Cost of Capital

One of the most famous events to happen on my birthday (May 17th) was the signing of the Buttonwood Agreement in 1792 forming the New York Stock and Exchange Board. Previously exchanges of ownership in companies were handled by auctioneers who added substantial cost to transactions. The initial 24 broker-members agreed to charge each other "one quarter of one percent Commission on the Specie value and that we will give preference to each other in our Negotiations."

The forest through the trees...

The odd thing about financial op-ed is that most of it is backward looking and generally useless for aiding a person's financial success as well as preventing financial ruin.

But every so often--usually about every 3 years, more recently every 6 months--an article appears that if it was the only thing you read, I mean really read with complete awareness, then acted on it, your financial situation would be free from worthless concerns about which growth fund will perform better next year. Sometimes these treasures exist outside of the financial press, but are more difficult to discern in my opinion.

Individuals not Institutions

In the midst of a financial crisis everyone (myself included) looks to place blame. And we find a name--the worst of the worst--Madoff. Prior to finding that name we blame the institutions who propogated the crisis. But an institution is nothing more than a conglomeration of individuals who being of sound mind have the capacity and requirement to make judicious and ethical decisions every day.

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...