investment that goes up when fuel prices rise.  The result is that the airline's net exposure to fuel prices is smaller, which means the airline isn't as at risk to fuel price changes.  This use is a "hedge".

By comparison, derivatives can also be used to speculate - I can buy those same derivatives without being an airline - if fuel prices go up, I win my speculative bet - if they go down, I lose my money.

Derivatives that are used as a hedge are sort of like "insurance" - they provide compensation to the buyer when bad things happen.  If I buy a put option on the S&P, I have bought insurance against the stock market falling.  If the market falls (and I lose money from my stocks) the party who wrote the put will pay me - my insurance payout.  The cost of buying that put option was like a premium.

It should be noted that a derivative contract can be insurance to both parties!  If an oil company writes insurance on fuel prices going up and sells it to an airline, this is good for both parties. If fuel prices go up and the oil company has to pay out on the insurance, that's okay, they're printing money because fuel is expensive.  If fuel prices go down, they get to keep the premiums just when they need it.

(I mention this because A.I.G. has just cost us tons of money by writing insurance policies that came due using derivatives.  A.I.G.'s mistake was not writing the insurance - it was writing insurance that they didn't have the money to pay out.  What they did is equivalent to me starting to write insurance on an earthquake in California.  If it happens, I don't have the millions of dollars to pay out claims.  Maybe I could get a bailout and $165 million in bonus money...)

A New Kind of Home Insurance

So here's my scheme: home depreciation insurance.  The home owner agrees with a third party to:

• Pay the third party if the home price goes up and
• Receive money if the home price goes down.

This effectively lowers the market swings.  If I have a $400,000 house and buy a $200,000 depreciation policy, then if my house price falls by 25% I am only out $50,000, not the full $100,000.  (The other $50,000 "lost" is a loss for the third party.)  If the house goes up by 25%, I only gain $50,000, not $100,000.

In other words, I have given up some of the up-side of owning a home to avoid some of the down-side.  Given that a home is a single asset that is more expensive than most Americans savings, this improves the balance of the home-owners portfolio (which is normally over-weighted in non-diversified real-estate).

Homes are bought with leverage (e.g. I buy a $400,000 home with only $80,000 of my own money), to use the financial lingo.  Leverage (borrowing money to buy more of something that changes in price) amplifies the change in value of whatever you buy.  So our use of mortgage financing is making us all more susceptible to housing market price swings, relative to our personal income, savings, etc.  Depreciation insurance is an attempt to counter-act this problem, by letting the home owner "sell" some of the risk to a third party.

Who would be on the other side of the equation?  I can think of a few possible parties:

• Real estate investors who want exposure to house price appreciation but don't want to have to manage a rental property.*
• Pension fund managers who want to balance a series of asset classes that are unrelated (e.g. stocks vs. bonds vs. houses) to optimize return on volatility.
• Home owners who would consider buying a second home as an investment but don't want to buy less than a whole house worth of exposure.

* Buying a rental property to speculate in real-estate is a little bit tricky - the tenant and land lord have opposite incentives financially.  By comparison, in an owner-occupied house the owner and occupant are one in the same, so there is no conflict.  In other words, if you buy part of the appreciation of someone else's owner-occupied home, you don't have to be as worried that they'll scratch the hell out of the new wood floors.

What's A Bonus Anyway

I heard a commentator on the radio say "people know what a bonus is but they don't know what a credit default is". The commentator was getting at why we all have our shorts tied up over the A.I.G. bonus payout, but I think he is wrong; we (the American people) apparently don't know what a bonus is in the finance industry either.

When I did my first job for Austin, I was paid by the job - I received my payment in two lump sums (one part-way through and one upon completion) based on showing the progress of my work.  I would describe this as "deferred compensation":

• The amount of payment was predetermined.
• The work was done significantly before I received the money (this project took over a year of part-time work).
• The amount of payment was unrelated to the quality of the work.  Either the work was acceptable and I got paid, or it wasn't and I wasn't considered done.
• We had a binding contract enforcing this agreement - had Austin decided not to pay me for my work, my recourse would have been to sue for my due compensation.

That sounds a lot like the A.I.G. "bonus" situation: money promised earlier to employees based on a contract that is now enforceable.  (I can only assume that if the contract was not enforceable that Liddy would have done the easy thing and not paid the employees in the beginning.)

By comparison I received a traditional "bonus" at the end of a different project - it was simply a one-time extra payment, the amount specified by Austin, after finishing my work, as a way for Austin to reward me financially for work that he was "extra" happy with.  That's what we all know of as a bonus.

Now don't get me wrong, I am in favor of not paying the bonuses.  But...not because I think the employees don't "deserve" them for ruining the economy.

I am for not paying the bonuses because, as a tax payer, I now own A.I.G., and as an owner of a financial institution, I think that:

1. The compensation of finance employees is way, way too high.  Simply put, I feel that we bought a company with overpaid employees and we should use every technique we can as an owner to reduce salary!  Call me the Frank Lorenzo of financial services!!*
2. We bought A.I.G. not out of profit motive but to preserve the stability of the financial system. To that end, retaining the legacy employees should not be a goal.  If a side effect of cutting costs is to shed the old employees, I am okay with that.

Of course, there is one very dangerous situation: if employees who know A.I.G.'s "positions" (what derivatives A.I.G. owns/sold/is invested in) quit, can they then try to profit by trading against A.I.G.?  I can only hope that they have some kind of non-compete clause in their contract.  (If not, what on earth was A.I.G.'s management doing?)

* This is why I don't like the idea of congress taxing the bonuses to death - I am in favor of strong ownership by all businesses as a way to protect investor value - including the nationalized ones.  When we the people own a bank, we need to be careful not to let politics run operations, but that doesn't mean we have to be taken as suckers by management.  What drives me nutty about A.I.G.'s bonus payout is that it doesn't strike me as driving a hard bargain.

The Worst Finance Book Ever?

I didn't think I would find a source of financial advice worse than CNBC, but I was wrong. "Conspiracy of the Rich", at least in its present form, should be retitled "Robert Kiyosaki gives you financial advice that is somewhere between negligent and completely destructive to your financial health, while advertising his other books and trying to push your buttons."  Kiyosaki has one good point: we (Americans) are terribly uneducated, financially speaking.  Reading his book will only make the problem worse.

The book is available for free online (if you have an email address you don't mind giving up) - it is very possible that the page numbers I quote will have changed; I don't intend to spend any more time reading it.  Here's just some of what horrified me in the introduction:

"The old rule of diversification tells you to buy a number of stocks, bonds, and mutual funds. Diversification, however, did not protect investors from a 30 percent plunge in the stock market and losses in their mutual funds." (p. 7)

Either this is a gross straw man, or Kiyosaki doesn't understand what diversification means. Diversifying into a broad index of stocks rather than one or two stocks protects you from a particular stock doing something particularly bad. Diversification means that you don't get totally wiped out when Bear Stearns goes down. Diversification among stocks does not protect you from the entire market going down, and no investment advisor with more than 3 brain cells would ever say it does.

Diversification across asset classes protects you from strong movement in one asset class, sometimes. Investors who held both stocks an bonds saw less of a dip than investors entirely in stocks. For a thorough and correct discussion of the capital asset pricing model (which is at the heart of modern portfolio design) see A Random Walk Down Wall Street; for a discussion of why things sometimes still blow up, see Fooled By Randomness.

At the heart of the issue with stocks is not diversification, but volatility. Stocks as an asset class have a history of sometimes getting killed, and now is no exception. The issue at hand is risk tolerance, e.g. if your investments lose half their value, are you going to be okay?

In the end, diversification is a zero-sum game at best. If you are evenly diversified, when one asset class goes down, the other goes up. You lose money in one place and make it in another, but you don't gain any ground. You are static." (p. 8)

This is wrong too for two reasons:

1. Diversification lowers the volatility of your portfolio. If an investor diversified into bonds and lost only 15% when everyone else lost 30%, I can assure you the investor who lost only 15% will be happier than the one who lost 30%. When looking at investments, the "expected" (average) return is not the only thing you care about, and it's probably not even the most important. Diversification makes the worse case a lot less worse, which is hardly "static".
   
2. The investor who lost only 15% has more money, and now is in a much better position to exploit low stock prices than the investor who lost 30%.

Which brings me to the next quote:

"Rather than diversify, wise investors focus and specialize. They get to know the investment category they invest in and how the business works better than anyone else." (p. 8)

and later

"Don't diversify."

This is where Kiyosaki goes from simply wrong to dangerous. Telling an investor not to diversify is, to me, about the same as saying "why don't you bet your entire house on this hand of black-jack. It's a really, really stupid thing to do. It is astounding that he would put this in a personal finance book.

Of course, when you read what comes next...

"During this current financial crisis I took a few hits, but my wealth remainded intact. This is because my wealth is not dependent upon market valuesgoing up or down (a.k.a. capital gains). I invest almost exclusively for cash flow.

"For example, my cash flow decreased a little when the price of oil came down, yet my wealth is strong because I still receive a check in the mail every quarter. Even though the price of the oil stocks, capital gains, game down, I'm not worried because I receive cash flow from my investment. I don't have to worry about selling my stocks to realize a profit."

In other words, Kiyosaki invested in oil stocks, but he didn't lose his wealth when those stocks tanked, because he doesn't consider them to be part of his wealth. If this doesn't seem like the stupidest thing you've ever read, you need to read a book on basic accounting.

Now there is a grain of truth to this. If you have enough money to buy an investment that pays cash periodically and you never need that money back again, you only care about the cash it pays. But this strikes me as making a small fortune on wall street by starting with a large fortune. Let's imagine that Kiyosaki's oil stocks pay a 4% dividend. (That is a rich dividend, by the way!) If he doesn't count the principle (the stocks themselves) but only his cash flow, he will BREAK EVEN on the investment in just over 17 years. In other words, in order to truly ignore the value of the stock, he needs to hold the stocks for 17 years.

Of course, this ignores two huge problems: companies can cut dividends - they can go out of business. All sorts of things can go wrong. A bet that his dividend will stay at 3-4% for 17-24 years uninterrupted is a bad bet to take. The second problem is that there is an opportunity cost. Kiyosaki could have put his money in 2% TIPS (those are inflation-protected government bonds). In those 17 years, his TIPS will probably have doubled his money while he has only made up what he spent on the stocks with his oil stocks.

This is all a fancy way of saying that all investors with half a brain care about what happens to the principle, that is, the money they put in to start the game. It's too big of a chunk of money to ignore. There is no investment that pays such good cash flow that the principle is moot.

But my favorite is on page 10:

"The problem is that very few people know what derivatives are. To keep things simple, I explain derivatives by using the example of an orange and orange juice. Orange juice is a derivative of an orange - just like gasoline is a derivative of oil, or an egg is a derivative of a chicken. It's that simple: If you buy a house, a mortgage is a derivative of you and the house you buy."

Kiyosaki is correct about only one thing in that paragraph: apparently very few people know what derivatives are - and Kiyoaski is not one of them. I do know what a derivative is, and it's not that. A financial derivative is not a "processed" product like orange juice to oranges. A derivative is like a calculus derivative - an investment whose value is based on the change of a property of another investment.

(A stock option is a derivative - its value is based on how much a stock's value goes up - or down, depending on the type of market. A mortgage is not a derivative - it is a non-recourse loan. Fortunately web sites like investopedia can help.)

"Some of these new derivatives had exotic names such as collateralized debt obligations, or high yield corporate bonds, a.k.a. junk bonds, and credit default swaps." (p. 10)

Of the financial instruments on that list, only credit default swaps are actually derivatives. (A credit default swap's value goes up and down depending on the credit worthiness of a bond, that is, how likely is it that the bond is repaid.)

I think this quote from page 5 says it all: 

"Most people cannot tell a good financial advisor from a con man." 

Kiyosaki is 100% correct about that -- ironically it's why he may be able to sell this book.

Bob Vila is Tired of Getting Mugged

James Kwak has a great post about the AIG bonus money.  (The Baseline Scenario is one of my favorite econblogs...)  I'm not usually a fan of grandstanding and populist outrage winning out over pragmatism, but the AIG bonus situation is so outrageous that even I'm pissed off.

This year's bonus represents approximately 50 cents for every American.  That's not a lot of money...I just found two quarters the cats knocked off my desk, so clearly this isn't killing me. I think what is most offensive to me about the bonus money situation is that it took us (Americans, participants in our own financial system) such a blatant abuse to get our blood boiling. 

Apparently wall street doesn't just have to treat us like crap to piss us off, they have to do so after they completely trash the economy.

• If the economy is growing and wall street steals from us, we don't care.
• If the economy is growing, but wall street is stealing from us faster than the economy is growing, astoundingly we still don't care.
• Only if the economy crashes and burns hard and then they steal more from us do we get grumpy.

If there is a lesson for Wall Street CEOs and fund managers, it is this: take all you can during a boom - no one is paying any attention.

The problem is one of leverage.  $165 million is a lot for a small group of people.  But it is not much for the entire population of the US.  It's hard to say "I really want my 50 cents back"...it doesn't feel right.  And this is the problem with all of the ways that wall street takes our money: they take a little bit from us and it adds up to a lot for them.

Actually, it only seems like a little bit.  Consider one of my favorite rants: the lousy mutual funds that get passed off as savings vehicles for employee 401Ks.  If you are like my wife and get stuck with a lousy selection of 401K funds there's basically nothing you can do - don't use the 401K and you lose the tax incentive to save.

Consider the effect of a 1.1% expense ratio on your funds vs. a 0.1% expense ratio.  To make this simple, assume you invest $1000 in stocks when you turn 22, and then just leave it until you are 65.  What will your real (inflation-adjusted) result be when you retire?

If you invested in the cost-effective mutual fund, you have $11,763.22.  Not bad - for $1000 in principle you made $10,000 in returns!

But what about the 1.1% fund?  Should we be angry that the fund managers are syphoning off 1%?  1% doesn't sound like much.  But...in the same scenario, you end up with...

...$7,822.50.

Ouch.  33% of your returns are gone!  If you read a prospectus that said: we will take 33% of your retirement money, would you ever accept that?

So...perhaps we should be outraged about 1%.  Perhaps we should be outraged about $0.50. Because it starts to add up.  But more importantly, because the mindset that lets people syphon their 1%, their $0.50, is wrong and it's toxic.

Media Bias? Follow The Money

My views on media bias have changed from the days I used to work in commercial radio - the media business has changed too.  But this rant is directed at my favorite fish in a barrel, CNBC. Here's a taste of CNBC headlines:

• Bounce of The Century!
  
• Market Tips: Get Your Cash into This Rally
• Pros Say: Cash is Now the Riskiest Bet
• Hirschhorn: 5 Reasons to Get Back Into the Market

This from a network that was touting non-directional "absolute return" CDs.

I claim that CNBC's bias is toward advocating things that are bad for your financial health.  Market timing, active trading, complex, hard-to-understand investments with opaque fee structures, what's the connection here?

The answer is the advertisers...Charles Schwab, Fidelity, E-Trade, and off we go.  Wall Street makes its money in a number of ways, but the main way is by taking a piece of the action, often whether or not the outcome of the action is any good.  Examples:

• Investment banks take a fee for issuing bonds in a leveraged buy-out, even if the bought out company then craters under the weight of its own debt.
• Credit cards take 2.5% to 3.5% of everything from merchants, and then hit shoppers with 20% or more on an overdue balance.
• Mortgage brokers take a fee up front for a completed mortgage even if the home owner defaults.  The broker might take a bigger fee if the home owner takes a higher interest rate, regardless of whether this is good for anyone involved.
• Mutual funds take 1% of your money every year, whether their investments go up and down.  If they run up trading costs by trading like crazy, you pay that too.
• Hedge funds take 20% of the profit they make with your money.  They don't eat 20% of the losses.

So what is CNBC's bias?  I think it is to advocate strategies that create a "cut" for their advertisers.  If it wasn't they might say something like:

• Pick an asset allocation that makes sense for your financial goals.
• Build a portfolio using the cheapest vehicles that meet the asset requirements.
• Rebalance periodically, and let it sit.

And hrm...if you do that, you don't really care whether this is the bounce of the century, do you?

Let's Make Up the Biggest Number We Possibly Can

It must be fun to write articles about the derivatives market, because you can say things like "the derivatives market is now $75 octillion billion trillion dollars, or five million times the total wealth conceivable by Han Solo in Star Wars."

Okay, maybe not that much, but still, you can pick a really big number and then say some dire things.

I have blogged before that big numbers in financial reporting are often somewhat meaningless, and I suspect that the numbers being thrown around for the size of the derivatives market are similarly silly.  To illustrate, let's demonstrate how you and I can increase the size of the derivatives market by about $28 trillion.  It won't cost us much.

• We enter into a futures contract written against the US GDP.  Basically for every $1 of growth in the GDP from 2008 -> 2009 you will pay me $1 - for every loss, I pay you $1.
• We assign some kind of "value" to this contract based on the expected change in GDP (probably you will have to pay me to enter this contract - GDP is shrinking right now so I'm almost certainly going to pay you when the contract is up).

So we've exchanged some smaller amount of money based on the probably net change in GDP, and we've created a new derivatives contract with a notional value of $14,000,000,000,000.

Now we do the same thing again, but we reverse the direction.  (This is admittedly a very, very silly thing to do, but it is meant to illustrate a point.)

Now there are $28 trillion in new derivatives, and we are each in a position to make or lose exactly $0.  In financial terms, we are both "hedged" because our two derivatives contracts exactly cancel each other out.

The issue with the derivatives market is not how large it is notionally, but how well hedged all of the contract holders are.  It is possible that the major investment banks are not as well hedged as they thought (see what happened to LTCM), and in rarer cases they may not be hedged at all.  (See: AIG)

But the notional quantity of derivatives tells us nothing about their quality, which is what will really matter.

Madoff vs. LTCM

I've been trying to articulate this for a few days now...

There's this hedge fund...it returned too-good-to-be-true, above-the-market returns that were rock solid, never a blip.  Then one day people invested got a call: there's nothing left, the fund is wiped out, your money is gone.  If an investor got out of the fund early enough, they made a killing.  The ones who stayed in got nothing.

Am I referring to Bernie Madoff's ponzi-scheme of a hedge fund?  No -- I am thinking of Long Term Capital Management.

Madoff "blew up" his customers by paying old customers' pretend returns via new customers' pretend interest.

LTCM lost all their money by borrowing a ton of money and investing in international debt - the 1998 debt crisis caused bonds to do things their computers said was impossible, and they lost all their principle.

Here's what's bugging me: if you invested in either fund, the results are the same.  What Madoff done is clearly criminal; what LTCM did was pretty stupid (in hindsight) but completely legal. In both cases, people had to beg to get into the fund, everything was very secretive, and the methods were "too complex" for normal investors to understand.

Perhaps there is something fundamentally fishy about hedge funds if their normal investment behavior can look exactly like the results of a huge fraud.

Minor historical note: the principle managers of LTCM actually forced redemptions on some of their  customers.  The fund grew to a point where they had too much capital*.  The managers wanted to keep their own personal wealth in the fund, and as a result, they did their client what was in hindsight a favor and got their client's money out, while leaving their personal fortunes in the fund to get squashed.

* LTCM used leverage, that is, borrowing money cheaply, to amplify the effective return on investment.  Since there is a finite amount of money they could put into any given trade, they had to make sure their capital base was small enough that they could do the trade mostly with borrowed money, making the effective return on investment appear high.  Of course, it was that huge amount of leverage that caused them to go completely broke when the market went sour.

It's Not the Losses, It's the Fees

John Stewart had Jim Cramer as a guest last night and it was nice to see someone take a critical look at the meta problems of the financial news industry.  (What does it say about our media that the hardest hitting media criticism comes from Comedy Central?)

I think John Stewart captured "main street anger" toward the situation pretty well:

These guys at these companies were on a Sherman's March through their companies financed by our 401ks and all the incentives of their companies were for short-term profit.  An they burned the f---ing house down with our money, and walked away rich as hell.

I have to pick a bone with this though.  There is no question that the incentives of the money managers that got us here were grossly misaligned with the owners of that money (us).  And there are financial assets whose value has been destroyed that were not supposed to be destroyed.

But...the destruction in retirement savings has come about from the stock market plummeting. And, well, it's supposed to do that.  To me the problem is not that the stock market lost value, but that so many people were so heavily invested in it, perhaps beyond what was prudent.  (And you can't say that this was individual investors going crazy with E-Trade...pension plans, run by "institutional money managers", who are supposed to be well-trained professionals who know what they're doing, lost gobs of money too.)

I don't believe that it is practical to attempt to educate every citizen of the US to be his or her own certified financial planner.  We have professionals for that; I worry whether fiduciary responsibility has been lost.

But a bigger concern to me is not the losses, or the advice that got us into the losses, but the fees.  The financial sector makes its moneys by taking a cut, in the form of fees, whether they are percent of assets, percent of gain, or just fixed fees.  On every mortgage written, every security issued, every hedge fund and mutual fund managed, every stock and option traded, Wall Street takes a piece of the action.

So we should be concerned when growth in the financial sector is double the nation's GDP. That's another way of saying we're paying twice as much as we used to for our financial services. Proponents of securitization can make theoretical arguments about efficient deployment of capital, but if the industry as a whole is being more innovative and prices are going up, that's not the kind of innovation I want.

The side bets and trading and "fast short term dangerous money" that John Stewart rails against is not my main concern - I can simply stay out of it.  But the cost of doing business, the fees, the increasing price of financial services, to me that's the true danger, because they're taking our money, it happens all the time (good market or bad), and there is no indication that it's going to change because of what happened.

True Words About Facebook

My mother recently signed up for Facebook, and she wrote me this email:

Since I joined Facebook, I've gotten tons of messages saying people have confirmed me as a friend or relative but I still don't see the point of all this. Nobody has sent me a message that they could not have just as easily sent me by regular e-mail. I'm guessing I was already in all their address books. What's the point of all this???

Mom, there is no point. Facebook's most useful function is to allow office workers with uncontrolled internet access to waste time.

Robert Cringely's rant on Facebook spam is worth reading. Whenever I log in to Facebook (which is less and less often) I find myself ignoring more requests to join.

Hrm...now that I think about it, Facebook is really annoying. Can you imagine this kind of behavior in real life?

(Of course, that video was sent to me on Facebook.)

Who's The Sucker?

"Look around the table. If you don't see a sucker, get up, because you're the sucker." -- Amarillo Slim

A friend sent me this link...an "absolute return" CD.  What's not to love?

• Positive returns no matter which way the index moves.
• Guaranteed no loss on capital.
• FDIC insured.

An absolute return CD is a "structured CD" - that is, it's built out of a mish-mash of derivatives and other instruments that are complex enough that it's hard for the retail investor to understand what's going on here.  But I think Amarillo Slim has it right - if we can't see the sucker, better get up from the table.

I am not sure exactly how banks structure this investment, but a few things strike me as immediately problematic:

1. The investment is tied to an index, but synthetic instruments that track an index don't necessarily pay dividends.  The real historical long term return on stocks is around 6%, but a significant part of that is from dividends.  Lose the dividends and you're not really getting the kind of returns you'd get out of being in the underlying investment.
2. These structured CDs have a "barrier" feature.  Basically if the index exceeds some range band, you forfeit all of your interest - you only get your principle back.

This second point is easy for retail investors to ignore.  "If the market really tanks, I'm lucky to have my principle protected".  The fallacy here is to look at the possible returns (if the index tracks in-band) without considering the opportunity cost.  If I offered you a CD returning 0%, you would laugh at me, right?

And even worse, what if the market really out-performs?  Now the market is up and you get none of the up-side!  You don't even get interest.

From what I can tell, this "barrier" is necessary - that is, the banks couldn't offer you a track on the index in both directions without the barrier because the underlying derivatives that make the index tracking possible are more expensive than the interest you're not getting from the CD.

I looked up some S&P 500 option prices for six months in the future.  To create an investment that tracks the absolute value of the change of the S&P to an 8% gain or loss, we need to spend about 8.6% of our capital on the options contracts to make it work.  But the interest returned from the initial cash (in a fixed rate investment) is going to be a lot lower...less than 1% for treasuries, and certainly not 8.6%.

I figure the banks create a new derivative based on the fact that when the S&P goes out of the range they keep all of the returns and you only get the principle.  In other words, when the S&P is highly volatile, you gave them an interest free loan which they used to make money!  They can then write some kind of derivative that is backed by this "free money" and sell that derivative, to recoup the cost of the options above, and maybe make some profit.

One thing is clear to me though: if an absolute return CD is so complex that I can't even figure out how it might work, I certainly can't determine whether the expected return is a good price, or non-competitive.  (I don't even know what derivatives they use, so how do I know if I am being taken?)  I'm not going to buy what I can't evaluate!

(Of course, I'm also not going to buy what I saw on CNBC!!)