Barack’s Reforms make Big Banks Cry

Being that I own hordes of bank stocks in my personal portfolio -- and that I work for one -- you might expect me to decry President Obama’s recent pronouncement that big banks will no longer be allowed to engage in certain high-risk trading. On the contrary, I think it’s a perfectly acceptable idea, one that Wall St. professionals have known the practicality of for years.

In 1987, when markets crashed and big banks were “saved,” many thought that this set a dangerous precedent. It was believed that banks, confident that they would be bailed out no matter what their level of gambling, would start acting like hedge funds and go for broke. And they did.

So, while I am dismayed that my annual investment returns may decline a few points due to the proposed changes, I am also grateful that I won’t come back from the bathroom to find my stocks down 80%. In short, I expect my U.S. bank stocks to become more like the banks themselves: large, boring, and immensely profitable.
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“If we bail out this one (Penn Square Bank)…then the markets will know that, no matter what risks they take, the government will bail them out. Eventually, it’s going to lead down the road to nationalization of the banking system.” William Isaac, FDIC chairman, July 1982.
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“CMO equity is a particularly slippery mortgage investment. The CMO stands for Collateralized Mortgage Obligation, but bond salesmen call it ‘toxic waste.’” Michael Lewis, The Money Culture
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“I would confidently predict that most of the derivative books of major banks cannot be liquidated for anything like what they’re carried on the books at. When the denouement will happen and how severe it will be, I don’t know. But I fear the consequences could be fearsome.” Charlie Munger, Poor Charlie’s Almanac, 2005
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The Canadian Housing Market

The bubble is back.

Not content with a single housing bubble, Canadians have apparently decided to ignore reality and give it a second go, especially in Vancouver. Just a few days ago, my mortgage broker confirmed that, just like in the bubble years, multiple bids on properties are back with a vengeance. A typical, two-bedroom bungalow/rancher in the West Side is now priced at 1.3 million dollars, right back to where it was at the peak in 2008.

A few different factors are responsible for this brutal overpricing. First is the typical Vancouverite’s belief that theirs is the greatest city in the world. Granted, Vancouver is a nice place. But, everyone seems to believe the city is so spectacular that Olympic visitors will return to London, Paris, Tokyo etc. and immediately put their homes up for sale so they can move to Vancouver.

Second and more important is the Asian factor. In Vancouver a substantial number of immigrants, mostly from China, are buying residences primarily or completely in cash. Cash purchases are a big factor in propping up high prices; however, they are an even bigger factor in the decision making process for local buyers. Vancouverites are convinced that because of immigration, prices cannot drop; therefore, any price is justifiable, as one will always find a buyer at that new higher price (in economics, this is known as “greater fool theory.”)

Finally, the average Canadian is making a mistake typical for those who know little about finance: they are concentrating on monthly payment amount instead of amount of debt owed. To the financially naive, owing $500,000 at a 2.25% variable interest rate with a monthly payment of $1718 is better than owing $400,000 at a fixed rate of 4% with monthly payments of $1763. More importantly, people are not aware that today's 2.25% variable interest rate, and the resulting barely-affordable monthly payment, will soon be going up.

The governor of the Bank of Canada, Mark Carney, is trying his best to send out the warning ("It is the responsibility of households now to ensure that in the future, when the recovery takes hold and extraordinary measures are unwound, they can service their debts”), but it’s largely falling on deaf ears. While Americans have spent the last two years paying down their credit card and mortgage debt, Canadians have been busy racking it up. The Bank of Canada estimates that by the 4rth quarter of 2011, Canadian personal debt payments will reach record-breaking levels (shattering the previous record set in 2000).

Of course, after the housing bubble bursts for the second time, we’ll probably hear a chorus of, “It’s the fault of the banks. They shouldn’t be approving these loans in the first place!” As a banker, I can say without hesitation that trying to tell a customer they can’t afford to buy their dream home is like telling a child they can’t have ice cream: they throw a tantrum, threaten to run away (take their business elsewhere), and frequently do exactly that. If the next bank doesn’t approve them, they will keep trying until someone does, eventually lying about their assets or income if necessary. People don’t seem to realize that when your banker (who wants to give out loans) tells you that you can’t afford it, maybe you should listen.

And so, the bubble grows…

Mutual Fund 101 - Part II

This is the second post in the series of how to choose mutual funds for investment. Part I covered the very basics (what is a mutual fund) and common terms needed for this article. So now, on to the types of funds themselves and when to buy them…

Money Market Fund – These are very safe, low yielding funds that primarily invest in short-term government bonds and established companies. They are so safe that on financial statements they are considered “cash,” not “investments.” They are not a place to put your money for a long time since returns are low, and may not even beat the rate of inflation. Time Horizon: 6 months-2 years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: very low

Bond Fund – “Bonds” are essentially loans that you give to a company. In return, these companies pay you interest. A bond fund is a nice mix of short- and long-term bonds of good companies that pay a rate of interest beating inflation. Almost everyone should own at least some bonds in their investment portfolio.
Time Horizon: 2-3+ years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: low to medium

Short-term bond fund – These funds invest primarily in short-term bonds (generally loans that mature in less than 3 years). Short-term bond funds fluctuate in value less than regular bond funds, but also pay less interest. They are a good short-term investment.
Time Horizon: 1-3 years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: very low to low

World/International Bond Fund – These bond funds invest in companies all over the world. Since keeping track of the world takes more work, MERs are higher, and world bond funds thus generally under perform. World bond funds tend to fluctuate in value more than regular bond funds.
Time Horizon: 2-3+ years; Best time to buy: growth phase; Worst time to buy: Post-crash (since interest rates are low); Volatility: medium to high

Long-term bond fund - These funds invest primarily in long-term bonds (generally loans that mature in more than 5 years). Long-term bond funds fluctuate in value more than regular bond funds, but also pay more interest. They are a good long-term investment.
Time Horizon: 2-3+ years; Best time to buy: growth phase to bubble phase; Worst time to buy: Post-crash (long-term bond funds lose value when interest rates begin to rise); Volatility: medium to high

High-Yield Bond Fund – A bond fund that intentionally invests in low-quality companies that may be close to bankruptcy. In theory, by investing in many low-quality companies, any losses will be offset by their higher interest rates, resulting in a good overall gain. In reality, most high-yield bond funds under perform regular bond funds due to high MERs and losses. Time Horizon: 3-5+ years; Best time to buy: recovery to growth phase; Worst time to buy: boom and bubble phases (a good economy can hide mediocre business performance); Volatility: high to very high

Equity Fund – An equity fund is any fund that primarily buys company stocks. Generally these funds have a name, such as “US Equity fund” or “Emerging Markets fund,” that tell you where the companies invested in are located. In an equity fund, you pay a manager for choosing the stocks for you, and pay a management fee to do so. Usually these managers do not beat the market, so you are better off buying an Index Fund with a lower MER (ex. buy a US S&P 500 Index Fund instead of a US Equity Fund)
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: high to very high

Equity Index Fund – This is a type of equity fund that, instead of having a manager that chooses the stocks, simply follows a stock market index. For example, many index funds follow the “S&P 500 stock market index,” a list of 500 of the biggest companies in the United States. By owning an S&P 500 index fund, you will own a small portion of 500 different companies. The advantage of index funds is that since there is no active manager, the MER is very low (below 1%). And, because you are only buying large, respected companies, returns are good. For investors with a long time horizon, index funds should form a substantial portion of your total portfolio (50%-80%).
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: high to very high

Dividend Fund – This fund is a type of equity fund that invests in stable, generally older companies that make more money than they need for their internal growth, and so they pay out their extra earnings as dividends. Dividend funds largely consist of old-school companies like banks, insurance companies, and railroads. Though they can fluctuate in value, dividend funds make excellent long-term investments.
Time Horizon: 3-5+ years; Best time to buy: post crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: medium to high

Asset Allocation Fund – This fund is an equity fund that attempts to “time” the market, adjusting to buy the best performing companies at each phase in the market cycle. For investors, these funds usually under perform, due to the high amount of turnover (fees and taxes for buying and selling) and higher MER fees.
Time Horizon: 3-5+ years; Best time to buy: never, in my opinion; Worst time to buy: boom and bubble phases; Volatility: high to very high

Guaranteed Funds – These funds, which go by various names, all have a common feature: if you leave your money in for a certain period of time (usually several years), your principle is guaranteed. That is, if you invest $10,000, you are guaranteed to have your $10,000 returned to you by the maturity date, even if the stock market drops terribly. As compensation for this insurance, these funds typically charge a high MER, or allow you to keep only a percentage of the overall stock market return. Since the maturity date is far in the future, there is very little risk to the issuer that the final level will be below the initial investment; essentially, you are paying for peace of mind. If you have any tolerance for volatility, it’s better to simply own an equity fund with full participation in the market. Guaranteed funds are good, though, for those who are psychologically unable to tolerate volatility or declines. Time Horizon: specific to each fund; Best time to buy: post-crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: guaranteed principle

Income Trust Fund – An income trust is a fund that invests in companies with generally stagnant growth (such as sugar refiners and telephone book printers), but that make a steady income. Income trusts also invest in oil and gas companies, or real estate (known as a REIT). The income trust pays out regular dividends. In a sense then, an income trust is in-between a bond fund and an equity mutual fund. The holder receives regular payments (like a bond fund but with higher interest), but is also subject to higher volatility (like an equity fund). Income trusts are a nice addition to a portfolio.
Time Horizon: 3-5+ years; Best time to buy: post-crash to growth phase; Worst time to buy: boom and bubble phases; Volatility: medium to high

Hedge Fund – To “hedge” means to reduce risk. In the old days, the goal of a hedge fund was to generate a reasonable rate of return, regardless of whether the stock market went up or down. These days, hedge fund refers to a fund that uses large amounts of debt to fund ultra-risky purchases, hopefully providing a great rate of return. Hedge funds typically make spectacular rates of return for a few years, only to lose everything in a single season. Hedge funds are only open to investment by “accredited investors,” meaning either finance industry professionals, or those who are wealthy enough to lose their entire investment and not be destroyed.
Time Horizon: 3-5+ years; Best time to buy: never, unless you know enough about investing to make your own hedge fund; Worst time to buy: boom and bubble phases; Volatility: extreme

A good portfolio should consist of a mix of funds. Generally speaking, the longer the time horizon, the more should be invested in high and medium volatility funds; the shorter the time horizon, the more should be invested in low to medium volatility funds. There is nothing worse then seeing your portfolio value decline just days before you need the money: good time horizon and volatility selection will make sure your funds are available when you need them, yet still get a good rate of return. Good luck and happy investing!
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“Risk is the possibility that the holder of an investment may have to sell it at a time when the price is below cost (including inflation since purchased). ‘Risk’ is often wrongly used to describe cyclical or temporary declines in stock prices, even if the holder need not sell at that time.” Benjamin Graham, The Intelligent Investor.