Time to look at Financials?

November 30, 2007

Here’s my simplistic take on what’s going down at E*Trade:

E*Trade starts out as a discount online broker. They decide to create a bank once they realize they have easy access to cash deposits sitting in customer brokerage accounts. To make some money on these deposits, E*Trade Bank “reached” for yield by buying some sub-prime mortgages. (Banks make money by having a positive cost of carry on their assets. In other words, the bank pays depositors 5% on their money and lends it out at a higher rate of 6% or so, for a positive spread of 1%)

For a bank, customer deposits are liabilities. Loans – whether in the form of mortgages, investments in bonds, etc – are assets. Banks are required by regulators to keep a certain amount of net capital, or money held in reserve to pay back its liabilities (customer deposits). To illustrate, let’s say a bank accepts $100 in customer deposits. To be well capitalized, they should have about $110 of assets, which should be more than enough to pay back all the depositors when they demand their money back.

The problem at E*Trade is that they invested their $110 of assets in risky securities such as sub-prime mortgages. Now those assets might be worth only $90. So the bank actually has a negative book value – it doesn’t have enough assets to cover its liabilities.

However, as AccruedInt points out today, just because a bank has negative book value, it doesn’t mean the company is worthless. If investors are willing to bolster the capital of the bank, it can keep operating:

You are never bankrupt as long as investors are willing to keep funding you. In other words, running numbers and coming up with a negative net worth doesn’t necessarily equal insolvency. If so, the U.S. Treasury would have been bankrupt a long time ago.

So if an investor comes in with $20, the bank now has $110 in assets again and it can continue to operate. Plus, in the case of E*Trade, it also has a great online brokerage business which certainly has value. At least that’s what Citadel (hedge fund) must think. Today they announced a $2.55 billion deal to save E*Trade. From the WSJ:

Citadel’s Mr. Griffin, 39 years old, is confident the worst scenarios are already priced into the securities of a number of financial companies. That view extends to a $3 billion portfolio of E*Trade’s mortgages and other securities, which Citadel now has agreed to buy from E*Trade for $800 million. Citadel also is injecting $1.75 billion into E*Trade, in exchange for 10-year E*Trade notes that pay it 12.5% interest and shares boosting its stake to almost 20% of E*Trade’s stock outstanding.


As I mentioned in my 3Q portfolio review, I have stayed clear of financial stocks this year. At some point, though, it will make sense to buy. While I certainly don’t think we’ve seen the worst of the credit crunch, it’s possible that most of the future bad news is already priced into stocks and bonds of these companies.

Plus, nobody wants to see these companies fail — not the Dept. of Treasury, not the Fed, and not investors.

Perhaps this is overly simplistic, but it seems to me that as long as E*Trade doesn’t fail, the stock will go higher.

What do you think? Use the comments to let me know!


Hospitals Ripping Us Off

November 30, 2007

Today’s WSJ has a fascinating story about a man given a $1.2 million hospital bill that contains a huge amount of “bill padding”.  The article points out much of what’s wrong with the health care system in the United States.


Hospitals have three types of patients: Medicare/Medicaid, Private Insurance, and un-insured.  Typically, the hospital will bill Medicare or the private insurance company an amount far in excess of what they actually expect to get paid. 

As an example, I recently reviewed a hospital bill sent to my grandfather from Suburban Hospital in Maryland.  The hospital charged Medicare $30,000 but Medicare only “allowed” a charge of $10,000 for the specific services provided.  So $10,000 is what the hospital got paid.  For patients with private insurance, the process works in much the same manner because insurance companies negotiate with hospitals.  People who are uninsured get screwed because hospitals have no incentive to negotiate prices with them.

The reason the bills are so high in the first place is because of “bill padding”, a perfectly legal practice that almost all hospitals use to allocate their operating costs to patient bills.  From the WSJ article: 

Another issue is the widespread practice of bill padding by hospitals and other health providers. While hospitals say bill padding is their only defense against the aggressive cost-reduction efforts of insurers and government programs, the end result is that individuals can, with little warning, be left stuck with wildly inflated medical bills.

For instance, CPMC charged Mr. Dawson $791 for stockings designed to improve blood circulation. The same pair can be purchased on the Internet for as little as $12.

Allan Pont, CPMC’s chief medical officer, acknowledges that the charges on Mr. Dawson’s bill are “Disneyland numbers” that health insurers and government programs like Medicare and Medicaid never pay. But he says they reflect the hospital’s operating costs, such as paying for doctors, nurses and medical equipment, as well as markups to compensate for the fact that CPMC collects only a fraction of what it bills every year.

Charging a patient $791 for $12 socks cannot be justified under any circumstance.  The fact that inflated bills such as this one can force patients into bankruptcy is absurd!

This anecdote is not at all unusual in the US, and it is a great case in point about why our healthcare system needs a complete overhaul.  Healthcare is a major issue in the 2008 election but so far I have not heard many constructive ideas set forth by the candidates.  

 In the end, we’ll either end up with a socialist system like that of Canada or England, or a market-based solution.  I am strongly in favor of the market based solution and I plan to detail my ideas in an upcoming post.

Cost of Thanksgiving Rises 7-11%

November 23, 2007

From the Washington Post:

Merrill Lynch … calculated a Thanksgiving cost-of-giving index using the prices of traditional holiday meal items such as turkey, cranberries, sweet potatoes and pumpkin pie — as well as the cost of flowers, gifts ranging from toys to clothing and electronics, plus gasoline, hotels, air fare, and greeting cards.

The index has risen 7.9 percent year-over-year in the approach to the festive season — a huge swing from a drop of 4.4 percent a year ago. In fact, this is more than double the historical trend for this time of year and the second highest since 1999

If you look only at food, the increase is more along the lines of 11% according to the American Farm Bureau Foundation.


This is scary for a number of reasons. From the perspective of the Fed, it’s getting a lot harder to convince people that we have low inflation. Bernanke has argued that inflation expectations are anchored at a low level. In other words, it’s ok to focus on core inflation because people attribute price rises in energy and food to volatility, and not to structural/permanent price increases.

The other reason this is scary – and this is true of all inflationary periods – is that poor people feel the impact of inflation much more severely than rich people. If prices for food and energy keep rising, we can expect an increase in social problems/tensions in this country.

Life Update Part II

November 20, 2007

Today I took the GMAT and I did great! It’s a HUGE relief to have this over with… I have been stressing myself out over these tests – CPA exam and GMAT – since I graduated college in 2004. If I had only spent as much time studying as I’ve spent stressing, I would have had them all done a long time ago! Alas, I guess I just don’t operate that way. Next step: prepare 7 applications by December 28th.

Second piece of good news relates to flag football: we ended our 7 game losing streak on Saturday! We finish the season with a 1-7 record. The win should give us a good morale boost heading into the playoffs.

Social Security Trust Fund Is a Joke

November 17, 2007

Yesterday’s mail brought my annual Social Security statement.  It shows how much money I’ve paid in and how much I would get if I were to become permanently disabled.  It also includes some lies about the Social Security Trust Fund:

In 2017 we will begin paying more in benefits than we collect in taxes.  Without changes, by 2041 the Social Security Trust Fund will be exhausted and there will be enough money to pay only about 75 cents for each dollar of scheduled benefits.  We need to resolve these issues soon to make sure Social Security continues to provide a foundation of protection for future generations.

This statement is very misleading – in reality, the Social Security crisis begins in the year 2017 because there are no actual economic assets in the Social Security Trust Fund.  The Social Security Trust Fund is merely an accounting entry; it shows what the Treasury has borrowed from Social Security.

“In 2017 we will begin paying more in benefits than we collect in taxes.”  So what happens then?  Well, the Social Security Administration will cash in the IOU’s from the Treasury in order to pay benefits.  Since there’s no actual cash set aside to pay, the Treasury will have to get the money from somewhere…either by raising taxes, borrowing from the Chinese, cutting expenditures, or simply printing money.

Good timing that today Paul Krugman would write a column arguing that “Social Security isn’t a big problem that demands a solution; it’s a small problem way down the list of major issues facing America…”

Krugman criticizes Obama for calling the Social Security situation a “crisis.”   After all, this is the type of language used by the Bush Administration a few years ago when they were trying to privatize the whole thing. 

As far as I can tell, acknowledging that Social Security is in crisis (which it is) is not tantamount to calling for privatization… it’s simply acknowledging the above-mentioned reality.

The importance of writing clearly

November 13, 2007

I found a great speech by Mark Sellers on Greg Mankiew’s blog today. Sellers talks about what it takes to be a great investor, excerpt:

Sixth, it’s important to have both sides of your brain working, not just the left side (the side that.s good at math and organization.) In business school, I met a lot of people who were incredibly smart. But those who were majoring in finance couldn’t write worth a damn and had a hard time coming up with inventive ways to look at a problem. I was a little shocked at this. I later learned that some really smart people have only one side of their brains working, and that is enough to do very well in the world but not enough to be an entrepreneurial investor who thinks differently from the masses. On the other hand, if the right side of your brain is dominant, you probably loath math and therefore you don’t often find these people in the world of finance to begin with. So finance people tend to be very left-brain oriented and I think that’s a problem. I believe a great investor needs to have both sides turned on. As an investor, you need to perform calculations and have a logical investment thesis. This is your left brain working. But you also need to be able to do things such as judging a management team from subtle cues they give off. You need to be able to step back and take a big picture view of certain situations rather than analyzing them to death. You need to have a sense of humor and humility and common sense. And most important, I believe you need to be a good writer. Look at Buffett; he’s one of the best writers ever in the business world. It’s not a coincidence that he’s also one of the best investors of all time. If you can’t write clearly, it is my opinion that you don’t think very clearly. And if you don’t think clearly, you’re in trouble. There are a lot of people who have genius IQs who can’t think clearly, though they can figure out bond or option pricing in their heads.

The whole speech is worth reading. It hit a chord with me because the ultimate reason why I write this blog is to become a better investor. Writing helps me to clarify my thinking about thorny topics such as inflation, investing, asset allocation and tax planning. I know I would be thinking a lot less clearly about these things if I didn’t write about them from time to time.

Life Update

November 11, 2007

Apologies to my five or six readers for the lack of posts lately. I am applying to business school for Fall ’08 and it is an all-consuming process.

Yesterday I got back from North Carolina where I visited Duke’s Fuqua School of Business. I toured around, visited a class, and interviewed with a second year student. One thing that amazed me about the place was how genuinely happy and nice everybody seemed. Students and professors were all smiling and laughing. Of course, it was Friday so that might have had something to do with it. Still, I got the sense it was normal. I wonder if this culture is unique to Duke or if it’s the same way at a NY school like NYU or Columbia..

Either way, the visit has helped me focus on this goal. So, until Christmas, my primary life focus is on applications, GMAT until 11/19, and Flag Football.