Author: Andrew

Why is the world so messed up?

Here’s another post inspired by the Trump election. What the hell is going on in the world? Why are people so angry? Why are the Brexits and the Trumps of the world winning elections? Why are extremists of the right-wing and the left wing, the populists, the isolationists, the politicians of anti-immigrant and anti-trade persuasion, the fascists and the socialists gaining power all across the western world?

It feels like in recent years that the world has taken a big step backwards. The short-lived optimism brought upon by the end of the cold war has been replaced by fears of global terrorism and the anxiety brought upon by power-hungry dictators and empowered rivals such as Russia and China. Meanwhile, belief in a prosperous “age of moderation” was shattered by the global financial crises and by the indisputable evidence of surging income inequality.

Many smart people have tried to explain the various factors causing our world-wide angst. Capitalism. Wall Street. Globalization. Trade. Technology. Immigration. Terrorism. Some get parts of it right. Some get none of it right. But few correctly see the larger picture, that is, the fundamental trends underpinning these trying times. We can do better.

I believe that the world is experiencing forces brought upon by a combination of two global trends: 1) massive financialization brought upon by short-sighted monetary policy, and 2) the growth of big government and its evil-twin, crony capitalism. Together (and they do go together), these two decades-long trends have depressed productivity and economic growth, subsidized job loss due to technological disruption and excess international trade, and sown the seeds for global terrorism.

No institutions have done more damage to the global economy over the past several decades than the world’s central banks. No idea has done more damage to the global economy over the past several decades than the belief that a centralized government agency can, and should, dictate the economy’s interest rates. Led by the U.S.’s Federal Reserve, this monetary policy experiment has lead to a world in which money is in massive over-supply, risk is massively under-priced and the financial sector has grown to become a massive drain on productivity.

Low interest rates are supposed to encourage investment. Financial bailouts are supposed to prevent disastrous depressions. Perhaps a short-period of monetary stimulus and a once in a blue-moon bailout might not do too much economic damage. But 30+ years of easy money and near-continuous bailouts of banks and the financial system have created such economic distortions that to categorize the U.S. economy as anything near a free market would be utterly wrong.

Of course, Wall Street is not the only entity in town that has grown substantially larger. Growth of federal governments has been almost as devastating to global economies. Marx thought that it was capitalism that was unstable and would inevitably collapse. He was wrong. Regrettably, it is democratic government that seems ultimately unstable and prone to collapse by slowly, but inevitably strangling the economy.

Democracy’s fundamental flaw is that it is biased towards its own growth. Growth of the government workforce, growth of regulation, growth of taxes, growth of disincentives, growth of monopoly. The flip side? Lack of productivity, lack of efficiency, lack of employment, lack of competitiveness, lack of growth, lack of freedom. What began as more or less a free market, becomes, through the growth of government and the cradle-to-grave welfare state, a system of crony capitalism, less and less distinguishable from socialism.

Decades of easy monetary policy combined with the growth of big government have, among other things:

  • Encouraged speculation and short-term financial results at the expense of long-term productive investment in infrastructure, research and development and human capital.
  • Subsidized consumption at the expense of savings, fostering a culture of indebtedness and instant gratification and exacerbating worldwide trade imbalances.
  • Subsidized investment in vastly unproductive uses, creating serial asset bubbles in the process. Nowhere is this more evident than in the technology industry where money losing companies funded with massive amounts of inexpensive capital that employ few disrupt profitable companies that employ many. This is not creative destruction, as some would claim. This is subsidized economic suicide.
  • Subsidized large, publicly traded and monopolistic companies at the expense of small, privately-held and entrepreneurial companies because of easy access to capital markets, crony capitalism and an emphasis on financial engineering, M&A and private equity activity.
  • Caused enormous inflation in non-tradable goods such as healthcare, higher education and real estate. Is it any wonder why the middle class is drowning in debt? Is it surprising that young people can’t afford to pay for college, can’t afford healthcare and can’t afford to buy a house?
  • Destroyed the centuries-old business model of local, relationship-based banking and is in the process of destroying pensions, retirement savings and the insurance industry. Collectively, these are the cornerstones of a capitalist economy.
  • Directly enriched the wealthy by funneling money through and to Wall Street and inflating financial assets, creating an enormous bifurcation of “haves” and “have-nots.”
  • Encouraged an entire generation of the best and brightest to become investment bankers, traders, venture capitalists and consultants, rather than scientists, engineers, doctors, and teachers.
  • Allowed governments (the U.S. in particular) to finance naive, adventurous wars in the middle east without the sacrifice of higher taxes, and thus without sufficient contemplation from the citizenry. Further, easy money and big government has subsidized a military-industrial complex lobbying for arms sales, arms subsidies, arms grants and general armament of questionable groups, not to mention all sorts of military involvement and war. Needless to say, the predictable result has been anarchy, terrorism (often, facilitated with our own weapons), untold number of deaths, and the largest migrant crises since World War II.
  • Fueled a worldwide energy and commodities boom that enabled petro-dollar dictators like Vladimir Putin and Hugo Chavez to stay in power, and countries like Iran and Saudi Arabia to sponsor and finance global terrorism and religious extremism.
  • Subsidized internet and communications technologies that have led to a less-informed global citizenry, the decimation of more-or-less non-partisan media coverage in favor of the consumption and belief in “fake news” and conspiracy theories, as well as aiding in the planning and recruitment of terrorists. Oh, and few if any productivity increases.
  • Destroyed entire manufacturing sectors because of regulation, tax policies, protected unionism, and the short-sighted policies of refusing to allow wages to fall. The result being outsourcing, offshoring and global trade far beyond what would likely occur under a true global free market, and significant unemployment.
  • Completely divorced the healthcare industry from competitive forces, resulting in the worst of all worlds, the privatization of profits and the socialization of costs (just as the government did with the financial services industries). The inevitable results being skyrocketing healthcare costs, a less healthy populace and monopolization within the entire healthcare vertical.
  • Created a bloated, wasteful and monopolistic education system that favors teachers, administrators and bureaucrats at the expense of students. The result of which is an education system that neither produces the “good citizens” necessary for democratic government nor the job skills necessary for a competitive economy.
  • Fostered a culture of dependency, blame, over-sensitivity and selfishness rather than self sufficiency, responsibility and community.

The ramifications of poor economic growth and the slow-motion implosion of the welfare state

The upshot of decades of absurd and counterproductive monetary policy and an ever-growing government? Economies especially prone to speculative bubbles and financial crises. Economic growth and productivity far below potential. A bleeding and resentful middle class. Easily financed and poorly planned wars with the terror and chaos that follows. And income inequality the likes of which the world has probably not experienced since before industrialization.

But it gets worse. Combine poor economic performance with the enormous welfare state and you get a downward spiral difficult, perhaps impossible to break.

First and foremost, poor economies hurt those at the bottom of the food chain, most notably young people. With job prospects few or nonexistent, young people delay or completely avoid forming households and having children. You wind up with an aging population with fewer and fewer workers paying into the ponzi-like welfare system and ever greater number of aging retirees taking money out. This is playing out all over Western Europe, but even more obviously in Japan, a country in its third decade of economic depression. (It is mainstream economics to blame Japan’s weak economy on its demographic challenges and aging population. However, this gets cause and effect exactly wrong. It is Japan’s weak economy and poor job prospects that causes its demographic challenges and aging population.)

Further, what happens when masses of unemployed and underemployed young people with poor prospects and little hope are further and further removed from productive society? They turn to drugs (witness the opiate epidemic in the U.S.), crime, and in some cases terrorism.

Moreover, a stagnant or shrinking economic pie causes everyone within society to take a zero sum mentality. That is, whatever government benefits you get, means less that I get. The result is a bifurcation of the populace into two groups: those within the system that are currently benefiting from the crony capitalist welfare state, and those outside it trying to get in. Most notably, who’s in the “out” group? The young and the immigrants. Naturally, this bifurcation leads to resentment and anti-immigration bias. It leads to a two-tiered society. It leads to an unassimiliated underclass, as has occurred in many Western European countries.

So now you’ve got a slow death cycle. The economy is weak and jobs are scarce. The young are unemployed. Immigrants are shunned. The population ages and more and more money flows to entitlements, to pensions, to retirees, to healthcare. Meanwhile local services, education, infrastructure and other forms of investment are cut. More money to unproductive uses, less money to productive uses. So the economy becomes even weaker, and the cycle continues. Yet the elite blame capitalism and ask for even more government. Sooner or later, crises ensues. Pensions can’t be paid. Local governments go bankrupt. Then state governments. Then federal governments. The implosion of the welfare state. It is occurring in Western Europe. Though less apparent and more slowly, it is occurring in the United States too.

The way forward: optimism or pessimism?

As I’ve mentioned several times, the twin maladies of easy money and big government have led to a stagnating world economy, financial bubbles in nearly every asset class, excesses of trade and technology, unprecedented income inequality, global terrorism and anti-immigrant and anti-trade sentiment throughout the world. Is there anything we can do? And are there any reasons to be optimistic?

First, we need to end the era of easy money. We need to stop subsidizing financial markets. We need to let banks and investors fail if they deserve to fail. We need to allow market forces to set prices, whether of financial assets or labor, and allow those prices to decline. We need to let our economy reorient itself from its short-term and transactional focus back to one based on long-term investment and long-term relationships.

We cannot continue to subsidize large corporations at the expense of smalls ones, just because large companies have the money to lobby. We must find a way to reduce pensions at the state and local level. We must return healthcare to a market system and recognize that one way or another healthcare consumption must shrink. We need to limit the power of the federal government, return power to local governments and reduce regulations that favor monopoly.

We must not turn our backs on global trade, but recognize, and acknowledge two truths. Yes, trade will always have negative effects on a small portion of the population (while having less obvious, but more significant positive effects on a larger portion of the population). And yes, there has been an excess of outsourcing, offshoring and foreign trade over recent years. But this is due to the prevalence of easy money and crony capitalism, not because of free market forces.

Similarly, we must recognize that while entrepreneurship is fundamental to a strong functioning and growing economy, the vast majority of recent entrepreneurship, specifically from the technology sector, has been wasteful at best, and extraordinarily damaging at worst. Only an end to stimulative monetary policy will fix this.

Finally, we must encourage not discourage immigration. Immigration is morally correct, is good foreign policy and is economically beneficial. Immigrants must be viewed as assets, which they are, not liabilities. And given aging populations and poor economic growth, population growth through significant immigration is the only chance to delay the inevitable implosion of the welfare state for another generation.

Are any of these things realistic given today’s toxic, and corrupt political system? Not a chance. There is absolutely no realization whatsoever among the economics profession, the mainstream media or the political community of the disastrous consequences of “modern” central banking. Nor is there any reason to believe that those in power who have benefited so much from decades of easy money will change their viewpoint.

Similarly, there is no political will to accept the near-term pain required of weaning the economy off of monetary stimulus and letting the economy restructure as needed. There is no political will to cut pensions. No political will to view healthcare as a consumer good, not an entitlement. No political will to end crony capitalism, to end the power of special interests. In short, there is simply no incentive for politicians to favor a long-term outlook. And herein lies the paradox of democratic government: it works until it grows too big to work.

So what happens next? Perhaps the world stumbles on for a while. Populists continue to come to power. The rich stay rich, the powerful stay powerful and the poor stay poor. Trade suffers, immigrants are shunned. Economic growth is weak. Capitalism continues to be viewed as the problem, big government as the solution. Maybe another financial crises that we can inflate our way out of. Maybe another financial crises that we can’t. Sooner or later the music stops.

About 100 years ago, the world sleepwalked into World War 1. Today the world sleepwalks into the next global disaster. Regrettably, I see few reasons to be optimistic.

Does the Federal Reserve’s loose monetary policy actually hurt employment?

It goes without saying that the Federal Reserve’s monetary policy has been extraordinarily loose since the financial crises of 2008. The Fed has had a zero interest rate policy (ZIRP) for 7 years now, not to mention its 3 rounds of quantitative easing (QE). The Fed’s balance sheet has grown over this time period from approximately $800 billion to $4.5 trillion. And even if the Fed raises rates 0.25% as it is expected to do in December 2015, it will be years (or perhaps generations) before we see anything like normal monetary policy.

There are many, many reasons to criticize the money printing policies of the Federal Reserve (and all the other central banks of the world). They blow serial asset bubbles. They create moral hazard. They favor borrowers over savers. They cause future inflation. They bail out undeserved banks. They create “too big to fail” conditions. They encourage risky investment and speculation. They contribute to income inequality.

Even supporters of easy monetary policy, a group to whom nearly all mainstream economists and politicians belong, will admit to some, if certainly not all of these risks. But, they would argue that these risks are worth it. Worth it to help the economy recover from financial crises. More specifically, worth it to help employment.

As you might know, when it comes to monetary policy, the Federal Reserve has two congressionally mandated goals. One is stable prices. The other is maximum employment. Since inflation, at least as measured by the Consumer Price Index (CPI), has been quite benign, the Fed has felt compelled, or at least free, to focus on helping employment. Hence the policy of low interest rates and printing money.

Related post: Why does loose monetary policy help employment (the mainstream argument)?

Low interest rates and printing money should lead to more borrowing, more consumption, more investment and more jobs. But, and this is a big BUT, what if that’s not what happens? Put simply, what if the Fed’s policy of easy money is actually destroying jobs, not creating them? That’s what I think is happening. Let me explain why.

The Subsidy to Growth

First, recall one of the most fundamental principles of finance: the value of any asset, such as a company or its stock, is inversely related to its cost of capital. In other words, the cheaper a company can access money, the higher its valuation. Since interest rates are the primary driver of a company’s cost of capital, the Fed’s loose monetary policy acts as an enormous subsidy to all companies and all asset classes.

But, the Fed’s valuation subsidy does not impact all companies equally. By suppressing interest rates the Fed has encouraged and even forced investors to take on incrementally more risk. Or in technical parlance, risk premia have been compressed. The higher the risk of the investment, the more that the risk premium has been reduced, and the greater the increase in asset value. So while all assets have received a valuation “subsidy” due to easy monetary policy, high risk companies have received a proportionally larger one.

You may be thinking, how can the Fed “force” investors to take on risk. We live in a free country. Nobody is forced to invest in risky assets, right? Not exactly. Consider an insurance company or pension fund that has future liabilities that it must fund. If the insurer or pension fund cannot meet its necessary investment return from safer assets then it has no choice but to take on more risk. The same concept holds for any investor that requires investment income, either now or sometime in the future. Need a 6% return but very safe assets pay nothing? Take on more risk.

In fact, risk premia are compressed not only by artificially low interest rates. They are suppressed even further by another central banking policy, known as the “Greenspan put.” Simply put (no pun intended), the Federal Reserve has made it very clear, since at least the stock market crash of 1987, that it will provide liquidity to support asset prices in the event of market “dislocation.” Hence, with the implicit promise of a bailout, risk premia are even lower and valuations even higher.

By encouraging risk and suppressing risk premia, the Fed has subsidized high risk companies. Who are these high risk companies? More than anything else, these are high growth tech companies. We see this subsidy through the high public valuations and trading multiples of the Facebooks, Twitters and Amazons of the world. We see it through the private valuations of the “unicorns” such as Uber, Airbnb and Dropbox. And we see it through the basic business model of venture capital where a higher and higher valuation for a winning investment can support more and more losing ones.¹

Creative Destruction or Subsidized Disruption?

Why is it a problem that the Federal Reserve is subsidizing high growth, high risk companies at the expense of lower growth, lower risk companies? Isn’t that a good thing and isn’t that exactly what the Fed should be doing to help grow jobs?

Unfortunately, the answer is no. High growth/high risk companies, as best exemplified by the tech industry are not adding to overall U.S. employment. In fact, in today’s world, high growth companies are typically net destroyers of jobs, not creators. To use the trendy term, tech companies are “disrupting” traditional employers.

There is no better example than the internet retailer, Amazon. Amazon is great (at least in the near-term) for consumers. You can shop in your pajamas, pay rock bottom prices and get fast, free delivery. And certainly, Amazon’s stock performance has been great for its investors and its management. But has Amazon’s enormous growth really benefited the U.S. economy? In terms of employment, the answer is clearly no.

As you can see in the table below, Amazon had about $100 billion of revenue over the past twelve months and accomplished that with approximately 154,000 employees. So in one sense Amazon created 154,000 jobs, or about 1.5 jobs for each $1 million of revenue.

Sounds like that’s great for the economy, right? But that’s not the whole story. For the most part, Amazon’s revenues come at the expense of traditional retailers. So the question to ask is how many people would traditional brick-and-mortar retailers have employed if they, and not Amazon had generated those revenues.

Again, looking at the following table, we can see that Amazon’s competitors, such as Walmart, Barnes & Noble and Toys R Us employ far more people for each dollar of revenue. A simple average of this metric for 6 traditional retailers indicates about 4.9 employees per $1 million of revenue, far higher than Amazon’s 1.5. And this figure is probably understated since smaller privately held retailers probably have even more employees per dollar of revenue.

So for each $1 million of Amazon’s revenue, around 3.4 jobs in the U.S. economy are lost or never created. Based on its most recent twelve months of revenue, Amazon is directly responsible for the destruction of more than 300,000 jobs.

 

Amazon destroys jobs

 

Now you may be thinking, doesn’t this sound like capitalism at work, like creative destruction? Old companies and old technologies being replaced by new companies and new technologies? The automobile replacing the horse and buggy? The digital replacing the analog?

In a proper world with normalized interest rates, you would be correct. Investors would make discriminating decisions on where to invest their money based on a company’s business model, its projected profitability and cash flows, and its perceived risks. Let the company with the better product or the more efficient operations win, and if that company happens to be more productive and employ fewer people, so be it.

But thanks to the Federal Reserve, we don’t live in such a world. We live in a world where the cost of capital especially for high growth companies is much, much lower than it should be. This is a world where companies are too easy to start and money is too easy to raise. A world where growth trumps profitability and where not even a plan for revenue, let alone actual revenue is a prerequisite for an IPO or a multi-billion dollar valuation.

This is a world where established companies with real business models and real profits are “disrupted” by an endless wave of companies, large and small, with full bank accounts and empty business models. Facing this subsidized onslaught, good companies, those that are profitable (or would otherwise be), forego hiring or worse, are forced to shrink or go out of business.

Amazon, with about 20 years of operating experience, has yet to show that it can be consistently profitable. Given the total absence of barriers to entry in Internet retail, it likely never will. Absent easy money, Amazon would probably not exist, and certainly would not be the disruptive retailing giant that it is.

But this phenomenon of Fed-subsidized job destruction is not limited to the retail sector. It is happening in nearly all sectors of the economy.

Profitless companies like Twitter and Pinterest along with a near infinite number of money-losing Internet content providers have decimated the journalism and print media industries with their free content to the tune of significant job loss.

So-called “sharing economy” startups like Airbnb, a company with a $25 billion valuation and a business model based substantially on flouting local occupancy laws is doing its Fed-subsidized best to disrupt traditional hotel companies such as Starwood and Hilton, companies that employ hundreds of thousands.

Stock market darling but profit-challenged Netflix, a company with about 2000 employees, having put video retailer Blockbuster (60,000 jobs) out of business some time ago now has its well-funded sights set on disrupting the TV and Cable industries.

These are just a few prominent examples of Internet companies that probably shouldn’t exist, fueled by cheap money, eliminating American jobs.

Conclusion

Traditional critics of the Federal Reserve’s extraordinarily loose monetary policy cite the blowing of serial asset bubbles, potential future inflation and “moral hazard” as cautionary tales. But as we’ve seen, the Fed’s actions have a much more direct and immediate effect on the economy. Current monetary policy is hollowing out the economy by subsidizing companies that destroy jobs, to the benefit of a few fortunate investors and entrepreneurs, and to the detriment of many working Americans.

Monetary policy is also an example of the failure of mainstream economics. That is, the failure of mainstream economic models to reflect the complexities of the real world. Textbook models assume that printing money encourages risk taking. This is correct. They further assume that risk taking will lead to investment and job creation. This is also correct. But they fail to realize that much of this new investment competes with established businesses and many of these new jobs come at the expense of a substantially higher number of existing ones.

To be fair, normalizing monetary policy will be a very painful process. In the short-term, many startups and even large tech companies will fail. Asset prices, including real estate and the stock market will decline. It is highly likely that the economy will fall into a recession. Politically this is very hard to stomach. But stomach it we must if we ever want to return to a vibrant economy with real and sustainable job growth.

 

 

¹ Assume a venture capital firm requires a 20% annual rate of return (IRR) and invests $1 million per company. Further assume that after 5 years time, the VC firm can exit one successful investment and all the other investments fail with zero return. If the successful exit has a valuation of $25 million, the VC can fund approximately 10 total investments. If the exit has a $100 million valuation, the VC can fund about 40 investments. If the exit is valued at $1 billion, then the VC can afford to fund more than 400 investments.

 

What is economics?

Let’s start with this: there is no single correct definition of economics. But in textbooks and other resources about economics you tend to see variations of two definitions.

1) Economics is the branch of social science that studies the production, distribution and consumption of goods and services.

OR:

2) Economics is the branch of social science that studies how individuals and groups make decisions to allocate scarce resources.

My personal definition is bit more comprehensive (and perhaps a bit cynical). Economics is the branch of social science that knows how to use (and misuse) basic math and statistics. To me, economics encompasses all of social science. There are really no boundaries between the questions economists ask and those asked by, for example, psychologists, sociologists or political scientists. What separates economists from those other social scientists (for better or for worse), is the former’s ability (and the latter’s lack of ability) to pose and answer their questions using math and statistics.

So rather than define what economists study, let’s define what social scientists study. Here, I think a variation of the second mainstream definition mentioned above, is a good starting point. Social science is the study of how individuals and groups make decisions, and how those decisions in turn affect the individual and the group. I personally think the words “allocating scarce resources” are unnecessary since absent perhaps only breathable air (at least on the surface of Earth), ALL resources are scarce.

As you probably know, economics is almost always divided into two categories: microeconomics and macroeconomics. Studying how individuals and groups make decisions is essentially the generally accepted definition of microeconomics. But I’d argue that macroeconomics is really a subset of microeconomics. Rather than study the decisions of individuals or such groups as a firm, macro-economists are studying the decisions of a specific type of group, called a government, and analyzing data of a specifically defined aggregate of individuals and groups, called an economy.

About EconomicsFAQ

In 2007 while I began teaching corporate finance and investment banking classes, I created a simple website called IBankingFAQ for my students to help guide them through and prepare them for the investment banking recruiting process. That site has grown into one of the most widely visited online resources about the investment banking industry and led to me authoring the book, How to Be an Investment Banker. Ever since then, I’ve been meaning to create a companion site about economics but I kept getting distracted by various other projects. Well, now it is 2015 and finally, I’m getting around to it.

While IBankingFAQ has a narrow focus geared towards students recruiting for investment banking, this site has a much broader focus. My not so humble goal is to, well, explain all of economics. Now you may be wondering why does the world need yet another economics resource when there are countless websites, blogs, books and periodicals covering this topic. Allow me to explain.

First, I believe that an awful lot of what is considered mainstream economics is flat out wrong. From the definitions of rationality and value to the causes of recessions and income inequality. From an understanding of inflation and deflation to the long-term drivers of economic growth. On these key issues, and many, many more I disagree with the mainstream economics you learn in school and with the economic commentary you read in the mainstream media.

As you will see, I am highly biased. Biased towards free markets, biased towards limited government, biased against active monetary policy and biased towards long-term, though not necessarily short-term, growth. There exists a view that economics is more faith than science. I tend to agree. And like all economic commentators, I believe that my economic faith is the one supported by evidence and by history. I’ll do my best to show you that. But I want you to make up your own mind. So wherever I do disagree with mainstream economics, I promise to try to both explain the mainstream view and explain why it is that I dissent.

We seem to be at the beginning of an intellectual and political war against capitalism. Or perhaps that war began the day after Adam Smith published “The Wealth of Nations” and we’re just at the start of its latest battle. Either way, tepid economic growth, declining middle class wages, rising income inequality, the expansion of Wall Street and the contraction of Main Street have led to a vocal chorus of criticism against the free market, against capitalism.

These symptoms of a broken economy are real, but the root causes are not too much free market but too little. We should be railing not against capitalism but against the pervasive and overwhelming crony capitalism, big government, and socialistic monetary policy that rot the economic system and invert the incentives necessary for growth, for progress and for well being.

The free market is misunderstood, no less so than by most economists. As Adam Smith knew, this is in part because the workings of the free market are not intuitive, and therefore nor is good economic policy. That self interest leads to societal interest. That trade is beneficial to both the exporting country and the importing one. That declining prices can be a sign of progress not impending disaster. That immigration can create jobs. That falling wages can benefit workers. That promoting high growth companies can reduce overall employment. These are just a few examples of economic concepts that can be difficult to comprehend and challenging to defend.

But defend them we must. The battle for economic freedom must be continuously fought, especially in the face of today’s political trends. If not, we risk the continued stagnation, cessation and indeed reversal of economic progress, as is currently happening in the U.S. and elsewhere. Those few fighting to explain and to defend the free market are losing. But we mustn’t lose. Explaining the free market and defending free market principles is the second purpose of this site.

Third, I believe that even when the concepts are correct, economics is incredibly poorly taught. So I will try to explain basic concepts as simply as possible. No graphs, no equations, no fancy math, no unrealistic assumptions. And occasionally, I’ll even try to share some evidence. I will also try to point out something that economists are loathe to talk about: what is known, what is unknown, and what is, likely, unknowable. Nearly all economic policies and regulations, and especially monetary policies, are based on the unknowns and the unknowables. I want you to know that.

As for my qualifications to do what I aim to do? You’ll have to judge for yourself. You can read my brief bio, which I hereby amend to state that I have no PhD in economics, merely a useless undergraduate degree in the subject, and an even more useless MBA. What I write is what I’ve learned from a short stint at the Federal Reserve, a somewhat longer stint on Wall Street, some time spent teaching finance and a bit of experience as an entrepreneur and in the general business world. And most importantly, what I’ve learned from reading. Reading some economics, yes, but more so from reading history. Long story short, take it all with a grain of salt. But I’m sure you already knew that.

Finally, I ask you to remember that this site is a work in progress. Right now the content is very slim, but my goal is to cover basic economics (and related finance) a few posts, a few questions per week. I may, from time to time, add some posts about more topical discussions as well.

On any and all posts, I welcome and encourage your comments and questions.

December 8, 2015

I’ve recently launched a new website/blog covering economics:  EconomicsFAQ.  This is a project that I’ve been meaning to do ever since I launched IBankingFAQ almost ten years ago.  I have three goals for this new site.  First, to explain pretty much all of economics in Q&A format, since I think economics is very poorly taught.  Second, to explain why I believe much of mainstream economics is wrong.  Third, to defend the free market, a concept this is misunderstood by nearly all, including economists.  While I’m just getting started, I aim to add a few posts a week so I hope you will check it out.

Since I get more traffic to this site, I’m cross posting all EconomicsFAQ posts on IBankingFAQ. You can see my latest post below or all posts under EconomicsFAQ.

I invite and encourage you to check out my book, How to Be an Investment Banker: Recruiting, Interviewing, and Landing the Job + Website (Wiley Finance). If you find this site useful for the investment banking recruiting process then I think you will enjoy the book. Basically, the book is an extension of this site covering in greater detail information about investment banking and lifestyle, recruiting and interviewing and the technical stuff that you need to know, including an overview of accounting, finance, financial statement analysis, valuation, modeling, M&A and LBOs.

I also want to remind you about my financial modeling self study program, which costs only $49. You can learn how to build a financial model in the comfort of your own home or office. Knowing how to build an integrated cash flow model will definitely help you in your interviews plus it is a great way to prep for those dreaded technical interview questions. Click to view more information about the financial modeling self study program.

For additional help with preparations for investment banking recruiting, please also note that I offer one-on-one coaching sessions.

As always, I look forward to your comments/suggestions/questions and emails (andrew [at] ibankingfaq.com).

March 3, 2013

I am excited to say that I’ve finished work on my book, How to Be an Investment Banker: Recruiting, Interviewing, and Landing the Job + Website (Wiley Finance) which will be released on April 1, 2013. It was a lot of work but I hope many of you find it useful for the investment banking recruiting process. Basically, the book is an extension of this site covering in greater detail information about investment banking and lifestyle, recruiting and interviewing and the technical stuff that you need to know, including an overview of accounting, finance, financial statement analysis, valuation, modeling, M&A and LBOs.

I’ve also recently launched a website called igokids. This has nothing to do with finance or investment banking but it is my full-time gig so feel free to check it out. igokids is local search and discovery site for everything kid related in New York City (in a nutshell, “Yelp for parents”). I’m proud to say that I developed it from scratch myself, being a totally self-taught programmer. See all the exit opportunities that investment banking can lead to?

I also want to remind you about my financial modeling self study program, which costs only $49. You can learn how to build a financial model in the comfort of your own home or office. Knowing how to build an integrated cash flow model will definitely help you in your interviews plus it is a great way to prep for those dreaded technical interview questions. Click to view more information about the financial modeling self study program.

As always, I look forward to your comments/suggestions/questions and emails (andrew [at] ibankingfaq.com).

How to be an Investment Banker

August 16, 2012

I hope everyone is enjoying your summer (at least those of you in the northern hemisphere). I haven’t updated this short section on the home page in a while so a couple of announcements:

First, I haven’t been so good at responding to questions asked on the site lately. My apologies for those of you who have asked some good questions that I haven’t yet answered. I will try to get to them soon. You are also always welcome to email me.

But onto more exciting news (for me, at least). I am hard at work on a book to be entitled, “How to be an Investment Banker” that will be published by Wiley Finance. It will be an extension of this site covering in greater detail information about investment banking, recruiting and interviewing and the technical stuff that you need to know. I’ll keep you updated but it is targeted for release in the spring of 2013.

I’ve also recently launched a website called igokids. This has nothing to do with finance or investment banking but it is my full-time gig so feel free to check it out. igokids is local search and discovery site for everything kid related in New York City (in a nutshell, “Yelp for parents”). I’m proud to say that I developed it from scratch myself, being a totally self-taught programmer. See all the exit opportunities that investment banking can lead to?

I also want to remind you about my financial modeling self study program, which costs only $49. You can learn how to build a financial model in the comfort of your own home or office. Knowing how to build an integrated cash flow model will definitely help you in your interviews plus it is a great way to prep for those dreaded technical interview questions. Click to view more information about the financial modeling self study program.

As always, I look forward to your comments/suggestions/questions and emails (andrew [at] ibankingfaq.com).

September 8, 2010

Are you ready for the fall recruiting season? Those of you who recently started your senior year of college or your second year of an MBA program know that the recruiting season is here. Good luck to all of you!

I want to remind you about my financial modeling self study program, which costs only $49. You can learn how to build a financial model in the comfort of your own home or office. Knowing how to build an integrated cash flow model will definitely help you in your interviews plus it is a great way to prep for those dreaded technical interview questions. Click to view more information about the financial modeling self study program.

I also want to remind you about my coaching services. We can schedule sessions in person (in NY) or over the phone and cover resumes, general recruiting and interviewing advice as well as mock interviews. Click to view more information about the interview and job search coaching.

As always, I look forward to your comments/suggestions/questions and emails (andrew [at] ibankingfaq.com).

August 3, 2010

Are you ready for the fall recruiting season? Those of you going into your senior year of college or your second year of an MBA program know that the recruiting season will be here soon (the summer just goes by too quickly, doesn’t it?). For you students and for all of the rest of you interested in investment banking, I want to bring to your attention a course that I’ll be teaching in New York City starting September 11. The course runs on Saturday and Sunday for two consecutive weeks and covers valuation and financial modeling as well as basic accounting, corporate finance and financial statement analysis. The course is great preparation for investment banking interviews, especially those stressful technical questions.

To register for the course or for more information, please visit the Institute for Finance website.

I also want to remind you about the financial modeling self study program, which costs only $79. So if you are not able to make it to New York for one of my lives classes, you can learn how to build a financial model in the comfort of your own home or office. Click to view more information about the financial modeling self study program.

As always, I look forward to your comments/suggestions/questions and emails (andrew [at] ibankingfaq.com).

July 12, 2010

Are you ready for the fall recruiting season? Those of you going into your senior year of college or your second year of an MBA program know that the recruiting season will be here soon (the summer just goes by too quickly, doesn’t it?). For you students and for all of the rest of you interested in investment banking, I want to bring to your attention a course that I’ll be teaching in New York City starting July 31. The course runs on Saturday and Sunday for two consecutive weeks and covers valuation and financial modeling as well as basic accounting, corporate finance and financial statement analysis. The course is great preparation for investment banking interviews, especially those stressful technical questions.

To register for the course or for more information, please visit the Institute for Finance website.

I also want to let you know that I’m offering a special price for the summer on the financial modeling self study program. I’ve reduced the price to only $19 from the old price of $49. I hope that you will take advantage of this limited time offer. Click to view more information about the financial modeling self study program.

As always, I look forward to your comments/suggestions/questions and emails (andrew [at] ibankingfaq.com).

January 27, 2010

To those of you who are still in the interview process for summer internships, good luck! And my congratulations to those of you who have accepted offers.

I’ve made some changes to the home page of IBankingFAQ (the page you’re on now) so it’s not so static. I intend to use this top section to highlight any changes or updates to the site and other communications to readers.  The old home page is the About page, where you can read about the site.  Below this section is a random FAQ that will change whenever you refresh the page.

You may have noticed a new purple banner at the top of the screen advertising a new self study program that I’ve developed to teach basic financial modeling.  This is something that has been in the works for a while and I’m pretty excited about it.  You can learn more about the Financial Modeling Self Study Program.

As always, I look forward to your comments/suggestions/questions and emails (andrew [at] ibankingfaq.com).

October 8, 2009

I have upgraded the site’s theme. I am still making some tweaks, but the upgrade is substantially complete. Please contact me if you find any bugs or have difficulty finding any of the content.

You have 100 balls (50 black balls and 50 white balls) and 2 buckets. How do you divide the balls into the two buckets so as to maximize the probability of selecting a black ball if 1 ball is chosen from 1 of the buckets at random?

Just to be perfectly clear, you are assuming that one of the two buckets is chosen at random and then one of the balls from that bucket is chosen at random.  You want to put 1 black ball in 1 of the buckets and all of the other 99 balls in the other bucket.   This gives you just slightly less than a 75% change of having a black ball chosen.  The math works as follows:  There’s a 50% chance of selecting the bucket containing 1 ball with a 100% chance of selecting a black ball from that bucket.  And a 50% chance of selecting the bucket containing 99 balls with a ~49.5% (49/99) chance of selecting a black ball from that bucket.  Total probability of selecting a black ball is (50% % 100%) + (50% * 49.5%) = 74.7%.

Is investing in stocks really investing?

No.  Buying stocks is speculating.  Even if you’re buying value stocks.  Even if you’re planning to hold stocks for the long-term (whatever that means).  I wish more people understood this.  Anytime you spend money on the hope and prayer that the thing you bought appreciates in value, you are speculating, not investing.  Here’s another way to think about it.  If you have significant control over your spent money (say, starting a business or building a new factory) then you’re investing.  If you don’t then you’re speculating.

Oh, and one last thing:  speculating is just a more acceptable synonym for gambling.

Does technical analysis work?

Yes.  No.  Maybe.

I think all three are correct depending on how we define technical analysis.  Academics have known for about 15 years that stocks with positive momentum tend to outperform stocks with negative momentum.  Traders and speculators have probably known this for centuries longer.  If we define technical analysis as using information contained in historical prices (and other information such as trading volume) to predict future prices than there is no question the answer is yes, technical analysis does work.  Most quantitative trading methods (including high frequency trading) is based on this sort of analysis.  In fact, I would go as far as to say that much of what people view as fundamental analysis is actually technical analysis.  I would argue that much of value investing (e.g. buying stocks with low Price/Book Value ratios or Price/Earnings ratios is actually a reflection of technical factors (the stock has gone down in the past) than it is of fundamental factors such as its book value or earnings.

If, however, we define technical analysis as humans looking at charts looking for patterns which they then give cool names, I am more than a little skeptical.  Not because the charts don’t contain good information (they contain the same information used by the computers discussed above) but because I am skeptical that humans can consistently and correctly interpret this information.  I do leave open the possible that certain exceptional individuals can indeed profit from interpreting such charts.

I’ve stated that technical analysis is essentially just momentum investing (I use the word investing loosely).  I think its worth mentioning that virtually all trading is based on momentum investing.  Of course the downside of momentum (from the trader’s perspective) as a strategy is that it works until it doesn’t.   Which is to say you’ve got to get out in time (no easy task), making it a risky strategy.  From the market’s prospective, it is not difficult to see the relationship between momentum and frothy markets.

Does fundamental analysis work?

As we alluded to when we were discussing the efficiency of markets, fundamental analysis works if and only if you can discover important enough non-public information AND that non-public information will become public within a reasonable time frame.  It is not enough to discover the information because if other market participants don’t learn about it (there’s no “catalyst”), prices won’t reflect it and you can’t make money on it.

Now, one type of non-public information would be to have a different (better) view on the company’s prospects or on say, macroeconomic prospects.  Three things make this very difficult in practice.  Firstly, it is very difficult to be smarter than the market.  Second, even if you are correct, it often takes much longer to be proven right, hurting your returns (or worse).  This is analogous to Keyne’s famous statement that the market can remain irrational far longer than you can be solvent.  I would, of course, modify this to say that the market can remain stupid far longer than you can be solvent. Third, since the market tends to lean towards optimism most of the time, having a contrarian view usually means being short the market.  Shorting the market brings its own set of risks and is a strategy that is extraordinarily difficult with which to make money.  You may have noted that numbers 2 and 3 help illustrate why bubbles can persist for a long time.

Who cares if investors are rational or irrational?

To some extent this is really an academic argument.  Why does it matter if investors make rational and stupid decisions (as I say) or irrational ones (as everyone else says).  I do think knowledge for knowledge sake is cool and to better understand how people make decisions is cool too.  However I also think there is something very important about the distinction as it relates to policy.

Given today’s economic situation, the irrationality of investors and economic actors is being used to justify hugely significant policy decisions.  Instead we should be focusing on, for example, the horribly wrong incentive structures throughout the finance system that led to (rational) decision making which in turn led to the our current economic woes (much more to come about this under Current Economic Situation category).   We also should be focusing on how to educate people to make smarter decisions (i.e. to understand economic and finance decisions).

It is also important to understand the fallacy of irrationality because it is being used as key evidence of the inherent failure or instability of a free market system.   This couldn’t be further from the truth, as we will also discuss in other posts.

How can you say that people are rational given all of the research that seems to show otherwise in addition to all of the booms and busts throughout history?

Okay, this is really important.  To really understand this point, let’s first understand how economists usually define rationality.  An economic actor (that is to say, a person)  is rational if he or she always makes decisions which will maximize his or her economic well being.  Now, there is an enormous body of research in psychology and behavioral economics (the same field by the way – just that the economics know how to use statistics) that shows otherwise.  This we do not dispute in the least.

What we dispute is the above definition of rationality.  It is wrong in three ways.  The most obvious way it is wrong is that we don’t maximize our current economic well being but the present value of our well being.  Now, I would guess that almost all economists would probably agree with this modified definition.  But it is a very important distinction because people have very different discount rates.  That is to say, some people place much more value on well being today versus well being in the future.  To place more value on well being today is not irrational if one’s discount rate at the time is higher.

The second error in the definition of rationality is that people don’t seek to maximize their economic being (that is to say, their wealth or income) but their overall well being or their “utility”.  (I have a lot more to say about the definition utility but for now leave it as one’s overall well-being).  Now again, most economics would agree with this modification to the definition but alas, fail to internalize the distinction.  Understanding that many decisions (even investing ones) are affected by things are than income or wealth goes far to explain many of the experiments that claim to prove that people are irrational.  For example, many studies have shown that individual investors trade too much even though they know that trading costs hurt their overall investment performance.  Therefore, they are irrational, right?  Not necessarily.  Most individuals who trade in and out of stocks get other utility out of their actions.  That is to say, trading is fun, not unlike, say, going to Las Vegas.  In other words, the entertainment value of trading adds more to their utility than the lost money due to trading costs subtracts.  There is nothing irrational about that.

The third and final error is probably the most important one and also the least understood.  Many experiments have shown that when faced with a probability based decision many people make the wrong choice (that is one that results in lower expected value) or given two sets of decisions, make inconsistent choices.  These types of experiments are used to demonstrate the irrationality of human beings.  But this is wrong.  What they demonstrate mostly is that humans are bad at probabilities (they demonstrate other things as well – for example that most of us would rather not lose money than gain money).  Perhaps we’re all dumb, perhaps we all slept through statistics class in college or perhaps our incentives are messed up.  That we don’t fully understand the question or that we didn’t bother (or don’t know how) to do the expected value arithmetic does not demonstrate irrationality.  So the third distinction that we need to make to our definition of rationality is that we make decisions to maximize the present value of our utility based on the decision maker’s understanding of the decision and NOT the experimenter’s understanding of the decision.

Assuming you’re still reading this and haven’t fallen asleep, you might be wondering so what?  Who cares if people are rational or  not?  Let’s talk about that next.

Even if markets are efficient then surely a boom or subsequent bust proves that market participants are irrational, right?

Wrong.  Not just wrong, but WRONG.  This is one question that everyone and I mean everyone gets wrong.  People are rational.  Period.  Full Stop.  (No, I’m not Milton Friedman writing from the grave).

I still don’t get it. How can fundamental value change in such a short period of time?

Now you’re thinking.  Fundamental value doesn’t change because there is no such thing as fundamental value.  Let me repeat that again:  there is no such thing as fundamental value.  This is perhaps the most important myth of finance (and economics).  There is only relative value.  Those of you that are on this site doing  investment banking interview prep know that the way you value a company is by comparing its value to other similar companies (even our so called “intrinsic value” DCF analysis uses comparisons to come up with forecasts, terminal values and WACC).  So, if Amazon in 1999 trades at a 100x P/E ratio than why shouldn’t Ebay or Pets.com?  Similarly, if my neighbor’s ocean front Miami beach condo sells for $1 million shouldn’t my identical one also be valued at $1 million?  That there is no such thing as fundamental value is true for not only financial assets but applies to all assets.

Aren’t you saying that there is no such thing as a bubble?

No.  Prices of financial assets can certainly rise to unsustainable levels due to overly optimistic forecasts.  And this is actually pretty easy to spot, at least near its peak.  You may recall that plenty of market commentators and academics spoke of an Internet bubble in the late ’90s and a real estate bubble in the last few years.  What I am saying is that just because asset prices may vary greatly over time (say NASDAQ at over 5000 in March 2000 and at about 1100 two and a half years later) doesn’t mean that markets are inefficient.  It just means that public information (i.e. market sentiment and forecasts) changed.

If you say markets are efficient, then explain the dot-com bubble or the real estate bubble.

Ah ha!  You think you’ve got me, don’t you?

Recall the definition of an efficient market:  that all public information is priced in.  I never said that prices were fundamentally correct (more on this in the next question).  I merely said to be efficient prices must reflect all publicly available information.  If the consensus amongst the public (i.e. market participants)  is that we’re in a new era of phenomenal growth to which the world has never seen before, then that public sentiment (or more precisely, that economic outlook or forecast) will be priced into stocks (or other financial assets).  That overly optimistic sentiment may be ultimately shown to be foolish or short-sighted, but it does not mean that markets are inefficient, or even wrong.

So how do you make money in the “markets?”

Since luck is pretty hard to control, let’s talk about the second factor:  having non-public information.  Now, of course there are two types of non-public information.  The legal type and the illegal type.  Here at IBankingFAQ, we recommend the legal type, at least in the United States (we give no such recommendation for those investing outside the U.S. )  Most of you probably know what the illegal type is – usually called “insider information.”  An example of this would be investing in an airline of which your Dad has influence over union decisions.

The legal type would be any information not known by the broader investing community that has not been obtained illegally (i.e. in violation of SEC or other regulatory body regulations).  For example, hedge funds that cover retailers might send consultants to a retail store to count cars in the parking lot or peak into stock rooms to count inventory levels, given them non-public insight into the financial results of the retailer.   Or perhaps a doctor, due to his or her own specialty has indirect insight into the likely success or failure of a new drug in clinical trials.  Or maybe a mutual fund manager has the ability to meet directly with a management team.  Even if no non-public information is disclosed by the CEO during that meeting, the fund manager might have insight into the quality of the CEO that other market participants, who do not have the ability to meet management, cannot have.  Keep in mind that often there is a very fine line between legally obtained non-public information and illegal insider information.

So how does one go about legally obtaining non-public information?  Well, aside from the examples I’ve given above, the answer is that it is usually extraordinarily difficult as an individual investor and still extremely difficult as an institutional investor.   The short answer is if you’re going to try to make money in financial markets,  concentrate on less efficient markets such as small cap stocks or emerging markets but ONLY if you have the ability to uncover non-public information.

The even shorter answer is, its nearly impossible for an individual investor (or institutional investor such as a hedge fund) to outperform the market so don’t even try.

What does it mean for a market to be efficient?

Essentially it means you can’t make money, without one of the following (1) luck or (2) non-public information.  Now, to be precise, the phrase “you can’t make any money” really means, “you will not consistently achieve risk-adjusted above market returns.”  And by “you” I do mean YOU, whether you’re a Harvard undergrad day-trading in your dorm, a retiree with a 401K, or  you’re running a $10 billion mutual fund or hedge fund.

Are markets efficient?

Let’s start with an easy one, albeit important one, albeit one that most people, academics included, don’t really understand.   And the answer is:  it depends on the market – but in most cases, for all practical purposes the answer is yes.  But before we can really answer this question, we need to define market efficiency very clearly (and very simply).  Forget what you’ve learned about weak forms and strong forms and the other stuff coming out of academia.

An efficient market is a market where all publicly available information is priced in.    What is public information?  Basically, any information that affects the price of that asset, such as information reported by the company, by its competitors, suppliers and vendors, macroeconomic data, etc.

So which markets are efficient and which less so?  For the most part, the larger and more liquid the market, the more efficient.  Large cap U.S. stocks, U.S. treasuries, currency markets?  All extremely efficient.  Small to mid-cap U.S. stocks?  Still pretty efficient but certainly less so than large caps.   Microcap stocks and emerging market stocks – less efficient still.

Continuing with the last question, on Jan. 1 of Year 3 the equipment breaks and is deemed worthless. The bank calls in the loan. What happens in Year 3?

Now the company must writedown the value of the equipment down to $0.  At the beginning of Year 3, the equipment is on the books at $80 after one year’s depreciation.  Further, the company must pay back the entire loan.  Income statement: The $80 writedown causes net income to decline $48.  There is no further depreciation expense and no interest expense.   Cash Flow Statement: Net income down $48 but the writedown is non-cash so add $80.  Cash flow from financing decreases $100 when we pay back the loan.  Net cash is down $68.  Balance Sheet:  Cash (asset) down $68, PP&E (asset) down $80, Debt (liability) down $100 and Retained Earnings (shareholders’ equity) down $48.  Left side of the balance sheet is down $148 and right side is down $148 and we’re good!

Same question as the previous but the company finances the purchase of equipment by issuing debt rather than paying cash.

First Year:  Income Statement:  No depreciation and no interest expense so no change.  Cash Flow Statement:  No change to net income so no change to cash flow from operations.  Just like the previous question, we’ve got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities.  Now, however, in our cash flows from financing section, we’ve got an increase in debt of $100 (source of cash).  Net effect is no change to cash.  Balance Sheet:  No change to cash (asset), PP&E (asset) up $100 and debt (liability) up $100 so we balance.

Second Year:  Same depreciation and tax assumptions as previously.  Let’s also assume a 10% interest rate on the debt and no debt amortization.  Income Statement:  Just like the previous question:  $20 of depreciation but now we also have $10 of interest expense.  Net result is a $18 reduction to net income ($30 x (1 – 40%)).  Cash Flow Statement:  Net income down $18 and depreciation up $20.  No change to cash flow from investing or financing activities (if we assumed some debt amortization, we would have a use of cash in financing activities).  Net effect is cash up $2.  Balance Sheet:  Cash (asset) up $2 and PP&E (asset) down $20 so left side of balance sheet down $18.  Retained earnings (shareholders’ equity) down $18 and voila, we are balanced.

A company makes a $100 cash purchase of equipment on Dec. 31. How does this impact the three statements this year and next year?

First Year:  Let’s assume that the company’s fiscal year ends Dec. 31.  The relevance of the purchase date is that we will assume no depreciation the first year.  Income Statement:  A purchase of equipment is considered a capital expenditure which does not impact earnings.  Further, since we are assuming no depreciation, there is no impact to net income, thus no impact to the income statement.  Cash Flow Statement:  No change to net income so no change to cash flow from operations.  However we’ve got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities.  No change in cash flow from financing (since this is a cash purchase) so the net effect is a use of cash of $100.  Balance Sheet:  Cash (asset) down $100 and PP&E (asset) up $100 so no net change to the left side of the balance sheet and no change to the right side.  We are balanced.

Second Year:  Here let’s assume straightline depreciation over 5 years and a 40% tax rate.  Income Statement:  Just like the previous question:  $20 of depreciation, which results in a $12 reduction to net income.  Cash Flow Statement:  Net income down $12 and depreciation up $20.  No change to cash flow from investing or financing activities.  Net effect is cash up $8.  Balance Sheet:  Cash (asset) up $8 and PP&E (asset) down $20 so left side of balance sheet doen $12.  Retained earnings (shareholders’ equity) down $12 and again, we are balanced.

How does ??? impact the three financial statements?

Varieties of this question are some of the most common technical question asked in interviews today.  This type of question attempts to test your understanding of how the three financial statements (income statement, balance sheet, cash flow statement) fit together.  The most common variation of this question is how does $10 of depreciation affect the three financial statements (answered below).  I’ve posted a few additional examples as well.

To answer this question, take the 3 statements one at a time. My advice is to start with the income statement.  Remember to tax-affect any change in revenue or costs (usually you will be told to assume a tax rate of 40%).  Work your way down to net income.  Next, tackle the cash flow statement.  The first line of the cash flow statement is net income so start with that and work your way down to net change in cash.  Last, take the balance sheet.  The first line of the balance sheet is cash so again, start with that.  The balance sheet must balance in order for your answer to be correct, which is why I recommend doing the balance sheet last.  Remember the basic balance sheet equation:  Assets = Liabilities + Shareholders’ Equity.

Don’t get too stressed when asked a question like this.  Just take it slowly, one statement at a time.

Should I take an investment banking course or training program?

For full disclosure, the author of this site is also the founder and senior instructor of the Institute for Finance Education and Career Advancement.  Now, having said that, I am going to try to answer this question as honestly as possible.

I do think a course or training program can be very helpful to your job search, provided that you select the right one and that you get the most out of it.  The course that I teach, entitled Introduction to Investment Banking is really geared towards individuals who are or will be in the process of seeking jobs in investment banking or other areas of finance. We start off with an overview of the investment banking industry and the necessary foundations of accounting and finance.  We then spend the bulk of our course on the core skills required of junior investment bankers, including financial statement analysis, valuation and financial modeling.  We devote the entire last class session to recruiting and the job search, including an extensive discussion of interviewing.

Obviously an 8-class session like I teach is not inexpensive.  And while it will by no means guarantee you a job or even an interview, I do believe that it can really help your chances.  Having taken a course like this will differentiate your resume from your peers and should (provided that you pay attention in class and do the homework!) really enhance your interviewing skills.  As you probably know from reading other parts of this site, technical questions are an integral part of interviewing for investment banking positions.  Taking a course like this will introduce you to or refresh your memory of nearly all of the accounting, finance and valuation topics that you are likely to be asked about in your interviews.  And finally, having already been introduced to the practical aspects of life and work as an investment banker will set you apart and give you a leg up once you do start your job as an analyst or associate.

What are some characteristics of a company that is a good LBO candidate?

Notwithstanding the recent LBO boom where nearly all companies were considered to be possible LBO candidates, characteristics of a good LBO target include steady cash flows, limited business risk, limited need for ongoing investment (e.g. capital expenditures or working capital), strong management, opportunity for cost reductions and a high asset base (to use as debt collateral).  The most important trait is steady cash flows, as the company must have the ability to generate the cash flow required to support relatively high interest expense.

Let’s say you run an LBO analysis and the private equity firm’s return is too low. What drivers to the model will increase the return?

Some of the key ways to increase the PE firm’s return (in theory, at least) include:

  • – reduce the purchase price that the PE firm has to pay for the company
  • – increase the amount of leverage (debt) in the deal
  • – increase the price for which the company sells when the PE firm exits its investment (i.e. increase the assumed exit multiple)
  • – increase the company’s growth rate in order to raise operating income/cash flow/EBITDA in the projections
    decrease the company’s costs in order to raise operating income/cash flow/EBITDA in the projections

Why do private equity firms use leverage when buying a company?

By using significant amounts of leverage (debt) to help finance the purchase price, the private equity firm reduces the amount of money (the equity) that it must contribute to the deal.  Reducing the amount of equity contributed will result in a substantial increase to the private equity firm’s rate of return upon exiting the investment (e.g. selling the company five years later).

Walk me through an LBO analysis…

First, we need to make some transaction assumptions.  What is the purchase price and how will the deal be financed?  With this information, we can create a table of Sources and Uses (where Sources equals Uses).  Uses reflects the amount of money required to effectuate the transaction, including the equity purchase price, any existing debt being refinanced and any transaction fees.  The Sources tells us from where the money is coming, including the new debt, any existing cash that will be used, as well as the equity contributed by the private equity firm.  Typically, the amount of debt is assumed based on the state of the capital markets and other factors, and the amount of equity is the difference between the Uses (total funding required) and all of the other sources of funding.

The next step is to change the existing balance sheet of the company to reflect the transaction and the new capital structure.  This is known as constructing the “proforma” balance sheet.  In addition to the changes to debt and equity, intangible assets such as goodwill and capitalized financing fees will likely be created.

The third, and typically most substantial step is to create an integrated cash flow model for the company.  In other words, to project the company’s income statement, balance sheet and cash flow statement for a period of time (say, five years).  The balance sheet must be projected based on the newly created proforma balance sheet.  Debt and interest must be projected based on the post-transaction debt.

Once the functioning model is created, we can make assumptions about the private equity firm’s exit from its investment.  For example, a typical assumption is that the company is sold after five years at the same implied EBITDA multiple at which the company was purchased.  Projecting a sale value for the company allows us to also calculate the value of the private equity firm’s equity stake which we can then use to analyze its internal rate of return (IRR).  Absent dividends or additional equity infusions, the IRR equals the average annual compounded rate at which the PE firm’s original equity investment grows (to its value at the exit).

While the private equity firm’s IRR is usually the most important piece of information that comes out of an LBO analysis, the analysis also has other uses.  By assuming the PE firm’s required IRR (amongst other things), we can back into a purchase price for the company, thus using the analysis for valuation purposes.  In addition, we can utilize the LBO model to analyze the trend of credit statistics (such as the leverage ratio and interest coverage ratio) which is especially important from a lender’s perspective.

A car travels a distance of 60 miles at an average speed of 30 mph. How fast would the car have to travel the same 60 mile distance home to average 60 mph over the entire trip?

Most people say 90 mph but this is actually a trick question!  The first leg of the trip covers 60 miles at an average speed of 30 mph.  So, this means the car traveled for 2 hours (60/30).  In order for the car to average 60 mph over 120 miles, it would have to travel for exactly 2 hours (120/60).  Since the car has already traveled for 2 hours, it is impossible for it to average 60 mph over the entire trip.

Three envelopes are presented in front of you by an interviewer. One contains a job offer, the other two contain rejection letters. You pick one of the envelopes. The interviewer then shows you the contents of one of the other envelopes, which is a rejection letter. The interviewer now gives you the opportunity to switch envelope choices. Should you switch?

The answer is yes.  Say your original pick was envelope A.  Originally, you had a 1/3 chance that envelope A contained the offer letter.  There was a 2/3 chance that the offer letter was either in envelope B or C.  If you stick with envelope A, you still have the same 1/3 chance.  Now, the interviewer eliminated one of the envelopes (say, envelope B), which contained a rejection letter.  So, by switching to envelope C, you now have a 2/3 chance of getting the offer and you’ve doubled your chances.

Note that you will often get this same question but referring to playing cards (as in 3-Card Monte) or doors (as in Monte Hall/Let’s Make a Deal) instead of envelopes.

A windowless room has 3 lightbulbs. You are outside the room with 3 switches, each controlling one of the lightbulbs. If you can only enter the room one time, how can you determine which switch controls which lightbulb?

Turn on two switches (call them A and B) on and leave them on for a few minutes.  Then turn one of them off (switch B) and enter the room.  The bulb that is lit is controlled by switch A.  Touch the other two bulbs (they should be off).  The one that is still warm is controlled by switch B.  The third bulb (off and cold) is controlled by switch C.

You are given 12 balls and a scale. Of the 12 balls, 11 are identical and 1 weighs EITHER slightly more or less. How do you find the ball that is different using the scale only three times AND tell if it is heavier or lighter than the others?

Significantly harder than the last question!  Weigh 4 vs 4 (1st Weighing).  If they are identical then you know that all of 8 of these are “normal” balls.  Take 3 “normal” balls and weigh them against 3 of the unweighed balls (2nd Weighing).  If they are identical, then the last ball is “different.”  Take 1 “normal” ball and weigh against the “different” one (3rd Weighing).  Now you know if the “different” ball is heavier or lighter.

If, on the 2nd weighing, the scales are unequal then you now know if the “different” ball is heavier (if the 3 non-normal balls were heavier) or lighter (if the 3 non-normal balls were lighter).  Take the 3 “non-normal” balls and weigh 1 against the other (3rd Weighing).  If they are equal then the third ball not weighed is the “different” one.  If they are not equal then either the heavier or lighter ball is “different” depending on if the 3 “non-normal” balls were heavier or lighter in the 2nd Weighing.

If, on the 1st Weighing, the balls were not equal then at least you know that the 4 balls not weighed are “normal.”  Next, take 3 of the “normal balls” and 1 from the heavier group and weigh against the 1 ball from the lighter group plus the 3 balls you just replaced from the heavier group (2nd Weighing).  If they are equal then you know that the “different” ball is lighter and is 1 of the 3 not weighed.  Of these 3, weigh 1 against 1 (3rd Weighing)  If one is lighter, that is the “different” ball, otherwise, the ball not weighed is “different” and lighter.

If, on the 2nd weighing from the preceding paragraph, the original heavier group (containing 3 “normal” balls) is still heavier, then either one of the two balls that were NOT replaced are “different.”  Take the one from the heavier side and weigh against a normal ball (3rd Weighing).  If it is heavier, it is “different,” and heavier otherwise the ball not weighed is “different” and lighter.  If, on the 2nd weighing, the original lighter side is now heavier, then we know that one of the 3 balls we replaced is “different.”  Weigh one of these against the other (3rd Weighing).  If they are equal, the ball not weighed is “different” and heavier.  Otherwise, the heavier ball is the “different” one (and is heavier).

If you get this right and can answer within the 30 minutes alloted for the interview, then you probably do deserve the job.

You are given 12 balls and a scale. Of the 12 balls, 11 are identical and 1 weighs slightly more. How do you find the heavier ball using the scale only three times?

First, weigh 5 balls against 5 balls (1st Use of Scale).  If the scale is equal, then discard those 10 balls and weigh the remaining 2 balls against each other (Second Use of Scale).  The heavier ball is the one you are looking for.

If on the first weighing (5 vs 5), one group is heavier, then of the heavier group weigh 2 against 2 (2nd Use of Scale).  If they are equal, then the 5th ball from the heavier group (the one not weighed) is the one you are looking for.  If one of the groups of 2 balls is heaver, then take the heaver group of 2 balls and weigh them against each other (Third Use of Scale).  The heavier ball is the one you are looking for.

You’ve got a 10 x 10 x 10 cube made up of 1 x 1 x 1 smaller cubes. The outside of the larger cube is completely painted red. On how many of the smaller cubes is there any red paint?

First, note that the larger cube is made up of 1000 smaller cubes.  The easiest way to think about this is how many cubes are NOT painted?  8 x 8 x 8 inner cubes are not painted which equals 512 cubes.  Therefore, 1000 – 512 = 488 cubes that have some paint.  Alternatively, we can calculate this by saying that two 10 x 10 sides are painted (200) plus two 10 x 8 sides (160) plus two 8 x 8 sides (128).  200 + 160 + 128 = 488.

Four investment bankers need to cross a bridge at night to get to a meeting. They have only one flashlight and 17 minutes to get there. The bridge must be crossed with the flashlight and can only support two bankers at a time. The Analyst can cross in 1 minute, the Associate can cross in 2 minutes, the VP can cross in 5 minutes and the MD takes 10 minutes to cross. How can they all make it to the meeting in time?

First, the Analyst takes the flashlight and crosses the bridge with the Associate.  This takes 2 minutes.  The Analyst then returns across the bridge with the flashlight taking 1 more minute (3 minutes passed so far).  The Analyst gives the flashlight to the VP and the VP and MD cross together taking 10 minutes (13 minutes passed so far).  The VP gives the flashlight to the Associate, who recrosses the bridge taking 2 minutes (15 minutes passed so far).  The Analyst and Associate now cross the bridge together taking 2 more minutes.  Now, all are across the bridge at the meeting in exactly 17 minutes.   Note, that instead of investment bankers, you’ll often see the same question using members of musical bands (usually either the Beatles or U2).

You are given a 3-gallon jug and a 5-gallon jug. How do you use them to get 4 gallons of liquid?

Fill the 5-gallon jug completely.  Pour the contents of the 5-gallon jug into the 3-gallon jug, leaving 2 gallons of liquid in the 5-gallon jug.  Next, dump out the contents of the 3-gallon jug and pour the contents of the 5-gallon jug into the 3-gallon jug.  At this point, there are 2 gallons in the 3-gallon jug.  Fill up the 5-gallon jug and then pour the contents of the 5-gallon jug into the 3-gallon jug until the 3-gallon jug is full.  You will have poured 1 gallon, leaving 4 gallons in the 5-gallon jug.

If the banking lifestyle is so tough, what’s the upside?

First and foremost, the money.  There are very few careers that pay as well as investment banking, especially taking into account the level of risk (trading or hedge fund compensation, while potentially equal to or vastly exceeding that of banking is significantly more volatile).  Second, the exit opportunities.  Many people treat investment banking as a stepping stone to other finance careers, including private equity and hedge funds.  Third, for what you learn.  Being a junior investment banker teaches you two things.  It teaches you about finance and it teaches you how to work and survive in a difficult and detail obsessed environment.  Both skills are likely to prove valuable regardless of future career choice.  Fourth, for ego.  Many people get a kick out of telling others that they are in banking and for seeing their deals on the front page of the Wall Street Journal.

Explain the concept of synergies and provide some examples.

In simple terms, synergy occurs when 2 + 2 = 5.  That is, when the sum of the value of the Buyer and the Target as a combined company is greater than the two companies valued apart.  Most mergers and large acquisitions are justified by the amount of projected synergies.  There are two categories of synergies:  cost synergies and revenue synergies.  Cost synergies refer to the ability to cut costs of the combined companies due to the consolidation of operations.  For example, closing one corporate headquarters, laying off one set of management, shutting redundant stores, etc.  Revenue synergies refer to the ability to sell more products/services or raise prices due to the merger.  For example, increasing sales due to cross-marketing, co-branding, etc.  The concept of economies of scale can apply to both cost and revenue synergies.

In practice, synergies are “easier said than done.”  While cost synergies are difficult to achieve, revenue synergies are even harder.  The implication is that many mergers fail to live up to expectations and wind up destroying shareholder value rather than create it.  Of course, this last fact never finds its way into a banker’s M&A pitch.

Why might one company want to acquire another company?

There are a variety of reasons why companies do acquisitions.  Some common reasons include:

  • – The Buyer views the Target as undervalued.
  • – The Buyer’s own organic growth has slowed or stalled and needs to grow in other ways (via acquiring other companies) in order to satisfy the growth expectations of Wall Street.
  • – The Buyer expects the deal to result in significant synergies (see the next post for a discussion of synergies).
  • – The CEO of the Buyer wants to be CEO of a larger company, either because of ego, legacy or because he/she will get paid more.