Hedge funds and snake oil...

I talked to someone today whose parents lost money with Madoff. The person when commenting on potential strategies his parents might use going forward said they are quite leery of alternative investments. Yet the investment strategy (real or perceived) is not the root issue as I explained to this person.

Madoff's firm was dually registered as both a registered investment adviser (RIA) and a broker/dealer. This means he was allowed to give investment advice on how (and with who) people invest their money, get paid to invest money for those who chose to implement through him, and as a broker get paid a fee for executing the transaction, and as the clearing/market making brokerage firm get paid the spread (difference between bid and ask price) on all trades. Shouldn't this have raised a red flag with people smart enough to know better?

So what is he in trouble for? Only looking at the RIA side he is cited for violation of 206 (1) and 206 (2)--basically fraud. In reality because his company was a brokerage firm it printed its own statements. Had it printed the truth of what was happening with the investments, or had it cleared through another brokerage firm, he would not be in trouble. He could still have lost all that money for people, walked away with his millions in fees, and likely be free from criminal prosecution. So why bother risking this outcome when another option with just as much upside and less downside exists?

--Because it wouldn't have as much upside. He was using word of mouth among influential people and the demonstration of consistent 1% returns per month to get more money for his ponzi scheme. Capital flows to places that are perceived by investors to be most productive. If someone consistently shows excess return without a commensurate increase in risk people invest. If not, they don't. Pretty simple, right?

So the snake oil salesman comes into a small frontier town with his wagon of tonics and potions. He displays a believable demonstration of someone being healed from an illness. And everyone buys. Really what is the risk? Well what if it was laced with a slow-acting lethal poison? But who would do such a thing? Once that frontier town had an objective doctor who could examine the contents of the snake oil to find the true ingredients and declare that it is not medically possible to cure blindness, little capital would be allocated to the snake oil. Because objective advice brought enough question regarding the likely excess upside over the likely downside. So we return back to the Australia regulatory system that regulates financial advice separate from product sales.

If you want to run snake oil salesmen out of town then bring in an objective doctor to give a dissenting opinion, which is all that is necessary. If instead the town outlaws snake oil, that same guy will come back with a miracle lotion.

As a side note, most hedge funds are structured as limited partnerships (Madoff was not). Didn't something happen in the late 70's and early 80's that displayed the consequences of mixing investments in a limited partnership structure that removes transparency and the ability to demand a return of capital quickly? A new color of lipstick on the same old pig...

Charles Ponzi would be proud. After he got out of jail from his first scheme in Boston (defrauding federal judges, celebrities, and Congressmen), went to Florida and started selling swamp land. So not only does he get credit for the "ponzi scheme" he also helped grow the term, "If you believe that, I have some land to sell you..."

Aaron

Should we bailout the auto industry?

During the Q&A time after a presentation I gave today, a number of people asked if we will/should bail out the auto industry. For brevity, I was unable to give the following sound answer.

I first cited Richard Nixon when hearing that a company was too big to fail responded, "Tell it to get smaller."

The estimates are slightly over 1 million US jobs are directly tied to the auto industry. Some say as much as 3 million when you count things like stores in auto manufacturing based areas. Yes, this is a serious issue. And yes, if the government does not bail them out, our economy will have some serious consequences. But this is not why I believe we should let them fail.

Instead I view the behavior of many large companies as emotionally unhealthy. Consequently, we need to view them in light of counseling principles.

Codependent people (those that live off of others) need an enabler to survive. And like any 4 year old, codependents constantly test any boundaries to see if the person is serious. When the enabler allows the codependent person to cross an established boundary, the codependent person instinctively pushes farther next time. This will continue until the codependent is forced to experience the full consequences for their own actions--sort of.

The sad truth is that when consistently negative behavior continually results in consistently tolerable results, behavior modification occurs. So if/when a first experience of negative consequences happens it is not viewed as a wake up call, but an anomaly. So they will try the negative behavior again. (i.e. Michael Milken, Savings and Loan, Long-Term Capital, etc.)

This is counseling/psychology 101. Sadly the lesson that good parents teach 4 year olds has escaped all of the most influential people in our capitalist and governmental structures. I know that bailing them out will only produce a bigger crisis later than whatever this one is now. I am not nearly as afraid of the pain today as I am of two times as much pain later.
Aaron

Why Australia has Avoided the Sub-prime Crisis...

So credit agencies are watching their tales and attempting to reposition themselves as objective thinkers. The following is the last statement I think they would make if it were not true.

“…the Australian banks benefit from strong asset quality, sound capital positions, and good earnings profiles, which are partly due to the country's relatively favorable economic environment. Moreover, we expect the Australian economy to grow further, albeit at a slower rate. In addition, Australian ADIs have limited exposures to U.S. subprime loans and associated complex structured transactions, and major offshore financial institutions affected by the loss of global investor confidence.”
-Standard and Poor’s October 13, 2008

So how did Australia avoid this? Was the whole country sleeping during the global gluttony of the past few years? In order to participate in the subprime disaster, financial institutions, and end investors would have had to buy these repackaged assets. Without someone willing to buy them, risky loans cannot be made.

This new reality of the true risk is feeding the current credit crisis in America. Credit card companies can't get people to buy bonds covering credit card balances. Does America finally have a healthy fear of the ability to get our money back?

Similarly, if Australian institutions did not lend to overtly risky debtors then garbage debt (sorry, I mean "CDO's") would not exist for purchase. In large measure Australian banks and individuals did lend. Here is a link to from the Australian regulatory authority website of a real-life Australian subprime situation from the 1990's.

John and Lynette Longstaff

--Almost Pollyanna. In hindsight, don't we wish American institutions were forced to care about the public similarly?

Notice the financial product was not the issue. The advice was inappropriate.

Subprime mortgages repackaged into CDO's should not be illegal. They were simply misrepresented through conflicted advice as a conservative investment. Hiding conflicts in financial instruments with fine print and confusing acronyms can never be prevented by regulation.

So how can this new found wisdom benefit you today?

• Educate yourself on how the Australian structure actually works. See "Getting Advice." and other helpful information at http://www.asic.gov.au/.
• Just because US law does not provide for objective financial planning, you can demand it from your financial professional. If they are unwilling, you will at least know how important your financial success is in relation to theirs.

As a service to the public, point out this obvious long-term solution to your legislators. In the past too much money was taken from clients by financial institutions to protect their interests in Washington. With widespread failures and financial industry lobbying viewed like GM's private jets, this is the first time in 80 years elected officials might listen to the public instead of conflicted institutions. Australia for its part has campaigned for widespread global adoption of their regulations to the International Monetary Fund (IMF) and the United Nations. If the IMF were to look in the mirror, maybe they would take personal responsibility for allowing this crisis by not adopting and advocating for Australia's structure.

As final illustration here is a link to a telling video satire on how Australia justifiably views the United States. Very worth while to watch.

Clarke and Dawe

Aaron

What's the real problem?

So all assets of all kinds are in a free-fall. Never to this extreme have stocks, bonds (conservative and aggressive), real estate, property (both commercial and residential), and commodities all taken it on the chin. Looking critically at this conundrum may give us insight into the root problem.

I.O.U.S.A. is available online!

Everyone needs to watch the 30 minute summary of this movie, and I mean EVERYONE...

Yes some parts seem to take a few partisan shots, but the information is factual backed up by organizations on both sides of the aisle.

Could fragility of money make this worse?

Presuming that the economic environment is not as tenuous as that of 1929 (which I think is a BIG presumption), a larger and more critical risk-factor exists today, and that is cash on hand.

To get to the core issue, I am speaking of a household's ability to cover the bottom of Maslow's pyramid if everything fell apart, or gave the appearance it might. In the early 1990's households had over $4,000 (inflation adjusted) on hand (or in checking/savings accounts) to cover bills should the worst happen to them. In the early 50's they had about $185. Today households have just over $1,000. So not quite as good as the early 90's but not as bad as the 50's right?

--WRONG... Why? You don't need an econ degree or research to figure this out. Yet instead of relying on common sense, I have done the research for you...

In the early 50's, the average household had around $300 of total debt. In the early 90's just over $30,000. Today the average household has over $128,000 of debt.

So the ratio of cash to debt declines from 65% in the 50's to less than 1% today. Why is this important? Two reasons:
1) If a household loses their income (or thinks they might), the amount of cash they need to eat and keep their house is much greater today.
2) If there were a perception of a run on banks, the fragility is much greater today.

Going into the Great Depression, people had cash in their wallets--they didn't use plastic. If today's plastic line of credit stopped working many people would be hungry in just a few days. Also in the Great Depresssion, the US was a more agriculturally based economy. Many households didn't need money because they grew and canned their own food.

So even if we make the presumption that our economy is healthier, systemic issues may promote situations that would otherwise not exist.

It is not illegal to yell fire at a movie shown outdoors at a park, but is illegal in a traditional theater. Why? Because the limitation of escape routes prompts panic that creates danger even if a fire does not exist. So the danger to our economy is not only that a fire may exist, but that people may think a fire exists with fewer escape routes and create mass hysteria.

If you think humans are more rational, realize that October 30th was the 70th anniversary of The War of the Worlds.
Aaron

Lemmings

In writing a letter tonight that will be distributed around our area, I was considering putting in "lemming-like behavior." After some brief research, I found the long-standing investment concept of lemmings who supposedly follow each other off a cliff is completely false. See snopes.com. The most entertaining thing about this factoid is that traditional Wall Street still uses this analogy all the time. These are the same people who followed each other off the cliff of CMO's, CDO's, CDS's, subprime mortgages, etc. Ironic...

CPI fun and the mismeasurement of all things

So for the past number of years, reporting of CPI has slowly transitioned to media reporting core CPI (not including energy and food). The rationale is that including those highly volatile commodity-based components brings unnecessary volatility to the understanding of longer trends of CPI. This is understandable when you think of gas prices going from under $2 per gallon to over $4 per gallon and back again over the past few years.



Yet those swings in gas prices we all know has had a real effect on our personal pocketbooks and the economy as a whole. So for me, give me the volatility, and let me know how much my purchasing power is changing. But that is not how concensus has seen it in the past few years.



But now we have a funny change of sorts. The Fed is introducing substantial liquidity by working the currency printing press overtime. In equilibrium (a term I learned about in econ that has never existed in the real world of greed and fear), increasing liquidity causes inflation. But the Fed has said they are not concerned about inflation because of the substantial drawback in energy prices.



So now we use total CPI because it suits our position. This is nothing new. In fact, numerous 'improvements' to the calculation of CPI have occurred in the past, and critics were dismissed as
anti-establishment zealous lunatics. Until Bill Gross spoke out, nobody considered that CPI might be understated. Yet consider the benefits to our government just from fractionally smaller increases in social security benefits.

Unemployment is another substantial funny number. Historically, anyone who was unemployed was counted. Now we only count those who receive unemployment, not those who are still unemployed after unemployement insurance benefits expire (they are counted instead as employed). Also, when created the figure considered those who had part-time employement but were desiring full-time employment as unemployed. Now they are employed. But the biggest misrepresentation is the fact that a household with both spouses working counts as two people fully employed, but the divisor for unemployment is the number of households. So are we in a recession?

One observer believes using original calculation methods, we currently have 15% unemployment, CPI of about 13%, and GDP contraction of 2%. So yes. For more information visit here. Depressing (or maybe depression).

Where there's smoke...

What is happening in the US Economy and the stock market? How bad could this get? Is the worst almost over? Don't we wish we all knew. Here is the analogy I have been giving to clients.

So far all we know is that we do not have an out of control forest fire. Could we? Who knows. But there is plenty of smoke in the air.

What would you do if you smelled something burning in a crowded theater and happened to have the seats farthest away from the exit? Maybe the person next to you has cigarette smoke on their clothes, or has been burning leaves. Maybe someone lit a cigarette. Maybe it is burnt popcorn. Would you yell, "FIRE!"?

Don't wait to figure it out to take action, because in the case of a once in a lifetime event (which this economic scenario already is) no one has a better sense of smell than anyone else. But if we are willing to inconvenience ourselves a little more than others, we can be ahead of the game with very little sacrifice.

To continue the analogy the wise thing would be to tell your loved one to get up and go to the back of the theater and wait for you. Shortly after they leave, you do as well and simply stand by the back door and continue to watch the movie. Leave your coat to avoid causing the crisis you hope to avoid for your safety. People will think you are going to the bathroom or getting a drink. Now watch the movie standing at the back by the doors. And if someone yells, simply turn and walk out. The worst that can happen to you is losing your coat and the discomfort of standing up watching some of the movie. Much better than the worst case scenario of sitting restlessly in your seat. If the smoke goes away, return to your seat.

In the case of this economic smoke, if you display a crisis mentality, you will cause one, even if unfounded--just like in the movie theater.

Bailout Update

I too have been sick over this whole financial mess, but unlike many other people (especially financial professionals) my malady started in April (see the first post).

What are we to do???-- see below

For me, the best part is that my malady is getting better, because I believe the most likely outcome is clear. And if an outcome is known, action can be taken. I am not advocating everyone run for the hills. But in 1972, with perfect foresight, nobody would have invested in long-term bonds when interest rates and inflation were set to skyrocket over the coming decade eroding purchasing power of interest payments and maturity value.

So clarity feels good... Even on a negative basis...

If the economy can pull out of this situation by mortgaging the future, it all but ensures, there is no saving the next situation that should happen within 4 years. Next situation? As any behavioral professional will tell you, when someone is being enabled in a dysfunctional system (America's financial structure is textbook) and consequences for actions are removed, the person ALWAYS attempts to get more next time.

The enabler in this situation (China) owns almost $2 trillion of our country now, and if they choose to let this one go by continuing to hold our government, corporate, and yes, subprime debt without dumping it at any cost, they won't next time.

Even if they (who are not exactly our allies) dumped all their US debt on the market at once, and only got pennies on the dollar for their holdings, they would still be a cash positive country. They don't have debt, and own debt of other countries that are not bleeding red. I read somewhere earlier this year that in 2 years China will reach economic parity with the US--meaning we are as dependent on them as they are on us. Prior to that they needed us more (as we imported more goods and bought them).

I haven't seen the numbers, but I would bet with this crisis, 2 years to parity went by pretty fast.

So if I were China (especially with the Olympics in the books), I would aggressively dump US debt at almost any cost. Maybe they are which is why our credit markets are frozen. In reality the short-term debt (commercial notes) has been the issue in the past month, and that doesn't require sale, simply no reinvesting.

Here is some sarcasm to use with friends:

Yes the moral decline of our country led to this situation (but indirectly). After all if politicians and the public still read the Bible they would know that the borrower is servant to the lender. So keep in mind that road you are driving on, and your public water supply, and now AIG and the country's largest banks are not REALLY owned by the American government, but by China.

--So maybe I feel better because my clarity is that I plan to learn Chinese.

"Neehow"

For you, avoid the financial dysfunction. Find objectivity. And ignore everything else, especially the media. CNBC is likely increasing their price for advertising, since you all are watching.

The Continual Bailout

Who pays in the government bailouts of companies, investors, and end consumers who took more risk than they were able to bear? The taxpayer...
...but not how you think.