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What the heck is what the heck?

What the heck is an informational, educational page that gives you easier answers about seemingly complicated financial jargon.

What the Heck is …… the FOMC?
Personal Savings?
a Hedge Fund?
CPI  (Consumer Price Index)?
a Tracking Stock?
a Cash Balance plan?
"triple-witching?"

 

What the Heck is ……the FOMC?

Seems these days all anyone talks about is – what is Alan (Greenspan) thinking? Of course, it’s not just Alan, and not just what they think – it’s what "they" do, and increasingly what they say they are thinking about doing. If there is one area where words seem to speak louder than actions, it may be here The "they" is the Federal Reserve, established in 1913 by the (aptly named) Federal Reserve Act. The "Fed" (as it is more commonly referred to) was established to provide "a safer, more flexible and more stable monetary and financial system" – born of a time when many of the country’s financial institutions didn’t "play" well together. Today, ALL nationally chartered banks are REQUIRED to join the Federal Reserve System (state banks CAN join).

The Federal Reserve Act itself established (up to) 12 Federal Reserve Banks (district banks) to coordinate policy with a 7-member Federal Reserve Board in Washington. The Federal Reserve Board became the Federal Reserve Board of Governors in the 1930s (and the members became "governors"). The Fed has 4 major areas of focus; (1) conducting the nation’s monetary policy, (2) supervising and regulating banking instutions and protecting the credit rights of consumers, (3) maintaining the stability of the financial system and (4) providing certain financial services to the US government, the public, financial institutions and foreign official institutions. We’ll come back to these in a minute.

 

Board members are selected by the President and confirmed by the Senate for 14-year terms, staggered to expire every 2 years. This provides members with a long-term perspective – and reduces the chance that any one president will be able to approve all 7 members. One member of the board is chairman (as in Chairman Greenspan) – and another vice chairman (was Alice Rivlin, who recently resigned). Both serve 4-year terms (and Chairman Greenspan’s is "up" next June – but it can be extended).

The District Banks are headed by a President, selected by a board of directors (which is in turn comprised of 9 members) selected to represent various banking, business and community interests. 6 of the board members are elected by member banks – 3 from stockholder banks and the other 3 appointed by the Board of Governors (the general public).

The Federal Open Market Committee (FOMC) has primary responsibility for conducting monetary policy. It is comprised of 12 members - - the (7) Board of Governors, the President of the NY Fed and 4 of the remaining Reserve Bank presidents (who rotate). The other members of the Federal Reserve "contribute" to discussions, but do not vote on interest rate changes. They are required by law to meet 4 times/year – buts since 1980, 8 times/year has been the "nrom." Oh, and they use their Beige Book (its name comes from the color of its cover, not its contents) as a reference guide to the economic state of each of the Federal Reserve "regions."

The FOMC influences monetary policy (see above) by adjusting either (or both) of 2 interest rates – the Fed Funds rate, or the "discount" rate. Banks that are part of the Federal Reserve System are legally required to hold a specific amount of funds in reserves (currently between 3% and 10% of funds in interest-bearing and non-interest bearing checking accounts)– either cash in the vault or balances at the Fed. If you don’t have enough, you can borrow it from OTHER banks (who may have more than they need on hand) via the Fed Funds market – at the fed funds rate. So, when the FOMC raises this rate, banks’ cost of borrowing goes up (and bank profits go down).

Banks also have the option of borrowing funds directly from the Fed at their "discount windows", at the discount rate. But the Fed "discourages" this except for very exceptional short-term deficiencies.

In any event, when the FOMC raises rates, it (can) set off a string of events. Most immediately it impacts the cost of acquiring money (for banks at least – who then generally turn around and increase the costs of borrowing for THEIR customers) – and that can lead to less borrowing/business investment and/or higher prices for goods and/or less spending by consumers and/or slimmer profits/lower stock prices and/or higher bond yields (which draw money from stocks, which can cause stock prices to fall. In sum, you have to be careful how fast you step on the brakes (and, thankfully Alan & the FOMC have been).

On the other hand, by merely expressing concerns about the potential NEED to take steps, these days the markets have been doing a (reasonably) good job of proactively reacting – which has let the Fed influence the economy without taking ANY action.

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That Rainy Day Feeling?

One of the signs of perilous times ahead is the (generally described as abysmal) US savings rate. In fact, over the past several months the savings rate has supposedly fallen to rates not seen since the Great Depression. Taken along with the coming pressures on Social Security, the decline in traditional pensions and the questionable investment savvy of 401(k) investors, it seems as though a lot of folks could find themselves working longer and enjoying it less.

Ok, that "personal savings rate" that finds its way into the headlines comes from the Commerce Department (already one senses we may be in the wrong place). But their measure tries to look at how much INCOME we receive – reduces it by the INCOME taxes we pay – and by the amount of money we spend – to get how much we SAVE (personal savings).

The savings rate is determined as follows:

 

What the Heck is.....    personal savings / (personal income - personal taxes)

Breaking it down a bit more, INCOME includes wages/salaries, rental income, dividend/interest income, realized gains and "transfer" payments (like social security, unemployment, etc.). In sum, the kinds of things you include for income tax reporting. Spending ("outlays") takes into account anything you spend (including housing, cars and other big ticket purchases).

Criticisms of the current calculation – "investments" in a home can be considered a form of saving, but are not treated as such in the calculation. But the one that has garnered most attention lately is the fact that the calculation is NOT taking into account the Unrealized capital gains – both in and outside of 401(k) plans. The beef is that not only does it not include these gains – but when your portfolio is growing that fast, you tend to spend more. So the tremendous market gains not only don’t show up in your income – the increased spending that tends to result drags down your savings RATE (though not necessarily your savings). Making things seem worse than they are.

ARE we saving enough? Depends on how much you need, how much you want – and when you’re planning to need it.

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What the heck is …a Hedge Fund?

These have acquired a certain "taint" in the media of late, but if you go pre-Long Term Capital Management, a good working definition is "a flexible investment fund for a limited number of large investors (typically $1 million)." Hedge funds can use almost any investment technique – INCLUDING those NOT allowed for mutual funds, such as short-selling (selling an asset you don’t own) and heavy leveraging (borrowing money you don’t have). This is "allowed" because these funds are typically restricted to "accredited" investors – i.e., those with enough money and/or financial acumen to take care of themselves (and thus don’t need the oversight of somebody like the SEC) – at least that’s the theory.

Theory (or at least the successful application of it) is critical to a hedge fund. Hedging is "taking two positions that will offset each other if prices change, in order to limit financial risk". In other words, tails you win, heads you still win. And if things go the way you plan (most of these use intricate computer models that make money on the relative differences in interest rates – using derivatives and leveraging (borrowing money) to do so. Of course, when things DON’T go the way your computer model predicts, and you have to make payments on the money you borrowed and those investments you made are declining (rapidly) in value…

A hedge fund is commonly structured as a limited partnership, where the investment company/manager is the general partner, and investors are limited partners. Current securities regulations (things can change, after all) limit the number of investors in each fund to 500. Individual investors have to meet certain income/net worth criteria to be an "accredited" investor (there are somewhat more complicated rules for institutions).

You won’t find much information about these funds in the newspapers (aside from those encountering trouble) - but there are rumored to be about 4,000 domestic and offshore hedge funds in existence with as much as $400 BILLION.

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What the Heck is the CPI?

By the time you read this, the Consumer Price Index, or CPI (as it is affectionately known) will be – known – at least May’s flavor (NOTE: Unchanged for the month – the core rate up just .1%). Of course, since this index supposedly measures how much we pay for goods and services, we should all "care" about how quickly it increases (the Bureau of Labor Statistics says it is "the principal source of information concerning trends in consumer prices and inflation in the United States"). But the reality is that these days most of us have an eye out not for what the CPI is – but for what the Federal Reserve Open Market Committee (FOMC) might do ABOUT it.

The CPI has been with us for awhile now, though it has undergone changes. It was born in the inflationary times of the first World War, when then-President Woodrow Wilson was trying to avoid strikes by the country’s shipbuilding union workers. Actually, he asked the Labor Department (who retains responsibility for calculating the index) to derive a measure of inflation that wage hikes could be tied to. It began being regularly published in 1921. Since WWII, it has been revised (just) 5 times – in 1953 (to expand its geographic focus to smaller and medium-sized cities), 1964 (including singles as well as marrieds – and introducing computer processing), 1978 (better sampling statistics) 1987 (updated for 1982-84 spending patterns and enhancements to computations and 1998 (changes to the stuff in the basket) – though these changes didn’t show up in the reporting until THIS year.

Today the CPI remains THE single best measure of inflation – how much (more) we pay for things than we used to – and some argue it may actually contribute to the problem. Among other things, many pensions – and even social security are tied to the CPI. It is used to adjust the tax brackets and income levels for personal income taxes – and these days used to determine the payout for TIPS (Treasury Inflation-Protected Securities).

How does it measure inflation? Well it tracks the prices of a select group of goods and services that supposedly give us a flavor for how we spend our money. It’s not perfect – in fact for some, it may be downright "out of touch". But for most of us, over time, it is probably a reasonably good measure (at least as good as those Nielsen ratings).

The table components are spelled out elsewhere in this issue – housing is a biggie (40%) and transportation (which includes gasoline, among other things) makes up 17%. Medical care makes up only 6% (oddly enough, so does recreation) - because the CPI only picks up the part that comes out of OUR pockets (not insurance). One other distinction – the "core" CPI rate excludes the more "volatile" categories of food and energy – more volatile because they can swing wildly from one month to the next – and therefore don’t tend to provide as accurate an assessment over a longer period of time.

Now, if you’re wondering why the Fed cares – the more things cost, the more money we have to spend to buy them – the more income we need to afford to spend to buy them – the more we (workers) demand from our employers in terms of wages to provide the income to afford to spend to buy – the more companies have to raise their prices to afford those higher wages that provide the income that allows us to spend to buy - - and so on. It CAN become a vicious cycle – particularly when the supply of workers is limited (as it apparently is now). The Fed just doesn’t want us to spend the first years of the 00’s the way we spent the last 5 years of the 70s.

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What the Heck is……a Tracking Stock?

Simplistically, a tracking stock is – a stock – one that is specifically intended to track the performance of PART of the issuing company’s assets. It is most commonly seen these days when a traditional company (like, say Disney) acquires a non-traditional (or at least not AS traditional) company, like a "dot.com". The idea is that you don’t want to "muddy" the performance waters of the traditional company – or limit the excitement of investors for the non-traditional (depending on which way the market is treating you at the moment.

The concept of a tracking stock itself is perhaps a bit misleading. While the company in many ways acts like a "spin-off" – it has separate financial statements, and is generally "run" like a separate business – but it ISN’T a separate company, there is no separate filing with the SEC and, in legal terms there is NO separate company – just another class of stock (sort of).

Why not just DO a spin-off? Well, there ARE some "efficiencies’ to be wrung from having a single corporation (legally), and in the absence of this approach, some large companies might shy away from making these investments. Doing so allows the market to "more accurately" value the prospective business, and you can sometimes arrange for more flexible funding as a result. More importantly these days, you can tie those equity incentives (stock options) more closely to the company to which an employee is actually contributing.

Some things you DO have to nail down; voting rights, dividend rights/policies, liquidation rights, mandatory/optional exchanges and retained interests.

By the way, tracking stock was first used by General Motors in its acquisitions of Electronic Data Systems (EDS) in 1984 – and again with Hughes Aircraft in 1985.

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 What the Heck is….a Cash Balance plan?

We might begin by asking what BellAtlantic, AT&T, Bank of America, Citigroup, CBS, Eastman-Kodak, Colgate-Palmolive and IBM have in common? Well, as you might guess they all have, or will have, or are thinking about having - a cash balance plan. Let’s start with the basics…it is a qualified plan under ERISA…and it is a defined benefit plan…but it "feels" like a defined contribution plan. Usually, it’s termed a "hybrid" ("…an offspring of two animals or plants of different races, breeds, varieties, species, or genera"). So, is it the best – or the worst of both worlds? A little of both – depending on your perspective.

Who benefits under a cash balance plan? Younger, more mobile workers – who tend not to collect much benefit under traditional pension plans. Employers – who tend to find traditional pension plans a very expensive, yet widely unappreciated benefit. And also when younger, more mobile workers "move on" with all those (expensive) matching contribution dollars. Who loses? Older workers with more seniority (and accumulated benefits) – typically those with more than 15 years of service and over age 55 (depending on the plan).

How does it work? Simply stated the employer funds the trust based on a formula (like a DC plan) – generally a flat percentage of pay (4-5% seems to be common) – and an account is established for each individual (also like a DC plan). You generally get a statement of your account balance (DC). Your account is credited with interest based on a pre-determined rate/formula – established and communicated prior to the plan year (different than either DC or DB). The employer funds the trust based on actuarial assumptions (DB), and the rate of return the trust actually receives can (and often is) totally different from the committed rate (DB) – and the employer is on the hook for any difference between the committed rate and the actual one (DB plan).

Other similarities – the plan IS insured by the PBGC (DB) – and the employer pays premiums (DB). If you get a distribution, you can roll your cash balance – balance - into an IRA.

More recent converts to the cash balance concept seem to be taking a couple of extra steps to "ease" the transition for employees, either grandfathering existing pension programs for older/longer service employees (though that isn’t required) – or expanding stock option programs. Legislation has been introduced by Sen. Daniel Patrick Moynihan, that would require employers to fully disclose to all employees how their personal benefits would be affected by a pension-plan switch.

On a historical note, the first cash balance plan was introduced in 1984 at Bank of America (ably assisted by Kwasha Lipton). They have been slow to take off – but the pace is definitely picking up. 

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What the Heck is "triple-witching"?

What it is is perhaps less important than WHEN it is – in this case, the third Friday in March, June, September and December. On those days, stock options, stock index options and stock index futures all expire simultaneously. That there are THREE things expiring explains the "triple". That they essentially go "poof" explains the "witching."

Now, the reason the question gets asked has to do with what happens WHEN – since when the options/futures (essentially the right to buy or sell something in the future) "expire", investors frequently scramble around trying to buy stock to cover their exercised option positions. That "scrambling" (especially the institutional variety) tends to create more trading volume and more volatility in the markets.

Note: on Fridays when stock index futures and stock index options expire, it is called a double-witching.

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