Socialism of Capitalism-Update on Australia Regulation #1

This post from November of last year on Australian regulation is still one of the most read posts on my blog, and rightfully so. I consider it one of my most thoughtful, original, and well researched. But in sharing this information with other professional peers, and the public, I have realized further truth that I believe is worth your time to read. I will focus posts on these thoughts over the coming weeks.

Watch the 2.5 minute Clarke and Dawe video, and pay close attention to the comments on how capital became available for subprime mortgages in the US. They talk of mortgage underwriters who don't lose money on subprimes, but get paid to create CDO's. The interviewer asks who would buy these "bag full of crap" loans.
The 'economist' explains, "They're fund managers Brian. They're paid to buy things. They don't make any money if they're not buying stuff."
The interviewer then asks, "But where do they get the money from?"
"They're fund managers Brian. People send them money. The money rolls in every hour Brian."


_________
The pendulum of US capital markets has to some extent shifted away from democracy towards socialism. This is a natural (and not unprecedented) event. The majority of American, middle class, capital wealth is in retirement plans (401k, 403b, etc.). The majority of upper class capital wealth is trust funds, self-directed IRAs, or individual investments. The disparity here is that the upper class is unconstrained in relation to investment options. The middle and lower class has somewhere between 4 and 10 diversified investment options (usually mutual funds).

During a presentation a few months ago I asked a middle class group, "If you were given $1,000 today with the condition that you had to buy and hold one stock for a year with it, how many would buy GM?"
--Nobody, even though a good portion of these people worked for GM suppliers.

I then asked, "If given 100 shares of GM with the condition that you had to own a stock, but could change to another, how many would change?"
--About 95%.

I then asked a series of questions to find about 75% have money in a retirement plan with limited options, and are invested in the domestic stock option. They were as surprised as I was to realize the implications when I suggested that likely over half of those people own GM stock, but they don't want to. And if they want to own US stocks, they have no choice, but to own GM.

Irrespective of what the educated fund manager thinks is worthwhile to invest in, the majority of these people want to vote against GM, and have lost their voting right with most of their investment capital, unless they want to vote against the full market. And that is just the mistake that many of them make. They make wild allocation swings based on recent returns, constantly buying high and selling low.

This drift toward socialism of capital markets for the middle and lower class happened just prior to the Great Depression, where investment trusts (the predecessor to today's mutual fund) was the only reasonable means for the the middle class to invest in capital markets. There were very few of them, and there was no disclosure of actual holdings.

The most important consideration here is how much control do you have over where your capital is invested? And don't allow tax rules, or conventional understanding to limit your options. For example, some IRA custodians will allow you to own direct rental real estate inside an IRA.

For further research:
"The Great American Bubble Machine," article by Matt Taibbi, Rolling Stone, July 9, 2009
The World on Fire- researches and discusses the clash of governmental structure and economic structure, and how consensus understanding may be wrong.

Unintended Consequences of Tax Policy

So Florida changed the basis on property taxes for non-residents versus residents. Non-residents have a noticeable increase. Off the top of my head I don't remember specifics. But let's just say that the average snowbird would pay twice as much per year if staying an Indiana resident ($2,000 and maintaining a Florida condo.

In flocks (sorry) these snow birds have decided to stop migrating (at least where residency is concerned) and set up permanent residency in Florida.

So they changed to Florida residents to have lower property taxes. They have also cited avoiding the 2% Indiana inheritance tax, and paying state income tax (which was true before but not enough to motivate change). Probably 60% of Indiana snow birds I know made this change in the past 2 years.

Most have no idea of the implications to their estate plans.

Some with complex issues may find the legal fees for this change will consume their tax savings for the next decade.

Government officials have no idea how much they can influence behavior with tax policy. For an academic who wants to make a difference outside their institution here is a great topic (think Freakonomics).

What if they changed the disincentives for corporations to pay dividends thereby making earnings more transparent? You can't give someone a check for amortized goodwill, or writing down debt the way Citigroup did last quarter.

Aaron

Update to Market Valuation and PE

This is an update to my blog entry on market valuation that is important enough to reiterate and has additional details I am now willing to share with those who are not clients. Just as important are other thoughts that may have serious implications for the future that I will write about in coming weeks.

The following chart is simple to understand. The left column heading is the PE, the top row is the earnings of the S&P 500, and the intersection is the price the S&P 500 would be given those two factors.

The PE ratio says how many dollars in current earnings investors will require a company currently generates for each dollar they pay for the stock. When investors buy a stock (knowledgeably or not) they are buying a stream of earnings. When people are more risk averse, they will want more current earnings per dollar. The prior blog discusses historic trends in PE at market highs and lows. As noted at the beginning of the year Standard & Poors estimated that earnings this year would be around $40. Well, with 99% of companies reporting for Q1 '09 they overestimated by 25%. Overestimates are common with declining earnings as are underestimates with rising earnings. The band highlights the rough range of where the S&P 500 is today given various forward earnings.

As I hinted before, either investors must have an historically unprecedented appetite for stocks in a bear market (PE usually ends below 10), or earnings have to ramp up in an unprecedented manor to justify current levels, or a combination of both.

I have a hard time believing a person should invest betting on something that has never happened before without tremendous upside. In this case this unusual bet is only to justify current levels of the market, not forward growth.

The following chart shows the inverse relationship of 10 year forward returns on the stock market in red, and current PE ratio in blue. There are deviations, especially over the most recent 10 year periods, but the relationship is strongest at extremes of PE (shown here inversely). Source data: Robert Shiller http://www.irrationalexuberance.com/index.htm

If S&P is correct at $40 per share of earnings, the PE at current levels will almost match that at the top of the dot com bubble (shown here as the low side of the chart). As an investor in the market, are you right or is Standard and Poors? Or are you betting against history?

To find recent S&P 500 earnings information visit http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS

Historical average PE is 14.29
1918 down to 5.74
1924 9.05
1942 7.97
1949 6.62
1975 8.30
1982 7.73

The Ultimate Self-Dealing Government-- not US

So GM goes sort of bankrupt... finally (see this post from November 2008), and two coincidental and seemingly unrelated events happen.

First, Tim Geithner (Treasury Secretary) has a visit to China to talk about currency issues (maybe to apologize for calling them out in January for currency manipulation). Um, excuse me. But didn't he know before he took the job that their Yuan is pegged to our dollar? That means they have to use market intervention to keep them the same.

Second, the Supreme Court, decides to give the cold shoulder (without even a hearing) to bond holders of GM (including the state of Indiana), who by long standing tradition and corporate law are first in line for any cash raised from the sale of assets.

So what is the connection of these three events?

The U.S. Government owns 60% of GM.

China owns 24% of the U.S. Government debt that is held by foreign governments, more than any other country. Since the U.S. Government doesn't have equity securities, and domestic held debt is immaterial (Peter and Paul), China is the majority external shareholder of the U.S.. In corporate terms this company, China LTD has a foreign subsidiary, U.S. Inc. which happens to own a dying subsidiary called General Motors. Equity wwnership by U.S. Inc. in GM SHOULD put US Inc. behind holders of GM debt.

Convoluted yet incontroversial, there are two more senior holders of GM debt. PBGC (a subsidiary of US Inc.) and then by default China LTD with the majority stake in US Inc. GM pension and retirement benefits are $54 billion in the red. The PBGC subsidiary of US Inc (a company that is itself drowning in debt), is already $11 billion in the hole on current obligations not including any result from GM.

The CFO for U.S. Inc. Tim Geithner takes a trip to China LTD headquarters to speak with parent company executives (I assume about what can be done with this subsidiary holding that has at least 3 digits more liability than Enron moved off balance sheet and didn't accurately report). US Inc. decides to have GM file bankruptcy and sell assets. Likely Saab and Hummer (2 mostly profitable brands with little to no pension liability) will be bought by subsidiaries more directly owned by China LTD as opposed to the fractionally owned subsidiary US Inc. Hummer has been held up by regulatory approval (read: stall to research viability of Hummer and likely gas prices).

Penske plans to buy breakeven Saturn, with good reason that excludes China LTD from wanting it.

So Mr. Murdock (Indiana's Treasurer), I have a great respect for you, ever since meeting you and learning about your forward thinking ESOP initiative. But in this case, you have to know, this is how it was going to be. Unfortunately, those managing state funds may not have been insightful enough for anything but traditional credit research methods in managing bond portfolios.

All of us can learn something about investing in companies that are seen as a subsidiary to U.S. Inc. (a subsidiary of China LTD) even before receiving stimulus. Every debt holder in a company with a material underfunded pension should sell at the first sign of financial trouble. Or you may be likely to find you don't hold senior debt.

--update 6/15- news report now states that Geithner "traveled to Beijing earlier this month to assure the Chinese government that the Obama administration is determined to get control of an exploding U.S. budget deficit..."
-related to story that foreign demand for US financial assets falls.

Unfortunately with debt, it matures. Foreign investors have to make a constant and continuous decision to repurchase at maturity. And our country's finances are so tightly leveraged, that it is on the order of a pyramid scheme or bubble. In those situations everything falls apart not when people sell, but when people stop buying. Are we about to see that nightmare?

Rearview Mirror Justice- Online Scams, Madoff Response, Charles Ponzi

Subtitled- "No Help for Dudley Dooright"

Last night I discovered (through the person's stupidity) an online scam on craigslist. The person attempted 2 times to sell a really nice Acura TL for $4,000 on Michigan based boards. They used the same e-mail address, and followed with the same Picassa account for more pictures. The first time they even had a picture of a carfax report from a different car. Different cars each time, but in perfect condition (likely from a dealer lot being fully detailed).

Both times 'Patricia Trump' claimed to be a single mother. The first time she would lose her house. Considering the houses in the background of the pictures $4,000 would have covered the mortgage for only one month. This time her son is in the hospital and this money will be the difference between his getting healthy or not.

The Indiana Attorney General referred me to www.ic3.gov to file a complaint.

I found that IC3 has no means to report an obvious scam before it happens. I am in the middle of negotiating with this person, and I have them on a string, so I want authorities to take it over or tell me what to do so this person can be caught. It starts by asking how you were defrauded. It asks for details of my means of payment, and how much I lost. With so little information, I wonder if my complaint will make it through their filter to actually being viewed by a human.

Apparently the Justice system is only thinking about solving problems after they occur, and can't open their mind to upfront prevention. How about a simple selection on the front-end, "I think I have something here, take a quick glance and let's get them before someone else is defrauded."

The past decade has again shown how this rearview mirror perspective pervades the executive and legislative branches. Sarbanes-Oxley would prevent another Enron as executives of public corporations would no longer manipulate information in financial statements without serious personal penalty. But they are shocked by the seemingly unrelated Madoff scheme and will fix that now.

In the next 6 months we will have legislation that claims to prevent another Madoff. I will stick my neck out and predict that the first (and likely only) law will be completely targeted at smaller registered investment advisors who custody client assets especially in a related broker/dealer. It will either impose a hefty burden of compliance, reporting, or filing fees or not allow it at all. For those who fall under custody rules but with an unrelated broker/dealer, the cost of compliance will be overwhelming. The worst case scenario may be that they expand the definition of custody that practically eliminates advisory firms like mine.

Many of my peers may disagree with me. They can't imagine our government is as narrow minded as I suggest.

After Ponzi served 3 years on federal charges, he skipped bail while appealing state charges, he went to Florida and started the Charpon Land Syndicate selling swamp land. REALLY. I am not kidding. That is where we get that term. Not only was our justice system completely incapable of putting Charles Ponzi away for any material length of time (even though numerous federal judges lost money to his first scam), they weren't even smart enough to catch the same guy doing the same thing with a different asset in a different state. How depressing.

Given that, I will say that when the name of the perpitrator changes, we should hold very little to no hope at all.

I hope our government makes me look like a fool instead of a prophet.

Keynes vs Minsky "Financial Instability Hypothesis" and GREED

John Maynard Keynes formulated the body known today as Keynesian economics is his largest work "General Theory" of 1936. Keynesian economics with its microeconomic cousin, neoclassical economics, is the basis for the actions of world governments over the past year of financial bailout and of the economic structure that preceded it (likely even fueled it).

Keynesian economics states that in the long-run economic systems converge on an equilibrium of stability. Any divergence from that is a slight swing off the convergence on the path to enlightenment, I mean equilibrium. The role of government is to facilitate that convergence.

Likely the most quoted phrase from General Theory is:
"In the long run we are all dead."

But if the quote is taken in context Keynes becomes the first proponent against his whole body of work in
“But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” (Keynes, 1923)

I seem to remember that he admitted that the chapter around that quote was a divergence hinting at another fundamental thought process but not developed enough to create another body of work.

Hyman Minsky developed the "Financial Instability Hypothesis" motivated from Keynes's above divergence and the interesting conversion story of Irving Fisher after financial ruin in the Great Depression. Financial Instability Hypothesis (FIH) in simplistic summary says that in very good environments economic decisions will be made with an overconfidence of financial stability. These decisions will typically (borrowing from Fisher's Debt Deflation Theory) motivate excess leverage that advance farther than a stable economy will allow. The result being a financial collapse.

For this theory to be true, an economy would start at a reasonably healthy period, follow with above average growth rates of investment, and borrowing that presumes and requires a new stability to last. At the same time, savings would drop (which also helps the economy grow through consumption or investment). This would necessitate a bubble burst bringing the economy to its knees.

If this school of thought had been introduced in my college econ classes, I am not sure I would have had the insight to decide which is more likely to be true. Currently I have no doubts. FIH explains our economy today where Keynesian economics by definition counts the current environment as a statistical impossibility and abberation.

I worry about our country solving a problem with a school of thought that says it could not even exist. Almost like a church getting consulting advice from an aetheist.

Fundamentally the analogy may be more applicable than at first glance. Keynesian theory says market participants will stop at good enough, FIH says they will want more. FIH not only allows the deceit we see today, but builds it in as a core assumption.

GREED.

It says that the GREED motivation grows as things get better until the Ponzi scheme ends (and that is the term used).

Keynes says that Madoff, Kenneth Lay, Jeffery Skilling really didn't happen.

Minsky says they happened and will happen more frequently the better things look because regulators become lazy or tied in, investors become lazy or too trusting, and excess money exists from excess borrowing. After a cleansing period where debt decreases, skepticism and fear rain, a higher level of decency will emerge.

So the question is one of original sin. Answer that and you will know which school of economics you should believe. For me I see far too much proof that greed and fear rule and stability is a pipe dream

--at least on this side of eternity.

Major proponents of Financial Instability Hypothesis:
James Kenneth Galbraith
Steve Keen

UPDATE 6/18/09
Here is a paper that more readily substantiates these claims by people far more equipped to make such claims.

Stock market and Swine flu pandemic panacea...

“There is a certain lunatic fringe in the stock market, and there always will be whenever there is any successful bear movement going on… they will put the stocks up above what they should be and, when frightened, … will immediately want to sell out… when it is finally rid of the lunatic fringe, the stock market will never go back to 50 per cent of its present level…

We shall not see very much further, if any, recession in the stock market, but rather … a resumption of the bull market, not as rapidly as it has been in the past, but still a bull rather than a bear movement.”

--Economist Irving Fisher 1929 to a conference of bankers 2 days before the 1929 crash.

The lesson here is that if the financial advice you hear (media, professional, or otherwise) sounds like this they really are unintelligent to speak in absolutes or have other motivations that depend on that outcome. If those motivations diverge from yours, you are no longer getting advice but a sales pitch. Yes, it is that clear.

As a side note, someone forgot to tell San Diego last week that there was a swine flu pandemic 10 miles south of them and spreading into their community.

Online Calculators

Here is a useful website with links to online financial planning calculators all over the internet for all types of situations.

http://www.choosetosave.org/calculators/

Looking forward to a presentation at a conference in a few days with Harry Markowitz, the father of "Modern Portfolio Theory." We'll see how he views his Nobel Prize work after the occurrence of a statistically impossible event. Well one could occur every 1,000 years. But we have had two of these in a little over 100 years.

Of course it has to be in San Diego. How far can swine flu blow if I am right by the border to Mexico?

An online personal financial planning course

If you want to gain knowledge of personal financial planning issues (for free), I just found a great course to help you get there. It is quite detailed, broken into lessons, and has some useful add-on tools.

http://ocw.uci.edu/courses/AR0102092/

Thank you UC Irvine for being so progressive to help the public, and thank you to Get Rich Slowly for pointing this out to me and helping the public take control of their finances from those who oppose their best interests (which seems to be everyone these days).

Osinski's "Manhattan Project"

The following link is an article by Michael Osinski, one of the main people responsible for developing and implementing the means to repackage mortgages into traditional bonds (so they could be resold), then into CDO's allowing for various levels of risk.

"My Manhattan Project"

Many parties share responsibility for what has happened in our mortgage markets, but I believe this article displays something important in core statistical understanding that contributed to this mess.

First, let me share a related story that refreshingly seems to involve one more step of self-examination. I recently met someone who was primarily responsible for developing and implementing Countrywide's change from selling mortgages through brokers directly to consumers. This growth in mortgage underwriting facilitated enough volume for Mr. Osinski's program to repackage them. This woman expressed her dismay over her respect for Angelo Mozillo, Countrywide's CEO. She seems shocked at what must only be a complete turn of core ethics he espoused while she worked there. She seemed to wish that she had never opened the door that contributed to this mess, even though she never crossed any ethical or moral boundaries in her role.

In contrast, Mr. Osinski expresses a lot of regret, but stops short of wishing he never contributed to the vehicle that "enabled Wall Street to decimate the investments of everyone in my family." Most importantly, his software seems to have missed an important technical point of correlation. The CDO securities were considered diversified by having a lot of mortgages. If one mortgage foreclosed, the others would prop it up. He missed the obvious point that the cause of a mortgage failure, tends to affect more than one mortgage, but many at the same time.

The vastly different conclusions of these two people results from a seemingly insignificant difference of intense inspection of every issue in each person's control. The one person looking for excuses and justification, the other accepting responsibility and wishing they had not contributed. The later has found healing and peace in all this, while I doubt the former will shed his nagging feeling of guilt.