In case someone has not heard it sometime over the past two years, the Chairman and CEO of FINRA, Richard Ketchum, pointed out that broker-dealers need to engage in a vigorous due diligence process. Investment News has a story about a news conference that Mr. Ketchum delivered at FINRA's annual meeting in Washington.
Mr. Keetchum is referring specifically to Reg D offerings, private offerings not required to register with the SEC or the states. These offerings especially come under scrutiny because there is no regulatory review of the disclosures made in connection with the offerings. His remarks apply to other investment products that advisors recommend to their clients.
The bottom line is that broker dealers and advisors have an obligation to conduct an investigation into an offering that is sufficient to uncover the material facts which will have an impact on the riskiness and profitability of an offering. Reading an offering document and third party reports is a part of the process but not sufficient. The broker-dealer and advisor must also satisfy himself that the characteristics that promote profitability exist, verify any risk mitigation, and reconcile any discrepancies uncovered. Occasionally this can be accomplished in a single desktop session. Usually, it requires multiple management interviews and extensive telephone follow up. It especially requires that the work be conducted on behalf of and under the direction of the broker-dealer or advisor. The firms that provide third party due diligence reports are consummate professionals with extensive knowledge and experience and and are of great value in the process. Broker-dealers can consider their work product only as another input into its own due diligence process.
(Disclosure: Clarity Finance, the sponsor of this blog, provides due diligence services on a consulting basis to broker-dealers and financial advisors)
Thursday, May 26, 2011
Wednesday, May 25, 2011
Real Estate Transparency?
The Wall Street Journal carried a small article about an affiliate of Cantor Fitzgerald acquiring a real estate services firm and speculating on the types of products that could be forthcoming. Specifically, derivatives based on commercial real estate rental rates are expected. The Chief Executive is quoted as saying, "You know you can hedge orange juice and you can hedge corn, but real estate you can't? It doesn't make any sense."
Cantor has a history of developing products that bring transparency to otherwise opaque markets. In the late 80s and early nineties, Cantor maintained a trading desk for units of limited partnership. As a part of the business, Cantor published a bid/ask quote for scores of partnerships, and stood ready to trade at the published prices. The revitalization of the REIT market, which allowed for the rollup or buyout of all of the big partnerships of the 80s, led Cantor to close the desk.
I can envision a family of swap contracts that have a group of rental rats on one side (e.g. northeast Class A office, national enclosed retail) and traditional financial rates on the other. Sophisticated investors might even want to swap one rental stream for another.
The development of derivatives based on rental rates will have a number of affects: Rental rates on comparable buildings will tend to converge, leases will reference the derivatives market in escalator clauses, Landlords will be willing to sign longer term leases. the greatest benefit, though, will be the creation of the reference indexes that will be the basis for the derivatives. This will bring a level of transparency to the commercial real estate market that has never existed. This should reduce both the cost and the time required to execute transactions, both leases and acquisitions. And as this information drives convergence and encourages liquidity in the marketplace, real estate will move closer to becoming a mainstream asset class rather than an alternative.
Cantor has a history of developing products that bring transparency to otherwise opaque markets. In the late 80s and early nineties, Cantor maintained a trading desk for units of limited partnership. As a part of the business, Cantor published a bid/ask quote for scores of partnerships, and stood ready to trade at the published prices. The revitalization of the REIT market, which allowed for the rollup or buyout of all of the big partnerships of the 80s, led Cantor to close the desk.
I can envision a family of swap contracts that have a group of rental rats on one side (e.g. northeast Class A office, national enclosed retail) and traditional financial rates on the other. Sophisticated investors might even want to swap one rental stream for another.
The development of derivatives based on rental rates will have a number of affects: Rental rates on comparable buildings will tend to converge, leases will reference the derivatives market in escalator clauses, Landlords will be willing to sign longer term leases. the greatest benefit, though, will be the creation of the reference indexes that will be the basis for the derivatives. This will bring a level of transparency to the commercial real estate market that has never existed. This should reduce both the cost and the time required to execute transactions, both leases and acquisitions. And as this information drives convergence and encourages liquidity in the marketplace, real estate will move closer to becoming a mainstream asset class rather than an alternative.
Tuesday, May 24, 2011
The Intersection of Doing Well and Doing Good
I have discussed impact investing and one version of what it might look like. The January 14 issues of Forbes describes another model.
VisionSpring is a non-profit organization formed to address unemployment in the developing world by providing corrective lenses to people who are unemployable due to poor eyesight. They have trained some six thousand local salespeople to fit basic reading glasses for the potential workforce. The article states that VisionSpring has distributed 600,000 pairs of glasses in seven countries. Thus the social aspect of the venture, promoting employment in third-world countries, is being accomplished directly and indirectly.
The finances of VisionSpring still resembles a charity. Revenue of $290,000 was dwarfed by charitable contributions of $1.7 million in 2010. However, there are signs that sound business decisions are being pursued and applied. The cost of a pair of eyeglasses has declined from nearly $20 per pair in 2005 to under $8 in 2010, partly as a result of changing the organization's distribution model. The company has opened its first optometrist's office in El Salvador, serving clients who need glasses beyond the drugstore readers, with higher margin product. VisionSpring is also investigating new sourcing for its product through strategic partnerships.
The model for this type of social investing is definitely in the venture capital/private equity mold. The capital sources are funding the long-term growth of the organization until it becomes self-sustaining. The measure of success is the amount of funds that are diverted from maintaining the social safety net for the local that become employed as a result of the introduction of VisionSpring versus the capital and time invested in growing the organization to sustainability.
VisionSpring is a non-profit organization formed to address unemployment in the developing world by providing corrective lenses to people who are unemployable due to poor eyesight. They have trained some six thousand local salespeople to fit basic reading glasses for the potential workforce. The article states that VisionSpring has distributed 600,000 pairs of glasses in seven countries. Thus the social aspect of the venture, promoting employment in third-world countries, is being accomplished directly and indirectly.
The finances of VisionSpring still resembles a charity. Revenue of $290,000 was dwarfed by charitable contributions of $1.7 million in 2010. However, there are signs that sound business decisions are being pursued and applied. The cost of a pair of eyeglasses has declined from nearly $20 per pair in 2005 to under $8 in 2010, partly as a result of changing the organization's distribution model. The company has opened its first optometrist's office in El Salvador, serving clients who need glasses beyond the drugstore readers, with higher margin product. VisionSpring is also investigating new sourcing for its product through strategic partnerships.
The model for this type of social investing is definitely in the venture capital/private equity mold. The capital sources are funding the long-term growth of the organization until it becomes self-sustaining. The measure of success is the amount of funds that are diverted from maintaining the social safety net for the local that become employed as a result of the introduction of VisionSpring versus the capital and time invested in growing the organization to sustainability.
Friday, May 20, 2011
How Much Green To Develop Green Energy?
Jerry Taylor and Peter Van Doren have a column in the April 25 issue of Forbes discussing what a green energy economy would look like and how much it will cost to get there. According to Taylor and Van Doren we have lived in a green economy - in the 13th century! Mankind has spent the intervening 700 years making life easier and cheaper, in no small part by harnessing energy sources that are plentiful, portable, and cheap. To return to the energy sources of seven centuries ago is going to cost on the order of 1/4 of the annual economic output of the United States. This capital goes into overcoming the four negative characteristics of green energy that the authors identify: diffusion, expense, unreliability, and scarcity. That subsidies are required to attract capital to these projects indicates that the economics of the concept are inadequate to properly compensate for the risks of the venture. The money quote of the article:
If green energy is so inevitable and such a great investment, why do we need to subsidize it? If and when renewable energy makes economic sense, profit-hungry investors will build all that we need for us without government needing to lift a finger. But if it doesn't make economic sense, all the subsidies in the world won't change that fact.I couldn't say it any better myself.
Thursday, May 19, 2011
Hedging Longevity
Possibly the biggest risk faced by today's retirees is outliving their assets. With active lifestyles and improvements in health care, life expectancy has been increasing steadily over the past seventy years. Now it is having an impact on pension plans and other institutions. These organization are having difficulty managing the tails of their liability because there are so few market participants that would naturally assume the risk that plans want to lay off.
Now Bloomberg reports that large investment banks are developing products for these institutions to hedge their risks. These instruments are talking the form of longevity bonds and swaps, and the payout are based on indexes developed by Credit Suisse and JPMorgan. These derivative are complex and illiquid, not least because their payouts will not be known for another twenty years or so.
These markets are very early in development and are limited to very large institutions. Right now, the only mechanism for hedging longevity risk for the typical retiree is an annuity with a cost of living rider. It seems to me that some combination of endowment contract and deferred annuity could be packaged to provide a contingent deferred annuity for pennies on the annual income dollar.
What would it look like? Assume the client is a male, age 65, wanting to produce $40,000 a year in income after he turns 85. A 20-year Treasury strip is yielding about 4.5%, which is about the same as a 30-year strip. The Social Security Administration estimates the life expectancy of an 85-year-old at 5.65 years, and the probability of a 65-year old reaching 85 at 40%. The present value of the $40,000 per year single life annuity at age 85 with a 3.75% discount rate (giving the insurance company a 0.75% spread) is $181,709. That investment would require the deposit of $75,344 today earning the current Treasury strip rate. That alone is not bad; less than two years of income to ensure that incremental $40,000 per year for life. However, if the probability of achieving age 85 is factored in, it would take a premium of only $30,138. The downside is that there would be no benefit paid in the event of death before age 85, and annuity payments would stop at death after age 85.
These insurance companies are full of very smart marketing executives and pricing actuaries. When they realize that this type of product is a natural hedge against their straight life insurance portfolio, in addition to the structure investment banking products being developed, I expect these longevity annuities to be available through the advisor market in 2-3 years.
Now Bloomberg reports that large investment banks are developing products for these institutions to hedge their risks. These instruments are talking the form of longevity bonds and swaps, and the payout are based on indexes developed by Credit Suisse and JPMorgan. These derivative are complex and illiquid, not least because their payouts will not be known for another twenty years or so.
These markets are very early in development and are limited to very large institutions. Right now, the only mechanism for hedging longevity risk for the typical retiree is an annuity with a cost of living rider. It seems to me that some combination of endowment contract and deferred annuity could be packaged to provide a contingent deferred annuity for pennies on the annual income dollar.
What would it look like? Assume the client is a male, age 65, wanting to produce $40,000 a year in income after he turns 85. A 20-year Treasury strip is yielding about 4.5%, which is about the same as a 30-year strip. The Social Security Administration estimates the life expectancy of an 85-year-old at 5.65 years, and the probability of a 65-year old reaching 85 at 40%. The present value of the $40,000 per year single life annuity at age 85 with a 3.75% discount rate (giving the insurance company a 0.75% spread) is $181,709. That investment would require the deposit of $75,344 today earning the current Treasury strip rate. That alone is not bad; less than two years of income to ensure that incremental $40,000 per year for life. However, if the probability of achieving age 85 is factored in, it would take a premium of only $30,138. The downside is that there would be no benefit paid in the event of death before age 85, and annuity payments would stop at death after age 85.
These insurance companies are full of very smart marketing executives and pricing actuaries. When they realize that this type of product is a natural hedge against their straight life insurance portfolio, in addition to the structure investment banking products being developed, I expect these longevity annuities to be available through the advisor market in 2-3 years.
Wednesday, May 18, 2011
Stimulus and Jobs
I found a paper addressing the effect of the Stimulus Bill of 2009 on jobs and job creation: "The American Recovery and Reinvestment Act: Public Sector Jobs Saved, Private Sector Jobs Forestalled" by Timothy Conley and Bill Dupor, economics professors from University of Western Ontario and the Ohio State University, respectively. The best estimate of the study is that ARRA created/saved approximately 450,000 state and local government jobs, while it destroyed/forestalled about one million private sector jobs. The authors discuss the margin of error for their estimates and the differences with the conclusions of others in assessing the effectiveness of the program. I am comfortable with the rigorous methodology applied to empirical data, and the impartiality of the authors.
The major conclusion to be be drawn is that the results of this traditional Keynesian prescription were not realized. The theory is that the government sector, with its unlimited borrowing and taxing authority, should take up the slack in generating aggregate demand in the economy. In this case, though, the policy had a negative effect of 550,00 net jobs lost.
This is not meant to be a criticism of the policy embodied by ARRA. Rather, I bring it up to inform future economic analysis in the investment decision making process when similar policies are pursued. That is, Keynesian spending can not be counted on to preserve private sector jobs, though it can offset those losses somewhat with public sector employment.
Special Thanks to: QandO.net
The major conclusion to be be drawn is that the results of this traditional Keynesian prescription were not realized. The theory is that the government sector, with its unlimited borrowing and taxing authority, should take up the slack in generating aggregate demand in the economy. In this case, though, the policy had a negative effect of 550,00 net jobs lost.
This is not meant to be a criticism of the policy embodied by ARRA. Rather, I bring it up to inform future economic analysis in the investment decision making process when similar policies are pursued. That is, Keynesian spending can not be counted on to preserve private sector jobs, though it can offset those losses somewhat with public sector employment.
Special Thanks to: QandO.net
Wednesday, May 11, 2011
New Rules for Money Market Funds
According to an Investment News article, the SEC is heading a a review of the regulations governing money market funds. The immediate objective is to stem any run on the fund that breaking the buck might cause. A couple of proposals adopt a kind of "loss reserve pool" mechanism to allow for defaults and provide liquidity when markets dry up. The most disruptive is a proposal to have money market fund NAVs float on a daily basis.
On the surface, these proposals seem reasonable. The sanctity of the $1 NAV is one feature that has made money market funds so popular. Investor confidence in the security of the funds invested. However, the new regulations would be costly. And in an era of 0.1% yields, it is not clear that the new costs could be born by the funds and still offer investor an attractive yield.
Perhaps the experience with The Reserve Fund is an indication that we are asking too much of a mutual fund. After all, most money finds rely on an arcane accounting methodology (called income equalization) to maintain that $1 NAV as it is. Most brokerage firms now offer an FDIC insured cash management option, often with comparable services and higher yields than their money market funds. Even the plain cash balance accounts at brokerage firms are insured by the SPIC, even if they don't pay interest. Money funds could be merged into short-term bond funds, which is what they would become under floating NAV proposals.
Update: FDIC Corp. Chair calls money market fund stable NAV a "fiction," and is not overstating the case.
On the surface, these proposals seem reasonable. The sanctity of the $1 NAV is one feature that has made money market funds so popular. Investor confidence in the security of the funds invested. However, the new regulations would be costly. And in an era of 0.1% yields, it is not clear that the new costs could be born by the funds and still offer investor an attractive yield.
Perhaps the experience with The Reserve Fund is an indication that we are asking too much of a mutual fund. After all, most money finds rely on an arcane accounting methodology (called income equalization) to maintain that $1 NAV as it is. Most brokerage firms now offer an FDIC insured cash management option, often with comparable services and higher yields than their money market funds. Even the plain cash balance accounts at brokerage firms are insured by the SPIC, even if they don't pay interest. Money funds could be merged into short-term bond funds, which is what they would become under floating NAV proposals.
Update: FDIC Corp. Chair calls money market fund stable NAV a "fiction," and is not overstating the case.
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