This blog is written weekly by Dock David Treece, a registered investment advisor with Treece Investment Advisory Corp. It is meant to share insight of investment professionals, including Dock David and his father, Dock, and brother, Ben, with the public at large. The hope is that the knowledge shared will help individuals to better navigate the investment world.

Tuesday, December 28, 2010

Year-End Financial Checklist

They say failure to plan is planning for failure. While many rely on a financial plan to outline their long term goals and strategies, each year it’s a good idea to take a little time to reassess what progress has been made and think further about long-term goals, as well as plans for achieving those goals.

Obviously we all have different financial needs and varying opinions on strategies for achieving our goals. There are many different ways to manage money, so while results are important, much more significant is what system is a comfortable fit for the client.

For example, diversification will, by design, tend to yield lower results than concentrated portfolios, the offset being, ideally, less volatility. Similarly, systems of actively managing money typically have higher fees, as well as better returns – or at least that’s the hope.

Consider for example that the Standard & Poor 500 Index is up roughly 12% for the year. Representing a wide array of stocks from varying sectors, the S&P500 essentially illustrates the direction of the broader stock market.

Given the results of the S&P this year, investors need to look at their own statements, and if returns aren’t in or at least near double digits, take some time to think about whether to stick with their current strategy.

For those using a diversified strategy, this is probably a good time to schedule an appointment with an advisor, if you have one. This is the time of year to look at the last year and do a little portfolio rebalancing. You might even consider “tilting” your portfolio in one direction or another, based either on your own research or on professional advice.

On the other hand, investors using active management systems like ours have more questions to ask themselves. First and foremost, they need to decide if they’re still comfortable with the system their money manager is using. While investors should obviously be pleased with their returns, these are hardly important if they aren’t comfortable with their advisor’s system.

Those attempting to actively manage themselves have quite a to-do list for the end of the year. They need to be doing research to come up with a forecast of what the market will likely do next year.

Then they need to decide whether they want to be invested. If so, what do they want to own? Are there particular asset classes that look more attractive than others? Do they want to make any moves immediately? Maybe they want to be patient and wait for opportunities to develop.

Few people realize how much work goes into money management. The number of people who think they can trade in their spare time and be profitable is astounding. And despite the odds stacked against them, people continue to try their luck in the markets – and make no mistake, the average investor managing money in their spare time without devoting any real time to research is basing their success on just that: Luck.

No matter the strategy, around this time each year it’s a good idea for all of us to spend a little time thinking about the upcoming year, what’s upcoming and what might develop. Make a list of any issues coming up this next year that might affect your financial life. If you have a child going to college, hopefully you’ve been putting money away for some time, but don’t forget about the costs of moving and/or travelling to visit.

Take an inventory of these kinds of issues, from travel expenses to health or medical expectations, kids’ school costs, and so on. While some of these require long-term preparation, others are good just to keep in the back of your mind. Ignoring them doesn’t solve the problem, but at least we can keep them from sneaking up on us.

Tuesday, December 21, 2010

The Next Motor City

Many of the issues currently causing worry among Americans, particularly among the working class, are based on several assumptions. Fortunately, many of these assumptions are flawed.

Of these worries, two stand out: First, that the national debt is growing too large and too fast, and that it will cause the US to go bust. Second, that employment in this country has undergone a substantial shift and that we must adjust to the “new normal.”

Oddly enough, these concerns are related, and both are based on the assumption that jobs which have been swept overseas during outsourcing wave of the past several decades are gone forever.

Since we at Treece Investments spend roughly 80% of our time trying to figure out where the economy is headed (so we can make profitable investments for clients) we feel fairly competent to address this topic, and qualified to comment. And given the set of economic circumstances that we see developing presently, we feel confident in saying that manufacturing must come back to the US.

As the economies of China, India and Russia have grown over the past several decades thanks to outsourcing and political shifts (Russia), each has begun developing a substantial middle-class that did not previously exist.

These growing middle classes are now getting to the point where they want access to many of the same luxuries that we have long enjoyed in this country.

For example, in Russia car sales have roughly doubled this year from last. In China, meanwhile, the average age of an owner of Mercedes’ luxury S-class sedan is a startling 26, all of 30 years less than it is in this country.

To date, as these countries have grown an increasing amount of their production has gone simply to meet demand within their own countries. Rather than building goods and shipping them to the Americas or Europe for sale, they are sold in India, Russia, or China without such high shipping costs.

Thankfully for the US, many of these countries are now getting to the point where they are having trouble simply producing enough to meet their internal demand, let alone those from other nations that had outsourced their production.

As the Asian nations have developed each has carved out a role in the manufacturing process, but in a strange twist of events it seems that they are missing a valuable link in the chain that few nations besides ours can fill: Russia has raw materials, India has technology, China does manufacturing, but none of them do engineering. The US, however, is one of if not THE world’s best country for engineering, and while other countries do have manufacturing sectors, few do it has efficiently as we do.

In fact, thanks to many of our contacts in various businesses, most notably automotive manufacturing, we have personal knowledge that the Chinese are actually looking at outsourcing a good deal of their engineering to the US.

We’ve also caught wind of several Chinese companies that are considering purchasing manufacturing facilities in the United States. Ironically, they’ve apparently grown tired of having a government that owns everything, and though the US has been looking increasingly socialist, it’s still not caught up to Red China.

Wednesday, December 15, 2010

Keep It Simple, Stupid

According to a recent USA Today article there is a new fad on the rise in the world of finance. Termed “mirrored investing,” this new concept being offered by several websites including Ditto Trade and Covestor allow investors to “mirror” the strategies of other, presumably more knowledgeable or successful traders.

Under this system, “master traders” place trades which are simultaneously executed for any investors following their strategy. Some traders that investors can choose to track charge a fee for their “guidance,” on top of the trading charges assessed by the brokerage site processing the trades.

This new strategy is incredibly inventive and actually follows many of the psychological trends that have brought success to websites like Facebook, Myspace and Twitter. Unfortunately, while mirrored trading might be the “latest and greatest,” if has some serious pitfalls from an investing perspective.

First and foremost, mirrored investing opens investors up to exploitation by traders, though not necessarily in the Bernie Madoff sense.

Given that this business model exists entirely in the virtual realm, how much oversight do you think sites like Ditto Trade or Covestor have of a “master trader’s” activities? What’s to stop them from having an account at a trading account at a different site and engaging in what is called “front-running,” which is illegal for money managers?

In front-running, advisors make trades for their own accounts ahead of client accounts in order to take advantage of the market moves created by their clients’ activity. A trader with clients mirroring their strategy on Ditto Trade could, for example, log onto E-trade to buy 100 shares of XYZ for their own account, and then enter the same trade on Ditto, which would be mirrored by anyone following their strategy. That trader could then sell the shares from the E-trade account after the share price has risen on buying among their Ditto followers.

Of course this obviously isn’t the only risk run by clients who used mirrored investing. Clients have little knowledge of the background of a “master trader,” other than what they are told. They may be entrusting their money to someone who has never been registered with the Financial Industry Regulatory Authority (FINRA) and knows little of securities law, or somebody who exaggerates their own experience and expertise. They could have just been laid off from a job in an unrelated field and decide to give trading a try.

Oddly enough, mirrored investing is not a completely new concept; though the delivery – being entirely only and taking on the feel of social networking – is original. There are many firms, often with far more brick and mortar, who have been letting clients mirror their trading for years. Our own firm has been using such a strategy since 1979. The difference is that we are registered with FINRA and the Securities Exchange Commission. Our companies and our employees are very highly regulated, so our system provides clients with increased safety and transparency.

Over the course of 30 years, we’ve seen dozens of fads come and go. From portfolio insurance to credit default swaps, we’ve outlasted them all. The problem is that most while innovative ideas can be profitable for their architects, they are often fundamentally unsound for one reason or another. Unfortunately, many people usually end up having to pay for the mistakes or gimmicks engineered by others.
Sadly, most people never look beyond the pitch. The same is true of investors buying annuities, life insurance, hedge funds or ETFs: salespeople use complicated language to describe complex products and systems, but they don’t know how they really work. Salespeople only know the sales brochure. Their job is to sell, not to understand how the products work.

Still, one would hope that clients might be skeptical of buying products from someone who can’t explain how a product works in simple terms.

In general, people would be better off sticking to the basics; quite often, the best solution isn’t the most complicated. Some people are inherently turned off by strategies that aren’t new and shiny with tons of moving parts that only a NASA engineer can imagine, but tried and true strategies can still do the trick. Slow and steady wins this race.

Thursday, December 9, 2010

Innovation: Death by Regulation

The theory of Diffusion of Innovations states that innovation begets further innovation; that when one person makes progress in some way, they spark or allow for various further innovations. So, theoretically, innovation ought to occur at an ever-increasing pace.

The truth, however, is quite different. As physicists Jonathan Huebner and Theodore Modis have noted in modern studies, it appears that global innovation isn’t occurring nearly as quick as it should be, and may actually be slowing down.

Many separate theorists including John Smart, founder of the Acceleration Studies Foundation, criticize elements of arguments made by Huebner and Modis. For example, Hueber argues that the number of patents issued per person peaked in 1873; while Smart notes that the vast population growth since then would seriously impact this calculation. Huebner also forgets to take into account innovations for which patents are not filed, including the development of existing “technologies.”

There is, however, a different theory – one most free market capitalists would probably find much more appealing. This argument looks past the scientific calculations and cuts down to solid fundamentals.

Simply put, innovation isn’t occurring at a quickening pace because governments, through their endless rules and regulations, are killing it.

Consider, for example, the incredible rate of progress seen in Russia directly following its conversation to capitalism less than 20 years ago. The amount of wealth created in the former Soviet stronghold has been incredible, and already the country is gaining prominence around the world, this time as an economic rather than military power.

Why, in just last year alone we saw the number of Russian billionaires more than double. That’s certainly nothing to shake a stick at.

To our point, though, the progress made in Russia is not by happenstance. The Russians and their trading partners can thank the lack of regulation in the region that resulted from the final collapse of the socialist government that previously controlled the region.

For more evidence, look at China. Though still technically a communist country, the Reds certainly got a few things right – but don’t tell that to Google. The Chinese may like to have a say in the crazy theories that infect the minds of their people, but the government still leaves its people mostly free to innovate. And thanks to cheap power produced from burning mountains of coal, the Chinese have left their role as trinket-supplier to the world and is now innovating, designing, and engineering right alongside the largest American enterprises.

Still not convinced? Consider the histories of two separate industries right here in America, perhaps the two that impacted people’s lives more than anything that had come before them: cars and computers.

Pop quiz: When did either of these industries experience their most rapid rates of innovation?

Answer: In their infancy, before the government started regulating them “for the public good.”

Now for a test of wits: Name one meaningful innovation that has come out of Cuba in the past 50 years.


It seems so simple, and yet some people just don’t get it. Unfortunately they’re called politicians. But mark my words, the more rules and regulations the government makes, the further they will slow innovation and the further people’s standard of living will fall.

For the better part of this country’s history it’s been headed down a path of increased government regulation. We’ve seen this progression with other societies before, and we’ve seen this movie ends. It’s our choice; this country can keep going the way it’s been headed, or it can choose a new path. If we keep going, we will see standards of living decline as innovation slows to a snail’s pace. But it’s not too late.

Wednesday, December 8, 2010

Obama Caught Between a Tax Cut and a Hard Place

The big news this week is Obama’s recent 180-degree turn on cutting taxes to help bolster the US economy. There has been talk of extending the tax cuts passed during George W. Bush’s first term; or possible structuring a new piece of legislation that would provide some variant of tax relief.

Unfortunately for President Obama, he seems to be caught in a catch-22 on this important issue. Since the midterm elections in November it has become obvious that he will need to cooperate with Republicans, who will control the House come January, despite what he’s been saying in recent speeches.

If Obama refuses to acquiesce, the US economy will see very little progress going forward and he’ll be headed back to Chicago after his first term. If, on the other hand, he DOES cooperate with Republicans in Congress to provide some form of tax relief to the American people, he will do so at the cost of losing his voting base. What’s more, if the tax cuts do encourage business and help the economy, Obama won’t be given the credit that will likely go to Republicans. Either way, he’ll probably be headed back to Chicago.

Surely by this time White House advisors are telling Obama not only that tax cuts are desired by the American people, but that they are necessary for the US economy to continue its recovery.

The theory among many [leftists] is that during hard economic times, people need to buckle down and sacrifice more for the greater good. The proposed sacrifice is primarily in the form of increased taxes that hopefully allow the government to ramp up spending, keeping business afloat through rough seas.

In reality it’s the GOVERNMENT that ought to be making the sacrifice by LOWERING taxes with the hopes of encouraging businesses, which will put people back to work. Lower unemployment should, in turn, support consumer spending, further helping the economy.

Much of the debate lately has centered on the Bush-era tax cuts, and whether they ought to be extended. Readers would do well to think deeply about the circumstances of those tax cuts for a moment.

The “Bush tax cuts” were passed in the early 2000’s (2001 and 2003 respectively) very early in Bush’s first term. And just what was happening in this country during that time? It was still reeling from the burst of the tech bubble. In fact, the country was struggling to gain footing to pull itself out of the recession caused by the market crash.

Perhaps the most important facet of the Bush tax cuts, given the circumstances under which they were enacted, is that they WORKED. In just five years both the economy recovered tremendously, as did financial markets. In fact, stocks soared to new highs that surpassed even those of the tech boom. This recovery was halted only by the financial crisis that ultimately led to the market crash of 2008 and the ensuing recession.

Given this history, some will undoubtedly feel that the blame for the financial crisis and the current recession from which we are trying to emerge ultimately lie with President Bush (II). However, the reality is that we are really talking about two separate and distinct things.

The financial crisis, it is widely known, was the result not of lower taxes, but of excess debt. As debt was the cause of this mess, it will not likely be the solution as Federal Reserve Chairman Bernanke has suggested with renewed lending.

Rather, fiscal policy dictated by the United States government CAN and SHOULD serve to foster economic growth by encouraging businesses. The all-important question still remains, though, what policies will come out of Washington.

Wednesday, December 1, 2010

The Heresy of Higher Education

In the past week Chrysler and GM have announced plans to hire roughly 1000 engineers EACH between now and the end of 2012. Amazingly, this story is not exclusive to big automakers. Even smaller companies have been looking for new talent for as long as a year.

The real question now is whether the United States is capable of filling of this new demand for engineers, or if this country’s educational system has failed us completely.

For years the growing trend in higher education has been towards soft sciences. With business now being the most popular college major, other programs attracting increasing numbers of enrollees include precursors to professional degrees like law, medicine, and teaching. The arts have also become increasingly popular.

The real irony in the recent preference of college kids to study business is in the phrase so popular among businesspeople and business students: “It’s not what you know; it’s WHO you know.” So many kids are going to college for a degree in business, though abundantly aware that their connections will play a larger role in their success or failure than their education.

In many ways it appears that the American education system has gone completely wrong. Far too many people today, particularly in western societies, are feeling the pressure to go to college and get a degree. They are further incentivized by government grants and student loans, though they still graduate with a mountain of debt that usually takes the better part of a decade to repay.

What’s more, many graduates don’t even end up working in the field they studied. Even for those who do, a college degree is often unnecessary.

The old saying goes that “the world needs ditch-diggers, too.” Perhaps a more appropriate (and modern) characterization would be that the world needs people designing new backhoes.

Whatever the wording, the underlying fact remains. Over the past several decades the American dream has sadly changed. Where once the hope was for the opportunity to roll up one’s sleeves and work for a living, the increasingly popular fantasy is that of a free lunch.

Nowadays everyone wants to order people around from behind a big comfy desk without really adding to the equation.

Ideas on where blame should lie differ, though the most reasonable theory I’ve heard is with the baby-boomer generation. It was under the baby-boomer generation that society began pushing all kids to go to college, claiming that a college degree gave you ‘keys to the kingdom;’ that the world would simply fall in your lap.

It was that thought process that transformed the American educational system. Suddenly the purpose of early education and high school shift from preparing kids to go out and make a living to preparing them for COLLEGE. An entire generation came out of high school with no real skill set to speak of, at least none that was learned in school.

At the risk of sounding ungrateful, the baby boomer generation has, for the most part, lived through the greatest periods of American prosperity, without a corresponding degree of work and effort. Their prosperity has been born on the backs of sacrifices made by the greatest generation before them, and fuelled largely by debt that will be inherited by those that come after, mine included.

The good news is that this country can change. Just because recent history has brought the United States down a wayward path doesn’t mean that we have to continue thereon. The problems with jobs and education in this country have developed largely in the past half-century. In the grand scheme of our cultural history, that’s hardly any time at all; and certainly nothing that can’t be fixed.

Admittedly, fixing the system will require this country to take some strong medicine, and there will likely be more unemployed and more without direction before all is said and done. The question now is whether we are willing to walk over coals to reach greener pastures, or if we’ll continue to play dumb and wander further down this broken trail.

Saturday, November 27, 2010

How Republicans Saved the Economy

The following is, or could be, a transcript from a high school history teacher’s lecture in the year 2030 on Obama’s first term. It is a continuation of the lecture series that began with “How Obama Saved the Economy,” written in October of 2009.

Just twenty-two months into Obama’s first term, his party suffered a major setback in midterm elections in what amounted to a referendum on policy shifts that had been occurring in Washington.

In the 2010 elections Democrats lost control of the House of Representatives, a half dozen Senate seats, as well as roughly a dozen states’ governors’ offices. The result was a much more equal distribution of power around the country and gridlock achieved in Washington.

The loss of the Democrats’ supermajority in the House was particularly decisive, as President Obama’s ability to push through new spending bills was essentially crippled.

Much more significant, though, was what unfolded after the beginning of the 112th Congress and inauguration of new governors in 2011. While Democrats still controlled the Senate and the White House, there was a noticeable change in policy that almost immediately began to produce tangible impacts on the American economy.

Before the Democrats lost their grip on government, President Obama had been able to push through an economic stimulus bill, a Healthcare reform bill, and a financial reform bill. At the time of the midterms Obama was still pushing for cap and trade legislation, which would have put expensive restrictions on carbon outputs and had been the source of much controversy among the business community.

Unfortunately, as many had previously forecast, these policies did not serve to help the United States’ economy. Instead they injected significant uncertainty into the business community and stifled its recovery from the financial crisis of 2008.

With the government passing expensive legislation like healthcare reform and proposing cap and trade laws, businesses effectively stopped expansion plans because they could not know how much their costs of doing business or hiring employees might change.

Before the midterm elections Democrats had held a supermajority in the House, as well as control of the Senate, White House, and the governors’ offices of most states. With such complete control, they had no reason to listen to or cooperate with Republicans, much less their constituents; so they didn’t.

Once the wrath of voters was felt at midterm elections, however, Democrats had no choice but to begin shifting their policies in a cooperative dialogue with Republicans to improve the economy. They quickly realized that real economic growth – substantiated by significant improvement in employment figures – would be the only way those remaining Democrats would win sufficient support among constituents to ensure their reelection in 2012.

In a move that was wildly popular among voters, particularly the supporters of the then-popular “Tea Party” Movement, incoming Republicans applied considerable pressure and succeeded in reversing many of the policy trends previously being pursued by Washington’s far-left Democrats.

Most notably, through additional influence on policy making Republicans were able to substantially loosen the stranglehold of regulation on the economic recovery which had already begun – to some extent – before the elections of November, 2010.

The government correctly decided that their budget

was better spent educating the public on the detection of fraud.

Thankfully legislators, after January 2011, halted their aggravating increase of regulation on the financial sector. Having finally realized that added regulation would not halt the perpetration of frauds and schemes on the investing public, the government correctly decided that their budget was better spent educating the public on the detection of fraud. In this way they were able to limit the impact of future schemes and effectively prosecute those rare cases of criminal wrongdoing.

More importantly for the economy as a whole, Republicans were able to ease oversight on the energy sector, a path many had originally encouraged Democrats to pursue when Obama first entered office.

With Obama’s inauguration the United States was caught at a crossroads. At the time global warming was still trusted, more as a religion than a theory; and increasing pressure among environmentalists at largely limited the use of many sources of energy abundant in the US. However, there was also a growing concern among informed Americans (and rightly so) of the nation’s growing dependence on foreign energy, especially oil.

By easing government energy regulation, the private sector was able to pursue power sources without fear of political pressure. Investment in new projects surged immediately as large power companies began building new facilities to power the US through a re-industrialization period.

These and other major projects were made possible largely due to another avenue pursued by Republicans: that of pressuring the Federal Reserve to force banks to start making loans.

Up until that point, the Fed, under the guidance of Chairman Ben Bernanke, had been paying interest to banks that held excess reserves on deposit at the Federal Reserve. Oddly enough, most of these reserves had actually been provided BY the American taxpayers in the form of low-interest loans legislated by bailout packages.

When Republicans began pressuring Bernanke to stop paying interest to banks on these excess reserves, and actually begin charging a holding fee, banks immediately began scouring the market for opportunities to make loans.

Of course, the United States had endured a lengthy deleveraging process following the financial crisis of 2008, and most American consumers and corporations were surviving just fine without borrowing. In fact, at the time American non-financial companies had racked up significant cash holdings totaling roughly $2 TRILLION.

However, because the Fed encouraged banks to make loans, cheap credit was readily available to fund further expansion projects that had been previously unaffordable. Of course, as new facilities were being built and opened they not only need employees, but those workers required food, homes, and other goods and services.

Between the employment needed to execute new expansion projects, as well as the peripheral jobs created to help provide for the newly employed, the encouragement of loan creation by American banks was able to lower unemployment significantly.

What’s more, all these workers in periphery jobs, once employed, now had a demand for goods and services. The trickle-down effect of job creation turned out to be enormous, and was just what the US economy needed to jump start a recovery not previously seen since the early 1980s.

Sunday, November 21, 2010

Will Holiday Sales be Worth Celebrating?

As Black Friday and the holiday shopping season quickly approach, the business community is focusing its attention on this year’s holiday retail sales as an indication of the state of the economy after the last eighteen months of recovery. The results of this season’s sales will also be viewed as a guide for whether the recovery will prove sustainable or whether recent government policy has fostered any real growth.

We expect this holiday season to provide mixed signals to commentators and policymakers. Considering historical averages, sales will probably still be relatively low. However, we do expect an improvement over last year as stores promote deep holiday discounts.

The real impact of this year’s holiday sales will be felt after New Year, once numbers are totaled and analyzed. Strong retail sales will hopefully instigate corporate investment in expansion projects, which would continue our economic recovery and begin to ease unemployment.

Conversely, poor sales could cause a major shift in government policy, particularly given the changing make-up of the incoming Congress.

If retail sales are week, some (not many, but some) policymakers are finally going to realize that extending unemployment benefits won’t make people shop. People are comfortable spending money when they have jobs; and a handout isn’t the same as income.

Additionally, there have been a significant number of Americans whose unemployment benefits have been recently expiring after Democrats in Congress failed to push through an extension of benefits, much to the chagrin of 99ers who made headlines rallying for such an extension.

Sadly, though the US economy has improved modestly since bottoming after the crash of 2008, this recovery will be fruitless unless our leaders can encourage job growth. With real unemployment in this country at 17%, according to the BLS, the Unites States lacks sufficient consumers to support a continued recovery.

Before the US economy can see real growth to resume pre-crash levels, we need to see unemployment drop significantly. The current stated unemployment rate needs to be down around 5-6%, rather than its current 9.6%. This nation’s policymakers need to be doing all they can to help business and foster job growth.

That brings us to the impact this shopping this holiday season will have on the investment world. From a financial perspective, the next several weeks should be very revealing as to whether monetary policy pursued as of late by Federal Reserve Chairman Ben Bernanke is having a positive impact.

Many people, particularly inflation watchdogs, believe that Mr. Bernanke’s policies are detrimental to the US economy and that a new plan of action is needed.

Interestingly enough, while Bernanke’s “quantitative easing” (read: printing money) has allowed for a mild economic recovery in this country, his policies have caused foreign economies to improve significantly more than domestically. Moreover, while his policies have helped to provide markets with liquidity, employment has not improved, but actually continued to worsen until just recently.

Consider Germany for example, who according to a recent Bloomberg article is preparing for its strongest holiday sales season since 2004. Though the rest of Europe remains bogged down in debt problems compounding fiscal policy worries, Germans are projected to spend more than 75 billion Euros between November and December.

Of course, since the financial crisis that began in 2008 Germany has pursued policies almost directly opposite to those of the United States. As a result, though doubts remain whether the EU can survive this mess, Germany has recovered much more substantially than its neighbors or the US.

In fact, leading up to the G20 summit in April of 2009, leaders in the US had the gall to attack German policy makers including Chancellor Angela Merkel by saying that they were failing to “fill the demand hole.” More than a year later it is grossly apparent how Merkel’s “boneheaded” policy has fared, as compared to the US’s expansion of money supply and government spending under Bernanke.

Saturday, November 20, 2010

The Rule of the Regulators?

Speaking with almost anyone outside the field of finance, the mere mention of rules or regulations will almost invariably result in glazing eyes and a frantic glance for the nearest exit. Few realize the changes currently developing in the world of regulatory oversight; oversight not just confined to the financial industry. Fewer still realize these changes potential effects for the rest of the world.

Recently FINRA, the quasi-governmental regulatory body for the financial industry that is funded by financial firms, has solicited the Securities Exchange Commission for additional regulatory authority over investment advisors. This is an authority typically reserved for the SEC.

At the same time, thanks to the Dodd-Frank Wall Street Reform and Consumer Protection Act, the SEC has been narrowing the number of firms it will oversee. The agency has been changing its rules in order to shift many “smaller” firms to state oversight, though it plans to retain the right to examine those small firms. This means that while the SEC is shifting liability to individual states; it will still be able to poke through advisors’ records. And if something goes wrong, the SEC will still be able to point a finger at the states.

Finally, the Commodity Futures Trading Commission (CFTC) has been able to gain significant oversight of the newly-regulated derivatives markets through substantial lobbying by its Chairman, Gary Gensler.

Each of these developments, along with the new rules and regulations that will inevitably follow, will impact the financial world. But not the way most people think. The real issue at hand is whether more rules make the investment world safer from theft and fraud. The answer, of course, is that they do not.

In the 1970s there were far fewer rules than there are today, but a much higher degree of customer protection. The rules then focused on keeping crooks out of this industry, rather than making sure that they acted ethically.

Since then, entire manuals of rules have been written and re-written; and yet Bernie Madoff was still able to steal billions from his clients. In fact, despite these new rules an entirely new market was able to form and flourish in derivatives, finally collapsing in 2008 and losing untold trillions of dollars for clients.

While government bureaucrats focus only on rules and regulations, they fail to see that rules do not PREVENT fraud and more than speed limits PREVENT anyone from speeding. The same misperception is shared by many naïve investors who fail to realize that the sole purpose of regulators is to come in AFTER a crime, clean up the mess, and decide who to prosecute.

Instead of protecting customers against theft or fraud as hoped, new regulations will impact clients negatively. With each additional rule firms incur increasing costs of compliance, costs that will ultimately be passed on to the firm's clients. This can already been seen in firms like Morgan Stanley and Merrill Lynch, who have been punishing small accounts for years.

While the big firms detest small accounts, regulators continue to create an environment that is burdensome for small firms who would otherwise pick up the small accounts shunned by big Wall Street firms. What FINRA and the SEC fail to realize is that they are getting dangerously close to burdening many small firms out of business.

The real irony is that it wasn’t the small firms who cost clients trillions of dollars in the derivates meltdown, but Wall Street giants – which, by the way, regulators have done nothing to prevent from reoccurring. Meanwhile Goldman Sachs and JP Morgan continue business as usual, aside from the occasional multi-billion dollar settlement in civil suits from clients.

Of course, it must be purely coincidence that most regulators have little or no experience in finance before going to work for FINRA or the SEC, and that they work for these agencies to gain experience until they can get a job with a firm – maybe even one they previously oversaw. The fact that the big firms are also the biggest employers is simply a coincidence.

The real fraud being perpetrated here is not among firms who are portrayed as money-hungry villains, but regulators who sing their siren-song that increased regulation results in more customer protection. The fact is that they don’t care about customers; they’re only looking out for their own best interest. The more rules they have to write, the more job security they have.

Consider this: If regulators truly cared about investors, would they be focused on fighting for oversight of the multi-trillion dollar derivatives market that has been previously unregulated and will require hoards of new rules and expanded budgets, or would they be doing something to shelter investors amid the bankruptcy filing of Ambac, one of the world’s largest bond insurers?

Answer: Regulators aren’t really worried about client protection, but about wrestling for greater oversight authority that translates to increased job security. Leave it to government….

Wednesday, November 17, 2010

Competition Moves Society Forward

Football season is in full swing, and nowhere else can one find a better demonstration of fierce competition, the glory of victory or the agony of defeat. All too often, though, we forget that these customs so often left to burly beer drinkers and couch potatoes truly express facets of everyday life.

There is a telling quote from the ancient Roman poet Ovid which translates roughly into “a horse never runs so fast as when he has other forces to catch up and outpace.”

While sports clearly illustrate the purity of rivalry and reward for the bold, we sometimes need reminding that the concept of competition is not confined to the playing field. It is an ever-present facet of life and a driving force behind progress, and should be appreciated as such.

Whether a long-standing champion boxer with no skilled challengers left to ward off or a powerful and reclusive Wall Street CEO with a cast of yes-men, examples abound of laziness and ineptitude that are bread from a lack of competition.

This is particularly relevant today as the federal government prepares to sell stock of General Motors back to the public. Many will recall that GM rival Ford declined a government bailout after the crash of 2008. Instead, Ford did what any competitor would do: hunker down, cut costs, narrow product lines, shrink payrolls, close facilities, and make every dollar count.

Now, though GM has done some downsizing, Ford is much more financial sound while its larger rival has failed to patch all the holes in its balance sheet and has lost market share. One can only hope that GM’s sale to private investors will increase pressure to shape up and fight to regain prominence.

The business world is froth with examples of fierce competition and bitter rivalry. One frequently studied in business school is that of Jack Welch and his tenure as General Electric CEO. Welch used a method known as 20-70-10. Each year he ranked his managers; the top 20% were groomed for upper management, the middle 70% were kept in their current roles and motivated, though not considered “rising stars.” Those managers in the bottom 10% were fired.

Competition can, unfortunately, also be restrained, especially by government intervention. When the government attempts to guide production or the allocation of resources, progress slows. As was the case with the birth of the cell phones and computers, and the auto industry before them, industries grow the fastest when they are in their infancy – BEFORE the government gets involved to regulate.

For more perspective on the government’s role in the economy and its impact, readers with enjoy F.A. Hayek’s The Road to Serfdom. Written in the early 1940s by an economist living in England, the book is an interesting study socialist and totalitarian governments (an important issue during World War II) of what was then termed “economic planning.”

The fact is that, as is the case with the private sector, competition also serves to drive sound (and popular) policymaking and efficient government. Partisan politics force parties to compete for supporters and use their times in power for the benefit of constituents, while those entrenched in power become inefficient and detached.

Such is the case with the US Transportation Security Administration, as illustrated by recent headlines. The TSA, with no apparent competitor to challenge its existence, much less its expansion, has no limitations when it comes to restricting personal rights or invading their privacy. It has no need to ensure contentment among travelers it shepherds.

Meanwhile there are towns like Sandy Springs, Georgia, whose services and agencies hardly extend beyond police and firefighting. Run by a city manager, Sandy Springs takes advantage of competition by outsourcing nearly all of its services to private companies.

With companies competing for contracts to provide such services, the citizens of Sandy Springs apparently feel that their needs to met with the minimum necessary cost; much more efficiently than could be done with an expanded payroll. It seems Sandy Springs residents posed themselves the question: What can the government do better than the private sector? Their list was rather short.

Competition, though enjoyable on a Sunday afternoon, is a pervasive aspect of life, particularly among western cultures. History has shown it to be the lifeblood of innovation and the driving force behind progress. We can only pray that our leaders learn that sooner or later – preferably sooner than later.

Wednesday, November 10, 2010

Congress Concedes to Fed Chief

In the days since Federal Reserve Chairman Bernanke announced that a second round of quantitative easing may be necessary to extend the US’s budding economic recovery, the market has been in turmoil. Investors’ reaction was swift as commodity prices and bond yields jumped in anticipation of inflation.

The backlash from foreign nations was equally firm, with many diplomats now beginning to do what the US Congress has so-far failed to find necessary: pressuring Bernanke to check his monetary policy and uphold the dollar’s value which is, after all, still the world’s reserve currency… for now.

A possible wave of global inflation is not just having an impact in the US. Like US Treasury debt, Irish debt has also seen rising rates – albeit to much greater heights. There bondholders are also concerned with the country’s ability to repay its debt, which has been increasingly difficult to roll over.

Though many problems remain to be sorted out both in the US and around the world, these events have illustrated a lesson which has hopefully been learned by investors the world over: Neither Bernanke, nor any other regulator or bureaucrat, can control the market.

As events have unfolded since 2008 and government officials have reacted to them (NOTE: not anticipated), the egos of many, Bernanke included, have stopped them from realizing that the “invisible hand of the market” described by economist Adam Smith is simply larger than they, and will ultimately dominate any feeble attempts made to steer a lumbering giant.

This Fed, however, has acted particularly brazen in its manipulation of monetary policy which well-regarded investor John Hussman recently argued has amounted to the exercise of fiscal policy legally reserved for Congress. To quote Hussman directly, “the central bank is not engaging in monetary policy, but fiscal policy. Creating government liabilities to acquire goods and assets, unless those assets are other government liabilities, is fiscal policy, pure and simple.”

Thankfully the last several years have made it nearly impossible for the Federal Reserve to hide its true colors. By now, anyone who still thinks that the Fed exists to look out for Americans’ best interests is either blind or naïve.

Beyond the obvious bank bailouts, interest payments on excess reserves, lack of transparency, and leniency with banker-crooks, consider another example – this one more economic.

Presently the Fed has pushed interest rates to lows not seen in a half-century, announcing in public the expectation that rates will likely remain low for an “extended period” in order to encourage an economic recovery. Is this policy of cheap money really an advocacy of recovery?

In order for this economic recovery to be sustainable, the US needs people and companies to borrow. Does the depression of interest rates, along with the announcement that they will stay low, actually provide a motivation for borrowers? Why would any corporation or consumer borrow today when they know that money will still be cheap tomorrow?

This is hardly the first – or the last time – that bureaucrats have demonstrated their ineptitude for real-world economics. While the Fed continues to weigh additional measures to help prop up floundering banks whose own policies put them in their predicaments, the public opinion on bailouts is by now abundantly clear.

Before bailouts will routine, General Motors accepted government assistance, while its rival Ford stayed out of Washington’s pocket. Now GM continues to suffer – typical of anything run at all like a government agency – as Ford thrives, having cut costs and gained market share over its crony-counterpart.

Now, with what seems to be an irrational and unfounded surge of confidence, the government is planning a resale of GM stock to the public. Under the deal, the UAW will own a substantial piece of the company, so we’ll see how well a union can run an automaker.

For our own 2 cents, we’ll go on record forecasting that if, after the government’s sale of GM stock, there isn’t a major change in management within 18 months (away from those who were government-appointed), the auto giant will be bankrupt within 4 years.

Tuesday, November 9, 2010

"Hello, Your PIN is now 'CASH':” How to Get a $600 Billion Hit from the Money Machine

Before the final votes had been tallied in many midterm elections, and the potential impact from the recent shift in power both in Congress and among governors around the country, Federal Reserve Chairman Ben Bernanke announced on Wednesday that the Fed will begin a second round of quantitative easing (dubbed "QE2" by market pundits).

Apparently the first round of quantitative easing – read: “money printing” – didn’t quite have the impact that regulators had hoped. This time around they’ll be printing somewhere in the neighborhood of $600 billion to buy back government bonds and inject liquidity into the market.

For those who enjoy little comparisons, imagine this: if someone were to stack 600 billion one-dollar bills on top of each other (NOT long-ways), the pile would be over 40,700 miles high.

In politics, though, all that money is just another line on an ever-expanding spreadsheet; and its “pounds of prevention” likely won’t add up to one ounce of positive economic impact.

The problem with all this “quantitative easing” nonsense is that none of the new funds being created are trickling down to the business community, much less consumers. Instead, all the Fed is doing is printing money and giving it to banks. The banks then turn around and redeposit that money with the Federal Reserve in the form of excess reserves, on which they are paid interest.

You read that right. Banks are being GIVEN money – at the expense of American taxpayers – and rather than using it to stimulate the economy, they hoard it. What’s more, they get REWARDED for their hoarding.

Although this series of events serves to expand the monetary supply – which is inflationary – that inflation is not realized in the economy because none of the new money is actually flowing around the economy. In other words, the velocity of money is too slow.

In order for any injection of liquidity into an economy to make any kind of positive impact, that new money needs to start flowing around the economy. Velocity must pick up in order to see a sustainable economic recovery.

Sound familiar? Maybe a little like the “trickle-down effect” that was a main focus for Reaganomics?

What few people seem to understand is that, contrary to popular opinion, the Federal Reserve has absolutely no desire to support either the business community or the citizens of this country.

Truthfully, the name “Federal Reserve” is a misnomer. The powerful central bank is neither federal, nor a reserve). In fact, it is little more than an interbank lending center that is privately owned by several of the world’s largest banks.

What this means is that the Federal Reserve is looking out for its own best interest by protecting the banks that own it. Like any good subsidiary, its sole focus – and Bernanke’s primary goal – is to help make money for its parent companies, namely big banks.

In order to increase velocity, the Fed needs to make some policy changes – possibly under pressure from a more conservative Congress.

First and foremost, the Fed should stop paying interest on excess reserves held by banks in the system. In fact, the central bank should start charging banks a holding fee for holding such excess reserves. That would quickly shift the banks’ motivation from wanting to hold reserves for small interest payments from the Fed. Suddenly they would have a reason – and a very strong one – for wanting to make loans to businesses and individuals.

This, in turn, would fuel economic growth in this country. Suddenly, instead of businesses and consumers have to bend over backwards to find banks willing to lend, banks would be competing for their business. Corporations would instantly find new expansion projects financially profitable and individuals would be able to loosen up their purse strings. Some might even start their own businesses.

If they’re smart, Republicans better do something to shift monetary policy in this country to encourage economic growth, and they better do it before the 2012 elections. While they might not have taken a majority in both houses of Congress, the ball is definitely in their court now.

Wednesday, November 3, 2010

Gridlock Achieved

[Author’s note: While this article talks about politics, the real focus is on economics, since it is now evident that, more than anywhere else in the world, economics drive politics. If the US economy does not continue to improve, politicians in this country will be punished by voters. The American people have shown that they will not tolerate policymaking that hurts American business and destroys American jobs.]

The night of November 2nd, as the results of elections rolled in from around the country, many political analysts (and politicians themselves) found themselves surprised – some pleasantly, others not so pleasantly. Though the final counts are still being tallied in several races, the broad ramifications of these elections are already evident.

As the market has been anticipating for months (and its opening this morning shows little surprise), the real achievement from midterm elections has been effective political gridlock in Washington.

In a tidal wave of Republican victories that have shifted the balance of power, the GOP was able to take back the House of Representatives. This is a major move against the Obama White House, since all spending bills must start in the House.

However, while the Republicans took back many seats and one house of Congress, their tour de force was not so complete that they will now be able to effect major policy changes in Washington. Fortunately, their accomplishment WAS sufficient to make it nearly impossible for EITHER side to enact any significant legislation.

In additional to numerous Congressional victories, the Republicans were also able to reclaim Governors offices in several states. The implications of these elections are every bit as great.

First and most notably, an increase in the number of Republican governors raises the odds that more states will be suing the federal government over the constitutionality of Obama’s Healthcare Reform Law (Ohio among them).

Even more importantly, these new governors are now be given the chance to change policies in their respective states, with the hopes of improving their states’ economies. If they are successful the chances are good that Republicans will be successful in reclaiming the White House in 2012. If they fail, the odds aren’t so good.

The real success of this election cycle from an economic perspective (distinct from the gridlock valued by the financial markets) is that it sent a clear message to Washington that the issue most concerning the American people isn’t healthcare reform or financial reform, but the economy.

Americans, it is now obvious, are far more worried about stimulating business and creating jobs. All that we can do now is to hope that this message was received on Capitol Hill and that policymakers in this country can change direction to help reach those goals.

Oddly enough, this goes back to the 1990s when Jim Carville, the “Ragin’ Cajun” and then an advisor to Bill Clinton, helped power Slick Willie into the White House with his now-famous catchphrase: “It’s the economy, stupid.”

Tuesday, November 2, 2010

Tight Ships Don’t Need Bailouts

For all-to-many Americans, it sure doesn’t feel like the economy has made any kind of recovery but the recent profitability of corporations tells a very different story. Lately companies like Ford have been racking up surprising earnings.

Profitability is particularly prevalent among those companies that were not the recipients of government bailouts. While Ford has seen startling sales numbers and growth in earnings its peer, Government Motors, continues to struggle.

This tells us several things, most of which were anticipated by those who opposed government bailouts from the beginning.

First, those companies that did not receive government assistance are now emerging from their predicaments. Their problems have only made them stronger and more responsible. They were forced to “take their medicine” and optimize their operations. Their sales may not yet be fully recovered, but they’re running tight ships.

Conversely, businesses rescued with government help – either through regulation or with taxpayer dollars – have not learned their lessons, as evidenced by the recent revelations of additional fraud in mortgage markets. Many of these companies continue to support outsized payrolls, possibly as a result of political pressure from those who wish to keep jobless claims low. In short, few of them have corrected the mismanagement that got them into trouble in the first place.

Second, the recent progress in America’s private sector illustrates that the economy, which many continue to fear may double-dip into recession, is actually recovering nicely with the exception of unemployment. As clearly demonstrated by comparing companies which did or did not receive bailouts, it is clear that this recovery is not the result of government intervention, namely “stimulus” packages.

The blame for this lagging recovery in unemployment rests squarely on the shoulders of the federal government. Though businesses had for years engaged in less-than-ideal business practices, growing payrolls beyond what was necessary and outsourcing manufacturing for cheaper production costs for example; recent government action has put an unnecessary damper on the creation of jobs in this country.

First the government enacted legislation like Healthcare Reform, which introduced significant uncertainty into the economy. Suddenly businesses didn’t want to hire because they had no idea how expensive each new employee would actually be.

Next, unemployment benefits were extended to “help those who fell on hard times.” The result was the complete destruction of any motivation for America’s unemployed to find work.

The question now is what this all means for the economy long-term, and where we go from here. Ultimately the hope is that the recently increased profitability seen in the private sector will “trickle down” into the economy, putting people back to work and stepping up consumer spending.

There is little that business loves more than political gridlock.

This process is likely to quicken after November if political gridlock results from the November 2nd elections. There is little that business loves more than political gridlock. Gridlock of this type increases the certainty of expected costs and benefits associated with hiring, firing, building, and selling.

While some ask whether there is anything the government can do to help, the better question is what the government SHOULD do to help; the only answer being that the government should do everything in its power to get out of the way of businesses big and small. Whether that means tax cuts, less regulation, or simply a vacation for Congress, when it comes to government corporations view no news as good news.

Oddly enough, this is almost precisely what British rookie Prime Minister David Cameron did on the far side of the pond. Rarely a country to emulate, the United Kingdom under Cameron’s leadership has lately responded to the global recession in spectacularly opposite fashion from the United States.

While the US under Obama’s leadership has seen the federal government grow to become the country’s single largest employer, Cameron has slashed the UK’s budget, last week announcing the elimination of almost a half a million jobs.

In perhaps the greatest case of leading by example ever recorded, the UK has allowed its private sector, by and large, to battle through its setbacks and grow stronger. Cameron can now boast of an unemployment rate that is nearly 2% LOWER than that of the US.

As if that weren’t sufficiently impressive, England’s economy has actually seen phenomenal growth even as the government has cut both its budget and its payroll. In fact, it is quite possible that the UK’s GDP growth for the third quarter of 2010 may equal the US’s growth in the same metric for the ENTIRE YEAR.

Perhaps our current president might learn from that example. Until he does I propose that all public Presidential appearances replace “Hail to the Chief” with “If I Only Had a Brain.”

Friday, October 29, 2010

What’s Missing Here? Feedback Welcomed

In further considering the current circumstances facing US monetary supply, some new revelations have come to light that have further clouded the so-called “-flation debate.”

Is it possible that recent developments in the US economy might be leading to a result other than what is being widely anticipated by the market? Something which Fed Chairman Bernanke might not be considering, much less defending us against?

The Facts

1. Since the liquidity crisis in 2008, most corporations have wound down substantial amounts of leverage and built up large cash positions.

2. After recent developments in the mortgage market, the process of securitization – which has been helping to fuel money velocity increasingly since the 1970s – is effectively broken. Many big lenders are in more trouble than they could even hope to realize, as are investment banks that failed to their due diligence and have lost the faith of many investors.

3. Hence, the traffic jam in lending money means that many companies can’t borrow – at least not at reasonable interest rates – and don’t need to.

The Impact

With the lending system slowed so severely in this country, there is much less velocity of money. Even though so much money has been created in recent years, it simply isn’t flowing around the economy. This trend shows no sign of reversing in the near future.

Is it possible that despite everything Bernanke, Geithner (and Paulson before him) have done, the decrease in velocity of money might offset the recent increase in money supply? In other words, are we about to see a period of relative monetary stability, as opposed to inflation OR deflation?


As we assess developments in the US economy and monetary policy we continually fine tune our view of where the market is headed and why. As we ponder these new revelations, we can’t help but wonder whether we’ve missed something.

We are open to other perspectives on these factors, and would encourage any readers with well-formed opinions on these matters to weigh in either by commenting on this article or e-mailing its author at

Wednesday, October 27, 2010

Market to Dems: You’re Fired!

Lately the market has continued its strong performance, closing in on highs not seen since spring. Many investors and commentators have claimed that this has resulted from the market’s growing consensus on next week’s elections.

The truth is that the market has been doing well lately not in anticipation of recent earnings reports – which have been very positive – or next week’s elections. Not that these different factors haven’t benefited the market. In fact, these are the reasons why the market put in several relative bottoms 4-5 months ago before rallying back to previous highs.

Many investors with formal training in finance will recognize this concept, as the stock market is said to be a leading indicator of economic activity. That is to say that it anticipates developments as opposed to reacting to them. This is why we continually preach that investors can’t make money from what has already happened, only by anticipating how the future will unfold.

According to this well-documented theory, it is safe to assume that the market was fairly certain of the outcome of next week’s elections several months ago; and how right it was. It is for this reason that the market resumed its upward trend months ago, as it began to anticipate the gridlock that would result in Washington from the likely outcome of next week’s elections.

In a somewhat strange phenomenon, anticipation of gridlock has been limited to the market as a whole; few cases can be found in the actions of individual companies. For the most part corporations are waiting for gridlock to be assured. This is why they haven’t been hiring or beginning any substantial expansion projects. Corporations have, however, built up large cash positions, becoming poised to act should political conditions become more favorable.

The fact remains that even if gridlock results after next week’s elections, there is still uncertainty of exactly what gridlock will look like. For example, though the creation of new spending bills may cease, should Democrats lose the House, corporations still don’t know whether Healthcare Reform withstand judicial scrutiny, or if Republicans can find a way to kill the bill through lack of funding.

Now, several months after the stock market ended a short-term correction and turned back up, the economy appears to be resuming its recovery as corporate earnings surprise investors the world over. This isn’t to say that all is right with the economy. This is far from true. There remain, for example, numerous problems which banks need to work through, illustrated plainly by recent headlines pertaining to the mortgage crisis.

What makes this truly interesting is the confluence of factors dictating the market’s behavior. For example, recent earnings reports are interesting in and of themselves, but even more so when coming just shy of election season as certainty continues to grow that the Democrats will lose the House, if not the Senate as well.

The question now facing financial markets, one which is being constantly settled by consensus, is what course of action will be taken by the new Congress beginning in January.

Wednesday, October 20, 2010

Mortgage Makers’ Billion-dollar Boo-Boo

It’s seems the time may have finally come to say goodbye to a lot of the big banks, among the Bank of America and Wells Fargo.

A recent Bloomberg article revealed that bond giant Pimco, money manager BlackRock, as well as the New York Fed, are all attempting to force Bank of America to repurchase mortgages that have gone bad. The real problem is the numbers. These bad mortgages were among others that were packaged into roughly $47 billion worth of bonds by Countrywide Financial (owned by BoA) and sold to Pimco, BlackRock and other investors as mortgage-backed bonds.

One Wall Street Journal Article claims that roughly 40% of Bank of America’s mortgages sold have been paid off. That still leaves $450 billion in outstanding loans, hardly covered by the loan repurchase reserves held by the four largest US banks which totaled $8 billion at the end of June.

Wells Fargo, in which Warren Buffett’s Berkshire Hathaway is a large investor, is in nearly the same boat. As the institution begins to brace itself for large loan repurchase requests, it does so with very little in reserves. According to a recent report from Wells, the company has just $1.3 billion of reserves to support approximately $144 billion in loans it sold to the public.

In short, banks simply don’t have the reserves to pay for the likely wave of loan repurchase requests about to come in. Looking at the degree to which these institutions have leveraged their reserves, it seems we may be watching the unfolding of the next Long-Term Capital Management.

At its peak, LTCM was leveraged about 100:1. Thanks to the housing market bulging with excess leading up to 2006, many big banks have leveraged their repurchase reserves beyond that insane ratio.

Long Time Coming

For years many of the big banks reaped windfall profits by taking advantage of their clients every way they could. Their offenses included:

• Making predatory loans, knowing that many borrowers couldn’t possibly down their debt.

• Bundling bad mortgages together, slicing and dicing them into tranches, and sold them as “safe” debt. They used the capital they received from the sale of this debt to finance further lending.

• Cooperating with the formation and pervasion of derivatives markets, which helped supply additional income by helping investors to use exotic new “securities” to “hedge” their bets on mortgage-backed securities against default. Banks did this while purposefully downplaying counterparty risk faced by investors in this unregulated market.

• Now many banks have been fraudulently foreclosing on homes, because the housing market grew so quickly that many didn’t take the time to properly execute and store necessary legal documents.

Now it appears the bill has finally come due. Big banks, particularly big mortgage houses and lending units are going to hurt in a big way, as are their employees and their shareholders.

Many will point to the government intervention as a possible means of staving off crisis. However, given current political pressure on Washington as election season approaches, trust in a potential bailout seems misplaced, particularly given the illegality of many actions taken by these institutions.

A quick note of clarification: Depositors in these institutions need not be alarmed, as bank deposits are still insured by the government through FDIC. Investors holding positions in these banks, however, may want to rethink the outlook for their holdings.

Tuesday, October 19, 2010

When Business Talks Politics

Oh, how we long for the old days, when business and politics were two totally separate spheres of American society, never mixed even around the water-cooler. For the longest time, it was simply considered inappropriate for corporations to exert any influence in the political realms.

Those who did, including many of the industrial titans who built this country and prospered after the Industrial Revolution, received staunch criticism. Significant legislation aimed at RE-leveling the playing field, such as the Sherman Anti-trust Act, resulted.

And yet, lately the distinction between politics and business is again becoming blurred as businesses feel an increasing need to defend their own interests, a trend that will likely continue.

In modern history the line between business and politics was first crossed by mostly left-wingers, particularly environmentalists hoping to reshape American policy. More conservative businesses, however, remained mostly detached from the happenings of government. Meanwhile, men like George Soros and Warren Buffett began crossing the proverbial line in the sand in highly publicized ways.

Warren Buffett has been particularly vocal about his political views. The Berkshire Hathaway Chairman frequently attacks large companies and investors for aggressive structuring designed to diminish tax bills, but he also readily admits that he pays less in taxes than anyone in his office, despite his billionaire status.

Buffett is at least partially motivated in this new venture due to his previously-stated stance against inherited wealth. This sounds an awful lot like redistribution of wealth so highly held by communism as an ideal.

Unfortunately, the majority of more conservative businesses simply refused to enter the ring, or at least to take sides. And as history will show, when a pacifist meets a warrior on the battlefield, the pacifist tends to lose.

If there is any lesson to be learned from history, it’s that there must be a balance between the private and public sectors. Business simply can’t submit to government; the long-term results can be disastrous. Consider, as examples, Argentina, Venezuela, recent headlines regarding BYD in China, or the Mexican oil industry for a more historically perspective.

BYD, for example, is a Chinese auto manufacturer, in which Warren Buffett’s company Berkshire Hathaway is a major investor. BYD was recently fined by the Chinese government after apparently building several factories on land that was reserved for farmland. The factories were subsequently confiscated by the government, providing BYD little recourse for recouping their investment in building these facilities.

Conversely, business also can’t be permitted to exert excess influence on government. America’s robber-barons of the 1800s, largely resulting from the Industrial Revolution, showed just what can happen when industrialists are permitted to build vast business empires and accumulate the resources to defend their monopolies politically.

Over the past several decades, many businesses have been finding that they can no longer afford to remain on the sidelines. Originally they began to venture into the world of policymaking through the practice of lobbying.

However, thanks to the cloak-and-dagger practices associated with this dirty business, lobbying has become stigmatized, both for businesses and politicians, to such a degree that corporations today are much better off (from a PR standpoint) being involved directly rather than secretively.

Now, thanks to the recent US Supreme Court Decision of Citizens United versus Federal Election Commission (2010). Corporations no longer have to take a clandestine approach to political involvement.

As a result of the increased involvement from organizations like the Chamber of Commerce, the pendulum is swinging back to the right, further than many could have imagined. This has obviously led to substantial resistance from several more liberal sources, including David Axelrod’s recent challenge that the Chamber proves its innocence of funneling money to campaigns, as recently alleged.

Meanwhile, many Democrats have received campaign contributions just as dirty as those alleged by Axelrod.

After all, with the government now having involved itself in America’s private sector through bailouts, the expropriation of automakers, and financial reform bills government the operations and compensation of financial institutions, businesses are being forced to get aggressive and fight back.

As has been demonstrated repeatedly, especially in this election cycle, Congressman Tip O’Neill’s famous phrase that “all politics is local” is being proven increasingly false. The new phrase may very well be that “no politics is local.”

Thanks largely to the internet and e-commerce Americans have access to a greater amount of information – and the power to exert greater influence – than ever before. Look no further than Christine O’Donnell, whose campaign coffers exploded after she was praised on Rush Limbaugh’s show. Or consider the fundraising boost provided to American Crossroads, a Republican group backed by Karl Rove, after recently being slammed by Obama.

This growing trend among businesses to enter the political arena in a more visible and partisan way is one not likely to end anytime soon. Now more than ever companies have a responsibility to their employees and shareholders to defend their best interests by any morally defensible means necessary. Big business has been backed into a corner, and it isn’t likely to go down without a fight.

Wednesday, October 13, 2010

The Last Straw for Big Banking

Over the past several weeks, stories have emerged regarding potential fraud by big banks foreclosing on homes. The pressure of these charges was such that several banks went so far as to declare a freeze on foreclosures, despite President Obama’s apparently disapproval.

The question being raised now is whether these developments will prove to be the final nail in the proverbial coffin of big Wall Street banks.

After more than a decade of poor policy decisions ranging from lax lending practices to the creation of new, exotic but misunderstood securities, it seems the bill has finally come due for big banks. With the blow-up and a great deal of the ensuing fall-out having been crammed into just a few short, terrible years, many of the world’s most prominent financial institutions are seeing their empires of influence, as well as their financial resources, dwindle by the day.

[Note: The banks being referred to are not community banks or regional commercial banks, but prominent Wall Street investment banks and mortgage lenders.]

Those who have the painful events of the last several years seared into their memories will recall that the first domino to fall in this great collapse was in the derivatives markets (e.g. interest rates swaps, Credit-Default Swaps, etc.). Suddenly investors in this relatively new, unregulated market that had been growing exponentially for several years, found out the hard way that the ‘securities’ they were trading would not necessarily behave the way they had hoped or planned – or how they had been told.

Now, just as the derivatives mess seems to have been winding down, there is more trouble surfacing; and it seems to be related.

It now appears that big Wall Street banks have not only been hoaxing investors in recently created derivatives markets; they’ve also been defrauding clients in more traditional banking practices, from nearly every angle.

Back in the 1970s lenders who wanted to get loans off their books and gather more capital to lend began working through investment banks using a new process known as securitization to bundle up loans (a great deal of them being home mortgages) and sell them to investors, who would receive the monthly payments as they came in.

For a while this worked wonderfully, and helped to fuel economic growth as lenders finally found access to more capital. However, this also created a conflict of interest because these lenders suddenly found that they had no reason to make safe, reliable loans. They were just going to sell them to investors anyway, so they had no reason to care whether the loan would ever be paid back.

Unfortunately, not realizing this conflict of interest, hapless investors continued to expand the market for mortgage-backed securities. Many of the investors in these new securities were big pension funds, insurance companies, and other large institutions, which are usually very focused on safety.

Thanks to inadequate regulation in this new market, many debt-backed securities were marketed as extremely safe investments, nearly as safe as government debt. As we have learned since 2008, and are now being reminded, this was far from the truth.

The banks didn’t stop there. There’s a second side to the securitization equation that was just as open to deception.

Thanks to all the new capital available to banks since the advent of securitization, there were plenty of loans to go around, but few qualified lenders. As a result, the banks eased up their lending practices even further, in some cases even making what could be considered predatory loans (loans they could reasonably assume would never be repaid).

With many of these unqualified lenders having defaulted on their loans, many banks have had the messy job of foreclosing on homes. Here is where the most recent controversy has occurred.

It seems that many banks, in an effort to process loan and foreclosure documents speedily, may have acted outside the law by manufacturing documents, in some cases even falsifying client signatures or inventing liens on properties that were paid for in cash.

The result of this final development, once events finally play out, is that many people will likely stay away from big bankers; both for loans and for structured investments. Investors will likely clear out of the mortgage-backed debt market, and as a result of decreased demand securitization will likely slow to a snail’s pace. A much larger portion of loans made will be kept on banks’ books. This will mean tighter lending practices as banks have more motivation to make sure that the loans they make will be repaid.

In general, over the next several years we’re likely going to see a shift back toward community and regional banks as Wall Street banks fall from grace. Some larger banks – both lenders and investment banks that securitized loans – will probably be indicted; lenders for falsifying documents, investment banks for misrepresenting mortgage-backed securities.

Lately one idea that has been floated around to help solve this mess of bad debt is the use of an entity similar to Resolution Trust Corporation (RTC), which was used to help unwind the Savings and Loan Crisis in the 1980s and ‘90s.

Though this is certainly a possibility, it’s important to remember that circumstances today are vastly different from the S&L Crisis 20 years ago. Back then securitization wasn’t as popular, so a good deal of the bad debt was still held by the banks in crisis and was easy for the government to gather through RTC. Thanks to rampant securitization of loans since then, the debt now going bad has been spread around the globe.

The crisis facing banks today is one founded on bad debt but intensified by a lack of a confidence and trust. It will undoubtedly be unwound over time; the question is which banks will still be around to see its end.

Tuesday, October 12, 2010

Working in Socialist America

In the past two years the United States has become more of a socialist nation than ever before in its entire history. We rode here, not as at a snail's pace, but galloping on the backs of vague notions like "Hope" and "Change." Yet few people, whether at the top of the political food chain or the bottom, ever stopped to think about what employment might really be like in the United Socialist States of America.

By the middle of the Great Recession that began with the financial crisis of 2008, the United States had begun to get a better picture of just what socialism looks like. With real unemployment over 17% and an increasing tax burden as a portion of GDP, the federal government became the “Nation’s single largest employer” with a payroll about 2 million strong.

According to the Bureau of Labor Statistics, in 2009 more than 7.5% of all jobs in this country were government jobs at some level. Even more disturbing, a recent report released by the Heritage Foundation reveals that the average government employee is paid 30-40% more than their private sector counterpart.

Of course, this astounding figure doesn’t even include the automakers and banks that were bailed out by the government, acting in conjunction with the Federal Reserve, nor does it include the US postal service, all of whom effectively work for the government.

Even though the federal government has grown to a grotesque size as an employer, it still provides assistance (read: handouts) in other ways. Of the 307 million people living in the US, July saw a record 41.8 million collecting food stamps (aka “nutrition assistance”). Then there were the 4.4 million Americans continuing to file for unemployment, not to mention government welfare programs, Medicare, Medicaid; and the list goes on.

Late last month AFL-CIO President Richard Trumka called for the US to “re-establish popular control over the private corporations…” What’s truly odd is his choice of words: “re-establish?” It sounds like Mr. Trumka needs a quick refresher course on American History.

This notion certainly isn’t completely outlandish; certainly not in the United Socialist States of the Americas, where the nationalization of business would be a commonplace occurrence. In 1938 Progressive Mexican President Lazaro Cardenas nationalized the then-wildly successful oil industry in Mexico.

At the time the oil companies operating in that country were foreign-owned and thought to employ anti-labor practices. Thanks to President Cardenas’ forward thinking, these anti-labor practices declined significantly, as did Mexico’s oil production. By 1957 Mexico had become a net importer of oil.

Like Mexico, the recent shift in the US to the left has changed the relationship between Americans and their government. The government has essentially become one big corporation, stretching its tentacles into every aspect of American life. Those at the top understand this shift, mostly because they orchestrated it.

The US Government, Inc., like any corporation, has expenses to pay. However, unlike most good corporations, its concerns regarding revenue to support those expenses are rather skewed. Its sole concern is raising revenue to expand operations (in Socialist speak: “give back to the people”), regardless of whether revenue increases are burdensome for productive citizens.

Unlike those it governs, the vast bulk of government produces almost nothing. Admittedly there are a few small exceptions (e.g.: bailed-out automakers) which actually create, engage in commerce, and contribute to society. However, most branches and agencies of the US government, particularly at the federal level, are completely UN-productive, but serve only as outlets for the redistribution of wealth. Examples include the EPA, the Departments of Education, Interior, Agriculture, etc).

These agencies, as opposed to producing, act solely as a drag on the US economy. There is an old quote from long-time House Speaker Thomas O’Neill that “all politics is local.” The same is largely true of business. By and large, government that is closer to the people tends to be significantly more helpful. The more distant it gets, the less positive impact it has on citizens’ lives.

The real challenge facing the United States today is in disconnecting the dots, bringing government back home to put what little power the government ought to have back where it belongs: in the hands of the governed.

Wednesday, October 6, 2010

Bear Stearns: The Real Story

On Friday March 14, 2008, the US government, acting through the Federal Reserve, took steps to prop up the 85-year old investment bank Bear Stearns. Originally thought to be the end of the institutions woes, regulators gave Bear that weekend to find a buyer for the firm, as it had become insolvency and was on the verge of failing, which would have created a massive downdraft in the markets and potentially a wave of bank failures that could’ve ground the global financial system to a halt.

Executives from Bear Stearns and other banks, along with Fed and Treasury officials worked feverishly over the weekend to find a buyer for the firm. Ultimately bank titan JP Morgan Chase structured a deal to purchase Bear for less than the firm’s Manhattan headquarters was worth at the time.

The government’s decision to rescind offers of support left investors around the world, as well as Bear Stearns 13,000+ employees, in shock. When all was said and done, many questions remained about what went wrong, and why this once-great institution was allowed, even encouraged, to collapse, especially when other institutions like AIG were provided substantial, lasting financial support.

The real story of why Bear was allowed to fail can be traced back to a decade before its demise, and the downfall of a young, world-class hedge fund, Long-Term Capital Management (LTCM).

Founded in 1994, LTCM was headed by John Meriwether, who had just left his position at the head of bond trading for investment bank Salomon Brothers following a regulatory scandal involving one of his traders. With him at LTCM, Meriwether had 10 partners, including several of his brightest former colleagues at Salomon.

The management team at LTCM was thought to be the best ever assembled. It included two future Nobel Prize Winners, seven PhD’s (six of which were from MIT), four current or previous Harvard professors, one Vice Chairman of the Fed, and a combined 250 years of experience in finance and investments.

The other big thing that LTCM had a lot of, which proved to be its undoing, was leverage. When they founded the firm, partners were able to raise just over a billion dollars in capital. They then “leveraged up” (borrowed a TON of money) and began trading.

By 1998 LTCM had achieved several years of fantastic returns, building their equity capital up to roughly $4 billion, and had borrowed enough money to amass a portfolio worth over $100 billion – an incredible leverage ratio of 25:1.

In September of 1998 Russia defaulted on their debt, an event that LTCM’s partners, mostly academics, never could have imagined. Their portfolio fell apart almost overnight.

That same month the heads of nine of the biggest (at the time) Wall Street banks were called into the Fed to arrange a bailout of LTCM. As many people have lately been up in arms over the government’s 2008 bailout of banks, this was even more controversial. Regulators weren’t bailing out a bank, but a hedge fund engaged in speculation on behalf of very wealthy clients.

The fear, though, was that without some form assistance, Long-Term Capital Management would be forced into bankruptcy and the liquidation of its portfolio so quickly that it would destabilize the market. With a $100 billion portfolio to unwind, the fire-sale that would ensue would surely push stock prices down, which would hurt smaller investors and also cause several banks to fail, as LTCM owed many of them large sums of money.

In the bailout, which ultimately involved more than a dozen Wall Street banks, there was one lone institution that refused to participate or provide any kind of help to LTCM: Bear Stearns.

Less than a decade later, the tables had turned on this former powerhouse. Rather than being the puppet-master, deciding whether to help a struggle firm or simply let them perish, now Bear needed the help, and desperately.

Wall Street, though, is fond of team players. As cut-throat as the industry can sometimes be, banks have long memories of both favors and faults. Put simply, 2008 provided other banks with their opportunity to get payback with Bear Stearns for having to shoulder the LTCM bailout a decade earlier. Even then-Treasury Secretary Hank Paulson was an alumnus of Goldman Sachs, who was involved with the LTCM debacle.

There’s surely more to the story of Bear Stearns’ fall from grace and final days that is largely unknown, and many of the details may never be revealed. We can be certain, though, that there’s more than meets the eye in this cloak-and-dagger tale.

Monday, October 4, 2010

Business Hungers for Lame Duck

So far the trend has been subtle, but big business has begun to behave as though President Obama’s time for influencing American policy may be drawing to a close. Many companies that had been sitting on hefty cash reserves have begun deploying capital. Some, including Walmart, Microsoft, and AutoZone have been using cash to buy back stock. Others have been investing in plants and equipment for expanding operations.

Even better, it seems like the stock market likes what it sees from big business, and has begun to trend up again.

As students of the markets are surely aware, stocks historically tend to lead the economy by roughly six months. For example, after 2008 the stock market made a major bottom late in the first quarter of 2009. As we now know from the National Bureau of Economic Research, the recession officially ended in June of 2009, and the economy made significant advancements in the second and third quarters of that year – about six months after stocks turned up.

Now, after a mostly stagnant summer, the stock market seems poised to begin traveling north as it heads into winter. This hints at further economic recovery to begin in the first quarter of 2011. Interestingly enough, that would coincide with the beginning of 112th United States Congress.

We know from history that the market favors political gridlock, as that adds some degree of certainty to policy changes (or lack thereof) to be expected out of Washington. There is little that Wall Street likes more than certainty, even if it’s the result of gridlock. By turning up, the market seems to be anticipating that gridlock will result from the November elections.

So while Obama technically won’t be a lame duck until he loses his bid for reelection, the market is anticipating that he’ll only be a one-term president. Moreover, if he loses Congress (which seems likely) he won’t be able to do anything, especially spend. Essentially, the market is indicating that Obama will be harmless in six months.

In fact, even if Obama somehow avoids losing control of Congress, he won’t likely get anything passed. After all, Democrats in Congress still want to get reelected, not matter how unlikely. They seem to be realizing that helping to pursue Obama’s agenda makes their reelection much less likely.

Many policymakers, even administration officials, have been jumping ship as of late. Even Obama’s chief enforcer, Rahm Emanuel has been rumored to be thinking of a change of scenery.

And still Democrats reportedly have 20 bills are on docket for the Congressional lame duck period from November through December. The real question is what centrist Democrat would vote for such an unpopular hard-left agenda? Anyone who would do so is ensuring that they’ll never get reelected to Congress. Many might have trouble running for local school boards.

Wednesday, September 29, 2010

Market Inefficiencies Prove Exploitable

One of the biggest debates within the investment world is whether markets are truly efficient. The business school explanation of the Efficient Market Hypothesis (EMH) states that a given stock’s price at any given time take into account all data, as well as opinions and interpretations of that data, relevant to a that stock.

While this argument may seem trivial to some, it does have far-reaching implications for investors and how they structure or manage their portfolios.

Investors who believe that markets truly are efficient tend to believe in passively portfolio management, as they find it statistically impossible for active money managers to beat the market over the long run. So, they purchase of a diverse set of securities across a range of asset classes. This portfolio is rarely altered, but may occasionally be rebalanced.

Conversely, there are many people believe that markets are inefficient for one reason or another. As an example, our own philosophy is that markets are inefficient because stocks prices only consider what has already happened, as well as current expectations. However, these expectations are likely to change as economic circumstances change.

Those of us who deny EMH tend to shy away from diversification, which Warren Buffett once characterized as “a hedge against ignorance,” in favor of actively managed portfolios of one type or another.

Passive investors and EMH subscribers frequently try to invalidate active money management theories using statistics. They contend that the average money manager is no better that picking investments than a monkey throwing darts at a dartboard.

Not that anyone asked us, but of course the average money manager can’t beat the market. After all, the market is the average, which would include both money managers who lost money, as well as those who significantly outperformed the market. It’s the same as saying that the average stock won’t beat the market’s average. Of course, there are always outliers. Some can beat the market; others will go broke.

For better understanding, consider that the average temperature in Washington, DC is between 48 and 66 degrees Fahrenheit. At those temperatures people would be pretty comfortable in a sweater. Of course, that doesn’t mean that if you were planning a trip to our nation’s capital, you would pack for average temperatures. You’d pack according to the season.

Similarly, while the average money manager won’t beat the market, it is possible to find those who dedicate their time and effort to studying the markets and can routinely outperform their peers as a result.

However, the only way to accomplish that goal is by looking forward and trying developing forecasts.

Unfortunately, the vast majority of the investing public has a faulty method of selecting investments. Most spend their time studying history. They look at old data, historical financial reports, charts, etc. The oldest trick in finance is to show a client a mountain chart and ask whether they would’ve liked to have been along for the ride.

The problem with looking at history is that is investors can’t make any money from what has already happened. The only way to make money investing is to develop a reasonable picture of how the future will unfold, and take positions in securities that will benefit as a result.

To accomplish this, investors don’t need a crystal ball, but they at least need to be forward-thinking. Obviously no one knows exactly how the future will unfold. Still, most investors are driving along and steering by what they see in their rear view mirror. This method works OK, until the road turns. It’s always better to look ahead, even if the view is hazy.

Sunday, September 26, 2010

Re-Industrializing America

Few realize it now, but despite its current political unrest, regulatory uncertainty, unemployment, monetary policy, tax rates, and general lack of international standing, the United States is well-poised to take back its long-held position as THE leading global industrial power.

There is no reason why business, particularly blue-collar manufacturing jobs, shouldn’t be flowing back to this country. Neither China nor Mexico has proved to be the panacea that businesses had hoped they would be. Companies with operations there are constantly dealing with problems of quality control and theft of intellectual property.

In fact, recent studies have shown that the costs of labor have declined to such an extent that production on a per unit basis is hardly more expensive here than in the global sweatshops of Southeast Asia. There’s also the added benefit of good PR and lowering shipping costs.

That’s right, my fellow Americans: We’ve got ‘em right where we want ‘em!

The only thing left is for this country to find some leadership who is willing to provide incentives for business and a little backbone in the international community. Instead, the current administration which frequently floods the markets with uncertainty and can be best be described as “apologetically American.” It might be said best in Proverbs, that “Where there is no vision, the people perish.”

Even as many of the world’s manufacturing jobs were shipped abroad in the “Flat World” Movement (so-called because it culminated in 2005 with the publishing of Thomas Friedman’s The World is Flat), those occupations that required the most thinking have predominantly stayed stateside. Most management jobs in US-based firms are still here. After all, this country has many of the world’s best business schools. Most of the Engineering jobs stayed as well – perhaps because our Engineering schools rank among the world’s best.

For the most part the jobs that left this country were in manufacturing, and not necessarily because they were cheaper abroad. Many Americans simply haven’t wanted to get their hands dirty. Having been convinced that the US is the most educated, developed nation in the world, many feel that a college degree entitles them to a $100,000 per year desk job.

In what has become one of the biggest farces of modern times, higher education has largely failed the people of this country. Starting in the 1970s, the academic community (or should we say: “colleges and universities who charge tuition and reap hefty profits based entirely on their reputations, whether earned or otherwise”) began pushing the idea that every American should have a college degree.

All this despite the fact that half or more of the careers in this country don’t inherently require a college degree, and would easily be learned with simple job training. Instead, over the past 40 years this country has trained a generation of sociologists, art historians, and liberal artists.

It’s about time this country shed its arrogance, put down the Xbox controller, goes out and rolls up its sleeves and gets back to work. We have been presented with an opportunity not seen in this country in a generation to regain our prominence as a global leader in business. With Europe and much of the world still floundering, the US could drastically improve its global standing, if it can find its footing.

Production isn’t just coming BACK to the US, it some cases it is coming to this country for the first time. Volkswagen, Hyundai, and Czech tire company CGS are just a few foreign firms that have been increasing their US-based production operations.

Recently Bloomberg Business Week ran an article profiling Foxconn, the Taiwanese manufacturing company that produces many electronics for the world’s consumers. This exhaustive story proved very insightful, none more discerning than a simple image portraying what appeared to be woven awnings extending roughly 20 feet from the sides over several buildings on Foxconn’s campus.

The caption underneath read simply: Suicide nets.

That’s not exactly something we routinely worry about in this country, is it? Certainly not enough to install nets on office buildings.

We have it pretty good in this country. Strike that: We have it VERY good in this country. But it’s just about time we all woke up and realized that we can maintain our role as a global industrial leader, but not without working to earn it.