Too Big to Fail

The Glass-Steagall Act had been around under the Banking Act of 1934 until it was terminated during the Clinton administration. It separated regular banking activity from investment banking.

A similar law can probably be passed, without all the talk that casts gloom over industry and finance and sees to it that we remain in a deep recessionary funk longer than we ought.

Problem: It is easier to talk about, than legislate the separation of investment banking and ordinary banking, once the two have been so connected for years.

The question of proprietary trading arises. Both regular and investment banks execute such trades, ordinary banks to a lesser extent. Moreover, such trading generally represents a very small, insignificant amount of activity and income.

Furthermore, the definition of what is a proprietary or “prop” trade is hard to delineate.

The result we get, with all our populist politicians, and, it now appears, the Number One Populist in the White House, we have bombast, finger-pointing, and economic panic and damage.

We will probably wind up with a new version of old Glass-Steagall, named in honor of the politicians who introduce it.

The AIG Debacle

I have recently reported on human error as being instrumental in the financial meltdown and various bubbles that we have had.

In each case, there has been finger-pointing, usually by left-leaning, anti-business politicians and by bureaucrats whose immediate impulse is to blame big business, bankers; the usual scapegoats. That is the litany of criminalization in left-wing lexicon.

I have always blamed human error. Whether it be loose monetary policy of the Federal Reserve, in inflating currency, or inappropriate accounting rules for a securities market situation, to hasten the ruin of investment liquidity.

In the case of AIG, the value of its derivative insurance coverage was also being determined on the basis of fictitious existing market value. This time, not on possible claims in the future, at the maturing of company obligations, but at supposed current valuations.

That produced a condition that induced a premature bankruptcy, in a panic venue. Yet, once more a rush to judgment when cool heads and hands ought to have been the hallmarks of expertise.

Another incidence of rescuers acting in the AIG panic was evidenced by the rescuer’s paying of debts on the basis of 100 cents on the dollar to some bankers in this country and abroad. Especially after the government unfortunately decided to take over 79.9% of the business in its panic-driven haste.

Would not a government guarantee have sufficed, instead of all this taxpayer outlay?

Bankers, Ball Players and Bonuses

Do bankers make too much money?

They may if they earn commissions and options of hundreds of millions a year. But they do work at a job that takes years to perfect, a task that many cannot adequately handle.

Do baseball players earn too much money?

They certainly do, if they earn up to $30 million a year for playing a kid’s game. And which many sandlot amateurs do for nothing, but just a little less efficiently. The real difference in their ball-hitting capability is not learned but in their eyes to see the ball.

Do gymnasts deserve more than they earn?

They get practically no income despite all the incurred pain, and years of training and practice, and the need to overcome initial physical fear.

I have had personal experience with all three working practices, and for the life of me, it is difficult to see how bureaucrats and politicos in Washington are so ready to damn many hard-working bankers as a group for making “too much” money while other genuinely overpaid groups are left to make their fortunes politically undisturbed.

By the way, a high-priced TV star still gets a fancy bonus for leaving a job from a giant broadcaster, whose parent company is getting Uncle Sam’s bailout money. And ballplayers are indirectly being financed by bailout funds of their bosses’ subsidized ballparks.

How Much Will Your Portfolio Earn in The Future?

I find a major disconnect among investors on Main Street and Wall Street about what they expect to earn from their securities portfolio over the next ten, twenty, even fifty years, after tax and inflation.

Admittedly, that is a tough prediction because investors must take income taxes and inflation into account, along with projected securities’ yield and market returns. None of that is simple.

In one survey I noted net/net/net predicted return by a number of experts over the next fifty years. Interestingly, returns ranged only between 2% and 3% annually.

That is unusual and shocking to many. Investors’ experience from the past would have had expectations to be close to about 6%.

In other words, many securities markets observers believe that potential, along with taxation and inflation bites, will impair future market returns.

There is a possible solution to this quandary. Most investors who look ahead many years, some as much as fifty, tend to overlook it. It concerns the use of the corporate bond market and proper implementation of duration, to suit the investor’s personal horizon.

Corporate bonds can help overcome inflation and the dearth of income and potentially limited growth from stocks. Estimated earnings can well be at least 6% on a net, net, net basis, PROVIDED, strategy is wisely used.

I have broadly commented elsewhere on the subject. But be sure you invest in a low-cost bond mutual fund where interest earned is automatically reinvested in shares of the same fund each month.

Picking Stocks Like an Owner

Further to my recent report on buying securities on Wall Street:

I have found and investigated over 1,500 investment strategies.There are scores that an average investor can use, in which he or she can imagine buying as if they would their own business.

As such, the investor can take the same attitude as any owner would. The strategy can revolve around what an owner wants the company to accomplish. Everyday prices and values never enter business consideration. Not while the business is on a growth path.

As for the short-term, quick-buyers and sellers, most are trading company names.They really have no clue about what the business is, that they are buying and selling. Most of the financial reports they see are little more than hearsay and gossip from Wall Street pundits looking over each others’ shoulders.

And always remember, the clunker stock you are selling is usually considered a diamond-in-the-rough by the buyer.

Trying to Pick Stock Winners

It is harder to pick stock winners than you may think from reading some of the financial media. Yes, everyone believes they can, but after all the effort, how many Googles do they really find?

You hear about the big stock winners but how many of those potential lottery winners are available? Most importantly, how many are recognizable early on? It’s always easy to find those who did, well after the fact.

Furthermore, when you look at these relatively small numbers, you find that they had their periods of struggle. The profit numbers look excellent only after years of market wear and tear. How many investors had the stomach to buy those stocks at their lows and to hold on to them to their highs?

None of the successful securities had gone up in a straight line. Most hit bad cycles when most of the original holders lost faith, deserted ship and sold.

Market psychology is always a serious factor that dictates the lack of discipline in investors. Most take what profits they see on the way up, and run. So the odds of achieving huge winnings are even steeper.

And besides, it is almost impossible for an outside observer to properly evaluate management. Analysts who make it their profession cannot evaluate managers wisely or adeptly from the outside. Why believe the public can?

Therefore I have found the odds of this sweepstake are too steep in the long run, and suggest investing in low-cost index funds as your best bet.

Bashing Wall Street or Using Wall Street Wisely

There has been too much Wall Street bashing from left-leaning politicians, as well as the like-minded media.

I would, therefore, further explain criticism I have directed in the past at some in Wall Street who may have contributed to government=enhanced actions that helped foment financial panic.

I always have made this distinction about Wall Street: It’s both an investment and also a constant-trading medium.

Both are essential. But trading aspects can go to extremes. When extreme actions occur, there can be potential danger. It is thus essential that the public understand how Wall Street operates.

One: The knowledge opens the public’s eyes to the left-leaning politician’s Wall Street-baiting.

Two: The explanation lets individuals know how to be better investors.

I have found from experience that the average investor does well by avoiding trading extremes. That’s possible by sticking to a disciplined, favorite strategy and then forgetting daily market prices. You don’t need constant financial news, unless your investment strategy calls for it. Relatively few strategies do.

Short-term, in-and-out, frenzied trading by the pros is what causes financial meltdowns. It is the segment of Wall Street that I avoid. Stick to the good medium that Wall Street can offer individuals and institutional investors.

And avoid the siren song of Wall Street bashing from left-leaning politicians and the equally ignorant like-minded media.

Be Aware of Investing Moods and Sentiments

Moods are relatively long-lasting emotions. Sentiments are shorter-term.

They can affect how stock market cycles react and can precipitate booms and busts.

That is because cycles can easily grow into the fully grown varieties. It is the way minor bear markets start and deeper recessions fester. Given enough impetus and human error, financial meltdowns will eventually occur, as I outlined in a previous report.

It is the reason why an astute, wise president seeking to prevent a deep recession, NEVER, NEVER makes it a practice singling out industry, whether industrial types, insurance or financial, as scapegoats when he wants the economy to recover and produce jobs.

ETFs and Short-Trading Profits

Exchange-traded funds (ETFs) differ from mutual funds, in that they are traded on exchanges. Mostly they are indexes that are not managed by advisers.

From time to time, their securities may be lent to others for purposes of short selling. It’s a source of added income. The stock lending profits of such ETF funds can be substantial.

Question? Do earnings go back to shareholders of the ETF, or to its managers?

In some funds, almost all go to the shareholders, while as little as half may be returned to other holders.

You should check your ETF investments, to see how your managers treat these earnings.

Preventing Financial Meltdowns: Mark-to-Market

Further to my comments about a common thread in U. S. financial breakdowns: They usually have to do with governmental “experts” in the past reacting to problems in a panic mode.

I feel the rescuers had come from the financial community, attuned only to the short term, and thus could not see how caution and avoiding panic would overcome problems. Nor did they truly envision the danger of acting in haste.

Example: The value of collateralized debt obligations, CDOs. or their derivatives, were “marked-to-market,” under so-called fair value accounting. The latter is part of the Generally Accepted Accounting Principles (GAAP) rule in place since the 1990s.

But that rule could have and should have been suspended for the emergency. CDOs are not widgets or some other product that accountants usually measure in balance sheets.

As a result, bank and investment company net worth figures were daily being devalued to so-called “toxic” levels. Those levels were actually a fiction, brought on by an illiquid market, where true fair value was impossible to determine. The rescuers were blinded by their own personal and business backgrounds.

Thus, there were defenders on Wall Street for this sham. Some insisted that GAAP rules were rules to be defended as if they were cast in stone. And after all, the rules became a boon for Wall Street short sellers and the avalanche of constant traders that make up the financial community, The folks to which the media give far too much attention.

Ever-lower values were thereby being created for securities with little or no true market with which to establish real market values. And it produced volatility that makes for tremendous trading profits among short-term traders who predominate the scene.

This created havoc among all other small and large investors in pension and institutional funds, who look to the long-term and are not interested in daily or even weekly pricing. All true investors got run over by this mark-to-market onslaught.

I have always felt that there are two kinds of investors. Traders who need daily quotes which can be unrealistic. And long-term investors who get misled and potentially hurt, if they act on those abhorrent, volatile short-term quotes.

The financial meltdown was certainly an error by Government appointee “experts” thinking too short-term and subject, therefore, to panic–driven decisions.

Preventing Financial Meltdowns: Mathematical Models

I would like to review why vaunted mathematical models have done so poorly in preventing recent financial meltdowns.

I refer, as examples, to the LTCM debacle of 1998 and the subprime mortgage disaster of 2008.

Could they have been prevented or mitigated? Who and what were to blame?

These math models were made up by top researchers, mathematicians, and celebrated “quants,” who figured they had anticipated all cyclic contingencies.

Yet, bond markets eventually fell apart despite their calculations. Afterward, they found they should have looked at contingencies even further back than they had.

But I see a bottom line weakness in math models, no matter how much research is done. It happened with the LTCM breakdown. It very definitely is what I feel was a factor in the subprime crisis, which haunts America and the world to this day.

There is a common thread between the two breakdowns which has to do with the fact that we react to problems in a panic mode. That is because our “experts” who come to the rescue are unfortunately from the financial community, attuned only to the short term and cannot see how caution and avoiding panic can overcome the danger of acting in haste.

There was a human error in these instances, other than in mathematical calculations. Often that error is enforced by government in the form of strict regulation that is actually a reaction to the very panic that such regulation supposedly has been developed to suppress.

The formulae probably would have worked over the longer term, had that panic not arisen. These are never successful for short-term markets that regulation overlooks.

I will have more in the future.

Central Bank Independence Threatened

Central banks were set up for independent banking functions, on the premise that it would be best for a country to keep its financial system from undue political influences.

Over time, politicians have always let their natural tendency to exert influence produce financial and economic pressures. It generally is harmful to change objective banking independence, particularly during stressful economic times.

How are major central banks doing with regard to their current national financial crises?

The Bank of England: Relatively independent but rather involved with its government bond market.

Bank of Japan: Somewhat independent since 1998 but it often has been politically directed.

U.S. Federal Reserve Bank: Congress, which always loosely supervised it, now wants audits and more semi-annual disclosure, which would exert pressure.

The Fed now goes more deeply into the American economy than it had before, aside from any additional legislation regarding regulation.

Human Behavior and Investing

Quite a bit of research exists on human investment behavior. Personal psychology has lots to do with the way securities markets operate.

I have mentioned in past comments, my studies and evaluations of over 1,500 investment strategies, and their pros and cons. In addition, I have always said there is no one that I have found to be better than any other. What makes for investment success is strict discipline of strategy use.

Furthermore, discipline can be mastered, with proper personalized control over the psychological hazards that beset investors.

I would suggest Main Street and Wall Street investors alike look at the work done by Kahneman and Tversky on investing behavior. It will provide a glimpse of how investors think, often to their disadvantage.

Psychology does affect the way folks make securities market decisions, by affecting the discipline I always suggest as so necessary.

Over-Hauling Derivatives: A Teaching Moment

Remember the big hullabaloo about securities derivatives, such as interest rate swaps and credit default swaps? Along with their connection with subprime mortgages and collateralized debt obligations? With their role in the financial meltdown? And how they just had to overhauled and re-regulated?

You heard how these complicated, arcane deals undermined global finances? Because those “greedy” bankers, intent on “obscene” profit-making schemes used them to the detriment of us all?

Well, lengthy investigations were duly made, and our politicians in Washington have completed their pious, populist speeches. The media have duly contributed their remarks.

And then Congress made its conclusions.

The result? Perhaps some insights were finally gained on how derivatives really work and their purpose, after all.

The upshot of all the nattering? Draconian regulation was not necessary after all. The derivative markets continue to operate as they had before the ruckus started.

As you will gather from my previous reports, the financial meltdown had causes, that had little to do with derivatives as investment instruments.

Bashing Bankers

I have found from my personal experience, listening to public comments and opinions of those from all walks of life, most folks know little about finance and banking.

I include politicians, particularly those on the left, among this group of the financially ignorant. (I maintain, If they knew more about finance, they would not be intellectually on the left.)

So, it is entirely understandable that bashing bankers is fashionable, especially when economic times are rough. Finding scapegoats is handy. It makes up for any guilt politicians may have in helping foment the economic distress we have.

After all, government excesses, such as poor monetary policy, most often produce economic problems, not bankers who become bystanders by necessity and happenstance.

What else succeeds as political ploys when all else fails? Blame the bankers! Most folks haven’t a clue to disagree.

The Japanese Economy

The Japanese Nikkei Stock Average of 225 companies is about one quarter of its value on 12/29/1989 and is still dawdling these days.

We know of Hitachi and Nissin Foods and their corporate growth but the Japanese economy has been flat and practically dormant for the past twenty years. This has been the case despite huge Japanese government spending. In fact, Japan public debt is now about 200% of GDP.

Unfortunately, it does not appear at this time, their economy will recover anytime soon.

The problem for the U.S. is that the Obama administration has been on a wild tear to “stimulate” the American economy, much the same way the Japanese did theirs two decades ago. That is, spend their way to prosperity. Which they have failed to do.

That ought to be a lesson for the Obama administration. But it obviously isn’t.

Media Portfolio Advice: A Questionable Practice

Portfolio advice, at least the way it is practiced in the media, is a farce.

The idea of giving advice on investment portfolios without due regard to the client’s age, family condition, and needs. is ridiculous. Everyone has a different investing time horizon and current and future income needs. Those factors affect the choice of securities. In turn, they influence the percentage ownership and type of stocks or bonds to be held. And where bonds are chosen, the “duration” of the bonds used.

I would strongly advise everyone to be fully aware of what duration is and how it works. Very few media pundits write on the practical use of bond duration and its adaptation TO inflation, rather than avoidance OF inflation.

Much of the practical value of media portfolio advice is, unfortunately, used merely to fill up space and not to truly enlighten.

Credit Card Debt Reduction Ads

When you see or hear a credit card balance reduction advertisement, two points will probably never be mentioned. That will mislead you about credit card usage.

One, is that you pay income tax on any amount of debt you have reduced. Therefore, cutting that balance is not as simple as it may appear. Reduce your balance by $4,000 and it’s as if you had a taxable gain. Something for an accountant to consider at tax-filing time.

Two, you have also hurt your credit standing by resorting to credit card debt reduction. This may not bother you at first, but it may eventually cost you.

And another point: How many folks who have so much credit card debt, they have to resort to drastic measures, are actually permanently getting out of debt?

You can be sure their spending habits will be getting them into the same situation again in a few years.

Those 12b-1 Mutual Fund Fees

There are still 12b-1 mutual fund fees around, plaguing investors. These were originally permitted by the SEC to allow mutual funds to market their service to new investors. They are actually a small sales load that manage to add up over the years. Most funds no longer use them.

The 12b-1 charges originally were used to pay fees for the distribution of funds by brokers. But they still persist today, even when brokers are not involved, but are ostensibly used for sales and marketing.

My suggestion: Avoid any mutual funds that charge them. Those fees become significant deductions from your accumulated holdings over the years.

High Frequency Trading: A Recap

Small investors have benefited from a reduction in trading costs due to high-frequency trading.

Among costs, added to the "expense ratios" with which fund investors are familiar, is the bid-ask spread. A wide spread means the fund must pay significantly more to acquire a stock than it could sell it for.

High- frequency trading has reduced this cost by narrowing spreads, Generally, wide spreads are seen as inefficiency, with buyers and sellers having difficulty agreeing on a price that accurately reflects what is known about a stock. Narrow spreads mean the market is working better.

Another transaction cost arises from the fact that a fund's huge trades can drive prices up or down by tipping the balance of supply and demand. High-frequency trading has helped reduce this "market-impact" cost by making it easier to break big trades into many little ones while still conducting them very quickly,

Trading costs from spreads and market impact have been cut in half over the past decade, From 0.5% of the trade amount for big company stocks to 0.25%. For small stocks, trading costs have dropped from 1% to 0.5%.

Moreover, high-frequency trading helps bring out hidden liquidity.

Don’t Overdo Credit Card Balance Transfers

When you make lots of credit card transfers it appears you may be applying for fresh credit.That tends to hurt your credit card score.

Should you get offers from credit card companies to transfer your current outstanding balance to another card account because of lower charges, you may be tempted. Especially if you have good credit, and those offers are frequent.

But remember, you may be hurting your credit score, should you take the bait

Investing Overseas Always a Currency Concern

Investing overseas usually is done for investment diversification. The investor wants the benefits of business growth opportunities that are to be gained globally. Perhaps those prospects appear better than domestic possibilities.

Remember, currency moves are always involved. Will the dollar be getting stronger or weaker? If the dollar gets weaker, such investments become more valuable as translated currency works in favor of the U.S. investor.

However, should the dollar get stronger, the reverse become true. The investments become less valuable as translated currency works against the interests of the U.S. investor.

Credit Score Danger: Maxing Out Your Card

It may be necessary to take down the maximum amount of credit your credit card permits, but it does not help your credit score. Therefore, do so only in an emergency. It’s nice to know that your credit permits you a certain liberty for spending, but don’t let that enthuse you sufficiently to take extreme spending binges.

Of course, if you don’t use your card at all, or only occasionally, you may be dropped or the maximum available credit may be reduced.

That is because credit card companies are getting more sensitive these days about account activity.

Despite public misinformation, credit card companies are not doing well. They have lots of bad debt to write off. So, use credit cards intelligently.

Mutual Funds Management vs Indexes

Stop looking for the best mutual fund managers when you choose funds to buy. Experience and research show that the so-called “best” in any year are achieved mostly by chance.

In any category of mutual funds, or for that matter exchange traded funds (ETFs), only a small percentage of active managers beat the performance of indexes or un-managed funds. Furthermore, those who distinguish themselves in any one year, generally cannot repeat their performance the next, or on any consistent basis.

A very isolated few managers can outperform indexes over a few years time, and if they do, it is pure luck, not ability.

Expanded Stimulus Action and Recessions

When left alone, interest rates usually adjust to supply and demand forces and adjust economic events. However,when the government imposes its stimulus proposals to raise credit and lift the economy, the system is disturbed and distorted.

This unbalances the economy and does the exact opposite of what has been intended.

Ludwig von Mises wrote fully about the phenomenon in the 1920s but the economist in fashion during the 1930s recession was, unfortunately, John Maynard Keynes. He became the poster child of that recovery movement.

The Keynes government pump-priming thesis that employed prolonged stimuli actually deepened, and helped induce the Great Depression. Nevertheless, it is the premise of the Obama administration’s failed current policy.

Politics and Bank Credit: Part 2

I recently noted that banks are not making sufficient loans to small business, even when they have the ability to do so. And that they make more money these days by borrowing cheaply from the Federal Reserve and investing in government bonds.

Also, that there is political meddling and strict bank supervision adding to the bank lending confused picture.

Some banking groups are now complaining that they have the money to lend, but with few takers because of the recession.

Yes, commerce is in a slump. But many viable, thriving businesses, especially commercial real estate operations, are genuinely seeking loans from banks with funds.

Yet, too many lenders are hesitant about extending loans they once more readily made.

Do Not Rely on The Federal Reserve

We make a habit of using Federal Reserve edicts as gospel, even though they are often proven wrong. This has been proven the case in almost half the decisions we have gotten, whether they have been those of Alan Greenspan or Ben Bernanke.

We have to remember that economists are fallible, even when they direct the Federal Reserve.

In the past, those in the Fed who worried we may have deflation and who therefore inflated the economy, instead added too much currency. In fact the Fed, almost automatically, has been on the side of targeting some inflation, in an attempt to prevent deflation.

Thus, the Fed has been the chief culprit causing the bubbles which invariably lead to busts and eventual depressions.

Politics and Bank Credit

Many smaller banks do not have sound loans on their books as bank examiners would like to see. They are, therefore, under constant pressure to clean up their financials and/or add to basic capital.

Unfortunately, politicians in their area are putting pressure on the bank examiners to allow these banks with questionable standing to make loans which ordinarily should not be made.

Unfortunately, banks are not making sufficient loans to small business even if they have the ability to do so. The truth is, they make more money these days by borrowing cheaply from the Federal Reserve and investing in government bonds.

So, there is a double whammy besetting small business requiring credit.

This unhealthy environment is perfect for the likes of meddling politicians in Washington whose influence is being made in the wrong place, in the wrong manner.

Solution? Supervise banks gingerly but independently of politics. Secondly, permit banks to make riskier small business loans and restrict their tendency to borrow cheaply and invest in government bonds.

It is also time to raise the cost of Fed money to banks, so the latter do what they are in business to do.

Annuity Pitfalls

Annuity sales people often compare the benefits of their product with the investing risks that attend stocks and bonds. They mention all the hazards of securities markets and possibilities of market loss. But annuity salesmen often overlook the downside of what they offer.

Annuities do have negatives. They are not for everyone. They have an insurance factor which may not be needed. And if not required, why pay for it?

There are annuity management fees, contrary to some sales pitches and also early termination charges. The strength of the company is always important to consider.

Then there are fixed or variable annuities to select that further complicate the picture. Fixed annuities have set returns which means the buyer has no protection from any future inflation. Variable annuities tie into securities markets but not as directly as you may want.

So be alert to annuity sales patter, as much as you ought to be when it comes to securities considerations.

The Options Market For You?

Options offer an investor the right but not the obligation to buy or sell a security at a set price.

Options are used for investments becoming more impervious to swings in the markets, Also, to protect shares from under-performing. And to make money when market conditions are extreme.

To invest in options, you must take time to learn fully about them. Know the difference between a call and a put, strike price and all the rest of applicable terms.

There is no quick options course, Take your time because of the complex nature of this arcane aspect of the securities business.

Do not attempt to get involved unless you learn about options both academically and in practice. Therefore, run through some fantasy dry-runs with no real funds, just to see how you would have done with real money.

Then use your own real capital.

Avoiding Investing Style Changes MidStream

You know an adviser has no clue about strategy when he or she tells a mutual fund investor not to buy a fund that clings to a particular “style” of investment, such as small cap or large cap. But to pick and choose what is just right for the “season.” or times.

That advice will tip you off that the adviser has no specific strategy. The adviser is willing to change strategy to suit whatever style may be popular at the time.

My experience has shown that such undisciplined investments with no set strategy tend to not do as well.