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: 12 (всего у книги 14 страниц)

Although we’re dealing with a small business, not a big, publicly traded corporation, you’ve been a victim of insider trading. An insider got information you weren’t privy to, and made money on it. What happened here isn’t technically illegal because the ice cream parlor wasn’t “public,” but it gives you an idea of what could happen when owners, directors, key managers, or employees disclose certain private information to privileged investors and not to everyone.

What You Should Know

Insider trading is the illegal trading of a public company’s stock or other securities based on “insider information”—information acquired as, by, or from someone who creates or has access to privileged information about a company not available to the general public. “Insiders” include company officers, directors, or beneficial owners (more than 10 percent) of a company’s stock. The general rule is that employees, by virtue of employment, put shareholder interests ahead of their own—all shareholders’ interests—so disclosing inside information to certain shareholders violates this principle.

That said, especially in today’s teleconnected world, you can see how easy it would be, say, for a large hedge fund manager or individual investor to get—or even buy—the “inside scoop” from even a fairly low-level employee and trade big on the tip. Think of what someone in a financial reporting, sales, or even a shipping department might know about a company’s products and prospects. Think of what professional securities analysts, who make their living talking to companies and following their fortunes, might know, act on, and disseminate illegally before the general public finds out. Think of what politicians and government officials, who might know what contracts are coming up or what purchases are about to be made, could do.

Several high-profile insider-trading cases have come up in recent years, and recent rulings have strengthened the hand of regulators to go after the perpetrators. Former hedge fund manager Raj Rajaratnam was sentenced to eleven years for his role in an insider-trading ring, where he set up at least four different insiders, three of whom were Harvard classmates, to pass information his way. This high-profile case has led to a greater crackdown on the activity, but it remains difficult to enforce, and especially to gain convictions. Still, the prospects of greater enforcement and jail terms have sent a powerful signal to corporate executives about disclosing anything that might be considered sensitive information.

Why You Should Care

First, if you’re an investor, know that you’re putting a lot of pressure on your friends and colleagues if you ask them to tell you what’s going on in the companies they work for. And if you work for a public company, be careful about what you tell others around you. Aside from that, insider trading has led to untold millions in profits for the perpetrators, at least indirectly at your expense. On the flip side, many feel that the recent crackdown has led to faster disclosure of information to the general public (once available to everyone, it isn’t “insider” any more), a good thing for all investors.

86. MARGIN AND BUYING ON MARGIN

Buying on margin refers to borrowing from your broker to buy a security, usually a stock, a bond, or a futures contract. The security, or other securities in your portfolio, is used as collateral. When you borrow to buy on margin, you pay margin interest rates set by the broker, usually a fairly high rate, but not as high as a credit card. Margin buyers are trying to buy larger positions than they can afford out of pocket in order to get more exposure—leverage—from their investments.

What You Should Know

To buy on margin, you must set up a margin account with your broker. Typically that means depositing a certain amount and signing several forms indicating you understand the terms and conditions. This can be done online with online brokers. And not all securities are marginable; some low-price or risky stocks, for instance, do not qualify for margin buying.

When you buy a security on margin, you must have enough collateral to make the purchase. This test comes in the form of a margin requirement, 50 percent for stocks, set by the Federal Reserve in the wake of the 1929 stock market crash. That means you must have at least 50 percent of the entire purchase available in your account as cash or equity. This is, of course, to prohibit you from borrowing too much, as many did in 1929 and before, when they borrowed up to 90 percent of their securities purchases.

That 50 percent requirement only applies to the initial purchase. After that, rules set by your broker apply. There is a minimum maintenance requirement below which your equity portion will trigger a sale or a request for more equity (cash) to be whole—this is a margin call. A typical minimum maintenance requirement is 35 percent, meaning that once your equity falls below 35 percent of the entire stock position, you get the call. So if you buy 100 shares of a $10 stock for $1,000, you can borrow $500 of the $1,000. If the stock drops below the point where the equity portion of the investment is 35 percent, you’ll trigger the call.

What is that price? The formula is: Borrowed Amount/(1−Maintenance Requirement). Got that? So if the maintenance requirement is 0.35 and you borrowed $500, the formula would give you the total securities value to match 35 percent, in this case $500/(0.65), or $769.23. That means that if your $10 stock goes down to $7.69, you will get a margin call.

Margin positions are evaluated each night for sufficient equity. The calculation of margin sufficiency is more complex with multiple securities in an account. Also, this example applies to stocks; the initial and maintenance margin requirements are different for commodities.

Why You Should Care

Margin can add power to your investment portfolio, but like any other borrowing, it can be dangerous, and should be treated accordingly. Margin interest rates, while moderately high, can be lower than some other forms of short-term borrowing, so it might make sense to use margin to get some cash from your investment account for certain purposes. On a larger scale, when stock margin borrowing levels increase in aggregate, it’s a sign that too many people are speculating on stocks and that a bubble might be forming, leading to a bust later on.

87. SHORT SELLING

Short selling in financial markets is the practice of borrowing a security, usually a stock, and selling it in the market. The idea is to borrow and sell with the hopes of buying the security back, or covering, later at a lower price. It is done when you think the price of the security is too high. Note that short selling means something different in real estate (see #90 Foreclosure/Short Sale).

Short selling made the front pages during the height of the 2008–2009 market meltdown, when large hedge funds and short sellers drove down the prices of certain stocks, mostly in the financial sector. It was felt that short sellers “ganged up” on some of these stocks, creating an unnatural downward momentum. During that time the SEC initiated some short selling curbs on certain financial stocks, but many feel that such artificial curbs don’t have much real effect on the markets—a “sick” stock will go down anyway, with or without the curbs.

What You Should Know

In stock market parlance, “going long” means you are buying the security; by “going short” you effectively own a negative quantity of a security. You owe the security and will pay margin rates (see #86) to borrow it, with many of the same margin rules in effect. In normal practice, you borrow the security from a real lender, arranged behind the scenes through the broker network. The lender is entitled to receive any dividends that may accrue during the borrowing period, and of course, to receive the shares back once the short sale is covered.

Short selling is inherently risky. Why? Because a stock can only go to zero on the downside, but rise, theoretically, to infinity on the upside. If it rises “to infinity and beyond,” you’re liable for the entire amount of that rise from the price you shorted it at.

Most short sellers are knowledgeable and seasoned professionals who employ good risk-management techniques to control potential large losses. In recent years there has been a rash of “naked” shorting, where sellers sell shares they don’t borrow or have (sometimes such shares can be in short supply). Naked shorting probably exaggerated the slide during the financial crisis.

If a stock or other security is being sold short, that isn’t always a bad thing for investors in that stock. Active short selling does mean that some investors—probably pretty good ones—are betting against the stock. It also adds supply to the market, driving prices down. But all shares sold short must be bought back, or covered, eventually, so assuming your company isn’t going bankrupt, that demand will all come back to market sooner or later.

Why You Should Care

Short selling serves a useful purpose in allowing individual investors to bet against a stock or company. It also adds liquidity to the market, and prevents the market from rising beyond reality—it is sort of a check and balance on the markets.

Unless you’re a fairly active and knowledgeable investor, short selling probably won’t be in your bag of tricks. If you do sell short, you must choose wisely and be prepared to follow closely. When short selling becomes rampant in a market (not always easy to tell, for so-called short interest statistics are published only monthly), it’s a sign of a “bear,” or down, market. The reversal of a short selling pattern can be quite sharp to the upside, as short sellers rush to cover; this phenomenon is called a short squeeze. In sum, short selling isn’t for the faint of heart; neither is owning stocks that are short seller favorites.

88. MEDIAN HOME PRICE

If you’ve been reading along, we’ve covered about every financial and financial market topic except real estate. For this and the next three tips, real estate assumes center stage.

Real estate is both a commodity and an investment. As a commodity it serves a useful purpose, and its price reflects the laws of supply and demand. As an investment, it requires an upfront purchase to generate cash returns later, either as income or as a capital gain upon selling the property. If you own your own home, those “cash returns” come in the form of rent you don’t have to pay.

Real estate markets operate quite differently from other financial markets. As the saying goes, “all real estate markets are local.” Aside from real estate investment trusts (REITs) and other investment vehicles, each piece of property is unique, and its price is determined by the supply and demand in that local market, as those of you who have tried to buy beachfront property or a home in the most expensive neighborhood in town already know.

Still, like all markets, we need some kind of pricing benchmark—like a market index, a commodity futures price, or an exchange rate—to know where that market stands compared to its past, and to determine how affordable a certain property is. That’s where median home price enters the picture.

What You Should Know

Median home price is a statistics-based figure used to measure pricing in a given area. That area can be nationwide, regional, by state, by city, or even by neighborhood. For that geographic segment, the median home price means that half of the homes in a given area sold for more than the median price, and half of them sold for less.

If the national median price for single-family homes was $199,000 in mid-2013, that means that half of all of the single-family homes sold for more than $199,000 (think of those fancy mansions on the beach in Malibu), and half of them sold for less than $199,000 (think of the large numbers of modest homes in, say, St. Louis). That figure was over $230,000 in 2005 but dropped to $169,000 in 2009, so you can see how much the real estate market has fluctuated in recent years—and in many markets like Las Vegas and Phoenix it has fluctuated quite a bit more than that.

Median home prices are calculated by several agencies, the most prominent of which is the National Association of Realtors (NAR). The NAR publishes a quarterly list of Median Sales Price of Existing Single-Family Homes for Metropolitan Areas, with data stretching back to 1979. See www.realtor.org/topics/metropolitan-median-area-prices-and-affordability/data and other resources on that site.

Why You Should Care

Median home prices affect you as a homebuyer on a few levels. Of course, it is a quick read on the real estate market, and whether your home is worth more or less than it was, say, this time last year. Since medians are just that—medians—it’s important to look at median prices in your city, and better yet, in your neighborhood, to get an idea of your home’s worth.

You might also consider the varying regional median prices as a litmus test for where you can actually afford to live. While the national average as of mid-2013 is $199,000, you can look at prices, and the inventory and sales figures, which affect prices, in your city at the National Association of Realtors databank mentioned above. You can get median prices at your neighborhood level on Zillow (www.zillow.com).

89. HOUSING AFFORDABILITY

Can you, or anyone else, afford a home in your area or in another area you might be hoping to live in? Clearly that’s not an easy thing to figure out. Equally clearly, your ability to afford a home in a certain area is a function of your income, and the average incomes of those in that area. So to determine affordability, economists and real estate professionals take the median home price for any given area and compare it to the median income for the same area to determine whether or not the housing stock is actually affordable. Can the people who live and work there actually afford to buy what’s on the market?

What You Should Know

The measurement of home prices was covered in the previous entry. But these home prices don’t exist in a bubble; they exist in real communities that have real people with real jobs and incomes, and affordability actually lies in whether the average Joe in any given place can afford to buy at the median home price. If the median price for an existing single-family home in the West is at present $247,800, how many of the folks in that area make enough money to be able to comfortably afford that price?

In addition to median home prices, the NAR publishes the Housing Affordability Index. This index takes into account several factors, and gives you an idea of what it takes to afford a house in any given region.

The index, which is calculated over time and by region and is available at www.realtor.org/topics/metropolitan-median-area-prices-and-affordability/data under “Affordability Data,” compares median home prices to median income and determines whether the median income affords exactly the median home (index=100), affords more than the median home (>100), or affords less than the median home (<100). Factors included in the affordability calculation include the median price, the average mortgage rate, monthly principal and interest payment (P&I), payment as a percentage of income, the median family income, and the qualifying income. The calculation assumes a down payment of 20 percent and a total P&I payment not exceeding 25 percent of median income.

Here’s how the calculations work. Suppose we want a snapshot of housing affordability in the Midwest for example. Assuming a standard 20 percent down payment on a single-family house with the current median price of $143,100 at a mortgage rate of 3.66 percent and a thirty-year, fixed-rate mortgage (360 payments), the monthly P&I would be $526. This would be 10.1 percent of the $62,359 median family income in that area. In order to qualify for that loan you would have to have an income of $29,088, giving an affordability index of 206. So, is Midwest housing affordable based on this measure? You bet.

Why You Should Care

Housing affordability, like the median home prices, can help you determine whether a certain area or region can provide the kind of lifestyle you want at a reasonable price. Of course, beyond median family incomes, whether you can afford an area depends on what you earn, not the averages, and it depends on the home you choose. Still, housing affordability helps you make important lifestyle choices, and it also helps indicate whether real estate prices in a locale are in line with reality.

90. FORECLOSURE/SHORT SALE

Not too long ago, the words “appreciation” and “opportunity” were the first to come to mind when the topic of real estate came up. Then came the bubble and the bust, and the words “foreclosure” and “short sale” dominated the listings and the conversation. Since then, the number of foreclosures has dropped significantly, but they still stubbornly remain an important part of the market, at least for the time being.

Foreclosure is a formal process that occurs when an owner cannot pay the mortgage on a property, and ultimately transfers title on the property from the borrower to the lender. A short sale is designed to “short circuit” that process; it’s an arranged distress sale to avoid the foreclosure. Both processes serve to get distressed owners out of an untenable situation, typically with both the lender and the borrower losing some in the deal.

What You Should Know

Foreclosure is a lengthy and costly process that typically starts with a notice of default, which goes out when a payment is 60–90 days overdue. At that point, as an owner/borrower, you still have time to cover the obligation or arrange an alternative. After 90–120 days, the notice of default turns into a notice of sale where a court determines that a lender can start sale proceedings and evict the owner. When the title is transferred to the lender, it is known as real estate owned (REO), especially if the lender is a bank. Banks and other lenders, as a result of the huge numbers of foreclosures that occurred in 2008–2010, ended up owning far more property than they knew what to do with (see #88 Median Home Price). Just as bad, the foreclosure process is estimated to cost the lender some $50,000 to $60,000 to carry out.

Because of the glut of REO and the cost of fully pursuing foreclosure, many lenders opted to accept proposed short sales. A short sale is a negotiated deal between the borrower/owner and lender to accept a lower price on a sale to a third party, and in turn the lender is willing to accept less than the full amount owed for a property on which they hold the mortgage. Often the seller has little or no equity and might even owe more than the property is currently worth, and the seller usually must convince the lender that the situation is due to financial hardship. Regardless, it can be a win-win, for the borrower/owner gets out of the home and doesn’t take the hit of a foreclosure on the credit record, while the lender doesn’t take on any more REO, saves fees, and doesn’t have to worry about property deterioration while held as REO.

A borrower/owner must approach the lender for the short sale; the lender will not propose it. The owner must also show effort in trying to sell the property for market price for some period of time.

Why You Should Care

You don’t want to go through foreclosure, if at all possible. Not only do you lose your home and any equity you might have built up in it, but your credit rating can be blemished for as long as ten years. If you’re in trouble, you should evaluate all options, including short sales, deed in lieu of foreclosure (where you simply hand the keys back to the bank), and an assortment of government programs that continue to be in force, although they tend to have fairly strict qualification guidelines.

It’s also worth learning the mechanics of foreclosure if you’re a buyer. Foreclosures and short sales signal opportunity, and if you play the game right, you can still get a bargain. Most local realtors have developed the skills and knowledge (by necessity!) to deal in foreclosed homes.