I needed to buy a new car at the end of the year. After all the news about GM, I really wanted to buy an American car. But try as I might, I ended up buying a Japanese car, although I suppose it may have been assembled in the US.

A bit of background…. I actually like American cars. My first car was a 1965 Buick Electra 225 that my parents gave me (in 1977). I cherished that old Buick and I have owned GM cars ever since. I currently lease a GMC Yukon and own a Cadillac DeVille. Sure everyone I know makes fun of the DeVille because it is an “old man’s car,” but I still like it.

My family needed a new car and we decided that a good time to shop was between Christmas and New Years day. I assumed this would be an easy exercise; after all, I was a cash buyer and had done research.

A few weeks ago I started looking in the local paper and noticed the GM “Red Tag Sale”. My wife and I decided to test drive Chevrolets and Cadillacs. Even though my wife hates my DeVille, she thought that the CTS might be OK. And, based upon local newspaper ads, the price for a CTS could work for us.

So, off we went to the car dealerships. Surprise, surprise, we ran into a few problems.

Problem #1. We knew more about the cars than the sales staff. The sales staff at the dealerships fell into two broad categories. Two thirds of the salesmen were retirees and had an average age of 75 years old (not an exaggeration). Most of the older guys had worked at the dealerships for less than 2 months. The other group of sales staff was young, very young, so young that I wasn’t sure that they were old enough to drive. It was immediately clear that the very young and the very old had been hired because they were cheap, not because they knew anything about the cars that they were selling.

For example, when we test drove the Chevy Malibu (a very nice car), my wife asked what one of the buttons on the steering wheel did and the sales guy said he didn’t know. When we asked about another button we got the same response. He admitted that it was his third day on the job and he didn’t really know what most of the buttons did. He was able to tell us a lot of about his prior career (he was one of the retirees) but he couldn’t tell us anything about the car we were in. During the test drive he suggested we learn about the car by trying the buttons and seeing what happened. When I asked him about the price of the car the salesman didn’t know about that either.

Problem #2. The advertised Red Tag Prices weren’t really the prices for the cars.

I mistakenly thought that the newspaper advertised prices had some relationship to the prices that were offered to buyers at the dealership. I was wrong.

We test drove the Cadillac CTS and liked the car. It was advertised by the dealer we were at for $26,938. However, the sales manager told us that the real price was approximately $32,000 plus another $1,500 in dealer fees. When we asked about the advertisement, the sales manager just shrugged and told us he wasn’t selling the car for anything less than $33,500 (including dealer fee but not including taxes and tags). We didn’t purchase the car. As we walked out of the door, my wife heard the salesman pleading with the sales manager, “Come on, they’re walking out the door!”

After the Cadillac experience, my wife and I went back to the Chevy dealership. My sister recently purchased a Malibu and liked it, so we thought that it could be a good choice. When we got to the dealership, we found our salesman (who was now on the job for 4 days) and asked for a quote. The salesman found the sales manager who told us that the car would cost approximately $19,000 plus $1,500 in dealer fees. The advertised price for the exact vehicle we wanted to purchase was $17,500. When I asked about the $3,000 discrepancy, the salesman told me that the dealership had many stores and the ad was for the Ft. Lauderdale store and not the Delray Beach store (they are 20 miles apart). He tried to tell us that the Ft. Lauderdale store was participating in a special GM program that reduced the price of the Malibu to the price in the newspaper. When we pointed out that the ad specifically was for the Delray Beach store, the salesman told us what he really thought we should do.

Problem #3. The salesman at the Chevy dealership told us to buy a Toyota.

The salesman at the Chevy dealership told us to buy a Toyota. He said it was what he drives and that it is a better car than the Chevy. He said that if we went to the Toyota dealership we would be treated fairly. He was loyal to the people and company that had treated him well in the past.

It doesn’t matter how good GM’s products are, if the dealers are bad GM isn’t going to survive. GM isn’t managing its dealers and they wasted their marketing dollars on the “Red Tag Sale”. Rather than building the brand through a marketing program and disciplined execution, my experience showed the “Red Tag Sale” to be a disorganized “bait and switch” program. Actual prices bear no relationship to newspaper advertisements.

The dealerships made “amateurish” retailing mistakes. Obviously, they never heard that first impressions are important and the damage that a bad sales staff can do is often irreparable. And, a combination of “dealer fees” and not sticking to advertised prices raise fatal integrity issues.

My wife and I took the advice of the Chevy salesman and went to the Toyota dealership. The sales staff was responsive, experienced and knowledgeable. The pricing was straightforward. We ended up purchasing a Camry that had been used as a dealer loaner for a great price.

I am rooting for GM. Everyone should be hoping that they make it. But, if my experience is typical of the GM car buying experience, there isn’t much hope for survival.

Posted under Automobile, Finance, GM, economy

Forest Gump said “stupid is as stupid does” and the latest move by the SEC and CFTC to license clearinghouses for credit default swaps is about as stupid as it comes. Rather than questioning the underlying economic rational and legality of credit default swaps, the SEC and CFTC have decided to facilitate the proliferation of these financial derivatives by licensing “casinos” for gaming of these contracts. On Tuesday, Federal regulators approved a clearing system for credit default swaps which is the first in series of anticipated actions that will increase and legitimatize the overall use of these over-the-counter instruments. However, Federal regulators have missed an essential truth - credit default swaps fall into two categories; they are either insurance contracts or gambling, and most of them constitute gambling. A clearing house for credit default swaps will essentially legalize electronic gambling by speculators posing as legitimate investors. In their current form, credit default swaps are bad for the United States and financial regulators aren’t using common sense in what they are doing to regulate these instruments.

Credit default swaps are agreements between two parties that bet on the credit worthiness of a company. For a fee, one party agrees to indemnify the other party in case of a credit default of the company that is being bet upon.

The vast majority of credit default swaps are used for one of two reasons; hedging or speculation, with the numbers heavily tilted toward speculation.

Credit default swaps for hedging.

When a credit default swap is entered into for hedging purposes one of the parties in the credit default swap has a financial interest in the payment or default of an underlying debt obligation. Usually, the party purchasing the credit default swap is owed money by the underlying company and wants to make sure that if the underlying debt obligation defaults they won’t take a loss. In case of a default, the party that purchased the credit default swap is indemnified against loss by the person selling the credit default swap. Of course, this transaction is indistinguishable from credit insurance but for some reason regulators have decided to look the other way and not regulate credit default swaps as insurance contracts.

For about two months, from the middle of September until the middle of November, it appeared that New York was going to regulate credit default swaps as insurance contracts. Governor Patterson announced this initiative in a September 22^nd press release sections of which are set forth below.

Eric Dinallo, New York State Insurance Superintendent, said: “The severity of this crisis was substantially increased by what the government chose not to regulate, principally credit default swaps. This is primarily a credit crisis, not an equity crisis, and that is where the focus should be now. What New York State is doing fits our role as insurance regulators. We are providing an appropriate way for those with an insurable interest to protect themselves and we are going to ensure that whoever sells them that protection is solvent, in other words, can actually pay the claims. There is currently no such protection for policyholders…”

…The primary goal of insurance regulation is to protect policyholders by ensuring that providers of insurance are solvent and able to pay claims on policies they issue. The goal of regulating these swaps is not to stop sensible economic transactions, but to ensure that sellers have sufficient capital and risk management policies in place to protect the buyers, who are in effect policyholders. At AIG, for example, insurance companies regulated by the state are required to hold substantial reserves and as a result those companies are solvent and able to pay claims. However, a major part of AIG’s problems were created when credit default swaps were issued by a non-insurance unit that did not hold sufficient reserves…

…Credit default swaps played a major role in the financial problems at AIG, Bear Stearns and the bond insurance companies. A credit default swap is a contract under which the seller promises to pay the buyer if the insurance provider of the bond cannot pay principal and interest. Credit default swaps can be used by the owners of bonds who want to protect themselves if the company that issued the bonds is unable to pay interest and principal. In those cases, the swap is insurance, because the swap buyer is like a homeowner insuring a home…

…The new guidelines establish that when the buyer owns the underlying security on which he is buying protection then the swap is an insurance contract. Under these new regulations, such swaps would be subject to regulation for the first time and can thus only be issued by entities licensed to conduct insurance business.

But by the middle of November, Governor Patterson reversed his position and decided not to regulate credit default swaps used for hedging as insurance. Just before Thanksgiving, Dinallo stated that the change was because there was going to be a clearinghouse for trading credit default swaps. Dinallo’s reversal because of a proposed clearinghouse has nothing to do with the underlying transaction and shouldn’t have been a consideration in deciding whether or not hedging swaps are insurance contracts.

Credit Default Swaps for Speculation

Governor Patterson’s press release from September states:

“…most swaps are now used by speculators who do not own the bonds and the value of swaps outstanding are generally much more than the value of a company’s debt. Swaps bought by speculators are known as “naked swaps” because the swap purchasers do not own the underlying bond… “

Unfortunately, Governor Patterson concluded that New York State didn’t have jurisdiction to regulate naked swaps. But he was wrong, the state has such jurisdiction. Naked credit default swaps fit the definition of gambling contracts and are illegal in New York (as well as most states). Section 225 of the New York State Constitution defines “gambling” to be when

“A person… stakes or risks something of value upon the outcome of a contest of chance or a future contingent event not under his control or influence, upon an agreement or understanding that he will receive something of value in the event of a certain outcome.”

In the case of naked credit default swaps speculators bet on future contingent events, the ability of companies to pay their debts. And, when the speculator doesn’t have an underlying economic interest or other underlying reason to purchase the contract it’s high stakes gambling at its best.

The Clearinghouse For Credit Default Swaps Redefined

Governor Patterson said it best when he stated that most swaps are used by speculators and for “destructive speculation” that damages “the health of targeted companies.” The proposed clearinghouse will mostly be used for naked credit default swaps and will be the biggest and most technologically advanced gambling joint in the world. And, the destructive impact of naked credit default swaps will grow.

Rather than facilitating the casino mentality that has almost ruined the economy, the SEC, CFTC and other state and Federal regulators should be outlawing naked credit default swaps as gambling contracts and regulating hedging credit default swaps as insurance contracts. And, New York shouldn’t have abandoned its effort to regulate these derivative contracts.

Stupid is as stupid does and until financial regulators and government officials start to use common sense the United States won’t be able to fix its economy.

Posted under CFTC, Credit Default Swaps, Finance, Public Policy, REGULATION, SEC, economy

Set forth below are my predictions for 2009. Let’s hope that at least some of them come true.

1. Early in 2009, the banks start lending again

   In January, the banks will realize that they cannot avoid lending forever. The Federal Reserve will financially punish any bank that refuses to lend by manipulating interest rates so that banks that hoard cash lose money. From the industry ashes a banking prophet will emerge who will preach the gospel of positive net interest spread through responsible lending.

2. The Obama Administration passes the largest fiscal stimulus program in the history of the United States
   

   The fiscal stimulus plan will be bigger, better and more socially responsible than anything the Federal Government has ever done before. When the program starts to kick in James Carville will declare Obama has earned his place in history as “one of the greats” and will suggest he should be immediately added to Mt. Rushmore. Others will declare that the fiscal stimulus plan proves that Obama is a Marxist.

3. GDP falls in Q1, stabilizes in Q2, begins to rise in Q3 and is in full recovery by Q4
   

   Despite most economists predicting Depression 2.0 and the “end of the world as we know it”, the economy will begin to recover in 2009. However, the day after inauguration, right wing talk show hosts will declare the beginning of the “Obama Depression”. When the economy starts to do better, the same right wing talk show hosts will proclaim that Bush was right when he said the economy was “basically sound” and will give Paulson credit for engineering the recovery.

4. Deflation fears give way to inflation fears
   

   It turns out that the Federal Reserve wasn’t able to un-print money anymore than Eve could un-eat the apple. Economists will be relieved that they can predict Hyperinflation 1.0 and the “end of the world as we know it”.

5. Europe and Asia do worse than the U.S.

   If you think it is bad here, just go over there. Jean-Claude Trichet will be exiled to the Island of Elba for starting his 2007 preemptive economic war on inflation. Tichet won the war but lost the economy. Liberal EU politicians will realize that exile is very “19^th Century” and Elba is really kind of nice (good windsurfing, scuba and cute female Elbans). Trichet will escape but will be recaptured and made to work in the ECB audit department (after all regulatory audit work is worse than exile).

6. Hedge funds, funds of funds and other money management products are regulated and taxed.

   Distraught former fund managers still won’t be able to accept that Madoff killed the golden goose. Soon, no one will be able to find an investor that actually admits to ever having put money in hedge funds; it will be as if the industry never existed. A rumor will spread that before the end of the Cold War hedge funds were invented by the Soviet Union to destroy America. Ann Coulter will say that Democrats invented the hedge fund industry to destroy the Bush legacy.

7. Obama makes enforcement of securities, banking and consumer protection laws a priority.

   Wall Street bankers will burn Sarah Palin in effigy. After all, if she hadn’t blown the Katie Couric interview things could have been different. Aspiring white collar criminals will have to deal with prosecutors and regulators who actually try to do their job. 20 and 30 year old former investment bankers will be found in bars all around Tribeca trying to figure out what to do next. Graduate school will be out because they will all already have MBA’s and their parents will refuse to pay for more school. Some will get “real jobs” and hate it.

8. Stocks go up then down then up then down then up then down. But, major stock indexes end the year up.
   

   Investors realize that market analysts don’t have a clue whether individual stocks will go up or down. But, liquidity created by the Federal Reserve, a slowly recovering economy and massive fiscal stimulus all conspire to push the Dow, S&P and NASDAQ up by year end.

9. Regional tensions rise and countries face internal strife because of the poor global economy. Most of the U.S. is an island of stability.
   

   Sarah Palin does the ultimate maverick thing and declares that Alaska has seceded from the U.S. and will be its own independent nation. Palin becomes Vice President (even if it is only Vice President of Alaska) and Ted Stevens becomes President. Stevens hopes that by being President of Alaska he will be able to avoid going to jail. After watching Palin and Stevens, Illinois Gov. Rod Blagojevich immediately declares Illinois’ independence. Around the same time, dissenters in China challenge the status quo (independence isn’t openly discussed because in China execution is the penalty for sedition). Economically motivated riots break out in Vietnam and other parts of Southeast Asia. Seeing weakness in the EU, Russia continues to expand its influence. The Middle East remains a problem. But, in a moment of historic unity and at a conference sponsored by CNN and Anderson Cooper, Arabs and Israelis agree that nothing has changed and the “world will continue as we know it”.

Posted under 2009 Predictions, BANKS, Credit Crisis, Deflation, Economic Statistics, Finance, Fiscal Policy, Inflation, Madoff, Monetary Policy, Obama, Politics, Public Policy, Regulatory Reform

The Federal Reserve is forcing banks to lend or face financial disaster. The Fed’s latest strategy gives banks the stark choice of lending or losing a lot of money from operations. Everyone knows the Fed cut its target Federal Funds rate to the bone this week. In a less obvious move, the Fed is also forcing down rates on Treasury bonds and other securities. As a result, banks have the choice of buying bonds that yield less than their cost of funds or lending. Any bank that decides not to lend will suffer losses. Cash is trash and if banks don’t recycle it, they will slowly bleed to death.

The Federal Reserve is returning banks back to the lending business in two ways.

First, the Fed is providing banks with cash to lend by dramatically increasing money supply. Newly created money becomes new deposits in banks. For the last 3 months, money supply as measured by M1 increased by an astonishing annual rate of 37.6%. The largest components of M1 are cash deposits at banks and those components are growing very rapidly. The Fed is making sure that banks get A LOT of new cash to lend.

In normal times, banks gather cash by accepting deposits and then recycle their cash into loans. But, these aren’t normal times and banks aren’t reacting the way they have in the past. Instead of recycling cash into loans, banks have tried to avoid risk by recycling their cash into low risk bonds that are like cash equivalents. So, monetary easing didn’t really do anything for the economy because cash was recycled into cash look alike instruments rather than into loans. The banking sector’s huge demand for cash equivalent investments caused yields on short term Treasury and government securities to drop to almost 0% (and was even negative for brief periods of time).

This led the Fed to its second, less obvious, strategy. The Fed has starting purchasing the cash equivalent investments that banks are buying and in the process driving down yields. Banks are losing money on their formerly safe investments because their all-in cost of deposits is higher than the yield they are earning from cash equivalent investments. This is similar to a retailer buying inventory for $100 and then selling it for $95. It isn’t a good business strategy. To make a positive net interest spread between their all-in cost of deposits and their investments, banks are being forced to lend. Loans to businesses and consumers have high enough yields for banks to make a profit.

Even when banks pay 0% interest to depositors if they don’t lend money they will lose money. Banks have a marginal cost of holding deposits that is much higher than the interest cost of 0%. Bank deposit costs include: operating expenses, FDIC insurance, cost of equity and regulatory compliance costs. These costs are generally between 1% and 3%. And if banks accept deposits that are CD’s which have an interest rate of between 1.5% and 4.5%, their all-in cost of funds gets even higher.

The types of investments that the Fed is initially targeting to drive down yields include Treasury securities, Federal Funds, Agency bonds and Agency and government guaranteed mortgage backed securities. These investments have historically been considered low to no risk investments that are as good as cash. One by one, the Federal Reserve is going to take away the hiding places that banks have used to avoid lending.

While yields on low risk cash equivalent investments are around 0%, the rate of interest that “real” borrowers need to pay for new loans has remained high. Most real measures of loan availability for businesses and consumers indicate a continuing credit crisis, incredible risk aversion and a relatively high cost of borrowing. It is into this lending void that the Fed is driving banks.

However, if banks continue to avoid lending to businesses and consumers, the Fed is making sure that they will feel a lot of financial pain. The Federal Reserve has put banks between a rock and a hard place. Either they lend, or destroy their institution with a negative interest spread and risk regulatory discipline. The Federal Reserve has morphed the strategy of hoarding cash equivalent investments into a very risky decision.

The Fed’s innovative approach goes far beyond the “qualitative easing” that bankers and economists were expecting. Sometime in the next few weeks, after corporate planning staffs and consultants grind out models and analysis, it is going to dawn on bankers that they have to participate in the economic recovery by lending. The Fed’s two-pronged strategy will get banks lending again. And, with fiscal stimulus from the new Obama Administration, the economy will respond sooner than most people expect.

Posted under BANKS, Bernanke, Credit Crisis, Deflation, Economic Statistics, Federal Funds Rate, Federal Reserve, Finance, M1, Monetary Policy, Money Supply, Politics, economy

As the SEC comes to grips with the Bernie Madoff scandal, I am reminded of a law school course that I took 25 years ago where I was taught that good regulation requires good regulators. Unfortunately, the SEC has turned into a bad regulator and has lost the respect of the public it is supposed to protect.

The SEC leadership doesn’t understand or acknowledge why the SEC exists or what its role is supposed to be. Missionless and confused, the SEC is currently a lost agency that needs to be refocused and remotivated.

The SEC used to know its mission. On the SEC web-site, it still articulate why it exists when it states that “First and foremost, the SEC is a law enforcement agency.”  (bold, italic and underline for emphasis). That means, first and foremost Chris Cox is the “Chief of the SEC Enforcement Police.” Unfortunately, Mr. Cox appears never to have embraced or understood his enforcement responsibilities or the SEC’s role to protect the public.

Instead, the SEC indirectly encouraged scamsters and fraud artists through lax enforcement standards. Crime prevention is the most important role of any law enforcement agency and prevention takes place because potential criminals know that they will be caught and prosecuted by a tough but fair cop.

Instead of being a cop, Chris Cox had a nonsensical theory of law enforcement that primarily relied upon self regulation and enforcement. The invisible hand of capitalism was supposed to ferret out frauds and act as the main barrier to illegal and dishonest behavior. However, real criminals don’t self regulate and enforcement usually means economic intimidation and extortion.

In the Madoff scandal, the SEC’s performance as a law enforcement agency is beyond horrible. I was hoping that Cox’s statement that Madoff “lied” to the staff when he was asked if he stole from investors was a misprint or a bad joke. But it wasn’t. Of course Madoff lied to the staff. But then again, what law enforcement organization takes the word of the person that they are investigating?

I have watched enough Law and Order to know that very few people confess unless they have to and then it is as a result of vigorous investigations and vigilant prosecutions. And, I am pretty sure self regulation and market enforcement never entered into Bernie Madoff’s mind when he stole $50 billion. Madoff confessed because he ran out of money to keep on perpetuating his lies. Until the end, Madoff was trying to keep the Ponzi scheme going and was actively marketing for new investors by promising “special deals” for those that he could rip off.

Cox and his immediate subordinates are responsible for not investigating Madoff. Cox was in charge and clearly didn’t have an internal reporting system to keep track of open investigations, cases and clearance. After all, if he did he would have noticed a $50 billion fraud tip that had credibility and might have asked questions. Instead of taking responsibility for the scandal, Cox threw his staff under the bus and blamed them for the mess. He is an out of touch leader who showed little courage or backbone.

I think that most of the SEC staff are good hard working Americans who don’t like being humiliated in public. If they are like most people they also can’t wait to get rid of Cox and get a real leader.

Fortunately, the SEC won’t have Chris Cox much longer. President Elect Obama is nominating Mary Schapiro to be the new Chairman of the SEC. She is known to be a tough and effective regulator who understands the role of law enforcement. Ms. Schapiro has a big job ahead of her but her reputation suggests she is up to the challenge. Her staff will need strong leadership and rebuilding. Ms. Schapiro is going to be a fixer, leader and good regulator.

After all, good regulation requires good regulators.

Posted under Chris Cox, Criminal Law, Finance, Madoff, Mary Schapiro, SEC

Last week I published a blog article that discussed energy policy and suggested that an effective energy policy requires federally established minimum oil prices. Low and volatile oil prices destroy private investment in energy projects because returns become too uncertain to attract financing. As oil trades between $40 and $50 per barrel investment capacity for energy projects is disappearing. On Monday, the New York Times published a great article written by Jad Mouawad that articulates examples of supply destruction occurring from low and volatile oil prices.

If the U.S. wants to break its addiction to imported oil, setting and maintaining floor prices for oil, gas and coal must be a centerpiece of U.S. energy policy. Without minimum prices, “in the real world” investors won’t commit enough capital to domestic energy projects so that the U.S. can become energy independent. Domestic free market capital can’t compete with foreign government sponsored capital and energy policy needs to recognize this inconvenient truth.

Also, without minimum energy prices “green energy” will remain a mirage on the horizon, always there but always beyond our reach. Green energy is more expensive than government sponsored Middle Eastern oil and, without price supports, it won’t attract the necessary investment dollars to compete with cheap foreign oil. Green energy advocates fail to realize that government mandates aren’t the same thing as market solutions. Only minimum prices established through a variable surcharge will provide the market solutions that are needed to get green energy alternatives into the mainstream.

Below are some excerpts from Jad Mouawad’s New York Times article.

From the plains of North Dakota to the deep waters of Brazil, dozens of major oil and gas projects have been suspended or canceled in recent weeks as companies scramble to adjust to the collapse in energy markets…

…But the project delays are likely to reduce future energy supplies…

…The precipitous drop in oil prices since the summer, coming on the heels of a dizzying seven-year rise, was a reminder that the oil business, like those of most commodities, is cyclical. When demand drops and prices fall, companies curb their investments, leading to lower supplies. When demand recovers, prices rise again and companies start to invest in new production, starting another cycle…

…Investment in alternative energy sources like biofuels that had flourished in recent years could dry up if prices stay low for the next few years, analysts said. Banks have become reluctant lenders, especially to renewable energy projects that may prove unprofitable in an era of low oil and gas prices…

…According to research analysts at the brokerage firm Raymond James, domestic drilling could drop by 41 percent next year as companies scale back…

…”We expect operators to significantly cut their activity in the coming weeks due to the holiday season, and many of these rigs will not come back to work,” the report said.

Posted under Energy, Finance, Oil, Politics, economy

The Federal Reserve cut the target federal funds rate on December 4^th and apparently few people noticed. According to data found on the New York Federal Reserve Bank’s web site, beginning on December 4^th federal funds traded on average in a range from 0.20% to 0.11%. The New York Federal Reserve web site states that December 3^rd was the last day of a maintenance period and on December 4^th the effective Federal Funds rate began trading in the new target range that was announced yesterday. So, the Federal Reserve’s target federal funds announcement wasn’t breaking news but rather the confirmation of decisions that had taken place and been implemented days earlier.

Set forth below is the actual trading data since Thanksgiving for federal funds as reported by the New York Federal Reserve Bank. As can be seen by the data, once the maintenance period was over, the Federal Reserve cut the federal funds rate. Economists and commentators who express surprise that the Federal Reserve “dropped rates more than expected” weren’t looking at actual data published by the Federal Reserve about Federal Funds trading.

Posted under Economic Statistics, Federal Funds Rate, Federal Reserve, Finance, economy

We’ve entered the twilight zone. This week’s money supply and economic data is surreal.

Money supply is growing at an unbelievable pace. As measured by seasonally adjusted M1 and M2, the Fed announced that money supply set new all time records. The quick rate of growth for money supply is actually accelerating. Over the last 13 weeks, seasonally adjusted M1 has grown at a 25.3% annual rate, while seasonally adjusted M2 has grown at a 10.5% annual rate. If the economy wasn’t already suffering from deflation, a liquidity trap and a potential depression, money supply growth would have already caused raging inflation. Instead, money supply growth is distorting investment decisions as demonstrated by Treasury securities trading at bizarre negative interest rates.

Quietly, the Federal Reserve enlarged its balance sheet by more than $123 billion last week. A few months ago, this news would have made the headlines and could have triggered Congressional Hearings and ritual suicide by inflation hawks. Instead, no one seems to have noticed or cared.

Federal Funds traded as low as 0.1% despite a target rate of 1.00%. While no one knows what the target Federal Funds Rate means anymore, everyone expects the Fed to lower its target again at its meeting this week.

Almost all of last week’s data was bad except for retail sales, which temporarily halted its downward spiral. This indicates that sooner or later people will buy things when the Fed pushes money at them.

While the automobile bailout deal died in the Senate and the entire world is on Big 3 death watch, that news was pushed off the front page by the horrific losses created by Marc Dreier and Bernie Madoff. I am hoping that as long as I live nothing will top these frauds. With global ramifications, Madoff announced that he evaporated more than $50 billion of value. As the Madoff losses ripple through the global economy, what little confidence remains in the financial system will dissolve.

The once in a century grand prize for incompetence goes to Chris Cox and the SEC. It is the primary regulator of Madoff Securities and somehow didn’t notice that $50 billion of securities were missing. If the SEC can miss the Madoff fraud in an entity that they closely regulate, what sort of fraud will they catch? What do they do with their time and budget?

I wish I could overstate how bad I think last week’s news was, but I can’t. The deflation cancer continues to grow and the side effect of the cure appears to be hyper inflation.

I remain skeptical of Fed and Treasury statements that this economy is different from the Depression. These are the same public officials that told us just before Bear Stearns folded that all was well. They have been behind the curve for the last 18 months and I don’t see any sign of them catching up. President Elect Obama takes office soon and hopefully his administration will provide the leadership, planning and common sense that have been missing in recent years.

Vice President Cheney summed it up best when he said to Congressional Republicans that it’s “Herbert Hoover time”.

Yes, we’re living in the twilight zone.

Posted under Cox, Deflation, Depression, Economic Statistics, Federal Funds Rate, Federal Reserve, Finance, Hoover, Inflation, M1, M2, Madoff, Monetary Policy, Money Supply, Public Policy, SEC, economy

I didn’t think that the uber-rich needed my advice until the last few days. After all, they are the uber-rich and I am one of the “little people”. I figured they knew more than me and it was from their special knowledge that they got their uber-status. But after the last few days I believe that the uber-crowd is just like the rest of us, clueless, scared and in trouble.

As if the last 18 months of banking and brokerage meltdown weren’t enough to prove that the world is broken, the Petters and Madoff collapses are beyond rational comprehension. Both frauds were predictable, stupid and massive. The Tom Petters fraud was based upon a ridiculous “investment” strategy that barely had the trappings of sanity. And, Bernie Madoff’s investment magic was based upon being a nice guy who belonged to cool clubs. Of course, no one had a clue what he did with their money but lots of people liked to play golf with him.

If the uber-rich follow my 10 simple investment rules they should be able to avoid the next Petters and Madoff.

Rule #1 – Don’t Invest In Stuff You Don’t Understand

Over the years, uber-investors have tried to explain to me how a “split strike conversion strategy” works. But since I was a little person, I was never smart enough to understand what they were talking about. Even using historical data to reverse engineer Madoff’s strategy, I couldn’t figure it out. As it turns out, no one else understood either.

Many structured bonds sold since 2001 fall into the category of “too hard to figure out”. For example, I can’t figure out most collateralized debt obligations (”CDOs”). And, there are uber-rich who right now are putting their money into funds that were formed to invest in cheap CDO’s but have no idea of what a CDO is or why it is cheap. These investors are investing in stuff they don’t understand and will sooner or later get burned.

Rule #2 – Try To Use Common Sense

Petters claimed that his business made tons of money buying and selling more than $15 billion per year of name brand TV’s, refrigerators and other consumer goods because top line manufacturers wanted to keep it “secret” from retailers that they had inventory to sell. As an example, Petters claimed that every year Sony wanted him to sell staggering numbers of TV’s to retailers at big markups because Sony needed to keep it a secret that they were in the TV business. Apparently investors forgot that that it isn’t a secret that Sony is in the business of selling TV’s to retailers. And, Petters wasn’t keeping anything secret. He quickly told all his important secrets to anybody with cash that he could steal. His business plan made no common sense. The uber-rich need to remember that common sense is important when deciding where to invest their money. If it doesn’t make common sense, don’t invest.

Rule #3 – Risk and Return Are Correlated – The Higher The Return The Higher The Risk

Uber-rich don’t borrow money at really high interest rates and neither do little people; that is unless little people are a bad credit risk or desperate. In 2005 and 2006, the uber-rich and their uber-investment banks thought that little people and their businesses would pay really high interest rates even thought they had lots of collateral and good credit. For some reason it never occurred to the uber-crowd that there were thousands of old style commercial banks and thrifts who were quietly lending to good borrowers at low interest rates and that high rates of interest were being paid by high risk borrowers who probably weren’t going to pay back their debts. The simple idea that high returns are correlated with high risk was forgotten. The uber-rich need to realize that when lenders claim to have low risk portfolios but lend at really high interest rates they aren’t telling the truth. If someone says that they can get really high yields without taking risk, don’t invest.

Rule #4 – Leverage Increases Risk, A Lot

The uber-rich need to learn that they shouldn’t buy into investments or companies with bad balance sheets. These are crummy investment opportunities. Too much leverage makes good operating businesses bad investments. Before doing anything else, investors must analyze balance sheets to determine if the business has a good financial foundation. If the balance sheet stinks, don’t bother looking at the income statement and don’t invest.

Rule #5 – Cheap Isn’t The Same As Valuable

Many uber-investors think a strategy of buying well known stocks because they have gone down in price is the same as being a value investor. Unfortunately, often stocks are cheap because the underlying company is terrible and doesn’t have a future. As an example, early investors in bank and brokerage stocks thought that because some of the stocks had gone down in price they were a value. But, those investors didn’t do fundamental balance sheet, income statement or business analysis. They didn’t know that that when it comes to stocks, cheap isn’t the same as valuable. Don’t’ buy stocks because they are cheap unless fundamental financial analysis also says that they are valuable.

Rule #6 – If Management Acts Like Thugs Don’t Invest, Even If They Are Really Well Dressed Ivy League Educated Thugs

The uber-rich are often fooled when management teams are well dressed, well educated and use big words. What the uber-crowd doesn’t understand is a good education doesn’t teach good morals. Some of the smartest people are some of the rottenest. Thugs never let people really know what they are doing because what they are doing is wrong. Really good thugs pick the pocket of the uber-rich by hiding behind complicated words and sentences that prove their educational pedigree but mean nothing when torn apart. If management doesn’t tell investors what they are doing so that a little person can understand, don’t invest.

Rule #7 – Uber-Country Clubs Aren’t A Great Place To Make Investment Decisions

The uber-rich believe that their cash has magical powers to grow when they make investment decisions in the rarefied air of an exclusive country club. However, scamsters love exclusive country clubs because they can quickly and efficiently figure out where to find large concentrations of uber-victims. Also, country club deals provide scamsters the added benefit of gathering together investors who believe it is socially unacceptable to go “postal” if they lose their money. The Madoff scandal will test the social bonds that underlie the postal theory. Until the uber-rich stop making investments because of the magic of their country club they are destined to continue to blow their wealth.

Rule #8 – Ronald Regan Was Right; Trust But Verify

Trust but verify. It works for financial nukes just like real nukes. The one common thread connecting all of the major financial scams of the last 20 year is the inability to verify what was going on. Investor shouldn’t invest if they can’t verify what they are being told.

Rule #9 – Don’t Invest In Stuff You Don’t Have Time To Figure Out; Buy Treasury Bonds Instead

A whole cottage industry grew up around the idea that uber-investors were too busy to tend to their investments. After all, uber-rich were too busy to raise their kids, clean their houses or mow their lawn. It only stands to reason that they were too busy to worry about their investments.

So “fund of funds” sprang up so that the uber-rich could hire someone else to do the pesky work of deciding which exclusive investments they should put their money into. The idea of hiring someone to hire someone to invest in companies that hire people to do actual work is dumb. After fees are paid to the multiple layers of advisors, there is little left for investors without unreasonable risk. And, it is no coincidence that most of the money lost in both the Petters and Madoff frauds was funneled into these scams through funds of funds. Don’t invest in any fund of funds. Treasuries are better.

Rule #10 – When In Doubt Re-Read The First Nine Rules And Then Don’t Invest

If you aren’t sure, don’t invest. There will always be another opportunity.

Posted under Business Environment, Finance, Investments, Madoff, Petters, economy

President Elect Obama nominated his energy team yesterday and emphasized that energy policy is a national priority. Every President since Jimmy Carter has talked about U.S. energy independence, but no President has actually broken the U.S. addiction to imported oil. In the 1970s, I studied energy economics and policy and learned that mandates, slogans and “feel good” policies based on fads don’t work. Only economically and financially sound policies will break the U.S. addiction to imported oil.

A lot is riding on a successful energy policy. National and economic security, the automobile industry’s future, the cost and availability of food, the future of the environment and the nation’s economic recovery plan are all tied to energy policy.

Unfortunately, for as long as anyone can remember the United States has lacked an effective energy policy. Our country has never been more dependent on imported oil than now. Hopefully, $145 per barrel oil and our fear of running out of oil all together will move us to a consensus on energy that will actually work.

In the past year, a public consensus has formed around four principal energy policy goals. These goals are:

• Minimum dependence on energy produced outside North America;
• Low environmental impact from the generation of energy;
• Reasonable cost; and
• Preservation of the American “way of life” including strong national and economic security.

Current energy policy hasn’t achieved any of these goals and policy failures are becoming more and more dangerous for the United States. A successful energy policy must achieve each of the above objectives and be self sustaining. Initiatives that spend money on “green” energy, conservation and domestic production but which aren’t sustained by the private market when the subsidy goes away don’t work.

However, before “good” energy policy can be enacted, three unpopular inconvenient “truths” need to be recognized and dealt with. Disregarding any of these three energy truths will result in energy policy that won’t work.

Inconvenient Energy Policy Truth #1

There is no magic bullet that is going to make the U.S. energy independent. Successful energy policy requires a decentralized multi-strategy approach.

Large, simple solutions to the energy problem don’t work. Breaking the imported oil addition requires mass participation in decentralized energy production and conservation. Unfortunately, the American public has never embraced decentralized energy solutions. Virtually every major energy initiative generates opposition from groups that are dedicated to the status quo and are able to block or slow widespread adoption of energy solutions. Even windmills and passive solar panels are resisted by interest groups that frequently kill projects.

Renewable energy production and conservation is decentralized because renewable energy sources are incredibly spread out. Wind, tides and sunshine (some of the more promising renewable energy sources) aren’t concentrated in one place and require a lot of windmills, water turbines and solar panels to have a meaningful effect. And, conservation requires the commitment of every individual to succeed. Energy independence will only be achieved through the accumulated results of a lot of little things undertaken by many people at the same time.

Energy policy needs to rip down the local barriers, societal prejudices and zoning rules that prevent decentralized solutions. A “kitchen sink” approach to domestic energy production and conservation is needed because everything that can be done needs to happen at the same time. Environmental laws and other regulations need to be immediately modified so that interest groups that “don’t want that thing in my neighborhood” can’t mount irrelevant challenges to prevent renewable energy alternatives. While cheap imported oil was great while it lasted, until everyone decides to be part of the national energy solutions, the U.S. won’t be energy independent.

Inconvenient Energy Policy Truth #2

Energy policy needs to make everyone a winner. Policies that make losers out of existing energy suppliers, investors and workers will fail.

Historically, the policy debate has been insensitive to the people, investors and companies that manufacture, distribute and deliver energy. Virtually all energy initiatives have the unintended effect of leaving large investments to be written off because of obsolescence or lower demand. Policy makers don’t think about the vested interest groups that stand to lose from new and different fuels and conservation and, not surprisingly, existing energy producers have generated silent but deadly opposition to change.

As an example, while everyone agrees that cars need to get better gas mileage, virtually no one has thought about what happens to the people and companies that make and distribute gas for us to use. Better gas mileage has a side effect of hurting the refiners, transporters, wholesalers and retailers of gasoline. Better gas mileage destroys demand for gasoline and will create lower prices and over capacity. It isn’t surprising that vested interests in the oil industry are quiet but effective opponents of energy policy proposals. After all, how many industry leaders support federal initiatives that are the equivalent of economic suicide?

Similar issues exist for ports, ships and terminals that are used to import oil. Energy policy makers are naïve to assume that workers and investors haven’t noticed that government policy is going to kill their jobs and destroy their investment.

The issue of obsolete and underutilized resources is the same for owners of electrical power plants. Solar, wind, tidal and other renewable resources are a great idea unless you own or work in an existing power plant that isn’t going to produce power when the sun is out or the wind is blowing.

By the way, foreign oil producers aren’t too happy about losing U.S. business. This week’s edition of 60 Minutes featured the CEO of Saudi Aramco and the Saudi Oil Minister. They were clear that they want to keep the U.S. as their largest and best customer. Saudi Arabia isn’t going to give up without a fight and we can expect all sorts of trouble from foreign countries if the U.S. is successful in reducing its dependence on foreign oil.

Even worse, it will take years for the U.S. to achieve energy independence. We will need new investment to preserve existing infrastructure will be needed. For example, oil refineries need constant investment to operate. During the summer, with great fanfare, the media announced that it had been more than 30 years since the last new domestic oil refinery was built. Politicians acted like it was a national crime when the refinery industry was caught short of capacity. But, what rational investor would put money into a new oil refinery knowing that it is U.S. policy to reduce demand for their products and create overcapacity. And, for that matter, why should Saudi Arabia invest in production capacity to serve American demand if our stated goal is to leave their infrastructure stranded without its best customer.

The concerns of existing energy producers are legitimate and need to be addressed. If Obama’s energy policy forgets to take care of incumbent energy interests it will fail. Energy policy needs to make sure that investments in property, plant and equipment that are rendered obsolete or made uneconomic because of overcapacity are paid for through their useful economic lives.

Inconvenient Energy Policy Truth #3

Reducing America’s dependence on foreign oil causes imported oil prices to drop which makes the U.S. want to burn more cheap foreign oil. Energy policy needs to break this loop which undermines policy.

A successful energy policy will reduce oil consumption which will cause oil prices to fall. Cheap oil kills domestic energy production, renewable energy initiatives and conservation. It happened in the late 1980’s and 1990’s and, as prices drop below $40 per barrel today, history is repeating itself.

Low and volatile oil prices are bad for energy investments because investors can’t reasonably expect to make money on new energy investments. When investors fund energy projects, they create financial projections that assume different price levels for oil, gas and coal. If energy prices drop below a minimum level, the projections show that the investment won’t make money and the project isn’t funded. Highly volatile prices cause investors to create projections with wide price swings. There are very few new domestic energy investments that make money with oil prices at $40 per barrel. And, when investors create a price sensitivity analysis and assume that prices could potentially drop from cur