This Week's Carnival Of The Capitalists

This week's COTC is up at TriplePundit. There's lots of good material this week. Here's some of it:

Coyote Blog has some interesting thoughts on the “Payday Loan” industry.

James Hamilton at Econbrowser discusses the latest GDP figures.

FMF at Free Money Finance gives us Seven Ideas for Maximizing Retirement Savings.

Harvey Multani at Fiscal Times presents A quick guide to stock market technical analysis.

Abnormal Returns has a piece on the difficulties of forecasting with regards to investments.

Old Niu blogs about Market Index Target Term Securities. For the finance folks among us, their payoff is esseentially the payoff of a portfolio of zero-couppon bonds and a long-term call option on the S&P.

David Porter at Pacesetter Mortgage Blog believes "Stated Income" Mortgage Loans are bad for America. He also shares how Mortgage Pre-Approvals create problems for many Realtors.

Finally, although this is not finance related, BigPictureSmallOffice has some good stories on how people mess up in interviews.

As I've said before, look around - my tastes are probably different from yours. That's what makes it interesting.

Update 11/1/05: The link to BigPictureSmallOffice was a bad one. It's been fixed.

Is The Yield Curve a Leading Indicator?

Lately, there's been a lot of talk about how the changing shape of the yield curve means that we're either going into a recession, not going into a recession, or have a healthy economy (take your pick). Arturo Estrella, Senior VHF of Research at the New York Fed (and all-around smart guy) that reviews the academic research on this topic. The whole piece is pretty technical (and probably not suitable for the layman), but he also provides a FAQ (Frequently Asked Questions) page with the "quick and dirty" answers. Here's a summary of the evidence from the first question on the FAQ:

Q: What Does the evidence say, in short?

A: The difference between long-term and short-term interest rates ("the slope of the yield curve" or "the term spread") has borne a consistent negative relationship with subsequent real economic activity in the United States, with a lead time of about four to six quarters. The measures of the yield curve most frequently employed are based on differences between interest rates on Treasury securities of contrasting maturities, for instance, ten years minus three months. The measures of real activity for which predictive power has been found include GNP and GDP growth, growth in consumption, investment and industrial production, and economic recessions as dated by the National Bureau of Economic Research (NBER). The specific accuracy of these predictions depends on the particular measures employed, as well as on the estimation and prediction periods. However, the results are generally statistically significant and compare favorably with other variables employed as leading indicators. For instance, models that predict real GDP growth or recessions tend to explain 30 percent or more of the variation in the measure of real activity. See astral and Hardouvelis (1991). The yield curve has predicted essentially every U.S. recession since 1950 with only one "false" signal, which preceded the credit crunch and slowdown in production in 1967. There is also evidence that the predictive relationships exist in other countries, notably Germany, Canada, and the United Kingdom.

Click here for the whole thing.

HT: Economist's View for the link.

If you like pictures instead of words or numbers, Smart Money has a little Java applet that show you the "Living Yield Curve". Click on this link for a quick explanation of the yield curve and a picture show that goes through the changes in the curve over time.

Comparing Tax-Free and Taxable Bonds

Here's a little calculator that allows you to compare municipal bond yields to those offered on taxable investments (thanks to Sound Money Tips for the link). However, in case you're interested, here's the math behind the calculations.

Let's assume that you are in the 25% marginal tax rate (to see your actual tax rate, look at the table at the bottom of the page where the calculator is located). This means that if you earn an additional dollar, the government takes $0.25 of it in taxes. So, if you're in this bracket, you "keep" 75% (i.e. 1 - 0.25) of any additional taxable income that you earn.

So, for any taxable interest rate TI and any tax rate t, your after-tax interest (ATI) would be:

TI x (1-t) = ATI

Since the interest on municipal bonds is tax exempt, their after tax interest rate is the same as their stated rate.

So, assuming this 25% marginal tax bracket. let's compare a taxable bond paying 6% to a municipal bond paying 5%. The after tax interest on the taxable bond is

6% (1-0.25) = 4.5%

Since this is lower than the interest rate on the municipal bond (5%), the municipal bond is a better investment, since it gives you a higher after tax yield.

Next, what would the taxable bond have to pay in order to make it as attractive as the municipal bond? To answer this, start with the same equation:

TI x (1-t) = ATI

With a little algebra, you can solve for the equivalent taxable interest:

ATI / (1-t) = TI

or, in our specific example,

5%/(1-.25) = 6.33%

So, in this case, in order for a taxable investment to be as attractive as the municipal bond, it would have to yield 6.33%. If it paid this interest rate, it would provide the same after-tax return (5%) as the taxable bond.

Finally, here's how you calculate the tax rate that would make you indifferent between the taxable and tax-free investments. Start with the same basic equation, and solve for "t":

TI x (1-t) = ATI;

solving for "t",

t = 1 - (ATI/TI)

Using the information from this example, t = 1 - 5/6 or 16.67%. So, if you were in the 16.67% tax bracket, the two investments would give you an identical after-tax return (in this case, of 5%). If your tax bracket is above this rate, the municipal bond would be preferred, and if your bracket is lower than this, you'd prefer the taxable bond.

Betting on The Next Supreme Court Justice (redux)

It's time to look once again at prediction markets for the next Supreme Court Nominee.

As I've posted repeatedly, I'm a BIG fan these markets. For the unitiated, a prediction market (typically, but not always) trades "futures" contracts. These contracts pay $1 if a given event occurs (and $0 otherwise). Some simple math shows that the fair price for this contract is the buyer's (or seller's) subjective probability as to the event occurring.

Prediction markets are interesting tools for aggregating dispersed information. Let's see how they might be helpful (at least in theory) in helping to predict the next Supreme Court Nominee. In this case, I'll use the contracts currently trading at Tradesports as an example. To see the current contracts trading on this market, click here. Note: Information changes, and so will the prices for these contracts by the time you read this. The illustration I'm using here is as of 2:40 p.m.

As of the time of this post, the market has put the highest valuation on the contract for Samuel Alito (last traded at 27). This contract opened the day at 11.9 (reflecting a subjective probability of Alito's nomination of 11.9%). After the market opened, the marginal trader thought that the contract was undervalued at that price. In other words, this trader thought that the chance of Alito's being nominated was greater than 11.9%. So, he would put in a buy (called a "bid") order at above 11.9. As long as the next "marginal" trader" believes that the probability of Alito being nominated was greater than the current price, he would put in another bid order, which would push the price higher. This would continue until the marginal trader thinks that the price exactly equals his assessment of the probability of the nomination.

So why does this help aggregate information? It all rests on the idea that at least some individuals have superior information and are willing to trade on it. If the informed trader (say, someone who works in the Bush Administration, or has their ear to the Washington grapevine) has a good idea that Alito would be nominated, they would start buying if the price was too low (i.e. below their assessment of the probability of nomination). If they thought that the price was too high (i.e. above the price that reflects their assessment of the probability), they'd sell the contract.

This trading would take place until the marginal trader thought that the price was "fair" (i.e. reflected their individual assessment).

For those wanting to learn more, there's an extremely very comprehensive collection of materials on prediction markets at Chris Masse's website here.

Hedge Funds and Takeover Defenses

One of the things I always enjoy is the way the players in any game adjust to each other (and adjust to each others' adjustments, and so on...). Here's the latest example.

Finance theory says that the takeover market can help discipline underperforming managers: If the managers do a bad job they'll drive the value of the company down. If the value of the firm goes low enough, another firm (or investor) can buy the firm "on the cheap", fire the managerial turkeys, and reap the benefits of a firm that has gone up in value. However, underperforming managers realize this and often take steps to thwart this process either by enacting anti-takeover defenses before the fact (the so-called "poison pills) or by maneuvering to eliminate a takeover bid once it occurs.

Here's the latest installment of this continuing saga.

As hedge funds have grown in size, they've become an increasingly more important factor in the takeover market - they have money, sophisticated investors, and they're willing to throw their weight around. Not surprisingly, managers and boards don't like this trend, So, they've come up with some new anti-takeover tactics to thwart the threat to their continued control posed by the funds. Business week has an amusing (at least to me) article on this phenomenon titled "Take Your Best Shot, Punk". Here's one of the better anti-takeover strategies they highlight:

Hedge funds are usually savvy operators, but sometimes even they get outmaneuvered by a simple tactic. New York-based Pembridge Capital Management wanted change at iconic trading-card outfit Topps Co. and was set to nominate three directors. Before its annual meeting on June 30, Topps appeared to meet one of Pembridge's key demands when it hired investment bank Lehman Brothers (LEH ) to explore a sale of its candy unit.

So the board asked Pembridge to withdraw its nominees, which it did. Then, on Sept. 12, the company announced that it wasn't selling the candy business after all. Pembridge had fallen victim to one of the newest defenses thrown up by companies desperate to fight off tough demands or a takeover -- a ploy called the head fake. Topps did not return phone calls asking for comment.

There are a number of other clever managerial moves highlighted in the article. Click here for the whole thing.

It might be interesting to do an academic study on how the presence of a hedge fund investor effects takeover outcomes. Just off the top of my not-nearly caffeinated enough head, I'd guess that having one on board would make the takeover more likely to go through, and at a lower takeover premium.

Financial Services Parody (via Michael Covel)

Here's a little something to lighten your day. It's short clip that's a parody of financial services ads.

HT: Michael Covel

My Blog is Worth $29,356.08???

Business Opportunities has a "blog valuation calculator". Just a little higher and I'll be making minimum wage based on all the hours I put into this. But at least it keeps me off the streets.

Tip-o-the-hat to Marginal Revolution for the link.