By getting your debts taken care of as soon as possible, you can begin taking care of this goal, so that it, too, doesn’t overwhelm you later. After all, your goal is not to just eliminate debt or save for the future, but to do what you need to do, so you can get on with enjoying today.
Just like with retirement, there are things you should be doing today, even in the midst of getting out debt, to help prepare for future college costs:
Move to a different state. Just kidding. But there are some states that offer their residents a matching contribution for putting money into a Section 529 plan. For example, the Arkansas Aspiring Scholars program will match a $250 contribution to their state savings plan with up to $500 (depending on income).
Check with your state treasurer’s office to see if such a plan exists. Contribute toward college for holiday and birthday gifts. Consider opening college accounts for your kids at your local brokerage house and asking the grandparents to divert some of their holiday spending there. Trust me, your kids will appreciate it way more than a pair of socks.
Use UPromise and BabyMint. Both of these services are free to sign up for, and set aside money into a college account for your child every time you shop. It doesn’t actually increase the cost of your purchases, but instead is a way for stores to reward you for your loyalty. You can also have your friends and family register their cards to contribute to your child as well.
I’m not going to bore you with every possible financial goal, but if you plan on putting yourself or someone else through college in the future, it’s imperative that you begin to save for that now. Again, to save adequately, you’ll need to eliminate your monthly debt obligations as soon as possible.
Failure to plan for college expenses has two major effects in my experience. First, many people who have not planned and saved adequately usually stop saving for their other goals while scraping to pay for tuition. Even a small delay in getting started on saving can have a huge impact on what you’ll have to save later to play catch-up. Second, the failure to plan for college usually results in the accumulation of more debt in the form of student loans. While these are often a necessary evil, they can be one more financial weight around your already exhausted neck. (See Chapter 15 for more on student loans.)
The magic by which seemingly small income streams get magnified into huge market valuations is intimately tied up with the arcane mathematics of perpetuities. It sounds dull, but it is well worth understanding because it is the mathematical foundation of Wall Street wealth.
Aperpetuity is defined as an investment offering a level stream of cash flows forever. What is the value of a perpetuity paying $100 per year forever? Using a cost of capital of 12 percent, it would be the present value of the first payment, plus the second payment, plus the third payment, . . . , plus the fiftieth payment, and so on; that is, $89.29 + $79.72 + $71.18 . . . . The value of the payments gets progressively smaller. The value of the fiftieth payment is only 3 cents!
It turns out that the present value of this stream, no matter how far one goes out in time, cannot exceed $833.33. That number is the free cash flow of $100 divided by the cost of capital, 12 percent, or 0.12—a very simple relationship that we introduced earlier.
Mathematicians say simply that this series converges to a finite limit. This one converges fairly quickly—it reaches 90 percent of the limit in 20 years, and 95 percent in 26 years. So in a practical sense, realizing the value of a perpetuity does not take forever, just a period of time that is consistent with the lifetime of a durable business.
Competitor reaction to an innovative new development is always uncertain, but it is to be expected. Competitors have the power to obviate the assumptions in a business plan. Ignoring this power can lead to overvaluation of the option. We have seen this factor in the Amazon case.
Prior to the innovation, some competitor reaction is already built into the economic base case; after all, the existing price structure and market share has been established in a competitive environment. Changes tend to be incremental. But a new development typically may elicit an exceptional response.
Consider a hypothetical situation. Today’s catalytic converters on automobiles must meet government-mandated emissions specifications regarding performance and durability. They require expensive noble metals, such as platinum, palladium, and rhodium. Assume that Aardvark Catalyst Co. invents and patents a new formulation that replaces more than half the noble metals with nickel and can thereby reduce its cost of goods sold by a full 50 percent. It offers the customers, automobile manufacturers, the new product at a 25 percent discount. This discount reflects half the cost savings, thereby giving the customer a compelling value proposition, while adding the other half of the savings to Aardvark’s bottom line.
If innovation has been the source of our extraordinary prosperity, it is important to inquire about its future. The good news is that the rate of discontinuous innovation in Western society appears to be accelerating. This rate is likely to hold if the two bedrock premises of innovation also hold over time: (1) the willingness of investors to accept high risk and (2) the continued existence of opportunity.
Today, investors seem very willing to accept high risks. The level of financing is virtually unprecedented, with the prospect of more than $50 billion being invested per year by venture capitalists alone, a 10-fold increase over the previous decade. Whether this pace of investment will be sustained is another issue. Too much capital chasing too few good ideas is a sure way to drive down returns. But if we believe Daniel Bernoulli’s ideas about utility, the fact that investors have a greater stock of capital than ever before virtually ensures that they will, over time, be more tolerant of high risks.
What about the continued existence of opportunity? At the end of the nineteenth century, the commissioner of the U.S. Patent Office famously recommended that the office be shut down because everything that could be invented already had been. His colossal misjudgment is as widely quoted by speakers at innovation conferences as is Malthus in economics textbooks—but the number of issued patents continues to grow exponentially.
Service relationships—with vendors, consultants, and law and accounting firms—have been mentioned as a hidden part of a company’s intellectual capital. Partnerships and alliances can be even more important. To the extent that a company can effectively muster the energies and the brainpower of a powerful strategic partner, it can speed its product development, reduce the cost of manufacturing, and rapidly penetrate its target markets—all enormous competitive advantages. Major companies such as IBM enter hundreds of such relationships. These relationships are intellectual capital of a most important type—mutual understanding of capabilities and costs and trusted working relationships.
From the viewpoint of the real options solution, strategic alliances only create value when they enable plans. It is possible they will be formed because of personal relationships and a vague sense that working together can help both parties, as when two top executives meet on the golf course. But value will not be created until an option is framed. In time, when that option is exercised, the strategic capital represented by the alliance is translated into economic capital.
Cisco, which produces networking devices (the king of routers) and software, owns only two of the 38 plants that assemble its products. It connects component manufacturers, assemblers, logistics providers, systems integrators, and its own employees and customers in what is known as a b-web (business web). The arrangement leverages the strategic capital of the participants and appears to provide exceptional value. Nortel has embraced the same approach.
It is clear that during many of the past 50 years, risk-free investments such as Treasury bonds offered real after-tax returns that were either negative or in the low single digits for high-bracket investors. (For example, a 5 percent nominal return in a 40 percent tax bracket with 3 percent inflation is a zero percent real return.) Under these conditions, a safety-minded investor cannot create much value, and during long periods she may slowly see value erode.
But a high-risk investor can actually do a fairly good job of approximating total tax avoidance. If she invests in a basket of fairly high risk, poorly correlated securities, in an average year she will have some gains and some losses, but more probably a net gain. (Common stocks have averaged about 11 percent annual appreciation over the past 70 years.) She can sell all of her losers to establish tax losses and sell winners that generate an equal amount of gains. The tax-free proceeds of these sales can pay her living expenses, and any balance can be reinvested in new stocks. Until she runs out of losses, she will pay no tax. In effect, she can use risk—here viewed as a dispersion of returns—to create a tax shield, whereas we have shown why an investor who opts for a risk-free return has no such shield.
With a tax structure that favors value-creating high-risk investing and rather heavily penalizes more conservative investment patterns, it is no surprise that the United States leads the world in business innovation. The good news is that we seem, for the moment, to be better than the other guy. However, viewed through the lens of total value, the U.S. tax system is a large encumbrance when compared to an ideal system designed to maximize value creation. This is the bad news. But it is also good news, in a sense: There is room for improvement. As we get smarter, we’ll get better.
In this section, we examine the delinquency and roll rates, and the default and loss severity of subprime loans. The delinquency status of a loan indicates the number of days the borrower is contractually past due (i.e., days past due or dpd). The loan delinquency statistics may be calculated using either the Mortgage Bankers Association (MBA) method or the Office of Thrift Supervision (OTS) method.
Using the MBA method, a loan is considered contractually delinquent if the payment is not received by the end of the day immediately preceding the loan’s next due date (generally the end of the month). For example, a loan due on November 1, 2006 with no payment received on November 30, 2006 would be reported delinquent on the November statement to bondholders.
Using the OTS method, a loan is considered contractually delinquent if the payment is not received by the close of business on the loan’s due date in the following month. For example, a loan due on November 1, 2006 with no payment received on November 31, 2006 would not be reported delinquent on the November statement to the bondholders.
The OTS method delays the reporting of delinquent loans by one month relative to the MBA method. It is important to know which reporting method is used by each originator or servicer when comparing delinquency statistics.
On July 30, 1953, the federal government established the U.S. Small Business Administration with the purpose of aiding, counseling, assisting and protecting small businesses. SBA financial assistance is vital to the growth and startup of small businesses. Over the years, the SBA has grown in its total assistance provided and also the types of programs offered. Almost 20 million small businesses have received assistance through one or more of the SBA’s programs.
In addition to financial assistance, the SBA also offers tools to manage a business from start to finish and has made improvements to its own business processes. Following the hurricanes of 2005 (Katrina, Rita and Wilma), the SBA experienced an overwhelming number of loan applications from disaster victims. Lacking the capacity to process all of the loans, the SBA established the framework for a recovery plan to deal with future disasters.
Analyzing CDO performance is challenging because there is no publicly available secondary market data. Furthermore, there are no readily available performance statistics or CDO indexes to gauge total returns. Certain proxies for CDO collateral performance exist, such as leveraged-loan closed funds (as a proxy for CLOs), synthetic residential MBS indexes, and leveraged-loan indexes, but due to structural and managerial differences, these are not always a good substitute for the various notes in the CDO structure.
Still, there is ample information available to investors to monitor their individual transactions. Most dealers publish surveillance reports. Moody’s publishes a series of monthly reports (see the appendix to this chapter) that detail CDO performance, broken down by vintage and collateral type. These reports are the closest publication we have to a market performance matrix. Moody’s even details CDO equity returns. The reports are extremely beneficial when examining macrotrends in the CDO market but, because names are not listed, the reports cannot be used to determine the performance of specific deals.