Ari Weinberg

Government Shackles Must Really Hurt

Major banks can’t wait to throw themselves from the TARPean Rock.

Take American Express and J.P. Morgan Chase, for instance. Both issued non-FDIC guaranteed debt on May 13. Now in the ranks of several other “banks” (Goldman Sachs, Morgan Stanley, Bank of New York Mellon), these firms are looking to crawl out from the burden of 5% preferred TARP funding by selling common stock or issuing non-FDIC-backed debt.

Where I get caught up is in the speed and pricing. Given the draconian, retroactive rule setting, the TARPtakers are finding operating on government cheese with government strings to be a little uncomfortable.  (Refresher, TARP is 5% preferred for 5 years and 9% perpetual preferred after that. But the salary rules and subsequent arguments “if you take X, you must do Y” are taking their toll.)

So, what does it mean when American Express sells 5-year notes at 7.25% just days after Microsoft sells 5-years at 2.95%? Better yet, J.P. Morgan Chase - deemed to be among the strongest banks - priced its 5-year at 4.65%.

Such wide spreads over Microsoft (and Treasurys!) prove that the finance companies will rid themselves of government’s grip at any cost. For J.P. Morgan Chase, of course they would issue the debt. It’s LESS than TARP. American Express - not so much.

American Express - where is the advantage? Are taxpayer bosses, threatening to turn common, really worth the nearly 600 basis point spread to Treasury securities.

Why doesn’t American Express avail itself to government goods until it too can refinance when business settles and spreads come in? What does AmEx know that we don’t which would make them willing to take such a large spread? Could it be that they are taking a real view on rates?

Better lock in those 5, 10 and 30s before inflation starts to make those 9% perpetual preferred look good.

Of course, the Treasury has made the financing decision now one of psychology, employee retention and executive pay as opposed to simple capital structure and finance.

When Products Break…And Innovation Fails

Originally published 9/29/2008 at FiLife.

As Congress attempts to pass the bailout bill, it’s a good time to reconsider how we got where we are. Consider financial innovation - the introduction of new products and ideas - as both a blessing and curse.

On the back of this credit crisis were new and complex financial products that launched in rosy markets - they weren’t stress-tested for darker days. These products weren’t just the playthings of financiers ( in the form of credit derivatives, mortgage-backed securities et al.), they were also in our wallets (think option adjustable rate mortgages, high-yield checking and savings).

Bankers put together new products and unleashed them to the world. And we bit.

Yet, the true test of a product or even a market - financial, technological, agricultural - is its ability to endure. Many of the products currently going belly up worked well in a world where asset values (houses, stocks, commodities) only went in one direction - UP.

But innovation eventually finds its limit. These products found their limits when markets started to tremble, investors grew skittish and pulled back in order to protect assets and any available returns. Suddenly, the risk of these products outweighed their potential to realize returns.

Now, the U.S. government might swoop in and put the buyers of these products out of their misery.

Robert Merton, a professor of mine while at Harvard Business School and part of the team behind rescued hedge fund Long-Term Capital Management, put an interesting spin on these products at a conference last week.

“Is there a structural relation between innovation and crisis? I think there has to be,” Merton said. “Successful innovation will always outstrip the infrastructure to support it, at least for some considerable time. That’s true because most innovations fail, so it’s not practical to build a new infrastructure to support every innovation until you find out they succeed. So it’s inevitable they will be mismatched for some time. We have to have oversight. But if it is too strict we’ll never get innovation. There really is a tradeoff, and we have to be prepared for that.”

This observation is particularly insightful. Merton, whose own tangles with market innovation are included in Roger Lowenstein’s book about LTCM, When Genius Failed, is putting finance on the level playing field of all innovation.

Sometimes the first round of breakthroughs isn’t up to snuff or is just ahead of its time. Think Laserdiscs, the Newton, early electric cars. Unfortunately, in finance, these products were incredibly complex and only as good as the people selling them.

Class Z Follow Up

Originally posted at Cake Financial.

In a previous post, I mentioned that the Class Z shares of Mutual Discovery have an embedded premium to other classes. (More than what is reflected in the NAV.)

HOWEVER, the fund is carrying 22% cash. That is similar to other funds mentioned in a Wall Street Journal story on Tuesday called “The Bearish Strategy: Cash and Parry.” These include the esteemed FPA Capital Fund (40%), Yacktman and Yacktman Focus Fund (25%), and Fairholme Fund (20%).

I can understand manager temerity with cash, particularly in a volatile market like this. They don’t want to be fully invested, having some dry powder for good opportunities. Yet, isn’t 20% to 40% in cash a little too bearish?

This brings up a fundamental question facing fund managers today: Are they asset pickers or asset allocators? Holding more cash lowers their beta, but I don’t think that’s really worth the expense ratio of some of these actively managed funds.

When cash is that high, I would expect at least an expense ratio reduction relative to the cash balance. There’s nothing I hate more than watching someone make easy money…especially when it’s on my dime.

Target-Date Funds: Should You Ask One Out?

Originally posted at Cake Financial.

Nascent, but maturing, Target-Date Funds now demand more scrutiny. Both The Wall Street Journal and Barron’s gave these funds-of-funds, also called Lifecycle Funds, a once over this week without hitting on obvious faults and room for improvement.

According to ICI, assets in Target-Date Funds grew to $183 billion in 2007 from just $15 billion at the end of 2002. That’s 1133% asset growth compared to 88% asset growth for all non-money market mutual funds over the same period. Minute compared to over $12 trillion in all U.S. long-term mutual funds, a shift is clearly on into fund-of-fund products.

The industry has itself a winner, but I still cant figure out why or how. Asset allocation is all over the map for funds with similar retirement dates. The articles point out discrepancies in short-dated funds (2020) in which the Wells Fargo Advantage Dow Jones Target 2020 Fund is 58% invested in stock and the AllianceBernstein 2020 Retirement Strategy fund is 80% in equities. Then Barron’s points to SunAmerica 2020 High Water Mark C, with a 2.3% expense ratio holdings 50% CASH!

For the right people, Target-Date Funds are better than nothing. And, in fact, companies are using these funds for default 401(k) investments following the 2006 Pension Protection Act. Still, I was surprised to read in Barron’s that target funds represent 20% of 401(k) plan assets.

The pricing structures for these funds sound a bit screwy. Vanguard quotes an expense ratio that is the weighted average of the underlying funds. There are some funds, however, that charge a premium for the asset allocation decisions. Never mind that the Target-Date Funds are simply another asset funnel into a fund company’s own sometimes inferior products.

My 401(k) option includes Fidelity Freedom Funds. I would be in line for the Fidelity Freedom 2040 option. The fund is 67% U.S. stock, 18% non-U.S. stock, 5.2% investment grade bonds, 10.1% high-yield bonds and 0.1% other assets. While I may like the underlying fund selections (I don’t), youd’ think that Fidelity might make their Target-Date product essentially an asset allocation recommendation engine and then allow the user to pick funds around that.

I might dial up non-U.S. stock. Swap out a few U.S. stock funds and tone down high-yield. The 401(k) plan does not make that easy. You have to go through Fidelity’s Brokerage Link, which means you have to hold non-plan funds in an account within the 401(k), complicating some of the simplicity of the account.

For those who do like the asset mix in a Target-Date Fund, but want more of one fund or another, you can simply buy it outside the Target-Date Fund and make your own allocation. Like the asset mix in a younger fund but don’t want as much risk? Hold cash or a stable value fund to minimize the equity risk.

Education around such options is not provided, but if the industry truly wants to make these products more user friendly, perhaps it should be.

The Class Z Premium

Originally posted at Cake Financial.

Last week I received the prospectus for Mutual Discovery, a much-lauded fund during the tenure of Michael Price, then David Winters.

The fund has 5 share classes, with front-loaded Class A shares comprising the bulk of the assets. I own Class Z shares, purchased on my behalf in 1996, which have been grandfathered in to significantly lower expenses than other classes.

Using FINRA’s Mutual Fund Expense Analyzer, I was able to forecast the return spread for Class Z vs. Class A in 20 years.

It’s significant. But is it worth it?

I’ve just started to put my portfolio together and am considering selling Mutual Discovery. My back-of-the-envelope analysis says that the price I’d get from Franklin Templeton is not as good as I could get from, say, a Class A investor in the same fund or anyone else looking to buy.

Mutual fund sales, unfortunately, do not work that way. The only way I could get that premium is by transfering the shares to someone who is willing to pay me for the favor. But, by then, I will probably have spent the upside in time and hassle.