I thought the first rule of investment was, "If you can't understand what it is, don't buy it!"

Credit default swap. From Wikipedia, the free encyclopedia

A credit default swap (CDS) is an agreement that the seller of the CDS will compensate the buyer in the event of a loan default. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults.

In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDSs contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan. The European Parliament has approved a ban on naked CDSs, since 1st December 2011, but the ban only applies to debt for sovereign nations.

Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion [ !!! ], falling to $26.3 trillion by mid-year 2010.

Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), although some are tailored to meet specific needs. CDSs have many variations. In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called a credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicle issuing asset backed securities.

CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the multi-trillion dollar size of the market, which could pose a systemic risk to the economy.

Credit default swaps and other derivatives are unusual--and potentially dangerous--in that they combine priority in bankruptcy with a lack of transparency. In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data) announced it would voluntarily give regulators greater access to its credit default swaps database.

A number of financial professionals, regulators, and the media have begun using credit default swap pricing as a gauge of the riskiness of corporate and sovereign borrowers, and U.S. Courts may soon be following suit.

For more punishment, go to http://en.wikipedia.org/wiki/Credit_default_swap

Tuesday January 31. Is risk ever to remain a subjective phantom, or can it be meaningfully quantified?

Tuesday January 31. Is risk ever to remain a subjective phantom, or can it be meaningfully quantified? Let’s try to deal with it conceptually first, then try to quantify it second, OK? Types of Investment Risk:

1. Asset-backed risk: Risk that the changes in one or more assets that support an asset-backed security will significantly impact the value of the supported security.

2. Credit risk: Credit risk, also called default risk, is the risk associated with a borrower going into default (not making payments as promised). Investor losses include lost principal and interest, decreased cash flow, and increased collection costs. An investor can also assume credit risk through direct or indirect use of leverage.

3. Foreign investment risk: Risk of rapid and extreme changes in value due to: smaller markets; differing accounting, reporting, or auditing standards; nationalization, expropriation or confiscatory taxation; economic conflict; or political or diplomatic changes. Valuation, liquidity, and regulatory issues may also add to foreign investment risk.

4. Liquidity risk: This is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). There are two types of liquidity risk:
Asset liquidity - An asset cannot be sold due to lack of liquidity in the market - essentially a sub-set of market risk. This can be accounted for by:

• Widening bid-offer spread
• Making explicit liquidity reserves
• Lengthening holding period for VaR calculations

Funding liquidity - Risk that liabilities:

• Cannot be met when they fall due
• Can only be met at an uneconomic price
• Can be name-specific or systemic

5. Market risk: This is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices:
Equity risk is the risk that stock prices in general (not related to a particular company or industry) or the implied volatility will change.

• Interest rate risk is the risk that interest rates or the implied volatility will change.
• Currency risk is the risk that foreign exchange rates or the implied volatility will change, which affects, for example, the value of an asset held in that currency.
• Commodity risk is the risk that commodity prices (e.g. corn, copper, crude oil) or implied volatility will change. Operational risk

Plus Operational risk, Reputational risk, Legal risk, Information Technology, and Model risk per Wikipedia. I would hasten to add let’s not forget Stupidity Risk!

A five factor model of investment risk ...

A five factor model of investment risk ...

The research shows that financial risk can be thought of in terms of five factors or dimensions:

Three Stock Factors

 1. Market: Stocks have higher expected returns than fixed income
 2. Size: Small company stocks have higher expected returns than large company stocks
 3. Price: Lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks

 Two Fixed Income Factors

 1. Maturity: Longer-term instruments are riskier than shorter-term instruments
 2. Default: Instruments of lower credit quality are riskier than instruments of higher credit quality

Two pieces of good economic news helped the market come back.

Two pieces of good economic news helped the market come back. A Federal Demand for business loans increased in the fourth quarter as economic growth accelerated, according to a Federal Reserve survey of senior loan officers at banks.

Seventeen of 56 banks reported stronger demand among companies with $50 million in annual sales or more, according to the survey released today. Six reported weaker demand. Demand among small businesses for loans increased by the most in any quarter since 2005. While business demand for borrowing increased, banks reported "little change in standards on commercial and industrial loans but a continued easing of pricing terms," the survey said.

Second, the Federal Reserve Bank of Dallas' monthly Manufacturing Outlook Index showed a big jump from -0.3 to 15.3 in its general business activity index. Most components in the index showed improvement.

From "Stocks shrug off Greek worries" By Charley Blaine on Mon, Jan 30, 2012 1:20 PM

I can’t figure out what to do in this market!

I can’t figure out what to do in this market: prices are too high to buy and too low to sell!

Where to put your money if the bond bull stumbles. Search for yield in less-popular areas of the fixed-income market.

Where to put your money if the bond bull stumbles. Search for yield in less-popular areas of the fixed-income market. By Wallace Witkowski, MarketWatch

SAN FRANCISCO (MarketWatch) — Bond buyers enjoyed another banner year in 2011, with total returns in all classes outperforming the broad U.S. stock market, and investors continuing to pile into bonds and shun stocks.

As Dow climbs, worries persist. The strong pace set by the market since Jan. 3 hasn't persuaded skeptics that the rally has legs, Brendan Conway reports on Markets Hub. (Photo: Reuters)

The celebrity status for bonds troubles some investors and investment strategists. They sense that this great bond bull market will slow in 2012. Not that sticking with bonds at this juncture is a recipe for disaster, but with more of their nest-egg tied to fixed-income securities, investors need to ask some hard questions.

Start with the worst case — what would an investor do in the admittedly unlikely event where a “perfect storm” collapses the bond market and spikes yields. (Bond prices and yields move inversely.)

For that to happen, several developments would need to converge, said Mark Luschini, chief investment strategist at Janney Montgomery Scott.

In this scenario, bond investors would be surprised as U.S. job growth accelerated dramatically, the sovereign debt crisis in Europe found a clear solution, China’s economy demonstrated a so-called soft landing and a pickup in growth, and the Fed ended Operation Twist and implemented a third-round of quantitative easing, Luschini noted.

“It would have to be a confluence of those things that could put pressure on bond prices,” Luschini said. “One ... alone would not be enough of a shock.”

A more realistic possibility is that stronger than expected economic growth spurs U.S. interest rates, raising yields and making existing bonds less attractive...

... Wallace goes on to describe various bond market segments that one can consider for investing. I don't understand Wallace's point here. He seems to be saying, if the bond market collapses, buy more bonds, just different ones, as if diversification into various bond markets will protect you if the bond markets collapse. It doesn't make any sense the way it is written.

Read his full article at http://www.marketwatch.com/story/where-to-put-your-money-if-the-bond-bull-stumbles-2012-01-20

Friday January 27. Free Tax Services and Filing. By Eva Rosenberg, MarketWatch

Friday January 27. Free Tax Services and Filing. By Eva Rosenberg, MarketWatch

LOS ANGELES (MarketWatch) — The IRS’s online filing system is up and running on time. No last-minute bits of legislation to change the whole playing field. What’s the big news this year? Lots of free advice and better question paths in all services.

About 145 million tax returns were filed last year. The IRS estimates that over 70% of taxpayers are eligible to file for free using the Free File Alliance program or the Free File Fillable Form system .

With that system, skilled computer adepts can avoid commercial tax firms. This no-frills system doesn’t integrate with any state filing systems. It’s useful for folks who are either in a state without a state income tax, or a state with an online tax-return system.

Meanwhile, under the Free File Alliance program, 15 companies offer free federal tax returns to taxpayers with income under $57,000. Each provider has different age and form restrictions and other conditions. Most service all states. But some don’t. For instance, ezTaxReturn.com says it covers “any state, except...” — then lists 30 states it doesn’t service.

Some providers have age restrictions. Most provide free services to active members of the military. Many services accept taxpayers with foreign address.

Drawbacks of both systems. While the federal tax returns are free, all of the companies require that you pay for the state tax return, if you need one.

One benefit of the Free File Alliance program is that the companies may not try to sell you additional products or services.

Once you’ve entered all the information, if your tax return doesn’t qualify for the free program, you’ll need to exit and start all over again with the company’s regular software. Neither system stores your information from one year to the next. So you always have to start over.

What’s the alternative? Today, most online tax-return processors offer free versions of their own these days. With lots of desirable benefits.

More free services. All major providers allow you to start your tax return for free. You can print or e-file the free federal returns. You can save your file with a username and password, without entering a valid Social Security number.

Test the services without worrying about compromising your security or identity. Once you become a user, even of their free services, they generally keep your prior-year tax return on file for years. Some of them, forever.

Don’t worry about selecting the right starting level. Start at the cheapest level and enter data. Before you finalize your tax return, the software will let you know if you have reached more expensive levels of service. While the federal return may be free, in all cases you must pay for the state return. They all provide accuracy guarantees.

What they each offer. What are the companies excited about this year? Look at them in alphabetical order.

CompleteTax. The basic tax-preparation service is free. That covers your 1040EZ for all filing statuses. You can produce estimated tax vouchers if you need them. You can import a PDF version of last year’s tax return from a competing company. You can import W-2 and 1099-INT and dividend data. If your tax return is more complex than the Basic level allows, your potential fee is locked in, based on the date you start your tax return. Free tech support is provided by email. For $19.95 you’ll get three months of unlimited phone support with a tax professional. (State return: $34.95.)

H&R Block Online. In addition to the 1040 EZ and 1040A, most common forms are supported. You cannot import prior-year returns or W-2s and 1099s at the free level. That capability starts at the Basic/$19.95 level. Although you cannot prepare estimated tax vouchers, you can prepare a full 1040 return, including itemized deductions, employee business expenses, capital gains, and more. Support is available online, via the new Tax Answers resource, or by telephone. Worry-free Audit Support® is included, at no charge, with the free version. That means, H&R Block will not only help you answer any tax agency correspondence, they’re even prepared to represent you at the audit. (State return: $27.95.)

TaxAct. The free service includes all forms that can be e-filed, including Schedule C for business and rental income. Extensions are free. You can import the PDF file of your prior-year return. Using that, TaxAct offers a prior-year comparison of numbers, for returning clients. Email support is free. You can expect a reply within 1-2 business days. Everything is iPad compatible. A one-time fee of $7.95 gives you phone support for the entire tax season, or upgrade to the Deluxe service for $9.95, which includes the phone support. They are the only company with a tool to help you with your FAFSA (financial aid) applications for private school or college. You can prepare multi-state tax returns (though the additional states are not free). (State return: $14.95.)

TurboTax. This free service includes lots of forms, including the Treasury Report of Foreign Bank Accounts (FBAR), installment agreements, and even the application for a federal ID number (Form SS-4). It does not include estimated tax vouchers. Most credits are included. Business and rental schedules are not included. Multi-state tax returns are supported (though the states are not free). This year’s software allows you to import practically all of your data, with little or no additional typing on your part. The big news is the free telephone support. Ask a Tax Expert provides free phone and chat support to anyone. Or use the Live Community database, with years of questions and answers. (State return: $27.95.)

Face-to-face help. While free online filing options abound, some people prefer the personal touch. You can get free, live, walk-in help at tax centers all around the country. IRS and the Taxpayer Advocate Service support the VITA and TCE programs for seniors and low-income taxpayers.

These programs are staffed by trained volunteers and tax professionals, who are required to pass an IRS test . They will answer your questions with great patience. VITA volunteers understand about support disputes, retirement distributions, and other complicated tax issues. They can help you find credits and deductions you may not realize are available to you. If the tax returns are too complex, they can often refer you to someone who can help.

VITA Program. The Volunteer Income Tax Assistance program offers free tax preparation and efiling assistance to low-income households outside urban areas and in hard-to-reach urban areas.

You qualify if your household income is below $50,000. You will find VITA centers at libraries, colleges, community centers, religious centers and more. For instance, starting Jan. 28, Golden Gate University has teamed up with Goodwill Services and Tax-Aid to provide Saturday open-houses to help taxpayers in San Francisco Bay Area. To find a site near you, call 1-800-906-9887 or scan this partial VITA site list .

The armed-forces version of VITA is called AFTC, for Armed Forces Tax Council. Volunteers and experts know the special credits, deductions and exclusions available to members of all branches of the armed forces, and their families. They understand about state income-tax exclusions.

TCE Program. Tax Counseling for the Elderly, or TCE, volunteers understand issues related to retirement income, Social Security, IRAs, etc. They may be able to provide counseling on other financial issues as well, since many of the volunteers and staff are in the same position as you. AARP’s Tax-Aide is one of the largest TCE programs in the country. Visit the AARP Tax-Aide website or call the IRS for a TCE location: 1-800-829-1040.

These programs welcome volunteers. You don’t need a tax background or education to participate. It’s easy to get hooked.

Eva Rosenberg, EA, is the publisher of TaxMama.com , where your tax questions are answered for free. Eva is the author of several books and e-books , including the newest edition of “Small Business Taxes Made Easy.” Eva teaches tax courses at IRSExams.com and CPELINK.