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Wendy,

You were the one who suggested that Fellow Fools take a look at the interest rate Superior Savings is offering, and you provided a link. That's a commendable action, and I want you to understand that my criticisms of Superior are, in no way, directed toward you. I'm am leaning on this issue hard, because it is myself that I blame for failing to have in place an easy and quick method to evaluate such opportunities, so I can determine whether they are opportunities to pursue or run away from.

Gut instincts told me the deal sucked, but gut instincts are an undisciplined way to make financial decisions. So I'm going to work through the example one more time and attempt to explain to myself, and any party of interest, why this offer should not be accepted.

Superior states on their web site that their offered daily interest rate is 4.40% and they imply that the APY for depositors (the Annual Percentage Yield) would be 4.50%.

The first thing is check is whether they've done their math correctly. (It isn't uncommon to find errors in either direction, by which either the daily rate or the APY/APR are understated or overstated.) In this instance, the math checks out. 4.40% compounded daily gives an annualized percentage yield of 4.4979586%. That's close enough. They aren't fudging their results, though it must be remembered that to achieve that 4.5% gain, the deposit has to be held with Superior for one year and that all coupons have to be reinvested.

An aside: For those who don't buy their own bonds, it might seem strange to talk about interest payments as “coupons”. But it is just as strange to a bond investor to consider coupon payments to be interest payments. Yeah, it is interest, aka, rent paid for use of one's money, but coupons is the term I prefer, because it facilitates comparisons when a more complicated problem is dealt with, namely calculating YTM's (Yield to Maturity) for couponed instruments.

For a depositor to achieve the 4.5%APY that Superior implies will be captured, the deposit has to be held on account for one year. Thus, though the transaction will be happening in a money market account, which must permit immediate withdrawals, what Superior is really offering is a 1-year CD. It would be trivial to determine whether their 4.5% rate is the best 1-year CD currently offered in the money markets. I suspect it isn't, but I'm not going to pursue that investigation –- which I invite anyone to do for himself on his own-- because a different line of argument interests me.

At the 12/29/2005 Treasury Auction, 182-day T-Bills (CUSIP: 912795XH9) were sold for 97.866556 per bill. Purchasers will receive \$1,000 upon maturity. What, then, is the implied, daily interest rate for those bills? 4.32517%, right? (And I'll leave it as an exercise for anyone else to figure out the APY/APR, which doesn't concern me.)

Now let's run a thought experiment. Let's relax the restriction imposed by Superior that the deposit be \$25,000. Instead, let's ask this question. If I deposited the same amount of money with Superior that I spent to buy a T-Bill, and held it for the same 182 days, would I receive more money? Obviously, the answer is “Yes” by \$0.38.

But consider, now, a further problem. Unless you live in one of the 5 or 7 states that have no income tax or that do tax the interest on government debt, you won't have to pay state taxes on your T-Bill profit, but you will have to pay them on the profit from Superior. Everyone's situation is going to be different, but I'm in the 9% state-bracket. So, for me the \$21.71 from Superior becomes degraded to \$19.76, which is a very inferior return.

Furthermore, something much more serious is going on. Though I don't know the interest rate I will receive when I bid for T-Bills through the non-competitive auction process, I do know that for the next 182 days, I will not be subject to re-investment risk. My interest rate is guaranteed. That is not the case with deposits made at Superior into their money market accounts. In fact, just opposite is the case. The rate is all but guaranteed to change for the worse, for the following reason: MEAN REVERSION.

It is an axiomatic belief for Fools that Mean Reversion is a very real thing, and they manage their financial risks and portfolios according.

Let's make the not-unwarranted assumption that BankRate is correctly reporting the nation-wide, 100-highest yields for MM deposits of \$25k. What is Superior's ranking? They are currently #1, right? By 9-10 beeps, or so. (A “beep” is a basis point, which is 1/100th of a percentage point, and often abbreviated “bps”). What is the likelihood that they will continue to be #1 over the next 182 days?

That question, my Fellow Fools, is what this Saving stuff is all about. So, let's game the situation. Let's divide BankRate's list into five bins, ranking the yields offered from highest to lowest according to the following number of issuers:

Top 10%
Second-tier 20%
Mid-pack 40%
Lower-tier 20%
Bottom 10%

We're going to talk mean regression, so let's ask: Where is the mean? and Where is Superior presently? The even-money bet has to be that Superior will regress to mid-pack status sooner or later. The smart-money bet (with 3 STD's of confidence) has to be that Superior will regress to second-tier status immanently and that they will tag at least lower-tier status over the long haul. In other words, not only will the would-be depositor at Superior receive a return inferior to what they might receive from owning T-Bills instead, they will have also taken daily re-investment risk for which they are not being compensated. (Superior reserves to themselves the right, at any time, to change the interest rate that they pay. Yes, they could raise their rates even higher, but that isn't the smart bet.)

There is, of course, a whole lot more that could be said about why Superior's offer is not superior at all, but there's no point in beating a dead horse further. I've leaned on this example hard because it is a reminder to me that I have been failing to do my due diligence. I do not have in place an algorithmic (i.e., a non-discretionary) means by which I can price yield and risks across any debt instrument. I need to build that for myself and doing so will be this coming week's project.

So, Wendy. Thank you again for calling our attention to an interesting investment problem, but do your due diligence before you pursue it further. There are likely to be better-assured, better-yielding opportunities out there.

Charlie

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