The Economics Exchange

Every new year we see a list of “great financial tips” for the coming year from various media sources and pundits. Most of these lists contain somewhat generic information about saving more money or only buying things we need. This advice is fine, but I would rather discuss two very specific ideas that we rarely see brought up in the mainstream media.

Max out your Employee Stock Purchase Plan (ESPP): Not everybody is fortunate enough to have access to an ESPP. But if you are, you likely have benefits that give you between a 10% and 15% discount on the lowest price of your company’s stock over a six month period. Normally this is limited to a maximum of 10% of the employee’s annual salary. It turns out that the typical ESSP is the best investment deal you will likely ever find.  The following example shows why:

Lowest stock price during six month period: $20

Number of contributions from employee: 12 (one contribution from each paycheck during six month period)

Dollar contribution per paycheck: $300

Discount: 15%

Discounted stock purchase price: $17

Stock price at end of period: $20

When can the employee sell the stock?: At end of six month period

A quick calculation of the total return from this plan gives us the following:

Total contributions = $300*12=$3600

Number of shares owned at end of period: $3600/$17 = 211

Total value of shares: 211*$20 = $4220

Total Return = ($4220-$3600)/$3600 = 17.22%

A 17.22% return sounds pretty good, especially since the stock price didn’t even go up during the period. But it turns out that the true annualized return is much better than this. In fact, it’s nearly 90%. Because the contributions were made over a six month period, on average the money was only tied up for three months. Since there are four of these three month periods in a year, the annualized return from this ESPP is (1 + 17.22%)⁴ – 1 = 88.8%! This is hard for some to believe, but this is the true annualized return. The return is even higher if the stock price goes up from its lowest point during the period. Compare this to the typical annual return of a money market fund, which is about 0.1% currently.

Given the incredible returns that ESPPs can deliver, it makes complete sense to contribute as much as the company will allow to the plan. Employees should absolutely max out the contributions to plans such as the one used in the example above. The return from ESPPs even beat the return from paying down auto loan debt or credit card debt and is certainly better than investing in the overall stock or bond market.

Be wary of student loans: Just last year the total amount of U.S. student loan debt surpassed credit card debt for the first time in history. There is now over $850 billion in student loan debt in this country. As tuition continues to climb, it is likely this figure will only go higher. Many parents and students alike look to student loans as one of the only ways they can afford college. But it is very important to understand one particularly nasty detail about these loans: They cannot be discharged in bankruptcy.

Nearly all debt can be restructured or even wiped out in a bankruptcy filing. Other types of debt, such as credit card debt, can even be walked away from without filing for bankruptcy at all. But student loans are different and the fact that they cannot be discharged in bankruptcy has led to years of headaches and stress for students and parents alike.

Part of the reason the law was written like this is because the federal government backs most student loans and it’s the federal government that wrote the bankruptcy law. To make matters worse, because the federal government is involved, the IRS can intercept any tax refund you might be entitled to until your school loans are paid off. Also, your wages can be garnished and you can be sued by both the government and any private lender that is involved. If somehow the borrower makes it through all of this without paying off the balance of the loans, the government will take social security benefits away from the defaulter until the loans are paid in full. Unlike most debt, the debt statute of limitations does not apply for federal student loans. They can pursue the borrower forever.

There is one small chance at a remedy if the borrower defaults on the loan. A student loan debtor can attempt to claim “undue hardship” and reduce the overall debt burden. But this process is expensive, time-consuming, and has a low success rate.

For both parents and students alike, it is of utmost importance to understand the terms of any loans the students might be taking on. There are certainly times when a student loan makes sense, but sometimes the potential problems they can cause are not worth the risk.

The news for unsecured creditors of Vallejo, California’s municipal bonds is in, and it is not good. They will only receive 5 to 20 cents on the dollar under a reorganization plan the city filed Tuesday in federal court.

The city regrets that it cannot pay a higher percentage,” Vallejo officials said in the court filings. “The city lacks the revenues to do so while maintaining an adequate level of municipal services, such as the provision of fire and police protection and the repairing of the city’s streets.

For the full article please see- http://www.bondbuyer.com/news/vallejo_california_unsecured_creditors_bankruptcy-1022294-1.html?ET=bondbuyer:e2782:2060276a:&st=email&utm_source=editorial&utm_medium=email&utm_campaign=BB_intraday_011911

It has been a long time since investors were overly concerned with losing their principal on municipal bonds. The last time there were a substantial number of municipal defaults was during the Great Depression. By 1935, 15.4% of municipal debt was in default. During our most recent downturn we have not seen those levels of default, but there are serious potential cash flow problems for states and cities alike. Vallejo is certainly going to be one of the worst cases, but investors should be prepared for a very tumultuous 2011. Muni yields in general are not yet nearly high enough to compensate for the risk.

In 2008 the Reserve Primary money market fund famously broke the buck as its Lehman Brothers bonds plunged in value. For those who don’t know, breaking the buck means that the share value for the fund falls below a $1 Net Asset Value.

It has long been sacrosanct in the mutual fund industry that money market funds must maintain their $1 NAV. But in 2008 this idea was finally exposed for the fraud that it is. And now in order to keep the charade going, the Investment Company Institute, a mutual fund trade group, has presented the idea of a liquidity bank that would be a bailout mechanism for money market funds if they are in danger of going below the $1 NAV level.

The idea from the ICI is for each money market fund to contribute .03% of assets to the liquidity bank. If a fund faced serious withdrawals then the bank could buy securities from the fund’s portfolio, propping up the NAV and giving it cash to meet investor redemptions. Part of the reason for this new idea is an attempt to assuage investor concerns about money funds in general. After the Reserve Primary fund broke the buck, total assets in money market funds began to decline. It also hasn’t helped that, thanks to the Federal Reserve, short-term interest rates are near 0%.  Because of these two problems, money market fund assets have plunged from the peak, as can be seen in the chart below (courtesy of the Wall Street Journal).

There are at least two glaring problems with the idea for a liquidity bank for money market funds. First, it creates one more moral hazard in an industry filled with moral hazard already. Any type of bailout mechanism will no doubt add to the incentive for portfolio managers to increase their level of risk and therefore the reported yield of their funds. Many money market fund portfolio managers already believe that the government will step in to guarantee their $1 value, just as happened in 2008, if the markets freeze up again. Secondly, it is highly doubtful that .03% of assets would collect enough bailout money in the event of another financial collapse.

There is one simple solution to all of this discussion around the idea of a never-changing $1 NAV for these funds. Let the NAV float like other mutual funds do. It is at best confusing and at worst fraudulent for these funds to advertise a $1 NAV every single day when clearly the underlying asset values change. It is akin to pegging the exchange rate of a currency. Letting the NAV float to its true value would also eliminate one of the worst problems that money market funds faced in 2008 and 2009: There would be much less risk of a run on the funds’ assets. There would basically be no incentive for investors to try to get out first before the fund breaks the buck because the NAV would float to its true value each day.

The last thing the finance industry needs is another bailout mechanism and further moral hazard. The $1 NAV for money market funds is the Maginot Line of the mutual fund industry. It is merely a mirage of stability when credit markets collapse. The proposal of a liquidity bank is one idea that needs to be shot down.

It is becoming more and more apparent to bond holders and investors that there is not enough bailout money in Europe to save all of the Eurozone countries that are in danger of defaulting. Portugal’s 10 year bond yield is up 24 basis points (bps) today alone, bringing it to 7.20%. That is an increase of 34 bps this week and 124 bps in a month. Below is a table showing how some countries on the euro are faring in the debt markets. 

 The markets are beginning to wake up to the dangers that Spain and Italy pose, but for now it seems their wrath is being directed mostly towards Portugal and Greece. As of the time of this writing, the Dow Jones Portugal index is down 4% today alone. But Portugal is more of a barometer as to how events might unfold with Italy and Spain. “While the relatively small size of Portugal’s funding needs suggests that a Portuguese bailout will not exert a huge amount of pressure on the eurozone support fund, it will raise the risk of a speculative attack on the Spanish debt market,” Jane Foley, senior currency strategist at Rabobank International, wrote in an analysis.

As for now, Portugal’s government is trying to hold the line against accepting a bailout. The government claims they don’t need financial help and that their own debt reduction plan will be enough. Obviously the bond market disagrees. It is also noteworthy that 44 out of 51 economists believe Portugal will become the third EU country to be bailed out by the European Central bank, according to a poll carried out by Reuters.

Next week Portugal plans to raise up to €1.25 billion in a bond auction. This will be a major test of whether or not the market believes Portugal can enact austerity measures on its own and actually reduce their debt load.

In the coming weeks look for the bond vigilantes to direct their attention more towards Italy. With a debt to GDP of 116% it is only a matter of time before investors realize that a 10 year yield of 4.81% is not nearly high enough to compensate for the risk.

Pressure is building on German Chancellor Angela Merkel as more and more German citizens are beginning to realize that they are bearing the brunt of the bailouts in Europe. Nearly half of all Germans want to go back to the deutschmark as the German newspaper Deutsche Welle reports:

It’s been a tough year for the euro, with debt crises in some eurozone countries chipping away at the common European currency’s value. Many fiscally disciplined Germans were frustrated to see their taxes going to bail out Greece and Ireland, whose governments’ debts had threatened to bring the euro down.Bildunterschrift:

For that reason, it seems that many Germans look fondly back to the days of the deutschmark, once one of the world’s most stable currencies. German daily Bild commissioned a survey by Cologne’s YouGov-Institute that found that 49 percent of Germans want the deutschmark back. Only 41 percent of those surveyed don’t.

The survey also found that the majority of Germans are worried about the stability of the euro and the possibility of inflation. Some 77 percent of the 1,068 people questioned by YouGov said they personally had not profited from the adoption of the euro.

Would they adopt the euro today?

If the country were currently not part of the eurozone, only 30 percent of those asked would today vote to adopt the euro and 60 percent would vote against such a move.

For the rest of the story see http://www.dw-world.de/dw/article/0,,14737918,00.html. None of this is surprising. It was only a matter of time before the German people said enough is enough. As I pointed out in a recent article, http://seekingalpha.com/article/244339-avoid-eurozone-investing-until-the-defaults-begin, there will be defaults in Europe and the beginning could be simply that Germany decides to end the bailouts.

As the new year approached we have seen a lot of predictions for 2011 being made. I am throwing my own hat into the ring and stating what I feel is an easy prediction. One of the members of the Eurozone currency bloc will default within three years. By creating a perpetual bailout fund and showing that they will not impose haircuts on holders of bank debt, the Eurozone has sealed its own fate. The moral hazard it has created virtually guarantees that profligate countries on the euro will not do the right thing. They will not cut spending to the levels that reduce their debt levels to any significant degree.

One thing that we’ve seen with the collapse of Greece and Ireland is that events unfolded quickly. Bond investors seemed to be asleep at the switch until it became absolutely clear that both countries were headed for default. Interest rates skyrocketed in just a few months. At the beginning of 2010 Greek 10 year yields were hovering around 6%. They now sit at 12.5%. Similarly, Ireland’s 10 year yield at the beginning of 2010 was 4.5%. Now it is 8.14%.

Looking at the table above, we can see that Italy is going down the same path as Greece and Ireland. Debt to GDP is already over 100% and their deficit to GDP is twice that of Germany. Yet their 10 year government yield sits at only 4.8%. Do investors really think Italy will get its fiscal house in order? It won’t happen. Watch for Italy’s bond yields to soar in 2011.

As for Spain, their debt is not nearly as onerous as some of the other member countries. But their deficit is. With deficits as high as Spain’s, the interest compounds quickly. If Spain doesn’t cut its deficit, its debt to GDP ratio will above 100% in only four years.

One important thing to keep in mind is that Italy and Spain have economies that are over 10 times the size of Ireland and Greece. A bailout of Italy or Spain will spell the beginning of the end for the euro. No way can Germany support a bailout of either country. If their citizens don’t stop it, the bond markets will. German interest rates would begin to climb, removing the final card holding the entire house of cards together.

Defaults are going to happen in the Eurozone. At that point look for stocks across Europe to get hammered. After the defaults begin there may be a buying opportunity. But until then, stay away from countries on the euro.

The 35% subsidy from the federal government, i.e. taxpayers, to the states is about to end. $185 billion in these bonds was issued in 2010. With the House changing hands next year it is unlikely the program will be resurrected. Watch for a very rough year for muni bonds in 2011.

http://www.businessweek.com/news/2010-12-23/build-america-bonds-end-poised-to-batter-muni-market.html

Defying most predictions, bank lending appears to actually be picking up. From the Wall Street Journal today:

Some big U.S. banks are starting to increase their lending to businesses as demand for loans rises and healthier banks seek to grab customers from weaker rivals.

After declining steadily for most of the past two years, the amount of commercial and industrial loans held by commercial banks inched upward during the past two months, according to the Federal Reserve.

Moody’s Analytics estimates that commercial and industrial lending in the fourth quarter has grown 0.2% from the third quarter, to $1.22 trillion, the first quarterly increase in two years. Moody’s predicts such lending will rise 3% next year.

There are two ways for GDP growth to rise in 2011. One is a decline in the savings rate, which is happening, and the second is an increase in lending. If both happen in 2011 we will see an uptick in the rate of GDP growth. Of course, this is not real growth at all. Any supposed economic growth caused by more debt-fueled consumption just postpones the day of reckoning. Regardless, the stock market will not see it this way.

It has finally become well known that gold is great to own in times of serious uncertainty. Investors ranging from multi-billion dollar hedge funds to blue collar retirees have been pouring money into the this metal, mostly through gold ETFs such as GLD and SGOL. If you ask these investors why they want to own gold, you will get a variety of answers. Some might say that they’re hedging against inflation. Others will say that they don’t trust the government and think the Federal Reserve will keep printing money to pay off our debt. There is the fear that the powers that be will debase the dollar vs. other currencies in a desperate attempt to juice exports and, theoretically, economic growth. And still others believe we will have to go back to a gold standard in order to hit the reset button on our impossibly overwhelmed national finances.

All of the reasons cited above have some merit to them. But it’s important to take a look at what has happened historically during large movements in gold prices. Let’s start with the ultimate meltdown- The Great Depression. Gold prices were not reliably published on a daily basis during this time period, but we do have the stock price of the largest gold miner in the U.S. at the time, Homestake Mining. In September of 1929 the Dow Jones Industrial Average (DJIA) hit its peak of 381. Homestake Mining’s stock was at 80. By December 1935 the DJIA was at 41, an 89% decline, while Homestake Mining was at an eye-popping 495, a 518% increase. Add to this the fact that Homestake actually increased its dividend payout, giving its shareholders a total of $128 per share over this time period.

There are a couple of things to keep in mind when looking at an analysis such as this. First, we are looking at a gold mining company, not gold itself. Gold miners are leveraged plays on the price of gold due to their swings in profits as the price of gold gyrates. Secondly, after passage of the Gold Reserve Act President Roosevelt devalued the dollar against gold in early 1934 from $20.67 an ounce to $35 an ounce. This was a boon to those who held gold, especially miners, and nothing short of theft from those holding dollars.

Even with the two caveats mentioned, the astronomic rise of Homestake Mining during this time period cannot be ignored. What makes it all the more interesting is that the inflation rate, as measured by the CPI at the time, actually fell by 21% from 1929 to 1935. This goes against the theory that gold is a good hedge against inflation. If this were true, gold and gold mining stocks should have done poorly during this time period.

Let’s now look at a time period when gold was a good hedge against inflation. From 1970 through 1975 gold started a meteoric rise, increasing by 375%. During this time period, as the chart below shows, the CPI also began to climb, peaking at a year-over-year rate of 12%. Gold also had a similar bull run in the early 80s when the CPI index hit a peak of nearly 15% y-o-y.

After the 1980 bull market in gold, we see something interesting happen. From its peak in 1983 through April 2003, gold fell by 51% while the CPI increased by over 118%. During this time period gold was a terrible hedge against inflation.

Why did gold do so well against the backdrop of serious inflation in the 70s and early 80s, but so poorly afterward? The reason is that the inflation rate, while positive, was relatively stable and low. It is tempting to make the following generalizations about what has happened historically to gold under times of economic stress and under times of relative stability.

But this does not do justice to the real explanation about what was happening during these time periods and what is happening today. During the Great Depression the credit system collapsed and the government was becoming involved in many more facets of our economy. There was widespread and justifiable fear that the only way out for the government was to print money. The world had already seen what Weimar Germany did to try and get out from under its massive debt and economic problems. They turned to the printing press. Now they were afraid that their own government would resort to the printing presses in order to break out of the deflationary spiral the U.S. was in.

We are in a similar situation today. Even though inflation as measured by the CPI is nearly 0%, the price of gold has gone up 133% since the housing market started its collapse in 2006.  We are still undergoing a massive deleveraging as the largest credit bubble in history unwinds. We have a Fed chairman who has told us that he wants inflation and will do whatever it takes to get it. The Fed is monetizing federal debt by openly buying U.S. treasuries in the bond market. Even though CPI inflation remains tame, there are plenty of people who sense trouble. There are those, like myself, who see the beginnings of the end of our fiat currency regime. Then there are those who simply know that something is inherently wrong with printing money and buying debt. Either way, there are enough investors out there speaking with their wallets and they are buying gold. There are skeptics who are pointing out that gold is at its all time high. Yes, but that is in nominal terms. If we deflate the price of gold by the CPI, even though it admittedly has a host of problems as a price index, we do see that today’s price is at least 30% lower than the peak achieved in 1980. Given the changes made over the years to the CPI by the government to help bias it downward, it is likely that the difference is greater than that.

One lesson to take away from this analysis is that gold is not a good hedge against inflation in the short run if inflation is relatively low and stable and there is no economic turmoil. Over the long run, yes gold will keep up with inflation and will protect your wealth. But the real upward swings happen when people begin to fear the collapse of the currency. The dollar is based on nothing but faith and in the end it is worth only the paper it is printed on. Gold has historically been the ultimate shelter for wealth as people flee fiat paper currencies. Based on history and the size of the deleveraging that has yet to occur, this bull run in gold is far from over.

Some see the bailout of Ireland and think that Irish citizens are the lucky recipients of free money, courtesy of the sucker taxpayers from the European Union. But this is no free money. And this is no bailout of the common Irish citizen. This is a bailout of the banks in Europe. Stepping back for a moment, let’s briefly summarize what happened in Ireland. In 2007 the massive and over bloated Irish banking sector moved towards its demise as the Irish property bubble burst. For years the banks in Ireland lent out money to nearly anybody who walked in the door. The day of reckoning began in 2007 as defaults went through the roof and became so bad that the government of Ireland took the outrageous step of guaranteeing all bank debt on September 30, 2008. But they didn’t know what they were getting into. The amount of debt the banking sector had taken on was enormous. Some put it as high as 500 billion euros. This is nearly three times as high as the total annual GDP of Ireland. The bank guarantee pushed total debt-to-GDP of Ireland up to 96%. It became clear that the government would never be able to pay it all back.

The banks of Ireland did not get all of that money from Irish citizens. Most of it came from other European banks. The exposure German banks have to Irish banks is estimated to be nearly 200 billion euros while the exposure of British banks is nearly the same. So the EU swooped in and gave Ireland a “bailout” that is really a bailout of the European banking system. The heavy hand of the EU and IMF will now be on Ireland, a country about to lose its sovereignty. Here are the terms of what some are calling the “terms of enslavement”:

• Ireland gets Euro 67.5 billion ($89.4 billion) in bailout loans
• The 16-nation euro zone, the full 27-nation EU, and the global donors of the International Monetary Fund each commit euro 22.5 billion ($29.8 billion).
• Interest rates on the loans would be 6.05 percent from the euro zone fund, 5.7 percent from the EU fund and 5.7 percent from the IMF.
• Ireland will have 10 years to pay off its IMF loans.
• The first repayment won’t be required until 4 1/2 years after a drawdown.
• Prime Minister Brian Cowen said Ireland will take euro 10 billion immediately to boost the capital reserves of its state-backed banks

None of this is free. This “bailout” will saddle every man, woman, and child in Ireland with debt of $32,000. Not only are the Irish citizens being made debt slaves to pay off the banks of Europe, they will be at the mercy of the EU and IMF when it comes to laws in their own country. At the top of the EU’s list is having Ireland get rid of its relatively low corporate tax rate of 12.5%. This has always been a pain in the side of other European countries as Ireland was attracting a multitude of corporations away from the higher taxing countries of the Euro zone.

This is a nightmare scenario for the poor Irish citizen who had nothing to do with the greed and excess of the past decade. Those responsible are being bailed out while Irish citizens get stuck with the bill for years to come, both monetarily and in losses to their freedom and national sovereignty.