Текст книги "101 Things Everyone Should Know about Economics: From Securities and Derivatives to Interest Rates and Hedge Funds, the Basics of Economics and What They Mean for You"

Автор книги: Peter Sander

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Текущая страница: 10 (всего у книги 14 страниц)

68. COLLATERALIZED DEBT OBLIGATION (CDO)

Collateralized debt obligations are a form of ABS (see #67 Asset-Backed Security) that might be analogous to a stealth fighter jet compared to a small Cessna prop job. They are highly engineered, highly customized, securitized assets based on fixed-income securities, with mortgages again taking center stage in the recent boom.

What You Should Know

For the average consumer, CDOs are one of those topics that the more you know, the more you don’t know. As it turns out, that phrase also applied to many in the financial world who didn’t really understand nor could properly value the CDOs they bought and sold, and we now know the result.

Like ABSs in general, CDOs are carefully created packages containing underlying securities. A financial institution, and most likely a “special purpose entity” residing off the books of a major financial institution like an investment bank, would package a series of underlying assets into a security. These assets could be individual loans and mortgages, or they could be other ABSs. They were often called “structured investment vehicles.” But it would be too simple to stop there. The CDO was then divided into segments, or “tranches,” according to risk and rank of underlying assets, and these assets could be sold individually to other buyers. It gets worse—there were “synthetic” CDOs, “market value” CDOs, “arbitrage” CDOs, and “hybrid” CDOs; the financial engineering details are beyond the scope of this discussion.

The now-defunct Drexel Burnham Lambert engineered the first CDOs in the late 1980s. The market grew furiously in 2004–2006 as CDOs became the favorite tool to resell and transfer the risk of real estate mortgages. Buyers of CDOs included commercial and investment banks, pension funds, mutual funds, and other institutional investors seeking higher returns, which ranged from 2 to 3 percent higher than corporate bond rates at the time. Suffice it to say that, due to the complexity of these products, buyers often did not know what they were really getting.

The boom in CDOs is made clear by the statistics. In 2004 some $157 billion in CDOs were sold; that figure rose to $272 billion in 2005, $521 billion in 2006, $482 billion in 2007—then dropped to $56 billion in 2008 as the market came to appreciate the risks and complexities of these securities. It has remained somewhere near that size.

The lucrative fees paid to the creators of these securities helped lead to the boom and subsequent downfall. Investment banks and individual investment bankers made millions capturing their percentages of these securities as they were sold; the incentive was to build them as big, and sell them as fast, as possible. Those who created these products simply passed on their risks, which now have ultimately been borne or at least backstopped by the taxpayers. Now that these characteristics have come to light, it is likely that CDOs will continue to exist, but in a more transparent, standardized, and regulated form.

Why You Should Care

You’ll never be approached to buy a CDO, but it’s good to know what goes on in the world of high finance. Once the fallout from the credit crisis becomes clear and turns into appropriate regulation, transparency, and controls, CDOs should continue to be with us, although not at “boom” volumes, and their existence will help make credit more available to all of us.

69. CREDIT DEFAULT SWAP (CDS)

There are CDOs, CDSs, ABSs, MBSs, and more. The three-letter alphabet soup of high finance reached all-time proportions in the middle part of the first decade of the twenty-first century. It became hard to keep track of what these new innovations were, how they worked, and how they led to the financial downfall at the end of the decade. It’s especially easy to assume that CDOs and CDSs—credit default swaps—were much the same thing, but in fact they were quite different. We examined CDOs in the previous entry; now it’s time to move on to CDSs.

What You Should Know

A credit default swap is a special kind of derivative contract (see #66 Derivatives and Derivative Trading) in which the buyer pays a sum, known as a spread, for a contract specifying that if a certain company defaults on a credit instrument, like a bond or loan, the buyer gets a payoff. For example, a buyer might pay a spread of $50,000 to $100,000 for $10 or $20 million of default coverage. If this sounds like insurance, it is, and as a legitimate financial product, CDSs help bond buyers insure their risk.

Like insurance, CDS contracts were custom-written for the situation; they were not set up as standardized, market-tradable securities. And like insurance, most CDSs were developed and marketed by insurance companies. But unlike insurance, CDSs do not require the buyer to have an insurable interest—that is, a stake in the matter being insured. You can’t buy life insurance on your next-door neighbor, but you can buy a few million in CDSs on company XYZ without owning any bonds or stock in that company whatsoever.

Because buyers of CDSs did not have to have an insurable interest, CDSs were used as a tool to speculate on the demise of companies. At the same time, in a manner similar to CDOs, financial companies and the individuals who work for them make huge commissions and bonuses for developing and selling CDSs. Hedge funds, among other large investors looking to boost returns, bought CDSs. Also, insurers like AIG looked at them as a way to generate relatively low-risk cash by collecting spreads against what were felt to be highly unlikely defaults. This turned out to be a dangerous combination—a handful of employees in a UK branch of AIG sold CDSs with a face value more than twice the value of the entire company, and we now know where that led.

Making matters worse was the fact that many CDSs were written not just to protect against default, but against the change in a credit rating or any other change in a company’s financial condition. These triggers, to the surprise of most involved, were hit far more often during the financial crisis than anyone anticipated. CDSs were the primary factor in the $180 billion federal bailout of AIG.

JPMorgan Chase created CDSs in 1997; the face value of assets insured grew to some $45 trillion by 2007. Their spreads became a de facto indicator of a company’s financial strength—or weakness; it was the rise in CDS spreads for Bear Stearns in early 2008 that spooked the credit markets, starved the company of credit, and led to its forced sale to—ironically—JPMorgan Chase. Today, financial regulators recognize the need for CDSs to provide the insurance intended, but are examining ways to regulate the market, including standardization of contracts and trading on an open and more visible exchange.

Why You Should Care

Like CDOs and most other asset-backed securities, you probably won’t receive any offers to buy CDSs in your mailbox. But it’s important to know where our financial system troubles came from, and to know that even the best and brightest of our insurance companies got caught with their hands in the proverbial cookie jar. Most likely the lessons have been learned, but if you hear of heavy CDS activity from an insurance or financial services company you’re dealing with, look out.

70. MUTUAL FUND

You may have money to invest and you want to participate in the American economy, or perhaps other economies beyond American shores. But you don’t have millions; more importantly, you don’t have the expertise, the time, or the interest in becoming your own investment adviser. You just want to throw that job over the wall to someone else, and you’re happy to pay a small fee for the privilege.

That’s where mutual funds come into play for the typical consumer-investor today. Mutual funds are a popular vehicle for the investment of individual wealth, and have become a standard for investing retirement wealth, particularly the assets of 401(k)plans and other employer-sponsored retirement plans. Whether you intended to or not, you probably own a mutual fund somewhere, somehow.

What You Should Know

Mutual funds are the predominant form of what’s known as an investment company. Investment companies are investment pools designed to achieve certain investing objectives, usually to capitalize on growth, income, or some combination of the two. They were chartered under and are governed by the Investment Company Act of 1940. The act is very specific about how investors are treated, how the fund discloses results, and how investors are paid by these funds. Compliance is strong, because the act is actively enforced by the SEC (see #44). There are about 14,000 mutual funds in existence today, and they have become a mainstay of Main Street, especially for retirement plan investing (see #51 Retirement Plans).

If you’re a typical retail investor, you’ll probably have to settle for the fairly ordinary returns these funds generate. They’re largely safe, but tend not to outperform the market. They diversify your holdings, they’re convenient, and they save you a lot of time. They work well when you have modest amounts, say $50,000 or less, to invest. And they’re clearly better than not knowing what you’re doing and getting stuck with the wrong individual stock investments—like Enron, AIG, or Washington Mutual, for instance.

With mutual funds, you do indeed pay for their services. Management and marketing fees can be typically 0.5 percent to 1.5 percent of your investment balance—whether or not your investment does well. If you lose 20 percent along with the markets, you still pay the fee, albeit on a smaller balance. Mutual funds also may create tax surprises if held in taxable (that is, nonretirement) investment accounts. Each year they buy and sell stocks, and if there are gains, you pay taxes on those gains. Since the fund share price is based on the “net asset value” of all securities in the portfolio, if you buy shares late in the year after a good market run, you will pay a higher price for the shares—and pay taxes on the capital gains that the previous owner realized when selling you the shares! Thus, it’s better to buy mutual funds in the beginning of the year, and to do some research on the so-called tax efficiency of the fund—that is, whether they take shareholder tax considerations into account when buying and selling shares. Again, this is only for mutual funds not held in a tax-deferred retirement account—an IRA, 401(k), or some such.

Why You Should Care

Mutual funds are a good way for an individual investor to gain exposure to stocks, and to invest in challenging sectors of the market, like international stocks. Mutual funds make it much easier for the typical consumer to invest, and, along with the growth of individually directed and employer retirement plans, have indeed raised the share ownership among U.S. households from 10 percent or so in the 1960s to some 65 percent in 2007, but it has fallen off a bit to 54 percent in the wake of the Great Recession. Still, the high percentage of stock ownership is a good thing in terms of making capital available for businesses, and for allowing the ordinary individual to participate in prosperity. So far as mutual funds are concerned, like any product you buy, you should know what you gain and what you give up by investing in a given fund.

71. EXCHANGE-TRADED FUND (ETF)

Exchange-traded funds are an increasingly important and relatively new investment “product” designed, like mutual funds, to give you an easy, “prepackaged” way to participate in the world economy or certain segments thereof. Exchange-traded funds are closely related to mutual funds, but there are important differences. The first widely available ETF, the SPDR S&P 500 ETF Trust, commonly known as the “SPDR,” released in January 1993. Since then, about 1,400 new funds have entered the fray, with some $1.6 trillion in assets—a large sum, but still only about a tenth of what’s invested in the traditional mutual fund universe.

What You Should Know

Exchange-traded funds are pretty much what the name implies. Like mutual funds, they are groups or “pools” of investments that you can buy a share of for yourself. Unlike traditional mutual funds, their shares trade on exchanges, like the NYSE Arca electronic exchange. As such, the prices fluctuate throughout the day, and you can buy and sell them like any individual stock. So if you decide that agriculture is your thing but don’t begin to know which company to invest in, you can simply buy shares of the Market Vectors Agribusiness ETF (ticker symbol “MOO”) and let your investment harvest a few bushels of cash for you.

The 1,400 or so ETFs available cover a wide variety of market segments; you can invest in anything from agriculture to European stocks to bonds to physical gold to certain baskets of commodities priced in Australian dollars. Most ETFs own individual stocks, but some may own physical commodities or futures contracts for those commodities. ETFs can be grouped into General Equity (like the “SPDR” mentioned at the outset), International Equity, Dividend, Fixed-Income (mostly bonds), Commodity, Strategy (for example, low-volatility investments or companies that buy back their own shares), and Sector (companies in certain industries, like auto manufacturing).

Most ETFs are tied to specially created indexes; that is, rather than being actively managed by a fund manager (a professional human), they are simply modeled after a pre-existing index, like the S&P 500 indexes mentioned in the SPDR example. Financial firms have created indexes for almost anything; the index determines what investments are owned, and in what proportion. The ETF manager simply buys and sells securities in the open market to track the index. There are more than a dozen financial services firms offering ETFs to the public; the three largest and best known are BlackRock (branded “iShares”), Invesco (“PowerShares”), and State Street Global Advisors (“SPDRs,” now an entire family of funds).

ETFs offer several advantages to investors:

Low cost. Fees and expenses are typically half of traditional mutual funds.

Convenience. It’s easy to buy, sell, and rotate these funds during the day, and to own as many or as few as you want at any time. ETFs cover wide or narrow swaths of the market, making it easy to participate, say, in the economies of Eastern Europe, without becoming an expert or trading those securities directly.

Transparency. It’s easy to see and track what they own—that is, what you own.

Why You Should Care

ETFs are easy for individual investors, and offer a low-cost way to participate in the segments of the market best for you. They’re easy to use and an excellent and relatively safe way to diversify. For the economy as a whole, they provide a low-cost and lower-risk opportunity for many more investors to invest and participate. Availability and use of ETFs in employer retirement plans (like 401(k)s) is growing, so you’re more likely to run across them as investment choices if you haven’t already. But because it is so easy to rotate, they can cause faster swings in the markets and between different sectors of the market—in short and to a degree, ETFs “speed” change in the markets.

72. HEDGE FUND

Suppose you’re fortunate to have a great deal of “investable wealth.” A million or more, tens of millions, even better. You aren’t content to just perform with the market. And picking individual stocks and managing your own investments just isn’t your thing. You want to be “in” with the big boys, scoring way better than average returns. You want 10, 15, or 20 percent or more, rather than the 5 percent everyone else is settling for. You want to invest the way other rich, famous, and privileged people do. A hedge fund might be your answer.

What You Should Know

As it turns out, hedge funds are the privileged-class answer to the ordinary mutual fund. In the interest of not meddling too much in the world of private wealth and capital, the 1940 act has two commonly used exemptions excluding certain types of funds from close regulation. These exemptions gave rise to what are now known as “hedge funds.” As a result, hedge fund governance is limited primarily to two areas: who can invest and how they’re sold. The early hedge funds did what the name suggests—they helped investors “hedge” against market downturns or other unforeseen events, because rules and predominant investing strategies made it difficult for ordinary funds or individual investors to do so.

There are two types of funds that exist under these relatively light rules. One type of fund is limited to 100 or fewer investors, and can only be marketed to investors with more than $1 million in investable assets, or verifiable income exceeding $200,000 a year. The other can have an unlimited number of investors, but each must have $5 million of investable assets. The first type doesn’t have to be registered with the SEC at all, the second only if it has more than 499 investors. Furthermore, there’s no requirement for the managers of either type of fund to be registered or otherwise qualified or credentialed with the SEC, or with any other regulatory body or trade organization. For most of their existence, the rules stated that neither type of fund could be “offered or advertised to the general public,” but that rule was overturned in mid-2013 by the SEC, and advertisements will be permitted going forward.

As a result, hedge funds are largely left to do what they want, and the managers can charge some pretty hefty fees for their services. Common was the “2 and 20” compensation rule, where the manager is guaranteed a fee of 2 percent of the fund’s net asset value plus 20 percent of the investment gains over a specified amount. That’s a pretty powerful incentive.

Without close regulation, hedge funds are allowed to sell short, borrow money, and invest in “derivative” instruments like futures and options to enhance returns. Effectively, they can leverage their portfolio, controlling, say, $10 million in assets with, say, $2 to $5 million in equity. That’s great when things are good, not so great when things go bad. Bottom line: hedge funds allow wealthy investors to chase high returns using exclusive private investments administered by managers with few boundaries, who tend to chase the highest returns possible to get the biggest fees. It’s a potent combination for success, but also for failure.

Why You Should Care

Despite some of the horrendous losses incurred by some hedge funds in the Great Recession, not all hedge funds are bad, and they do bring a lot of capital to market from the coffers of the wealthy. However, their power and numbers, some 10,000 funds managing some $2.5 trillion in assets, can cause some pretty outsized market moves and distortions, such as the oil price run-up in mid-2008. When markets do well, most hedge funds do well—and vice versa. When things start turning south for hedge funds, because of leverage they’re often forced to dump conservative investments, a factor that probably amplified the 2008–2009 stock and commodity market collapse.

Legislative attempts have been made to regulate hedge funds, and the 2010 Dodd-Frank Act (see #39) started to require managers of larger hedge funds with more than $150 million in assets and/or more than fifteen clients to be registered as Registered Investment Advisers, but not much else has happened in terms of regulatory oversight; hedge funds are still mainly in the “Wild West” corner of the investment markets.

73. PRIVATE EQUITY

Private equity is a general term for equity, or stock investments in businesses not traded on a stock exchange. Private equity is an important source of investment capital for distressed firms or brand-new companies, because they don’t have to go through the rigors of public listing, accountability, and disclosure. Venture capital, investments made in new business ventures, is one form of private equity.

What You Should Know

Private equity companies can be firms or funds that typically get their money to invest from large institutional investors or very wealthy individuals, and in turn make investments in or acquire companies outright. Private equity firms may acquire already existing “public” companies or the majority of a company through leveraged buyouts (see #74), and usually use venture capital to take a smaller stake in order to minimize their risk.

For sure, private equity firms and their investors don’t make their investments out of the goodness of their hearts; they are looking for a return, typically a substantial one, on their investments. If they simply wanted stock market or fixed-income returns, they would invest in stocks or fixed-income securities. Most private equity deals, including venture capital deals, seek to earn a large return, either by harvesting profits from the companies they invest in, or by selling them at a better price at maturity or after a turnaround.

Private equity was made famous by the many so-called “corporate raiders” who emerged in the 1980s—Carl Icahn, T. Boone Pickens, Kirk Kerkorian, Saul Steinberg, and others. These investors would buy large stakes of a company, in some cases enough to get themselves or their own people on the board of directors, and push for change. If successful, and especially if they employed leverage by borrowing to help finance their purchase, they reaped enormous profits. But that strategy didn’t always work, as shown by the recent experience of Cerberus Capital Management, which bought Chrysler out of the Daimler-Chrysler merger only to put it into bankruptcy shortly afterward. More recently, Michael Dell teamed up with private equity investor Silver Lake Partners and certain other investors, including Microsoft, to buy Dell and take it private—such transactions and attempted transactions are not infrequent. Beyond Cerberus and Silver Lake, some of the larger names you’ll read about in the private equity space today include Kohlberg Kravis Roberts (KKR), Bain Capital, Warburg Pincus, the Carlyle Group, and the Blackstone Group.

Why You Should Care

Private equity is important—and has become more important—as a source of corporate capital over the years. More often than not a company that “goes public”—starts selling shares to the public to trade on a stock exchange—has gone through a considerable incubation in the hands of private equity. You should know that when that firm goes public, it’s a sign that the private equity firm has maximized its return on investment—which may not bode well for the company’s immediate future. Also, while private equity serves a useful purpose in rescuing failing companies (when successful), when that company is taken public again, it may not be the best time to buy. Finally, there have been some cases where firms have been bought strictly for the short-term gain of the individual or private equity firm, then plundered for their cash and assets. Watch carefully if you invest in—or work for—one of these firms.

74. LEVERAGED BUYOUT (LBO)

Want to sound suave and sophisticated at a cocktail party when the subject comes around to finance? Just mention the words “leveraged buyout.” A leveraged buyout is simply the purchase of a company by another company using “leverage,” or borrowed money.

What You Should Know

The acquiring company may be a company in the same industry, or it may be a conglomerate or holding company (like Warren Buffett’s Berkshire Hathaway), or a private equity firm specializing in LBOs. The borrowed money may come from traditional sources like banks or investment partnerships. Sometimes at least some of the money may come from the cash coffers of the company being acquired, and sometimes it may come from selling off some of the acquired company’s assets. Finally, the acquired company’s assets may be used as collateral on any debt issued to make the transaction. In some cases, an investment bank (see #28) might put together a consortium of lenders. Typically the debt ranges from 60 to 90 percent of the purchase price, and any debt issued in an LBO is considered high risk.

LBOs are more likely to be used when the acquired company has significant cash, stable cash flows, or quality “hard” assets that can be sold or used as loan collateral. Acquiring firms are often looking for good corporate assets in need of a turnaround, new management, or other operational improvements.

LBOs hit their stride in the 1980s, culminating with the $31 billion buyout of RJR Nabisco by LBO specialist KKR in 1989. The next big wave of LBOs hit during the 2005–2007 boom, with such names as Equity Office, Hertz, and Toys“R”Us being “taken out” by various acquirers.

More recently, leveraged buyout activity continues at a brisk pace because of relatively cheap borrowing rates, but no real big names have been “taken out.” Some have involved major parts of companies, such as a recent $4.8 billion buyout of DuPont’s auto paint business by the Carlyle Group.

Why You Should Care

LBOs have changed the corporate landscape, affording more companies more power to make more acquisitions, and cleaning the corporate “forest floor” of some companies past their prime. If you work for a company that is a target of an LBO, watch out; the acquiring company may look to streamline and trim assets (including you).

75. INSTITUTIONAL INVESTORS

Institutional investors are large organizations, public or private, that amass funds for an assortment of purposes and invest them in the markets. Their objective in most cases is to invest money on behalf of others, and their success is determined by market performance.

What You Should Know

The importance of institutional investors becomes clear when looking at some of the different types of institutions:

Pension funds are among the largest and most influential groups of institutional investors. Not surprisingly, their objective is to build assets to fund retirements of private and public employees, although today more private retirement savings plans (see #51 Retirement Plans) are self-directed, like 401(k) plans, and are thus more likely to come into the markets via mutual funds. In 2012, total worldwide pension fund holdings were estimated at $30 trillion, with 79 percent of that in the United States, the United Kingdom, and Japan.

Mutual funds are investment companies that invest on behalf of individual investors (see #70). Worldwide mutual fund assets totaled about $17 trillion in 2010.

Insurance companies invest assets—collected premiums—in the markets to achieve growth, pay insurance claims, and ultimately (if things go right) reduce the premiums. Insurance company investments are typically fairly stable, but in the wake of major disasters, insurance companies may sell sizable chunks of assets to pay claims, which can cause some short-term pain in the markets.

Sovereign wealth funds (SWFs) invest funds on behalf of their nations. Many such funds, like those in the Middle East, are simply investing surplus government reserves; some may also cover public pension obligations in their countries. One estimate puts the worldwide total at $5.2 trillion. SWFs made headlines for large investments in banks weakened by the economic crisis, but some SWF investments are a little more glittery—witness the 5.2 percent stake in Tiffany owned by the sovereign wealth fund of Qatar.

Other types of institutions include investment banks and trusts, and some refer to hedge funds and private equity as institutions.

Why You Should Care

Institutions still make up the lion’s share of stock, bond, and commodity investment in the markets. They weigh heavily on market performance and overall economic performance, and on the allocation of capital to public and private enterprises. Your fortunes in these markets will depend in part on what institutions are doing, and in some cases, like insurance investments, investment performance may affect your personal finances.

76. MONEY MARKET FUND

Money market funds (MMFs), or money market mutual funds, specialize in investing cash assets in short-term securities to provide investors with slightly higher returns than banks, and liquidity—that is, unrestricted deposits and withdrawals. As a place for investors to park short-term cash, which is then used by public and private enterprises to fund short-term operations, money market funds perform a vital role in the economy.

What You Should Know

Money market funds are technically mutual funds, regulated by the Investment Company Act of 1940 (see #43) and subject to price variations based on performance of underlying assets. However, because money market funds invest in very price-stable, short-term debt securities (usually a “weighted average maturity” of ninety days or less), the asset base is extremely stable. As a result, the price of most money market fund shares is $1, and it is highly unusual for such a fund to “break the buck.” It did happen, however, to two funds in the 2008 crisis as a result of investments they had made in failed investment bank Lehman Brothers. Reserve Primary Fund fell to ninety-seven cents and the other, BNY Mellon, fell to ninety-nine cents—so you can see how stable these holdings are.

Most money market funds pay yields based on short-term interest rates, which in 2013 were practically nothing, below 0.2 percent in most cases. In more normal interest rate environments, money market funds pay 0.5 percent to 1.5 percent more than comparable bank savings instruments.

Money market funds are different from the assortment of money market accounts (MMAs) offered by banks. The bank MMAs pay slightly less than MMFs, but are not for the most part covered by FDIC insurance (see #45 Federal Deposit Insurance Corporation). Most money market funds are sold by mutual fund companies or are available through brokers, retirement plan administrators, and others. Most money market funds are taxable—that is, the interest earned is taxable—but some are based on government securities (for stability) or tax-exempt securities (for tax preference). Most MMFs charge modest fees, but in today’s low interest rate climate, even a tenth of a percent makes a big difference.