Now that we have seen the movie, we feel compelled to tell you just how good it really is.

It’s really, really good.

From what we are told this version is slightly improved over the rougher cut shown to the focus group at FreedomFest (Though we were at FreedomFest, we were manning the bookstore there and could not see the film then). In fact Addison was eagerly seeking audience input afterward on what could be done to improve the film further.

Though still not the finished version, it was obvious that the production values were high. The film just plain looks good and is a pleasure to watch.

The story itself is that of a group of treasure-hunting entrepreneurs who put everything on the line to make an honest buck only to find themselves harassed by governments at every turn.

We cheered with the entrepreneurs and booed at the chiselers, protectionistas, and the SEC.

But what struck us was the heroes’ unwavering faith in the possibility of good government…even as the government repeatedly tries to plunder them!

We kept hearing what government “needs to do”…and we agreed: stop ganging up with already big companies against the small but up and coming, remove the expensive barriers to entry in the forms of thousands of regulations for new businesses…

The thing is, we know better than to expect the state to reprise its role as umpire instead of its current role of game-fixing crony to big corporate interests.

Bribes–also known as lobbying–grease the state’s gears. It’s a matter of money. The big guys have plenty of it. The small guys who provide more than ⅔ of the jobs nationwide don’t have enough to compete for the government’s favors.

And then there’s the outright corruption between governments themselves that are just as destructive to our band of small businessmen. I don’t want to give everything away, but it’s an incredible injustice. Some already familiar with the story will know what it is. Others will be outraged. The movie is well crafted, but that part is especially painful to watch.  So much so that you may find yourself mourning a bit for the heroes, too.

At the end of Risk! we see the bittersweet results. Our heroic entrepreneurs survive and thrive, but they are forced to do it elsewhere. Their own government has made it clear that their innovation and economic drive is not welcome.

One of my companions said immediately after the film, “That is so…depressing.”

“What do you mean?” we asked. “They are expanding their horizons, going where they’re and they’re going to do fine.”

“Yes, they will,” she replied, “but I have children who will grow up here (in the U.S.) and this story means bad news for them.”

And that is the heart of the question that headlines this year’s symposium: fight or flight? The stakes are truly high. There is a vigorous political effort in the U.S. to do things that guarantee a poorer nation with a much lower standard of living. Does one stay in such an environment or does one seek greener pastures elsewhere (if one could)?

Those whose entrepreneurial energy could correct the mistakes of the government-induced excess and destruction are being financially lynched by regulation and outright attacks, and driven away, like members of a persecuted faith in less enlightened times.

It’s hard to say if the U.S. has slipped below some critical level beyond which it’s not possible to avoid full blown economic collapse. Has there been too much nationalization, too much debt, too much inflation? Has too much entrepreneurial energy been suppressed to provide the real innovation and growth government always promises but can never deliver?

Risk! beautifully presents a flagship story for this tragedy. There will be economic growth, new job creation and higher standards of living. But if we remain on our current course, none of those things will be seen in the U.S.

Regards,

Gary Gibson
Managing editor, Whiskey & Gunpowder

A Beautiful Risk was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Faith in the free market isn’t something that the United States has a lot of right now – with government stepping in with bailouts, stimulus packages and the like at any sign of a downturn. It’s even become fashionable to think of free markets as dangerous, an idea the government is in no hurry to dispute. After all, taming the markets with regulation gives government a raison d’etre and plenty to do. Never mind that what the government does often amounts to folly (and we are hard pressed to think of an instance when it doesn’t).

Government follies were a big topic of discussion at last week’s Freedom Fest, where Addison Wiggin’s new documentary Risk! had a focus group screening. Risk! picks up where Addison’s last film, the critically-acclaimed I.O.U.S.A left off – in the wake of the financial crisis. The documentary features insights from some of the world’s top economic minds, including Harvard professor and author of the Innovator’s Dilemma, Clayton Christiensen, economic blogger and pundit, Alex Tabborok; and Gary Shapiro author of The Comeback: How Innovation Will Restore the American Dream.

Using Odyssey Marine Exploration, a commercial shipwreck salvage company, as a case study, Risk! explores what has happened to the uniquely American model of risk, reward and failure in the current economic environment – an environment where the role of government has mutated into something the founders of the United States would never have imagined.

While Odyssey Marine has a set of very unique obstacles standing in the way of their innovative business model (and ultimately, their success), as the film unfolds it becomes clear that all entrepreneurs and small businesses are facing similar challenges. Though the U.S. government keeps reminding the public that job creation will get us out of this financial mess, over-regulation, litigation and a barely-understandable tax code make it almost impossible for entrepreneurs–the biggest contributor of wealth creation and jobs–to make an impact on the economy.

“The government does not create jobs,” Shapiro tells us in Risk!. “They take money from one person to give it to another person.  That’s not creating a job. Government’s role is to encourage people, and make sure we have the raw materials of innovation, which are bright people challenging the status quo.”

Shapiro – and the entrepreneurs featured in the film – remind us that the role of government is to “get out of the way” and to provide these wealth creators with a level playing field–one that punishes theft and force, but otherwise allows competition–so that they, and the country as a whole, can reap the rewards of their innovations.

The focus-group screening was well-received by the audience at Freedom Fest, and during the Q&A with Addison afterwards, many members of the audience echoed the frustration that the entrepreneurs featured in the film feel.

“It’s not too late for the U.S. to get it right,” said Addison during the Q&A after the film. “But if the rules of the game keep changing, and the incentives for small business aren’t there, we are looking at a long road ahead of us.”

Doug Hill, Business Manager
Laissez Faire Books

P.S. Risk! is scheduled to be released to the public before the end of the year. Stay tuned for updates. In the meantime, if you’re joining us at the Agora Financial Investment Symposium in Vancouver next week, you’ll get to attend a special focus-group screening. We hope to see you there!

P.P.S. Gary Shapiro will be speaking and holding a book signing at next week’s Symposium – and to hold you over until then, check out his excellent new book The Comeback: How Innovation Will Restore the American Dream. Click here now to see a special sneak peek at what Gary has to say in Risk! – and for a 20% discount on his book.

Federal Punishment for Risk was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The idea goes: If the S&P falls below 1,040, then we’re likely to revisit the lows below 700. Who knows if this widely cited “if, then” conditional probability is valid? We may find out soon enough. When universally accepted technical support levels are breached, we tend to see heavy bouts of “self-fulfilling prophecy”-based selling.

Regardless of how the technical conditions play out, there’s still a big difference between current stock prices and the prices that most value investors are willing to pay to assume the risks of owning stocks. The word “risk” is key. In periods of heightened economic and political risk, investors demand higher risk premiums to hold stocks. A simpler way of stating “higher risk premiums” is “lower stock prices.”

These risks include the speed at which politicians are driving national economies down Friedrich Hayek’s proverbial “road to serfdom.”

Austrian theory acknowledges both the “seen” and the “unseen” effects of government policy, while Keynesian theory ignores the unseen in the pursuit of managing this thing we call “GDP” at all costs. The conceit that GDP can be managed by enlightened bureaucrats usually undermines vital capital foundation. Too many people confuse economic activity (measured by GDP) with economic progress (which usually involves rising living standards driven by rising productivity and falling consumer prices; see the U.S. industrialization in the late 19th century).

The road to serfdom, originally outlined by Hayek, is now taking the global economy down one of two paths:

Painful austerity plans and deflation that salvage what’s left of today’s currency system by promoting savings and encouraging new capital formation;

OR

Endless stimulus injections into economies with the promise of austerity “once the economy recovers.” Unfortunately, most Western economies are now thoroughly addicted to government spending. Each fiscal and monetary injection into zombie banks will likely have to be larger in order to offset the withdrawal symptoms of losing the last stimulus plan. Entrepreneurs figure this game out and gradually withdraw from participating in the economy in a healthy, productive manner. This loss of entrepreneur confidence in the system will ultimately accelerate the demise of all paper currencies.

The second path one is more likely in my view, because it’s more politically popular – especially once the European “pro-austerity” camp discovers just how addicted their economies are to the welfare state. Hopefully, a critical mass of people who value freedom over the illusion of economic security can move to wean us off today’s frighteningly powerful roles for governments and central banks. But based on the decisions we’ve seen in recent years – decisions driven mostly by political considerations – I’m not holding out much hope at this point.

After this weekend’s G-20 meeting in Toronto, we’ll know more about the direction in which the “world improvers” seek to drag their constituents. Ideologues are lining up on either side of the political debate between a) austerity and b) “endless stimulus and money printing.” Where one stands in this debate will depend on one’s view of the proper role for government.

Based on polling data, I probably don’t need to convince you that confidence in Washington, D.C., is near an all-time low. This normally shouldn’t be a concern for the stock market or the economy. But it is becoming a growing concern, because politicians keep pushing unpopular big-government agendas in a truly tone-deaf manner – agendas that will further dampen the entrepreneurial spirit that made the U.S. economy the envy of the world (while other countries were sabotaging their own progress with various flavors of Marxism during the 20th century).

Threats from Washington, D.C., include everything from raising tax rates, to bailing out cronies at zombie corporations, to a debased dollar, to an energy policy that – regardless of how it’s sold – will, in practice, have the effect of dramatically raising prices and worsening the U.S. dependence on oil imports. Case in point: The answer to the BP oil spill is to take away the right for Gulf Coast oil workers to work on statistically safe drilling projects for the next six months, and then put them on BP-funded welfare checks.

No price was too high to bail out the financial terrorists at the “too big to fail” banks. There’s not much desire for the current Congress and the Fed to end embarrassingly large subsidies and guarantees for the big banks. Apparently, in the wee hours of this morning, bank lobbyists succeeded in watering down the “Dodd/Frank” financial reform bill enough to render it almost meaningless. This bill serves to ultimately transfer even more wealth from the middle class to Wall Street kleptocrats (mostly via the hidden inflation tax, engineered by a politicized Federal Reserve).

This bill also did nothing to reform the monstrosities most directly responsible for inflating the housing market with underpriced mortgage credit: Fannie Mae and Freddie Mac.

Bottom line: This environment is dangerous for the stock market. Bull markets require healthy risk appetites among those with capital to invest.

Regards,
Dan Amoss
Whiskey & Gunpowder

July 6, 2010

How to Profit on the Road to National Serfdom was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Shorting stock is probably one of the most unusual ways to make money on Wall Street. And I think the best way to explain it is with a story.

Say a friend lets you borrow his brand-new car for an extended time. So for all intents and purposes, the car is yours.

One day, a complete stranger sees you with the car and says, “I’ll give you $52,000 to sell this car to me.”  Unsure of what to say, you take his phone number and say you’ll think about it.

You’re very curious, so when you go home, you do some research and discover that $52,000 is a very fair price for the car. But you also learn that the local car dealership is having a big sale in two weeks, so there’s a good chance the car will sell for a lot less than it sells for today.

You call up the man who wants the car and agree to the sale. You meet him, and he hands you a check for $52,000. That’s a nice chunk of change…but now your friend is out a car. Luckily, you know what you’re doing.

Two weeks later, the car sale starts, and you’re able to buy the exact same model of car — from its color to its option features — for $42,000. You’ve now replaced your friend’s car and kept a nice $10,000 for yourself at the same time.

What you’ve done is known as short selling. And short selling a stock works pretty much the same way.

Make Money Selling Something You Don’t Own

When you want to short a stock, you simply call your broker and say how many shares of a company you want to short.

The broker then “borrows” the stock shares, either from his firm’s account or from other investors. He then immediately sells those shares on the open market. The money from the sale is yours to keep.

So if you short 100 shares of stock at $50, your broker will borrow 100 shares of the stock, sell them, and then deposit the $5,000 into your account.

But don’t make the mistake of thinking this is free money. Always remember that you will need to return the borrowed shares at some point. This is called “covering the short,” or “buying to close” your position.

The goal is to cover your short for a lower price than what you borrowed it for. For instance, if the stock you shorted falls to $40, you can instruct your broker to buy shares to close your position. Your broker buys 100 shares at $40, taking $4,000 from your account to pay for the transaction. The shares he bought are then returned to whom he borrowed them from.

Meanwhile, you’re left with $1,000 of pure profits.  But notice that the lowest a stock can go is to zero. So your maximum gains will never be higher than what you earned when you initially sold the stock. In the example above, you’ll never make more than the $5,000 you got for shorting the stock.

Now, the downside to this strategy should be clear.

If the stock rises, you could be in trouble. You might have to buy back the stock at a higher price than you sold it for. For instance, if you cover your short at $60 per share, your broker will need to spend $6,000.  Since you got only $5,000 when you originally shorted the stock, you’ll need an extra $1,000 in your account to pay to close the position.  If the stock goes to $70…$80…$100…you’ll have to pay that much to cover the short. In other words, your risk is theoretically unlimited.

But it probably won’t come to that. Since you’ll need enough money in your account to cover the short, your broker may ask you to deposit more money.  (This is sort of like a margin call.)

Short traders know this. So when a stock seems to be on a run, they’ll often race to limit their losses by covering their short positions. Unfortunately, their buying can run up demand for the stock. And as you know from basic economics, increased demand leads to higher prices.

This is called a short squeeze — traders covering their shorts artificially boost a stock’s price. (In my newsletter Strategic Short Report,  we want to avoid short squeezes at all costs).

Another thing to keep in mind is that when you sell someone else’s stock, they are still eligible to receive the stock’s dividends. Since you borrowed their stock, you must pay any dividends the stock pays out.

So as you can see, shorting the stock itself is a good idea only in very certain situations (situations that will be coming up this very summer, by the way). You are forgoing the biggest gains, but your trade will tend to be less volatile. Often, this is our best route if we are confident that a stock will fall, but less confident about when.

Also, some good short-selling targets are so small that they have no exchange-listed options.

Strategic Short Report will recommend short sales in situations in which it’s the only way to profit on the downside. More often, however, we will use another option which we’ll discuss in the next issue of Whiskey & Gunpowder.

See you then.

Regards,
Dan Amoss

Getting Prepared for the Best Short Market in Years was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Right now, the market has priced bank stocks for perfection, but the earnings outlook remains bleak. Investors are excited about the wide yield curve that’s enabling banks to borrow at ultra low rates and lend at much higher rates. But starting a few years ago — and going forward a few more years — losses on loans made during the bubble will matter more than the wide yield curve. More bank failures, capital shortfalls, dividend cuts and shareholder dilution are in the cards for most bank stock fans.

Because bank stocks usually act as a canary in the coal mine, a continued bear market in banks translates into a continued bear market in most other stocks. The evidence tells me we’re experiencing a bear market rally, not a new bull market. The promoters of the idea that this is a new bull market are ignoring one of the worst enemies of stocks: uncertainty. Right now, especially considering aggressive government policies, uncertainty about the future business environment is very high.

As regular readers of Whiskey & Gunpowder know, the government’s land grab is going to make things worse. It seems that there’s no end to the threats facing corporate profits, which will make corporate loans that much harder to pay back. This is not a garden-variety recession. It’s more like a depression, so the so-called economists parroting the “recession is over” message will have a rude awakening soon enough.

Let’s briefly consider the sentiment toward overall market. Aside from the investor sentiment polls, you can tell how bullish investors are by the multiples they are willing to pay for stocks. And right now, after the sharpest 5-month rally since the 1930s, the market is trading at valuations that require a strong economic recovery, and a return to credit bubble conditions. The rally was powered entirely by P/E multiple expansion, not earnings growth. That sort of rally would be justifiable if corporate revenues and earnings were about to soar, but they’re not. Most earnings surprises were due to cost cutting, rather than top-line growth, which is like burning your furniture to stay warm.

The market is not even that cheap when you consider how artificially inflated earnings were at the 2007 peak. Financial earnings made up 18% of the S&P 500’s earnings in 2007 — much more if you add the “earnings” from the finance divisions of industrial conglomerates like GE and GM. Any claims that the S&P 500 is cheap because 2007 somehow represents “normalized earnings power” are bogus. The corporate profit margins and earnings won’t return to that level for many years.

The talking heads are getting more creative in their rationale for owning stocks right now. Most money managers seem to be thinking: “I don’t believe in this rally, but I’ll ride it until it looks like it’s over, and then I’ll sell.” This is the type of dangerous crowd psychology that consumes most people during bubbles. When enough investors share this Ponzi sentiment, and nobody’s investing on the basis of sober, rational fundamental analysis, the result is sometimes a crash.

Bank Accounting: Educated Guesses about the Future

This brings us to the poor quality of earnings, particularly at commercial banks. Accounting — especially the accounting that produces income statements at banks — is more art than science. It’s as much opinion as it is fact. Bank executives have a lot of leeway in how and when they recognize credit losses. As you’d imagine, some of them have more creative imaginations than others. Some are actively engaging in “extend and pretend,” a practice in which banks refinance deadbeat borrowers to avoid reporting loan losses.

Banks make loans expecting to receive interest and principal payments in a timely fashion. Banks book revenues, expected credit and operating costs, and profits associated with every loan upfront. But as we’ve discovered, the credit costs, or losses, often wind up being much larger than originally expected. When this happens, banks must dramatically ramp up their “loan loss provision” expense, which cuts into earnings, often pushing earnings into the red.

So the ultimate credit costs associated with bank revenues often take a year or more to be reflected in earnings and capital cushions. That’s why regulators require banks to maintain an “allowance for loan losses.” This allowance is a contra account on the asset side of a bank’s balance sheet, and its purpose is to absorb credit losses from loans as they run through the default and recovery phases. Loan losses, net of recoveries, deplete the allowance. Banks can rebuild their loan loss allowance by booking larger provision expenses, but this process cuts directly into earnings.

The chart below shows how under-reserved banks are right now, so they still have a ways to go in accounting for the losses on loans made during the bubble. These numbers are the combined figures for over 7,000 U.S. commercial banks insured by the FDIC. In blue, you see the combined loan loss allowance climbed to $156 billion by the end of 2008. In red, you see that noncurrent loans — the raw material for credit losses — had soared even faster to $200 billion by the end of 2008, and are still climbing sharply. As a rule of thumb, to remain well capitalized, and to prevent their allowance from shrinking to dangerously low levels, banks should book provision expenses in line with the increase in noncurrent loans.

But since the credit crisis began, this has not been happening. As the green line shows, the ratio of loss allowance to noncurrent loans for the entire banking system has fallen below 100%. To rebuild the industry wide loss allowance back up to an adequate level, provision expenses will have to rise faster than delinquencies. Some banks can only catch up by raising new capital from investors. Those banks that are too far behind, and cannot raise capital, will be taken over by the FDIC. All of this translates into a strong headwind for bank earnings over the next few years.

Recall that bank executives have lots of control over the timing of loss recognition. Evidence that banks are delaying loss recognition is springing up all over the place. For instance, some banks that provided unsecured revolving lines of credit to highly indebted REITs have waived some restrictive loan covenants. In residential mortgages, we’ve seen lots of instances where banks are stringing along underwater homeowners with modifications that do little more than kick the can down the road.

It would make more sense to restructure mortgages on underwater properties where the bank receives a property appreciation right in exchange for a large reduction in mortgage principle. This makes more sense from a societal perspective, and would help accelerate the return to a healthier, less “zombified” banking system. But this idea is not popular among bankers, because doing so would force the bank to immediately recognize lots of losses, which could cut heavily into the bank’s capital.

This state of bank accounting is not limited to the U.S. In fact, in some instances, the accounting at some foreign banks is even more detached from reality than it is in the U.S. For readers of Strategic Short Report, I recently uncovered a non-U.S. bank that’s been especially tardy in disclosing its credit losses. It’s a very attractive short sale right now, especially because the market loves this bank, and is totally ignoring the wave of credit losses to come in the near future.

Regards,
Dan Amoss

August 13, 2009

Bank Accounting Fudges Loan Losses was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Yes, dear reader, the most volatile market in recent history could easily point its finger at a trader’s biology.

The conclusion will surprise you. The longer a trader’s ring finger, the more money he’ll make in the City (this study comes from across the pond in London, where top earners took home over $4 million – until just recently).  They measured the men up, and looked at their previous 20 months of P&L (profit and loss statements).  They also saw how long they’d lasted in the City.

Those with the longest fourth digit made over five times the money of their less-well endowed colleagues.  The average salary was $537k.  The long-ring group netted a healthy $828k, while the shorties had to make do with $145k.

OK, OK.  I bet you’re saying: what’s a couple of inches of bone and flesh gonna tell us about hormones?

Don’t know diddly about Darwin?  Think it’s just about DNA?  The real work of evolution starts with hormones. And the reminder of some serious prenatal hormonal action lies in the ring finger.

The Finger of Destiny: High-Stakes Day Trader or Value Investor

Measures are always relative to something. In this case, it’s the second digit: — the index finger.  They call this indicator the 2D:4D. This ratio is set before birth and stays with us throughout life.  Those with the longer fourth digit relative to the second often display rapid-fire execution ability. (See also: aggression, fertility, confidence, and sporting ability).

http://news.bbc.co.uk/1/hi/sci/tech/695142.stm

The accidental in utero testosterone junkie may well be set for high-stakes finance on the trading floor, simply because the developing brain becomes wired with a greater sensitivity to testosterone’s effects.

But before you run to get a ruler, let’s take a further look at what these 44 well-measured men reveal about the evolutionary life of Wall Street.

Testosterone, Cortisol & Your Next Investment

Coates, now Senior Research Fellow in Neuroscience and Finance at Cambridge, got a hunch while running a trading desk on Wall Street during the “dotcom” bubble.  He worked elbow-to-elbow with traders, when he noticed the change in traders’ behavior from pre-bubble methods.

Coates began to suspect a chemical was involved.  Just like Diane Fosse in the Rwandan jungle, Coates observed testosterone-related dynamics…even if the “competition” was between a trader at Goldman Sachs on 85 Broad Street and one working on the same trade, thanks to electronic trading, for Merrill Lynch halfway round the globe in Seoul.

The “winner effect” works like this.  Take two males in competition.  Testosterone rises.  They spar.  The winner comes out with even more testosterone and takes on a new opponent, while the loser skulks off with less testosterone.  Repeat.  And repeat.

Now for the end game (looking a lot like, say, former Lehman Brothers’ alpha wolf, Dick Fuld): the males, seething with testosterone, become overconfident.  Most importantly, they have increased appetite for risk.  They patrol areas that are too large (viz. commercial and residential real estate) and they pick too many fights (anyone starting another mortgage-backed securities pool in 2007).

So Coates remarked in the dotcom bubble and so we stand today.  The fact is, the dotcom bubble didn’t weed out anyone on Wall Street, because Manhattan Island is not a pure “Darwinian” island.  Instead, everyone just got shuffled around from investment bank to investment bank.  Top brass protected their own, sitting on each other’s boards and securing the “alpha wolf” salary and bonus.

And, sure, fast action juiced by higher levels of testosterone, is more likely to turn a profit — an abnormally large one at that.  But there’s one catch: cortisol.

Cortisol, a stress hormone, is seething in global traders everywhere…it comes when there’s the crash.  It’s the “fight-or-flight” friend that raises blood pressure, increases immunity, desensitizes us to pain. How does that translate into finance?  Cortisol renders the trader price-insensitive.  Monetary policy won’t matter.  He’ll see risk everywhere.

That’s because, long-term, exposure to cortisol ravages mind and body.  It affects memory recall — handicapping judgment with the shackle of fear — whether justified or no.  Like a kid who touches a stovetop for the first time, so is the trader who fears jumping back in the game that just burned him.

Is it time to fire all of Goldman’s males and change the name to Goldwoman?  The reason, in fact, Coates zeroed in on the testosterone test, was that the few female colleagues on the floor, he said, did not display the same behavior. Tellingly, the woman’s 2D:4D is almost equal and she has about 1/10 the testosterone of a man.  But she’s still got to contend with cortisol.  So the Wall Street ecosystem will remain chained to biological reflexes whose usefulness we may or may not have outlived.

Next Time You Hire: Measure Your Money Manager’s Index Finger

Here’s one more reciprocal fact.  A reverse advantage falls to those whose 2D is longer than their 4D.  It concerns a long-term market approach.

Taking a look at average finger ratios in university departments showed that the math, science and engineering-focused sport a longer index.  As you might guess it also suggest higher exposure to the opposite of testosterone – estrogen – in utero.  Estrogen helps the right side of the brain develop: good for honing sharp analytical skills.

Perhaps Mr. Madoff’s clients could have checked his pointer finger first, and those of his Florida club-hopping, dupe-hunting reps. But maybe we’d be surprised to find lengthy index fingers there…after all, the scheme was a “long-term” approach.

Most interesting of all, is that Madoff’s own sons and heirs cut short dad’s survival on the Wall Street three-ring menagerie.  He revealed the root of their inheritance, and they turned him in.  This positively Greek development in finance deserves the ushering in of the Furies from the wings.

Regards,
Sam Buker

January 23, 2009

Risk-Taking Traders Born Not Made was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

The noodle company got itself into some trouble. To simplify the story greatly, it basically lost a lot of money using derivatives to bet on dollar-rupiah movements. The loss suffered was, in fact, more than the capital of the company itself. At one point, Das writes: “What this had to do with producing noodles was a mystery.”

Exactly!

Unfortunately, this kind of story riddles the markets today like worms in an otherwise worthy cut of swordfish. There are so many of these incidences and they are ruining companies and investors across the world. It takes a nasty crisis like the one we are in to expose all these things. And the rot is extensive.

I want to share with you three little-reported events and one historical example that all show how pervasive this mindless risk-taking became during the last few years. They would be almost comical if they weren’t true.

First, consider the sad example of several Mexican and South American companies that made, large, company-jeopardizing currency bets. For example, Mexico’s third largest retailer, Controladora Commercial Mexicana (COMERCIUBC: MXK), recently filed for bankruptcy after losing so much money speculating in the forex markets. What does currency speculating have to do with selling tortillas, milk and eggs? Nothing. That’s the point.

Similarly, Sadia (SDA: NYSE), a poultry producer; Cemex (CEMEXCPO: MXK), a cement outfit; and Gruma in tortillas – all lost huge amounts of money on currency bets. Aracruz Cellulose (ARA: NYSE), the much admired pulp giant of Brazil, owes more than $2 billion to its banks for making bets on currencies that went sour. What was once a great franchise has been brought to its knees. It will take years to pay that back and debt payments now make up 40% of its pre-tax earnings.

The second example of mindless risk-taking is the story of so-called “portable alpha.” Apparently, the brain trusts that run pension funds thought this strategy sounded like a good idea. What is it? I still don’t understand it fully. But it basically amounts to a leveraged bet on the stock market. If you lose, you lose big as many pension funds are finding out. So now the Pennsylvania state employees’ pension fund, for instance, will have to take a multi-billion bath on this exotic investment strategy.

As the Wall Street Journal reports: “The stock-market downturn could force the Pennsylvania state employees’ pension fund to make cash payments of $2.5 billion or more to trading partners on Wall Street.” The fund has only $27 billion in total. At least, it had $27 billion.

Several other funds have reported billion dollar losses on portable alpha strategies. I can only imagine how many more institutional investors are in the same boat. The people running these things and advising these people should all find other work.

The third example is so-called “accumulators,” which is another kind of tactic for placing highly leveraged bet on stocks, currencies or commodities. I don’t want to get into the details. It’s so complicated; it would take me a page to explain it. Just know that, like “portable alpha” if you are wrong, you lose big.

And yet all kinds of wealthy individuals and businesses have gotten wrapped up in these things. Accumulator losses are showing up in some unlikely places. For instance, VeraSun Energy Corp. (VSUNQ: OTC), which makes ethanol, filed for bankruptcy in part because of big losses on accumulators tied to the price of corn. Citi Pacific (CIY: ASX), a Chinese conglomerate, lost $2 billion on accumulator contracts linked to currencies.

Billions and billions of dollars lost on nonsense. There was no reason for anybody to buy these things – especially when they clearly did not understand the risks involved. The losses are so bad in Hong Kong that Any Xie, an independent economist, said recently that “Accumulators are ruining Hong Kong.”

I’ll offer one other example of this kind of recklessness that is both a historical and contemporary study: Goldman Sachs.

I just recently finished perusing Charles Ellis’ new history The Partnership: The Making of Goldman Sachs. I was particularly interested in the early history of Goldman Sachs. I thought I would come away thinking how Goldman Sachs used to be a simpler business. I thought Goldman’s history would show how it took prudent risks with adequate equity backing those risks. My conclusion would then be that the current crop of leaders at Goldman were just reckless and ruined a franchise that had been around since the 1880s.

In fact, that’s not what I learned at all. From Goldman’s earliest days as a commercial paper specialist it operated with minimal capital. All through its history, it has been a business that took big risks and often took huge losses. That Goldman even exists at all today is something of a financial miracle.

In reading this history, I was struck by how the company found itself in the soup again and again and again. In the 1920s, one of the biggest speculative busts was in investment trusts in which a small amount of capital supported a spider’s web of investments in other companies. Guess who had the biggest blow-up of them all?

Goldman was big in this through a subsidiary called Goldman Sachs Trading Corporation, which basically lost everything for its investors. Ellis writes:

“While all the investment trusts suffered, Goldman Sachs Trading Corporation – because it was so large and so highly leveraged…became one of the largest, swiftest, and most complete investment disasters of the twentieth century.”

The loss to Goldman Sachs itself was enormous. It basically wiped out thirty years of profits and eliminated the “fruits of all the labors of a generation.”

Fast forward to 1970 and the biggest bankruptcy in the country at that time. You find Goldman was waist-deep in it. Penn Central at the time of its bankruptcy in 1970 was the eighth largest corporation in the country. Again, Ellis writes: “the loss it [Penn Central] threatened to impose on Goldman Sachs was not only larger than any prior loss, it was larger than Goldman Sachs.”

And so it is today, that the company once again finds itself in the middle of yet another big crisis that threatens its very existence. I don’t know about you, but I have to wonder about all the brains at Goldman Sachs and all the people who say what a great firm it is. Seems to me, for such a bunch of supposed geniuses, they routinely shoot themselves in the foot, time and time again. You don’t find Berkshire Hathaway fighting for its life every decade.

All of these anecdotes scream at me to avoid the complex and the leveraged, which often means a potential for a mega-loss if you’re wrong. The problem is these kinds of bets infect many companies, as I’ve shown, even when they have nothing to do with the core business. Even otherwise seemingly simple enterprises, like making tortillas or producing chicken, have been hurt.

The advice I have is not novel, but bears repeating since so many seem to forget it. Stay away from anything you don’t understand. (All those folks who lost money with Madoff in his $50 billion Ponzi scheme would’ve saved themselves a lot of money just with this single insight.) And avoid excessive leverage. It’s one thing to lose money. It’s another thing to lose it taking on stupid and pointless risks.

Regards,
Chris Mayer

January 8, 2009

Mindless Risk Taking was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.