It’s difficult to predict what the next bubble will be, or when it will develop. But there are “early warning signs,” that, like the tiny crocus flowers that push through snow cover in early spring, point to changes ahead. One of the most important harbingers is an abundance of liquidity.
Markets are driven, in a very real way, by liquidity — a high-toned word for plain old cash. The song lyric from Cabaret, “Money makes the world go ’round,” has never been more true than in recent years. From the supply of money flows credit decisions that grease the wheels, not only in financial markets but economies in general.
In simple terms, central banks and governments control the supply of money and credit through two “spigots:” monetary and fiscal policy. Central banks control money supply by managing short-term interest rates. Governments do it using taxation and public spending.
To balance economic growth, one institution may work independent of the other. That is, one spigot may be open while the other is closed. For example, a government might increase taxes, while a central bank reduces interest rates to mitigate the impact of those taxes.
However, to slow down an overheated economy, both interest rates and taxes oft en move higher, to reduce the money supply. To stimulate growth, on the other hand, both spigots can be open. You will then see the government lower taxes and the central banks lowering interest rates.
Our objective here is not to turn you into an economist, of course, but to give you a simple way to see how the ebb and flow of money is controlled, as central banks and governments turn the taps on and off.
While banks and governments control the supply, in a free market economy the financial markets determine the direction. That means available liquidity (i.e., cash) will flow into investments that the market considers will benefit most from the economic environment.
Watch the needle on liquidity
Problems surface, though, when there is an excess of liquidity — it can spill over and drive the value of investments way beyond their fundamental values, to irrational levels. At the other end of the spectrum, too little liquidity can push investments well below their fundamental value.
The key to spotting potential bubbles, then, is to:
• Monitor central banks and government action to see how
tight or loose the two spigots are that control money supply.
• Try to foresee where the liquidity is flowing. Is it moving away from stocks to bonds, for example, or vice versa? Is all the money going into real estate, or into commodities (oil futures, for example, are at about $120 per barrel now).
An excess of liquidity creates excess demand for an asset, which pushes prices higher, reflecting lower return expectations among irrational participants (who think of themselves as investors, when they are really speculating).
Consumers fuel the liquidity fire, too
Ample availability of cheap and easy credit turns consumers into spendthrift s in record levels, enticing homeowners to tap into the available cash in their home equities and credit cards, and use it to sustain their way of life. Evidence: By the second half of 2005, financial obligations as a percentage of household income stood at 16 percent, nearly the highest on record. At the same time, savings as a percentage of disposable income sank to zero, the second lowest since the Great Depression.
High-octane liquidity sparks liberal and rapid credit creation, which in turn inflates asset values beyond rational norms. The result? An uncontrollable, global-scale liquidity flow that pushes asset values, particularly real estate, commodities and emerging market debt to over-rich levels.
It is liquidity overflow that fuels all of this activity, and turns everyday people into unsuspecting speculators, if not gamblers. People looking to “make a killing” often dive into risky assets like emerging countries’ stocks and bonds, real-estate backed debt, fine art, private equity funds — and sophisticated investment contracts even bankers can’t understand.
The difference is that experienced speculators will walk away when a miniscule risk premium signals low compensation for high risk. The Wall Street Journal explains it well: “…as the price of an asset rises, the income it throws off — a stock’s dividend, a bond’s coupon, a building’s rent — automatically declines as a percentage of the asset’s value. This means investors are demanding less compensation than usual for taking on the risk inherent in owning the assets.”
In plain language, the risk premium needs to be high enough to compensate for the possibility that you will not get the return you expect (and might even lose your principal). What happens in bubbles, as we have seen in evidence dating back to the 17th century, is that sky-high prices, like the mythical Icarus, fly too close to the sun and inevitably fall back to earth.
Co-authors Jose D. Roncal and Jose N. Abbo share some 50 years of senior executive experience in international business, finance and economics. Both have authored numerous articles on business strategy, finance, accounting, capital markets and the global economy. For more on the authors and their book, The Big Gamble: Are You Investing or Speculating?, visit: Financial Speculation.
Filed under Finances by on Nov 29th, 2008. Comment. 
A good working definition of financial risk can be found on http://www.investopedia.com: “…the chance that an investment’s actual return will be different than expected. This includes the possibility of losing some or all of the original investment. It is usually measured using the historical returns or average returns for a specific investment.”
With that definition as a starting point, let’s look at the key components of financial risk. It’s important to take all of them into account when deciding on investing your hard-earned money.
Volatility
Volatility risk measures how much the value of an asset will deviate from the principal committed to that asset. This volatility is measured using a statistical concept known as standard deviation. Standard deviation predicts how much the value of an asset will deviate from its current value, based on historical data, within a certain degree of confidence.
Example: If over the last 10 years a financial asset has a standard deviation of 20 percent, we can assume there is a 67 percent possibility that it will fluctuate plus or minus 20 percent in the future. The big “if,” of course, is that the asset will follow its established historical pattern.
The more volatile an asset, the riskier it should be considered. When there is a high probability of fluctuation, it’s appropriate to demand a higher return to compensate for that risk.
Inflation risk
There is the risk that the dollar you receive in the future will be worth much less than it is today. You measure inflation risk through the real rate of return. If inflation is running at a 5 percent annual rate and you have your money sitting in the bank earning 3 percent, then your real return is a minus 2 percent. Inflation is eating away two cents for each dollar you’ve “saved.”
Now, here is a teaser: If you don’t know where the inflation rate is heading, would you call a savings account deposit an investment or a speculation? Is the interest rate you get on checking deposits a bargain? And what about the rate they promise on Certificates of Deposit? Are you investing or speculating, given what you now know about inflation-rate risk?
Interest-rate risk
Interest-rate risk most often applies to fixed-rate instruments such as bonds, but keep in mind that interest rates affect the cost of money. Since companies’ earnings can be affected by high costs of financing, up-or-down movement in interest rates will also impact share prices, or any other financial asset with a value that hinges on current interest rates.
All else being equal, if interest rates increase the price of bonds will fall, and if rates decrease the price will increase. Thus, if you buy a bond, you can expect its price to fluctuate until the maturity date, as would a stock until you sell it.
If interest rates rise after you buy one, a bond issued later will become more appealing, since it will offer coupon rates more in line with the higher rate. Since markets cannot change the coupon rate, adjusting the price of the bond can adjust the yield expected—bringing the expected return more in line with the higher rates.
Here is where interest risk comes into play. The bond you bought that pays a lower coupon rate will decrease in price, and as a result will show a principal loss on paper. In contrast, if interest rates decrease, your bond will increase in price, so you will show a gain on paper.
Credit or default risk
When you buy a corporate bond you are also exposed to what is known as credit or default risk. A bond is a debt instrument that amounts to a contractual agreement between the bond holder and the company that issued it. The company promises to pay interest and return the principal at a certain date in the future (called the maturity date).
What if a company can no longer fulfill its obligations to debt holders or creditors? In that case, the company will likely file for bankruptcy protection and the bond’s contractual agreement to pay interest and return the principal will no longer apply. Thus, credit or default risk means you will no longer receive the cash flow you expected and there is a high probability that you will not get 100 percent of your committed principal back.
Market or systemic risk
Then there is market risk. This risk, also known as systemic risk, is the risk that exposes your holdings to the daily up-and-down uncertainties of the markets. When there is a significant break in the positive trend of a market, your positions will be affected just because the market in general is being affected.
Examples include the aftermath of the tragic events of 9/11 and the current economic crisis, as the financial sector reacts to federal intervention in the bailout of investment banks caught in the fallout from the sub-prime mortgage collapse.
Market risk is not limited to stocks. It applies to all sorts of financial assets, including real estate, bonds from corporate or government issuers and commodities. Note however that market risk is not always negative. As shares move along the market — as measured by an index — they can move to the upside, too.
Liquidity risk
When you try to sell a financial asset and cannot find a buyer who will pay an acceptable price, you have just bumped up against liquidity risk. It is defined as the risk to which you are exposed when trying to sell a financial asset. The lack of buyers or interested parties may prevent you from selling the asset at a favorable price. In fact, if you must sell at any price, you most likely will realize a loss.
To allow for the possibility that you will not have immediate access to funds if you decide to “cash in your chips” when buying illiquid assets, you should adjust the expected return on these assets upwards to compensate for the lack of liquidity. Rule of thumb: The return expected should be significantly higher than a U. S. Treasury note.
Country and other risk
Country risk takes into account that an investor, speculator or corporate entity may lose all or part of its principal or capital expenditure when expanding operations outside its home country. This loss could be attributable to the economic environment or political actions such as nationalization of the company, forced confiscation of assets, or repudiation of debt. One example: The attorneys for Exxon, are now dealing with a $12 billion lawsuit against Venezuela for freezing the company’s assets.
There are of course, many other risks to which we are exposed. Unexpected and rare events that result from exposure to blind risks are called “Black Swan” events. A Black Swan event gets its name from the long and firmly held belief that swans came in only one color — white — and any other color variation was genetically impossible — until black swans were discovered in Australia.
Risk is a fascinating concept that is intrinsically related to what separates investment from speculation and speculation from outright gambling. The fact is that if you want to make money or, for that matter, succeed in life, you need to take chances. The important thing is to understand those risks and enter into any sort of investment with your eyes open.
Co-authors Jose D. Roncal and Jose N. Abbo share some 50 years of senior executive experience in international business, finance and economics. Both have authored numerous articles on business strategy, finance, accounting, capital markets and the global economy. For more on the authors and their book, The Big Gamble: Are You Investing or Speculating?, visit: Financial Speculation.
Filed under Finances by on Nov 29th, 2008. Comment.
If you have been thinking about a loan with bad credit, you will want to be certain that borrowing is your best option before signing on the dotted line.
Many people wonder why you would want to try to obtain a loan with bad credit, but in fact, a poor credit history can be due to many causes that do not reflect poorly on the personal or spending habits of the borrower. In fact, obtaining a loan, even if your credit history is poor can be a way to turn around your life and make a fresh start. New financial habits are important when you are looking for a better financial future. Don’t let poor credit reports from your past eliminate your opportunities to improve your situation in the future.
To Consolidate Debts
Another reason for obtaining a loan with bad credit is in order to consolidate debts that you may have incurred. These debts can be credit cards over expenditures, bank overdrafts, major medical expenditures or even personal loans from family or friends. Regardless of your reason for incurring the loan in the first place, it may be recommended or necessary to consolidate these debts into one more manageable payment possibly with a better interest rate. By consolidating the debts, the monthly payment cost may be reduced. Even better, the interest rate overall may be reduced.
To Build Equity
A loan with bad credit can be a good idea if you have the opportunity to build equity in your property by doing so. Even with a poor credit history, it can still make good financial sense to improve the value of your home by renovation, remodeling or major repairs on the property. When you increase the value of the home at a rate greater than the cost of the repairs that you put into the home, you have built the equity of your home. Even if you just maintain the market value of the home, that is an accomplishment in today’s markets
To Start a Business
In order to start a business, you sometimes need to take out a loan. Such a loan with bad credit is a hard sell. Yet, it is important to have the financial resources to carry a new business during the first few difficult months to avoid having the new business go under due to lack of financial resources. If you have an idea for a business, the ideal preliminary to starting the business is to clean up your credit, but sometimes that is not possible to do without gaining a loan that can be paid off in good order.
To Improve Your Credit Rating
A loan with bad credit history can actually help you to improve your credit rating in the future. Getting credit improves your credit score and paying off the debt regularly is another way to improve your credit rating. Although you have one bad credit experience, you can still improve and correct the rating where it is not correct. Choosing to be proactive about improving your credit rating can be a very successful way to put yourself in a better financial position for the future. To gain financial benefit and improve your credit picture at the same time is a very appealing package.
Because of the volume of accurate and comprehensive information on the internet, finding A Loan With Bad Credit is not that difficult. The web site found at http://www.homemortgageloan-refinance.com/Bad-Credit-Home-Loan-Refinance.php will help you to find just the right loan.
Filed under Finances by on Nov 29th, 2008. Comment.
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