The RBA has left interest rates on hold today on the back of overnight global woes. Most noticably, the Statement by Glenn Stevens states (in summary) the following:

• World economy has remained very weak following decreases in demand late last year
• Conditions in global credit markets have improved since November last year, but remain fraigle
• Demand has not weakend as much as in other countries and Australia has not experienced the sort large contractions seen elsewhere.
• Inflation is likely to decline over time.
• Overally, economy is not slowing significantly and therefore no need for a cut unless some event indicates it.

Thanks Glenn – ummm just to point out that overnight the Dow Jones Industrial Average (DJI) fell around 299.64 points overnight or around 4.2%. The S&P500 (GSPC) was equally slammed falling by 34.27 points or 4.7% to around 700.82 points and the Nasdaq (NASDAQ) also shed 54.99 points or 4% to finish at 1,322.85. Most of this bad news was on the back of the announcement by American International Group (AIG) that it posted a fourth quarter loss of around a $61.66 billion USD loss or around $22.95 USD per shore – much worse than the $5.29 billion loss in the fourth quarter last year when market proponents assumed the market was at its lowest point. This meant that the full year 2008 results for AIG were a reported loss of $99.3 billion USD or a whopping $37.84 USD per share.

Iconically, this is really an unprecedented fall and has never been seen in the history of the world and to put it in perspective – Australia’s total GDP is around $1 Trillion – so this is approximately about 1/10th of our entire countries GDP loss in one organisation. Surprisingly, the RBA should have really dropped interest rates on the back of this news and other continued severe credit-market deterioration, particularly in commercial backed mortgages in the United States, but they have decided against it – perhaps to keep interest rates cuts up their sleeve for the future and to wait for more economic data.

So what is all this going to mean ?

Well, I would think that things have still some time to go yet before we hit the bottom.

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I thought it would be useful to look at some of theories of capital structure and what their purpose is, how they apply to companies and whether we really need to know about them as investors. Evidently, the later part of this statement is true – all parts of finance are indeed useful – and capital structure is no less important. There are three main theories of capital structure – Trade-off Theory, Pecking Order Theory and Free Cash Flow – and today I am only going to focus on the first two. Please keep in mind that entire books have been written on these two theories and I intend on only covering the basics. A brief introduction to each are outlined below:

• Trade-off Theory – The Trade-off Theory is a theory which suggests that companies have an optimal capital structure based on a trade-off between the benefits and the costs of using debt. 
• Pecking Order Theory – The Pecking Order Theory – or the ‘Capital Shuffle’ as I call it – suggests that companies always follow a hierarchical pattern in financing sources such that internal funds are always preferred to external ones and borrowing is preferred to issuing risky securities. This theory is based on information asymmetry whereby all relevant information is not known by all parties interested in knowing it. Information asymmetry is the battle ground for most fundamental investors as it is involves the discrepancy between what insiders of a company know (managers) versus what those external to the company do (such as shareholders and lenders).

Trade-off Theory

The trade-off theory really emphasis the effects of taxes and the costs of financial distress in engaging in high leverage finance. This theory suggests that companies should borrow until the marginal tax advantage of additional debt is offset by the increase in present value of the expect costs of financial distress. Many opponents to the trade-off theory question how the theory actually explains capital structure decisions because there are many cases where corporate leveraging is much lower than what the trade-off theory suggests. Such opponents argue that many multi-national companies with high profit margins have operated for an extended period of time with low debt ratios and achieved solid credit ratings. Trade-off theory would suggest that these same companies could achieve significant interest tax savings by increasing their debt ratios without any remote possibility of financial distress becoming an issue.

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I have had a number of people write to me over the last few days asking how exactly short selling works and whether I can provide an example. This is a great question and often confuses many traders and investors alike in the market. The primary reason for this is the logic behind selling and buying the shares. When most people think about short selling they think about taking a ‘short position’ – that is , a position where they believe the shares are going to fall – but they aren’t 100% sure of how the actual process works. A few people seem to be confusing short selling with the logic of “put options” – and in reality they are very different.

Short selling is effectively – selling what you don’t own – to engage in short selling you need to find a person who owns shares and believes that the share is going to rise. In undertaking short selling, you do think that the price is going to fall. You are effectively “betting against” people who think its going to rise.

The following example should help to illustrate (please note that are differences between naked short selling and covered short selling which are explained in the link at the bottom of this post) :

1. Fred approaches his stock broker and says “I want to short sell NAB at current market rate of $20″
2. The stock broker would approach a large investor who has gone “long” on NAB shares and thinks they are going to rise (i.e. the large investor holds a bunch of NAB shares and thinks that they are going to rise)
3. The stock broker effectively “borrows” these shares from this investor and sells them at the current market rate – deriving a cash sum. The broker is now indebted to the investor for X  number of shares and holds cash for Fred.
4. The stock then falls to $18 and Fred wants to cash out and tells his broker.
5. The broker then uses the money from the sale of the shares “borrowed” from the large investor, and buys them at a rate of $18.
6. This costs $18 per share and the stock broker then gives the large investor the number of shares borrowed.
7. Fred has made $2 and pays a premium to the stock broker, who would have in turn been charged a premium from the large investor.

So a proper illustrate in a practical sense:

1. Fred “borrows” 1000 shares at $20 and immediately sells them at market price earning $20,000
2. Stock falls to $18
3. Fred buys 1000 shares at $18K
4. Fred “returns” the “borrowed” shares to the “borrower”
5. Fred keeps $2K profit
6. Fred’s $2K has a “premium borrowing” charge of 10% – so he has to pay this for “borrowing” the shares – $200 to the company.
7. Fred Nets $2K – $200 = $1,800

Obviously, you have to find an investor who is willing to “lend” the shares. Most big investors buy shares to go “long” not short – so many are “hesitant” to do this. However, the reason they do is that you have to pay a “premium” for “borrowing the shares”. Of course, the rationale is that big investors are in for the “long haul” and short selling is really just to gain from “short term” news. To learn more about short selling and the current affects on the ASX – read this article.

The good news is that the RBA has slashed interest rates by 100 Basis Points to a new modern era low of 3.25% – the lowest since 1964. So what does this mean for the average Australian ? Well, the good news is that on a 30-year typical $300K homeloan, a $170 bucks a month will be reduced over the entire life of the loan. This will amount to around a saving of $61K over the life of the loan.

Of course my advice has always been not to reduce your fortnightly interest repayments. Keep them at your current level and you will slash off around 5 years over the course of your home loan. Less on interest, more in your pocket.

Yep, this is the simplest recommendation that anyone can provide when interest rates decrease – don’t go out and spend this interest rate differential – “force save it” by keeping your homeloan and/or other loan repayments high. The higher the better really.

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