Torts, cookie jar accounting, butterfly options, and the Fed: Winter Semester 2013

Introduction and Conclusion

            As lengthy as this article appears, it is in reality not a comprehensive list of things learned this semester and because it was pretty hastily typed it also could have some inaccuracies. Inaccuracy also is the result of me being a straight “A minus” type student. I have included information about business law, corporate accounting, advanced investments, and banking and so feel free to only read a section you are mildly interested in. I didn’t put sections in about my Judaism or Joseph Smith Translation classes mostly because of time constraints but also because these classes are guaranteed above A minus type classes and so I’m not too concerned about jolting my memory on their topics. I will say that my teachers in those classes were experts and I my testimony and knowledge grew immensely from the material portrayed in those classes. I hope these brief random explanations of random things I remembered learning this semester will be useful to you and feel free to check out last semesters blog entry too.     

Business Law

            A kid said an interesting thing in one of my classes the other day. He said that our generation commits less to memory because we are reliant on internet searches. Why actually remember what a tort is if I can just Wikipedia it? Well turns out that torts were something I had googled numerous times before this class, I think that kid is right. So stick this definition to your memory and don’t Wikipedia it down the road: torts are wrongs. They are the violation of protected interests. Torts can be intentional, unintentional (negligence), or derived from someone’s strict liability. Examples of intentional torts are assault, false imprisonment (i.e. Wal-Mart inappropriately holding suspected shoplifters), or misappropriation of the right to publicity (i.e. I can’t use Michael Jordan even if he was dead or unknowing). Unintentional torts are harder to identify and relate to actual and proximate cause. To constitute negligence a plaintiff will have to prove the defendant had a duty of care, that he breached that care, and that injury was the result. Examples would be a video game being blamed for a school shooting or fireworks knocking down clocks when wrestled from a person bringing boxes onto a train (inside joke). Strict liability is liability without fault and deals with products. Companies have a responsible to reasonably inform consumers of danger. If there are foreseeable misuses then that must be identified; this is why irons say, “Caution hot: Do not iron shirt while wearing the shirt.”

            The stages of litigation are fairly interesting. It is funny our “business law” class started off talking about criminal procedure of murder, assault, and rape cases. The syllabus is definitely rigged to suck us in and then punch us in the face with contract law and agency formation after the add/drop deadline. In accordance with Jesus Christ’s teachings (“agree with thine adversary quickly”) well over 90% of cases are settled before they come to trial. Pre-trial includes pleadings (complaint filed, answer, affirmative defenses, cross-complaints etc.), and discovery (subpoenas, interrogatories, mental examinations etc.). If settlement is not reached, or neither motion for summary judgment or motion for judgment on the pleadings is made, then trial ensues. Trial includes jury selection, opening statements, direct and cross examinations, closing arguments, jury instructions, deliberation and verdict, and then entry of judgment. Then appeals follow chains through state and federal courts. Interestingly enough a judge can enter a judgment notwithstanding the verdict.

            Latin probably should still be taught to youth. I have been heavily exposed to it in medical classes and suspect I will get more than a small dose of it in law school. A couple good ones are stare decisis (let the decisions on previous courts stand in future ruling, related to common law) and res ipsa loquitur (as opposed to the plaintiff carrying the burden of proof, a defendant must prove their innocence, examples being malpractice situations where a patient was unconscious).

            I had never made the clear distinction between civil and criminal procedure. Criminal courts can give punitive damages (i.e. throw you in jail) while civil courts only relate to giving money (i.e. Jesus’ teaching about “eye for an eye” related to damaged eyes having monetary value tied to them).

            One of the few pieces of legislation we were introduced to was Sarbanes-Oxley. This law stipulates that officers (i.e. CEO, CFO, etc) in a company must put their stamp of approval on financial statements, personal loans are prohibited to officers and directors, evidence tampering is more scrutinized, and securities crime committer’s can be barred from serving on boards and as officers.

            Something good to know is that minors can always disaffirm a contract unless it is related to a necessity of life. Therefore a minor can buy a video game and return it after the printed due date and Wal-Mart must offer a refund. It is the risk of companies to sell to minors, let’s take advantage of this law a little more people.

            Individuals shouldn’t take advantage of fiduciary relationships and persons in certain positions need to be wary of exercising undue influence over subordinates. I will sue the caretaker of my grandma if it turns out grandmas will somehow got changed to give her inheritance to the caretaker. And I will sue my broker if he doesn’t act in my best interest.

            I missed the problem on exam 1 about quasi contracts. Quasi contracts are implied in law contracts and in reality not contracts at all. They are used to create equality and right wrongs. It is like restitution for a wrong someone did against me in a contract.

Corporate Financial Reporting

            This class had my favorite professor and so it is a shame that this section will be a little smaller than the business law section. Fact is there was just a ton of numbers stuff in this accounting class and that is hard to portray here. Dr. Drake performed a lot of case study for us and we got to learn interesting things about companies: Facebook sucks at avoiding taxes, Ryanair relies on ancillary revenues (i.e. flights into weird airports) and major cost cutting, Boston Market used franchising to a degree which made them profit more from franchising then from selling chicken, Microsoft has an gaudy amount of “cash” and is getting big returns on this asset because it’s actually being invested, and lots of other interesting things which make these companies unique in their approach to financial reporting.

            Arthur Levitt was the chairman of the SEC and called for regulation crack down on earnings management. His calls went unheeded and the auditing mess of the early 2000’s ensued. The encouraging tone of his initiatives illustrated to me that there are great moral people in the business world. His “Numbers Game” address was related to selective disclosure (private news preceding public release), transparency, big baths (pile on losses if one year will actual have losses), comparative acquisition (expense purchased R&D), cookie jar reserves (recognize cash as unearned revenue until there’s a down year on revenue, mess with your bad-debt expense, overestimate bad-debt allowance), materiality (round and accidently alter seemingly insignificant numbers which push EPS or other numbers to normal levels), and revenue recognition.

            Financial analysts need to pay attention to net income, comprehensive income, and other comprehensive income numbers. Other comprehensive income includes unrealized gains and losses on certain investments, foreign currency items, and certain pension liability adjustments. These numbers are important to review because according to GAAP only net income has to be reported although I think a note is needed for other comprehensive. Comprehensive has more variability to it might unfairly report a firms well-being.  

            Inventory theory is pretty fascinating. If there is an increasing tax rate and inventory was cheaper to purchase in the past then it’d be useful to use a FIFO strategy with inventory. If prices of inventory are inflating and you are looking for high profit margins then it’s good to use LIFO. LIFO generates income tax saving in times of inflation. LIFO isn’t allowed by IFRS because it lowers inventory costs on the balance sheet (assuming inflation). There are a surprising amount of inventory strategies but average cost is the last one worth mentioning. Earnings management is possible through inventory layers. Alright this is already getting pretty boring.

            I was interested in the pension portion of class because I like retirement stuff. Pensions are classified as being either defined benefit or defined contribution. Defined benefit plans usually are huge liabilities for companies and the investment risk falls on the company. Defined contribution shifts investment risk to employees.

            Bankruptcy can be predicted using Altman’s Z-score analysis. This fairly straightforward equation can be applied to companies to find if they are close to trouble. We used the WRDS website to look up financial data and saw the progression of Borders Books towards bankruptcy. The equation includes very well-known balance sheet and income statement numbers but is quite accurate in deriving a z-score which indicates probability of default.

            The statement of cash flows is the most useful financial statement. The balance sheet and P&L are merely items needed to make a statement of cash flows. Cash is king and the SCF shows where money is flowing within a company. The SCF reverses accrual accounting. The SCF is broken down into operating, financing, and investing sections which will give good indicators of company strategy. 

Advanced Investments

            A derivative “derives” it’s worth from an underlying asset. This class was fairly exciting because it took us pretty close to ground zero of the financial crisis. Examples of derivatives are options, futures, forwards, and swaps.

            Futures and forwards are fairly similar with a notable difference being that in forward agreements delivery of the underlying good actually occurs. Forwards have their roots in farming where farmers hedged against the risk of a bad crop by getting into a contract which stipulated the price they would be able to sell their goods, whether or not demand and supply changed the actual price of that good. Basis risk refers to the difference between the spot price and futures price of a forward or futures contract. As the maturity date approaches the basis risk naturally lessens.

            Options can be written or bought on a stock. A call option is the right to convert and buy a share at a given strike price. A put is the right to sell a stock at the strike price. Strategies with options include bull spread (buy a call or put with low price compared to and offsetting position in a higher priced call which you sell; executed if price jump expected), bear spread (opposite bulls strike prices), and butterfly spread (buy high strike, buy low strike, sell 2 of an intermediate strike; executed if very little price movement expected. There are combination strategies like straddles, strips, straps, and strangles which I won’t bore details on.

            European options are exercisable only at the contracts end date and American options naturally have more freedom and can be exercised at any time during a maturity window. Long and short positions are fairly well known, if you are long then you expect upward movements and have the buying position. If you are short you have the selling position and suspect that prices will be going down.

            Basis points is an important financial term. 100 basis points is equal to 1%. This is an easier term to use when analyzing small changes in rates. Saying a 20 basis point change occurred is clearer than saying 0.2 % change.

            We gained more insight this semester on the use of risk-free rates. LIBOR is the interbank lending rate of banks in England. These banks lend their excess reserves to each other at this rate; it is a market driven rate. LIBOR is used for short-term derivative trades. To derive present value using the CAPM or in many other situations a historical US Treasury rate is used.

            We memorized the Black-Scholes formula. Black, Scholes, and Merton were some dudes who made a break through on valuing options. They got a Noble Peace Prize (well Black didn’t cause he was dead) for their formula and thirty years later I got a headache memorizing and applying it.

            You have probably heard bad things about Credit Default Swaps. Let me tell ya just a little about them: They essentially are the insuring of one company against the risk of its borrowers defaulting. One bank pays premiums to an investment bank and the i-bank bails them out if the underlying asset defaults. Bad thing is that the investment bank sometimes gets bad information about the default probability and usually doesn’t care because it has already packaged up its CDS and divided it up to unknowing investors.

            Currency swaps exchange principal at the beginning and end of a contract and speculate, hedge, or arbitrage based on the appreciation of a certain countries currency relative to another countries.

            Interest swaps involve one party wanting to get out of a fixed interest agreement and move to a variable rate situation. An intermediary usually banks a little one orchestrating this exchange and both sides come out even (kind of).

            I will start a brief insight into the 2007-2009 financial crisis with a little insight into collateralized debt obligations (CDO). Loans are given to several homeowners. These loans are combined and sold as a Mortgage Backed Security (MBS). The MBS is divided into several tranches (senior, mezzanine, equity). When default occurs the equity tranche is affected first and the investors in that tranche possibly do not receive an return on their investment. Rating agencies therefore will give equity tranches a lower rating and the expected return of these securities, given their high risk, is higher. A sneaky thing which investment banks did was complicate this process by dividing the mezzanine tranche into its own senior, mezzanine, and equity tranches. The chance that the senior level of the mezzanine tranche got paid was extremely good and so rating agencies would go head and give AAA ratings to these levels. Problem is that when house prices drop and defaults skyrocket, well AAA rated securities go bunk and AAA rated securities aren’t supposed to do that. This played a large role in the financial crisis.

            Who is to blame for the financial crisis? You, me, and everybody. Homeowners bought beyond their means, mortgage officers gave bad loans, banks hid information from investors, government forced the American dream, rating agencies worked for money and not correctness, people lost foresight, and everybody but Goldman-Sachs hurt because of it. Greed was the underlying principle which cause this eye opener.

Money, Banking, and Business

            Manec 453 was a macroeconomic class. It is interesting that while we would talk for a half hour about local restaurants and the Marriott School dean search, I actually still found it to be my most useful class.

            Our first group assignment required us to gather historical data on the consumer price index (CPI), stock market, unemployment, inflation, money supply, and compare these to GDP. We ran regressions and found which factors had a strong correlation to GDP changes. Using p-values below .05 and t-stats over 2 as our test of significance we found that money supply two quarters previous had a strong positive effect on GDP change in the current quarter. We also found that inflation four quarters previous had strong negative effects on GDP this quarter.

            We also gathered CDS premium spread data and compared seven different countries on the changes to these spreads. We matched information releases with large changes in CDS premiums. The 2012 Euro Crisis happenings caused interested things to happen across the world and actions taken on by the European Central Bank (ECB) did a good job of stabilizing these prices.

            I was introduced to quantitative easing. QE is the federal reserve’s using of unconventional means to control money supply and interest rates. Because the federal funds rate is below the deposit rate the Fed is having a hard time keeping the interest rate down solely using normal means of control. Normal policy tools to reach their target federal funds rate includes adjusting discount rates, reserve requirements, and through open market operations. QE-3 is a reference to the latest batch of MBS purchases which the Fed made. Banks are still hesitant to use their influx of money to lend and thus it has been fairly ineffective.

            We had a mock FOMC meeting and I now understand the federal reserves structure a little better. There are twelve regional reserve banks which have input onto who is on the board of governors and FOMC committee. The FOMC meets to determine its target lean for inflation or for growth and its target federal funds rate. The reserve in New York is the most powerful and is where the discount window is open for trading. The Fed is the bankers bank and the governments bank and sets reserve requirements which therefore effect the lending which big banks do to each other in order to keep their reserves in line.

            I enjoyed our daily requirement to read the Wall Street Journal. My understanding of articles is up to 68% which is over a 100% increase from the previous all-time high of 31% comprehension. All indications are that by December when I graduate I will be comprehending at a 93% rate.

            We executed carriage trades which essentially involve a trader obtaining a countries depreciated currency, investing in its high interest rate and also getting gains from its appreciation relative to another country. In the end you exchange back into a certain currency having made gains both off of interest differences but also the change in the exchange rate.

            We debated whether over the counter (OTC) derivatives should be regulated more and moved onto exchanges. We were assigned the side which proposed moving to exchanges and though it wasn’t our true position we defended it well and mopped the floor with our unprepared opponent. Our argument centered around OTC derivatives effect on the financial crisis including the ability of dealers to enlarge counter-party risk and the volatility of the industry.

            Our final will include determining the effect of the money multiplier. This is an interesting concept which illustrates that one dollar lent out by the Fed will eventually trickle down to the creation of many dollars because banks will lend. This is how the Fed affects the money supply in our nation.

            This class will someday be called Financial Economics and joyously the finance students had to do extra work over fellow classmates. We were required to complete weekly excel modules and though I appear to gripe now, they actually were fairly useful and exciting to complete. The particular ones I enjoyed learning were efficient frontier, discounted cash flows, residual income, and Monte Carlo analysis. We learned cool hot keys, how to extract data from FRED and other sites, interesting formulas like RCH get element, and how to “give it a little formatting”.