Month: March 2009

The hot news yesterday morning was Mr. Vikram Pandit’s leaked letter about Citi’s profitability in the first two months of this year. Of course, by evening, the Dow had risen by about six percent — buoyed by the Citi news, and it replaced Citi as the topic of conversation everywhere.

I am quite used to Mr. Market’s mood swings, so I am not going to write about that, but, instead I will comment briefly on Citi.

A few weeks ago I had taken Citi’s example to get a better understanding of the current situation. In that post I observed the following three things about Citi:

1. Total revenues went down from 78.45 billion dollars to 52.79 billion dollars in 2008.
2. The Provision for Losses had to be increased from 17.91 billion dollars to 34.71 billion dollars in 2008.
3. The Operating expense went up from 59.8 billion dollars to 61.19 billion dollars in 2008.

It is obvious that the real troubles at Citi brew from falling revenues and growing Provisions for Losses. To read the details on that, go to this link.

In today’s context, pont 2 about “Provisions on Losses” is the crux of the matter. While Citi may be profitable in the first two months of the year — the real hit will come in the third month.

At the end of the first quarter (third month) — Citi will have to mark down its assets and that will hit its profitability. So, even if it is profitable in the first two months of the year, that doesn’t really show that it will be profitable in the first quarter.

The reason for that is simple — the main factor that has a drag on Citi’s profitability has not come into play yet, that will only come in the picture on March 31st. A look at Citi’s past  results show that the provision for losses in the last three quarters have been roughly 9, 7 and 5 billion dollars.

Vikram Pandit is not in a position to say that the bank  had a profitable two months and then turn around and show a loss in the first quarter– so I wonder if Citi would really show a profit in the first quarter. But with all the toxic assets on its books how can it still manage to show a profit?

I am intrigued by the lack of interest this angle has generated in the financial media, which has already taken quite a bit of stick for their failure to see the current bust.

So what is the real story behind this? How many of you think that Citi is really going to turn profitable in the first quarter itself?

An upside-down mortgage is a mortgage where the home – owner owes more on the mortgage, than the market value of the house itself.

This is a situation in which one in five home-owners find themselves today, and have to take a decision between continuing their mortgage payments or walking away from their homes.

Most people who are in such a situation continue to pay the mortgage if they have the resources to do so.

This is because of the sunk cost – both financial and emotional.

On an emotional level a family gets attached to the house that they live in and are usually reluctant to leave it. Most of my friends and relatives who are in this situation don’t want to dump their home just because it lost its value.

This surprises me a little bit because these are the same people who flipped about two or three houses in the last few years, and now don’t want to leave a house behind just because it lost its value.

On a financial level, if someone has already spent about 100k on their house – they don’t want to book that loss. They try and pay the remaining amount in the hope — that someday they will be able to sell the house at a higher price.

Interestingly, even Warren Buffet commented on upside-down mortgages in his annual letter to Berkshire’s shareholders, and said that most people stop paying a mortgage because they lose their jobs and are not able to meet the monthly payments, and not because the house is worth less than the mortgage on it.

There are several people who talk about the morality of walking away from a house because it has lost its value and chide home-owners who are contemplating walking away.

I think that it is perfectly sensible to walk away from a house if it is– under water – both in terms of money and in terms of morality.

Lenders who made such mortgages knew perfectly well what they were doing and were only doing so because they were able to securitize these mortgages and sell them off to investment bankers and such.

The Investment Bankers were really the most sophisticated of the lot and should have understood the risk that they were taking. If they didn’t understand the risk and made trades that went sour – in no way does that make it the moral responsibility of the home owner to bank roll them when they themselves have lost a lot of money.

What do you think about the morality of walking away from an upside down mortgage?

I was recently at UPS to pick up a package and got talking to one of the guys there, the hot – topic of that particular day was AIG’s 60 billion dollar quarterly loss, and how AIG’s ex CEO had sued the company for his personal losses.

In a CNBC interview that morning – Mr. Hank Greenberg – the Ex – CEO of AIG said that he lost over 2 billion dollars in personal stock of AIG, and had sued AIG for those losses.

The question that was bothering the guy at UPS was this – “Where did all the money go?”

The short answer to that question is – it just vanished.

Here is the long answer to it.

How did the Money Vanish?

The current melt-down has meant that the price of stocks and real-estate has fallen dramatically, which means – home owners who were invested in stock are much poorer now, than they were a few months ago.

So, in the case of Hank Greenberg, he may have had 50 million shares of AIG that were worth 40 bucks each, and the total value of his AIG stock would have been 2 billion dollars about six months ago.

When the same shares came crashing down to 40 cents — he lost those two billion dollars from his net worth (almost). And the wealth simply vanished.

How Do You Measure Your Net – Worth?

I am sure all of us have felt what Mr. Greenberg felt when he lost his two billion, but at a much scaled down level. We saw our net worth decline substantially because we measured it in terms of the value of assets we hold.

However, I am not so sure why the standard way of calculating a person’s net worth is to sum up his assets. In the case of companies the – Discounted Cash Flow – model is very popular, which is the sum of all future earnings that a company will make, adjusted for inflation.

So far, I haven’t seen a calculator that allows for this type of net worth calculation for regular people. If we were to go by this, we would calculate the net worth of a person based on:

1. his annual earnings,
2. number of years he has left to earn,
3. a growth rate and
4. a discount rate.

I think this would give a very good idea of how much a person is really worth. This model will be much easier on the nerves of most people, as the volatility in stock markets is much higher than the volatility in most people’s pay checks. It will also protect people from going on a shopping binge when the market is at all time highs.

On the flip side this model will not be good for people who have run up high levels of debt, as it doesn’t account for expenses and debt repayments.

So, what do you think, does the idea have any merit? If so, would you be interested in seeing a Net Worth calculator of this kind like the CAGR calculator?

The most curious thing I saw this week was Jon Stewart’s tirade against CNBC and financial journalism in general. If anything, this video is hilarious. Be sure to check it out.

Among other interesting things in the blogosphere this week, I found stuff about what to do when your credit cards get stolen, 401(K) mistakes and such. Here are some of the more interesting things I read this week:

1. 401(k) Mistake by The Oblivious Investor: This article talks about people who pass up the opportunity to get an equal contribution by the employer on a 401(k).

2. What the Forgotten Food Crisis Means for You by Investoralist: The food crisis was in the headlines about an year ago and is quite likely it will be the next big thing after we deal with the current crisis.

3.  What To Do When You Lose Your Wallet by Cash Money Life: Patrick has sound advice on what you should do when you lose your wallet.

4. Preparing My Income Tax Return by The Digerati Life: SVB has got some practical advice on how you can organize the documents that you will need in order to file your tax returns.

5. Investing in the Stock Market? Rules to Help You Sleep at Night by The Smarter Wallet: If you are thinking about jumping in the stock markets, keep these points in mind before you take your plunge.

6. Future Stock Market Returns by The Dividend Guy: Be sure to read the quote at the start of this article.

7. Basic Four Step Plan for Your Money In Case You Are Worrying by MoneyNing: This is a simple plan that I am sure will prove effective if you stick with it.

8. My Money Mistake #3 by M is For Money: This article talks about the set back that cashing out your 401(k) causes to your retirement plans.

9. Dealing with Retirement Planning Uncertainty by My Wealth Builder: If anything, this is a sobering article about the condition that the financial markets are in today.

10. Does Debt Control your Life by Master Your Card: This is a very insightful article about the mindset and how people feel when they are in debt. Makes a nice reading and an interesting case.

Finance Carnivals:

Carnival of Financial Planning

Festival of Stocks Carnival

Carnival of Investing Strategies

Just as Rick Santelli FROM CNBC went viral a couple of weeks ago, this video of Jon Stewart ON CNBC has the potential to go viral too.

I would like to think that this financial meltdown heralds a new age of financial awareness and savvy among people in the future, but that would mean that people like me would somehow develop the ability to learn from their mistakes, so I really wouldn’t count on that.

Enjoy the video  and I’d be interested to know what you think about it.

The Dividend Guy had this interesting chart on Dow Movements from May 26 1896 till Feb 2009. That’s right – it is 1896. The Dow was 40.94 on that date and on February 28th 2009, it was 7062.

In a period of 113 years, the Dow rose about 418 times. That should be a case for buy and hold right?

Wrong.

The Dow just returned 4.68% compounded annually in over a century. The power of compounding doesn’t become obvious till you play a bit with this concept. Use this CAGR calculator (Compounded Annual Growth Rate) calculator to do that.

How much do you think the Dow would be at today if it grew at 6% compounded annually?

It would have been at 28,984.

At 7%?

83,642

At 8?

239,300!

The power of compounding is really awesome and the best story to illustrate that power is the story of the Red Indians who sold Manhattan to America.

In 1626, Red Indians sold Manhattan to a group of immigrants in the equivalent of 24 dollars worth of beads and trinkets.

To understand what a great deal – the Red Indians struck, one needs to understand the power of compound interest.

At just 6% compounded annually – those 24 dollars would now stand at 118 trillion dollars!

A Case Against Buy and Hold Strategy?

Obviously, this is not good news for people who simply buy and hold. People who shun timing the market and instead focus on holding stocks for a long time.

I am part of this crowd with a slight difference. There are long periods of time when I keep accumulating cash and then there are long periods of time when I accumulate stocks. Most of the time, I don’t do both in the same period. Whenever I have done that – I have regretted it.

There is a lot of merit in buying and holding, but I feel that if I keep accumulating stocks, when the market is at all time highs, I will surely repent.

On the other hand, if  I keep accumulating cash, when the market is at all time lows, I will surely repent. The thing to keep in mind is that the cash that  I am putting in stocks is not earmarked for anything else for the next four or five years. If I need to sell these stocks for cash in the next four or five years – then I just keep such funds in a bank account.

I have been a heavy buyer since the markets went down and will continue to buy as long as the market remains depressed. Only time will tell, if I made the right or wrong choice, but, till then – Mr. Market, bring it on.

The Indian economy grew at just 5.3% in the last quarter, which is quite bad considering the fact that it grew at 8.9% an year ago.

Exports form only about 22% of the economy and that is the reason the Indian economy had not seen the kind of contraction that is being witnessed elsewhere around the globe. The fact that there are stringent banking regulations also helped protect Indian banks against sub-prime loans and such.

But, the global recession seems to be catching up with India. Luckily, for the Indian economy – the general elections are planned for this year and that will act as a stimulus to the Indian economy.

Business Line estimates the amount of money that will be spent on the elections to be in the vicinity of Rs.15,000 crores. That is about 3 billion dollars at the current exchange rate, and is a about 0.23% of the GDP, which is about 1.2 trillion dollars.

Traditionally, politicians have been criticized for spending large sums of money on their election campaigns and influence voters with endless propaganda. With this in mind, the Election Commission (the body that regulates elections) has put a cap on the maximum money that a candidate can spend on elections at Rs. 35 lakhs (70,000 dollars).

Needless to say, the candidates get their friends, relatives and party workers spend on their behalf and circumvent the limit. To that extent, the limit is not really enforced at all.

Rallies form a large part of the campaigns and candidates spend a large amount of money on paying people to attend those rallies. Candidates need to gather large crowds in order to make their rallies successful and therefore they end up paying people to attend these.

Party workers gather people from various places, both – urban and rural, and then these people travel from one place to another attending rallies of the respective parties. It is common to see truck loads of people traveling through states in order to attend political rallies.

The money made by people who attend rallies is direct economic stimulus, as there is a very high chance that this money will be spent (and not saved).

The transportation sector benefits quite a lot from election spending as politicians buy SUVs, hire buses and trucks, charter planes etc. This is a good thing as one of the first sectors to take a hit during a recession is the transportation sector.

I think the election spending needs to be encouraged this year, instead of being criticized, as is the usual practice. There are obvious ethical questions about this, but, I think it is an illusion to think that the cap on spending really works, and we are much better off removing this cap than keeping it.

If the cap is lifted – candidates may spend more than what they are used to, as it will become slightly easier to raise funds and spend money. That will provide a much needed stimulus to the economy and will channel some funds to the class of society that needs it the most.

So, what do you think? Should the cap on election spending be raised or eliminated completely?