Know Unknowns: Bank Balance Sheets & The Federal Reserve

Big Money Printing Press

I consider myself knowledgeable about many things financial: ETFs, stocks, bonds, options, the stock market, for example.  I know the difference between an income statement and a balance sheet, and can read financial statements and prospectuses as a matter of course.

I’ve had little luck deciphering bank balance sheets. Income statements yes, balance sheets no.  They tend to be very opaque, which is one obstacle.  Loans are assets while deposits (other than Federal Reserve deposits) are liabilities.  Accurately determining the quantity, quality, type, and duration of loans can be difficult if not impossible… at least to me.  Perhaps some of this info can be found in the bank’s 10K statements.  Also opaque are details of the bank’s interest rate swaps and other OTC financial contracts.

Historically, the old-style (commercial) bank followed the 3-6-3 rule:   Borrow at 3%, lend at 6%, be on the golf course at 3:00.   Such a bank would take in deposits and lend out with loans (mortgages, car loans, commercial loans).  However, banks could not lend out all the deposits; banks had to keep a fraction of the cash in reserve.  This reserve helps to avoid the “run on the bank” problem, where too many depositors ask for their money — all at the same time.

Keeping all of this spare cash at the bank (about 3-10% of assets) is cumbersome, and also encourages bank robberies.  Banks can transfer much of this physical cash to the Federal Reserve and sometimes even earn a tiny bit of interest (0% to 0.25%, “the Fed Funds Rate”) on it.  Thus the Federal Reserve serves as the bank’s bank.  The Federal Reserve System (or “The Fed”) also helps clear checks (remember those?) and move money between banks simply by moving reserve deposit balances between banks.  No need to shuttle hard currency to and fro.  Deposits are moved with a pencil, or computer transaction in the Fed’s books.

The Fed also lends out money to banks.  Banks can borrow from the Fed at 0.75% (the so-called discount rate).  This system leaves a 0.5% profit for the Fed on the difference between the Fed Funds rate and the discount rate.

Classically the Fed would try to guide the economy by moving the Fed Funds rate and discount rate.  If the Fed thought the economy was overheating (generating excessive inflation) the Fed would raise rates to “cool off the economy”.  The Fed tried to adjust the rates so as to give the economy a “soft landing”.    If the US economy got too sluggish, with high unemployment, the Fed lowered rates.  The interesting thing (no pun intended) about these rates is that they are all short-term rates.  So short-term that the Fed funds rate is sometimes called the overnight rate.

I keep saying “classically” and “historically”, is this is how things used to be done by the Fed.  What’s new, since Fed Chairman Bernanke, has been the manipulation of long-term rates with “quantitative easing” QE, and QE2.  Also new (with the cooperation of US Treasury Sec. Timothy Geithner, Congress, and President Obama) are measures such as the AIG bailout and TARP.

The Fed has shifted into uncharted territory, and in the process neglected one of its two prime mandates: price stability and low inflation.  It also seems to have overlooked the concept of real economic growth (GDP growth adjusted for inflation).  Instead the Fed seems to be fluttering in a course of wide-ranging, unprecedented, knee-jerk reactions.

Today’s Fed is not my father’s Fed, nor are today’s banks.  Today they are increasingly known unknowns.  This path is new and the ticket stub is unclear.  I don’t see a destination nor ETA, but when I look close, very close, I see a dim watermark.  Subtle, like grey on grey, I believe I see in faint yet bold letters INFLATION.

US Debt Ceiling… Sky’s the Limit?

The current debt ceiling is set at $14.294 trillion, and according to CNN Money we are days away from reaching it.  Treasury Secretary Tim Geithner estimates he and his team can keep the US out of default until early August.

I appreciate the increased attention on the US nation debt.  My concern is the the US is beginning to flirt with danger:  increasing risk of a debt crisis.   US debt is a fair ways removed from the debt crises of the PIIGS (Portugal, Italy, Ireland, Greece, and Spain).  However, the current trend of debt as a percentage of GDP is ominous.

A US debt crisis would look a bit different from that of the PIIGS because the US is not bound to a multi-country currency like the Euro.  Devaluation of the USD is likely to be a component of (or reaction to) a US debt crisis.  So are austerity and tax increases.

The danger is that buyers of US debt will demand higher and higher interests rates to compensate them for taking on three key risks,  inflation, devaluation, and default.   As debt increases so do these risks.  As the US refinances debt for expiring Treasurys it does do at greater and greater costs.  As the government raises taxes to combat debt (and pay higher borrowing costs) the US economy is increasingly depressed and tax raises do not result in nearly as much federal revenue as hoped.  Eventually only austerity and devaluation (via the printing press and increases in money supply).

The way I see it, playing brinksmanship now with the debt ceiling in an effort to but the brakes on the US deficit is a reasonable risk.  The current trajectory of the US debt is unsustainable and reckless.  With US debt 90% of GDP and closing in fast on 100%, we are in jeopardy.  This number puts the US next to the troubled Ireland and not far from Italy as shown in this table.

It is time for Congress to get its fiscal act together.  Time is rather short.  I hope we can start making some sort of progress.

Money and Investing Celebrities

Jim Cramer, Suze Orman. Warren Buffett, Peter Lynch, Bill Gross, John Bogle. The first two are the closest to household investing celebrities and arguably have the biggest media presence. The latter four are perhaps the biggest names in investing when it comes to mutual funds.

While I occasionally enjoy Cramer’s style, I generally dislike his advice. I believe that his high-energy style encourages high turnover, higher trading costs, reduced tax efficiency, and decreased diversification. Suze’s style is more focused on emotion, spending habits, relationships. I believe she offers a kind of emotional support and tough love that can help folks get out of debt and overcome financial life challenges. Suze’s style is particularly well-suited towards women investors (I’ve heard this from several of my female friends). She has a good grasp of mortgages, credit, foreclosures, and debt management. However, when it comes to stocks, bonds, mutual funds, ETFs, 401Ks, and the like, I find her advice spotty, inconsistent, and occasionally wrong.

I have a better overall opinion of the advice of Lynch, Buffett, Gross, and especially Bogle. I’ve found Lynch’s books useful and I’ve liked his advice about almost everything except bonds. And the performance of the Fidelity Magellan Fund under his management was exceptional. Gross balances out Lynch, because Gross has an impressive track record of bond investing with PIMCO. Buffett also boasts an impressive investing and management record. Finally, Bogle popularized and perfected index investing through Vanguard Funds.

It’s a shame that there is no investing superstar celebrity that provides solid, clear, and broadly applicable investing advice. Perhaps that is because prudent investing advice is somewhat boring. So generating excitement is done through either stock-picking mania (which I consider imprudent) or human interest stories (which tend to be getting out of debt, or get-rich-quick). Another challenge is appealing to a wide range of investing situations and widely different levels of financial literacy.

I’m frequently looking for ways to make this finance blog appeal to a wider audience. That’s why I’m looking at investing celebrities today for clues to make this blog’s message more powerful. As of now, my biggest takeaway is that if I focus more on the emotional and relationship aspects of investing and spending, I may be able to more effectively connect with women investors.

More Hypothetical Proprietary Fund Ideas

While the Σ1 Fund is currently a real 100% privately-held investment vehicle, all language and speculative plans about its future are currently (9/28/2010) STRICTLY THEORETICAL.  There is currently no SOLICITATION or even OPPORTUNITY for anyone other than Balhiser LLC shareholder(s) to invest in the fund.  Further, there is currently no SOLICITATION nor OPPORTUNITY to invest in Balhiser LLC at present. Thus the HYPOTHETICAL and SPECULATIVE language is merely just words at this point and time.  It is entirely possible that outside investors NEVER be given the opportunity to invest.

I’m wondering… should I revise my $10K minimum investment.  Perhaps $5K-$9K with a ~2% up-front load ($5000 yields $4900 of principal, $5000 yields $5100).  Increments above $5K are $1K with an up/down choice.  Increments are also $1K for investments over $10K.  Additional subsequent investments for current investors are $2K minimum with $1K increments.  Withdrawals minimums are $5K or %100 plus optional $1K increments.  Additional fund investments are subject to the same early withdrawal penalties as initial investments.  ALL requested redemptions are FIFO by default.

Distributions (realized capital gains, dividends, etc) are annual.  How they are distributed is TDB.  My initial inclination is that there is an ex-dividend date on the last trading day of each month, and dividend income is distributed in proportion to #months held * #shares.  Distributions are re-invested by default. Non-reinvested distributions are held in a non-interest-bearing manner until $500 is reached, upon which the total distribution will be paid in full by ACH or check.  Non-reinvested dividends may be paid, upon request, before the $500 minimum is reached, but a distribution-collection fee of $50 will be assessed.  For shareholders with >= $100K NAV none of these distribution restrictions or fees apply.

75% of redemption fees will be paid to Balhiser LLC, the remaining 25% will be paid to the Fund.

Requirements for potential investors:

  • Minimum of 5 years experience investing in stocks, bonds, ETFs, and/or mutual funds.
  • Acknowledgment that this is an investment of at-risk capital that may be subject to forced liquidation without notice during volatile and illiquid market conditions. This could result in severe or even total loss of investment.
  • Acknowledgment that options WILL be part of the Fund’s holdings/obligations.  While the primary target use of options is “covered-call” writing the notion of “covered” is not strict.  The fund may consider an RNM (Russel 2000 mini call option contract) to be “covered” by ownership of “an appropriate amount” of SPY (S&P500 ETF) shares.
  • Acknowledgment that ETF futures contracts may part of the Fund’s holdings/obligations.
  • Signed (and notarized) legal waiver that specifies that in exchange for participating in this fund, fund participant, fund participant beneficiaries and/or heirs, agree to hold legally blameless the fund manager and Balhiser LLC  for losses sustained by the Fund.
  • Solid familiarity with E-mail and the Internet and Internet-based “paperless” documents and communication.

In exchange for these concessions, the fund manager agrees to the following “skin-in-the-game” and transparency conditions:

  • So long as fund assets (or total net unredeemed funds invested) exceed $50K, the fund manager and/or Balhiser LLC will maintain a minimum of $25K invested in the Fund.
  • So long as fund assets exceed $50K, the fund manager and/or Balhiser LLC will reinvest all fund net distributions and net fund management proceeds into the Fund.
  • So long as FE>$50K. Fund manager and/or Balhiser LLC will be subject to same fees, terms, and conditions as all other investors PLUS will have to provide an ADDITIONAL 60-day advance notice to all fund shareholders (via email or other means) prior to any sale of holdings in the Fund.
  • 100% of Balhiser LLC/fund manager redemption fees (fees incurred for “personal” withdrawals) will be paid to the Fund.
  • End-of-month NAV reports will be delivered by email to shareholders. (delivered within 5 business days)
  • Subject to NDA: Unaudited Annual Report detailing complete fund holdings (delivered within 20 business days). Disclosure to CPA is permitted.
  • Subject to NDA: Upon request unaudited inter-year report (delivered within 30 business days). A $250 fee applies.  Disclosure to CPA is permitted.  Fee is waived once per year for investors with >= $100,000 invested in the Fund.

Base Management Fee Rates (similar, but not identical, to an expense ratio)

  • 7.8 basis points per month (0.078%) of previous close-of-month fund NAV.
    [~0.95% in simple interest, or ~0.9772% compounded annually]
  • Base management fee reduced by:
    • 10% for investors with >=    $50,000 NAV (or $50K net unredeemed investments).
    • 25% for investors with >=   $100,000 NAV (or $100K net unredeemed investments).
    • 33% for investors with >=   $250,000 NAV (or $250K net unredeemed investments).
    • 50% for investors with >= $1,000,000 NAV (or $1M net unredeemed investments).

Extreme Finance: The exhilaration and peril

I’m blogging live in the midst of transferring $25,000 for my LLC.   Bank A needs my physical presence to wire the funds, Bank B needs my online presence.  And, unfortunately, Bank A doesn’t have wireless internet so my laptop is not very useful.

Update 1.  Institution B’s website is down.  I called and they said, yes it is down and will be up in 10 minutes.  Its been exactly 10 minutes since my call and… website is still down.  So right now my business’s $25,000 is sitting somewhere in the ether.

Update #2:  About and hour since this whole process started.  On the phone I was informed they no they would not call back once things were resolved because they had no means of entering the callback information into their down computer system.  My only recourse was to file an online help ticket which I did.

Four hours later, Bank B’s website is back up and funds are successfully transferred.

Idea Publication: Investing Automation for improved dollar-cost averaging

Just a quick note to…

Get this idea out into the blogosphere before someone tries to patent it:

Flex-flow deposits that automatically (and dynamically) re-balance a portfolio.  A target asset allocation is set.  Weekly/monthly inflows are initially proportioned account to these ratios.  As time goes on and investments go up and down the inflows are adjusted to help keep to asset allocation close to target.  More $ are invested in under-weighted funds (below tgt funds) and less $ are invested in funds that are over asset allocation targets.

There are lots of neat mathematical/algorithmic implementations.  The simplest contributes to the most under-weighted fund 100% or whatever amount is need to bring into balance.  Then the next most out-of-balance fund… etc.  Another strategy is to perform a linear delta-weighted scaling factor.  Another means is any number of non-linear delta-weighted scalings.  In any case a unit-sum “percentage” vector (M-dimensional , where M is the number of funds in the target).

Buying new Vanguard Funds

I’ve been reading through the prospectus for some of the Vanguard tax-exempt funds.  There are four that generally cover the municipal funds markets:

Comparing Vanguard Tax-Exempt Funds

They all have great expense ratios of 0.2% and credit ratings (for what they’re worth) of AA or AA-.  What is most interesting to me is a comparison of duration to yield.  Duration, in brief, is a standardized measure of bond price sensitivity to changes in interest rates.  High duration bonds (or funds) swing more to a 1% change in interest rates than lower duration bonds.  When I graph the relationship I get a very straight looking line:

vanguard_tax_exempt_yield_vs_duration

In essence this is the current yield curve for this family of funds.  The leftmost point is the short-term tax-exempt bond fund, followed by limited-term, then intermediate term, and finally long-term.

So what was my decision?  I bought into 3 of the 4, the short-term, medium-term, and long-term.  They all look like great funds.  I’ll keep you posted.

Exchange-Traded Funds (ETFs)

There are two very different types of funds that are traded on the stock exchange(s).  The dominant form is the open-ended exchange-traded fund, commonly called an ETF.  The smaller cousin of the ETF is the closed-end fund commonly called the CEF.

According to a recent Forbe’s article ETFs currently contain $725 billion in assets and could top $1 trillion in the next two years.  According to this site CEF assets totaled $335 billion in 2007.

Closed-End Funds

The weakness of the CEF is that its assets are bound up in a closed financial package.  In a way a CEF is a bit like a financial black hole — the investments inside are not reachable by the rest of the financial universe outside the event horizon.  The only way that the money is accessed is indirectly through the current price of the CEF and through cash distributions.   To take the analogy further a CEF is a bit like a “white hole” in that the internal assets can slowly radiate out in the form of cash distributions.

Because there is no effective mechanism to keep CEF price in line with NAV (net asset value) they hold they frequently trade at a premium or discount to their NAV.  This yahoo finance chart shows the ever-changing relationship between price (red) and NAV (blue) for S&P 500 covered call CEF.

The price versus NAV tracking-error in CEF pricing is a big con to CEF investments.    It does also present a couple opportunities.  1) Buying CEFs at a steep discount to their NAV is sometimes possible and 2) shorting CEFs that are at a steep premium is another opportunity.  Generally, however, I don’t advice speculating or investing in CEFs, largely because of the superior alternate — the ETF, or exchange-traded fund.

Exchange-Traded Funds (ETF)

The ETF is a really great financial innovation.  ETFs excel over CEFs because they build in a financial arbitrage mechanism that minimizes price/NAV tracking error.   The underlying components (stocks, bonds, money, etc) can be be redeemed directly from the ETF issuer in large blocks of ETF shares called creation units.  Typically 50,000 shares of an ETF equals a single creation unit.  If the NAV is greater than the price of the ETF a large investor can buy a creation unit worth of shares and resell the constituent investment pieces for a profit.  This arbitrage mechanism helps to keep ETF prices in very close correlation with the underlying NAV.

The beauty of ETFs is that they incorporate many of the best attributes of stocks, closed-end funds, and mutual funds into an efficient financial package.  ETFs, like CEFs, trade like stocks.  Because they do, they can be bought and sold in virtually any brokerage account just like any other stock.  Additionally, ETFs can do essentially anything a mutual fund can do — provide diversification, passive or active management strategies, invest in foreign or domestic securities, etc.

Often a mutual fund company will offer a particular fund it two different packages– a typical mutual fund or as an ETF.  For example Vanguard offers the Vanguard Total Stock Market fund as a mutual fund under the symbol VTSMX and as an ETF under the ticker VTI.

I have just scratched the surface of the CEF and ETF investment world with this blog article.  Suffice it to say I am a proponent of ETF investing.  Understanding the disadvantages of CEFs helps illustrate the advantages of ETFs.  In fact, I believe ETFs are one the of greatest financial innovations since the index mutual fund.  One passing word of caution.  Please be carefully not to confuse ETFs with the similar-sounding ETN (exchange-traded note).  ETFs are backed by the underlying securities they contain, whereas ETNs are simply senior debt notes that are only as secure the issuer who sells them.  For this reason, I prefer the real McCoy, the EFT.