The Banks are Back, But Be Very Careful!
Joe El Rady

The banks are back and attracting investors; but, employ extreme caution in your banking sector investments. For your own portfolio, shy away from banks that borrow more short-term money than long-term money! If you don’t feel like reading why, you don’t have to… this is actually enough to steer you in the proper direction when buying commercial bank stocks. If you want to know why… read on for the details…

Let’s Play Yield Curve Arbitrage. This is a great game; you are going to love it! Put up none of your own money and make a bundle. Sound too good to be true… well, this is one of the rare cases in which something that sounds too good, actually is true. In fact, banks have been doing this for years. In fact, this is what banks do; it’s their meat and potatoes. Banks borrow short-term and lend long-term… it’s one of the greatest money making games ever invented! Borrow at 5%, lend the money at 7%, and pocket the 2%. Awesome, I love it… it’s why I’ve always wanted to own a bank—but wait.

Okay, why can we lend for higher rates long-term than we borrow short-term? Remember, investments returns compensate four items: inflation, loss of liquidity, opportunity cost, and risk. Money held for longer periods must compensate for more liquidity loss and more opportunity cost. This causes the arbitrage.

Okay, so what’s the problem? The problem lies in the mismatch of the assets and the liabilities: we need to pay back the borrowed money before we get paid back the lent money. Thus, the short term maturity of the borrowed money hinders the game. Generally, this isn’t a problem; we just borrow more short-term money to pay back the maturing short-term borrowed money. In banking, we call this “rolling over the debt.” This works like a charm, until short-term rates jump higher and we need to refinance at a rate higher than the one we charged our borrowers. Again, generally this has not hindered the game much because we can lend at floating interest rates; thus, if the credit market tightens, causing us to pay more to borrow, the parties to whom we lent would concurrently owe us more due to the same conditions increasing the spread over the reference rate we imposed on their floating rate loans. Even when we cannot lend at floating rates (say we wanted to lend or buy a bunch of 30 year mortgages at fixed rates) we could enter into a series of swaps to hedge that risk and generally, through sophisticated financial engineering, we would still be okay.

So what’s the problem? The real disaster occurs (and this just happened last year) when we have lent a bunch of money long term but nobody wants to keep lending to us in the short-term. Suddenly, we need to repay all of the money that we borrowed short-term, but we don’t have it, because we lent it long-term. This is what famously happened to Bear Stearns: they borrowed short-term and used the money to buy mortgage backed securities (MBSs), using the MBSs as collateral for the short-term borrowing. But one day, their creditors woke up and said, “hey, we don’t think the collateral is worth what you guys say it’s worth, so we don’t want to lend you any more money and want to collect the money we did you loan you.” This situation, along with the Financial Instability Hypothesis I noted in a previous post, causes liquidity crises.

So what should banks do? Well, the smartest way to operate is to mix the aggressive and money-making borrow short / lend long strategy with a more conservative borrow long / lend long strategy. Basically, allocate some of your business operations to each strategy instead of just doing one or the other. But wait, how can a bank charge more for money it lends long than it pays for money it borrows long? Remember, investment returns compensate not just for liquidity loss and opportunity cost, but also for risk. Notwithstanding recent credit turmoil, banks are pretty creditworthy and their customers are less creditworthy, so the rate arbitrage still exists even when borrowing and lending long, albeit at a smaller spread. This is why banks lock us into CDs. They want us to lend to them long so they can turn around and lend it themselves long. Sure, it’s not the fast and easy money of the borrow short / lend long strategy, but it is safer.

So, for your own portfolio, shy away from investing in financial institutions that borrow more short-term money than long-term money. Wells Fargo, for example, borrows about half as much short-term money as long-term money. More aggressive banks, such as Bank of America, borrow twice as much short-term money as they do long-term money. Check out Bank of America’s losses this past year and compare them to Wells Fargo’s performance.

Short-term aggressiveness can mint money in the short-term but it places a bank’s balance sheet at the mercy of sudden shifts in the credit market that have historically led to financial disasters such as the one faced by Bear Stearns last year. Remember, keep a long-term horizon. You may feel like you are missing out on big returns during go-go times, but when financial trouble starts, stable conservative financial institutions such as Wells Fargo maintain a competitive advantage over more aggressive banks that will find themselves in trouble. The more conservative financial institutions will have money when the others do not and that is a recipe for long-term success and shareholder value creation.

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Stop the Madness!
Joe El Rady

I have been hearing from a lot of people about a great number of stock market strategies lately. People with no background in finance and accounting have been making a lot of money day trading on volatility or technicals or whatever. And yes, they have been making money. But guys, really, let’s be honest, any idiot can make money buying into a market that crashed 50%. Congratulations, you’ve made money by riding a market that is simply snapping back because it was pulled too far into the negative direction… like a tight string. You’ve made money surfing the wave of money returning from its panicked flight. Do not fool yourselves into thinking that these half-baked strategies are winners. Invest the time to become an investor, or else risk becoming another of the carcasses of “stock-pickers” that have littered Wall Street throughout history.

If you want to invest, get serious—and by get serious, I mean learn basic accounting so that you can read financial statements. You have to understand accounting! It’s the language of business. Unless you are willing to invest the effort to learn accounting—how to read and interpret financial statements—you really shouldn’t select stocks yourself. Selecting stocks without researching a company’s financials is, quite frankly, the same as letting it ride on red in a casino—fun, but ultimately not profitable.

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Healthcare Reform Must Focus on Cost Control
Joe El Rady

US healthcare costs continue to rise not only steeply but also more steeply every year! The rapid multi-decade increase of US healthcare costs far outstrips both inflation and the rise in personal incomes. Regardless of any moral arguments for provision of care to the uninsured, we must address the brutal and potentially disastrous economic realities. Let’s be honest, it is a lot easier to expand health care coverage than it is to find ways to pay for it.

Currently accounting for one sixth of GDP, US healthcare spending far exceeds that of any other industrialized country. Aside from just the ballooning costs, American businesses face a competitive deficit against foreign firms with no healthcare costs. Like businesses, state and local governments have nearly buckled under heavier and heavier healthcare burdens. A 2007 report by the Government Accountability Office (GAO) concluded that health-related costs comprise a primary driver of the fiscal challenges facing state and local governments. As for the federal government, the projected cost growth of Medicare and Medicaid comprises the largest contributor to our nation’s unsustainable fiscal outlook.

In order to avert the looming disaster, Washington must set clear cost control targets and craft specific policies to achieve them. A mechanism to ensure results would also prove helpful. While the President has clearly emphasized “bending the cost curve,” almost all of the current policy proposals in Washington focus on reforms that are merely “deficit-neutral” and that for only the next 10 years. While ten year deficit neutrality is necessary, it is not sufficient. Congress needs a twenty year plan. Congress must pass a plan that not only funds itself for its first ten years, but also reduces the federal budget deficit for the following ten years based upon the “cost curve bending” achieved in the first ten. None of the current plans promise this. In fact, as the Congressional Budget Office reports, the plans currently under consideration increase the budget deficit after their tenth year.

Beyond raising taxes to pay for any expansion in benefits, truly bending the cost curve will require difficult choices.

1. We must budget for healthcare (as most industrialized countries do). It seems unfathomable that the US does not budget for one of its largest spending categories. A health care budget would force all constituents and stakeholders, including politicians, providers and the public, to prioritize health care spending in a responsible manner.
2. We must end our system’s ridiculous payment incentives. Reimbursing providers for each individual service raises costs by rewarding providers who perform more services regardless of results. It also encourages repetition of costly services (such as diagnostic tests) rather than coordination across and by different providers.
3. We must end our system’s ridiculous tax incentives. Tax breaks encourage employers to provide unlimited benefits through health insurance, a huge encouragement for higher healthcare costs by third-party, unregulated and unaccountable insurance companies that can simply pass the costs along to the tax incentivized employer through higher premiums… an upward cost spiral that we must break before it breaks us.
4. We must standardize care. Ubiquitous over-utilization of ineffective treatments, coupled with pervasive under-utilization of effective ones, resulting from insufficiently disseminated medical knowledge and evidence has led to massive variation in healthcare costs across states and even across counties within the same state, with no commensurate increase in quality of care. We must establish guidelines based on evidence of best practices.
5. We must not pass any of the costs on to the states in the form of unfunded federal mandates.

Implementation of the above guidelines, coupled with a strong enforcement mechanism would realize the “curve bending” reforms Washington seeks and our country’s fiscal health requires.

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