Surprise, Surprise, Surprise, (Part 3)

Surprise, surprise, surprise. They cheated their clients, too.

People who work with other people’s money are supposed to abide by a series of rules called fiduciary duties. The duty of care states that you’re supposed to know what you’re doing. The duty of loyalty states that you’re supposed to put yourself in the money-owner’s shoes.

This can conflict with an advisor’s self-interest. So when brokers “churn” client accounts, eating up principal with transaction fees, we say that they’ve violated their duty of loyalty. A rational investor wants to minimize his fees, not maximize them.

Well the conflict in the big banks is legendary. For example, when a large client provides significant fee-based business to the bank, everyone from the securities analysts to the retail brokers are encouraged to give preference to that issuer’s bonds, stock, and other securities. This was famously prosecuted in mid-decade. The everyday customers were used as a means to get big-fee underwriting business.

At the end of the mergers boom of the ‘80s, one smaller client summed up the mega-dealers’ approach this way: “Loyalty one, two, and three was to themselves. Four and five was to their buddies. The client came in last.”

Douglas R. Tengdin, CFA
Chief Investment Officer
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Surprise, Surprise — Not

So after all this, who do you trust?

Between Ponzi schemers and conflicted bankers, where do you put your money? After all, you can’t just stuff it in a mattress. It’s not very comfortable, and if everyone did that, there’d be a lot more stolen beds.

There are basically three criteria: you want someone competent, you want someone who understands you, and you absolutely want someone honest. They’re all hard to nail down. It really comes down to trust. Can you trust their skill, loyalty, and morals? To find out, you need to do some homework.

First, do they use outside experts: accountants, lawyers, and systems? Other professionals bring a critical eye. Second, could your advisor restate your financial goals back to you in words you understand? If not, they probably don’t understand you. Finally, could your advisor point to times when he or she has walked away from business for ethical reasons? If so, when? If not, why not?

There’s a theme here: advisors need to know their clients, and clients needs to know their advisors. Smaller institutions that still have a stable business mix offer a client focus that others can only wish for. Like Tom Thumb said, bigger isn’t better. The dodo and dinosaur are dead. Long live the ant!

Douglas R. Tengdin, CFA
Chief Investment Officer
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Surprise, Surprise, Surprise, (Part 2)

So that’s why we need financial reform.

That’s what some have said in response to the kinds of abuses I mentioned yesterday. Surely municipalities need protection against the depredations of financial shysters.

Only, it’s already illegal to hold sham auctions and collude. New regulations wouldn’t change a thing. That may be why the biggest banks are all getting behind the proposed financial reform legislation. Surely with the Senator from Fannie Mae—Chris Dodd—leading the charge, the big banks have nothing to fear.

Seriously, Congress is in the business of getting reelected every two years. The last time we looked at serious reform in the ‘90s—privatizing the agencies, raising capital requirements—the big banks got everything they wanted: new markets, relaxed capital requirement, and new barriers to competitors. And a lot of Congressmen got VIP mortgages and special loans to constituents.

Adam Smith noted that when business-people get together, the conversation usually ends in a conspiracy against their own customers. Add legislators into the mix, and you get a witches brew of self-interest and regulatory power. But you don’t have to put up with it. Just talk to your neighborhood banker.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Surprise, Surprise, Surprise (Part 1)

Surprise, surprise, surprise!

That’s how Gomer Pyle would respond to his beloved “Sarge” when he had something totally obvious to tell. Well that’s what’s in the news today: a surprise that’s not.

The news today is how a consortium of big banks conspired to cheat some municipalities. Apparently Bank of America, Bear Stearns, Smith Barney, and GE Capital were asked to bid on some municipal investments, called GICs—or Guaranteed Investment Contracts. Towns use these to park excess cash that they plan to use later.

The normal practice is to have banks compete for the business. But this time the government alleges that an advisory firm ran a sham auction and allowed the banks win below-market deposits in exchange for kickbacks.

This is an old story. Municipalities have some of the lowest-paid workers controlling huge amounts of capital. So it’s easy to see how a sharp operator can create a rigged game that cheats the towns and enriches himself and the banks.

Only, the banks should know better. But as bees are drawn to honey, crooks are drawn to money. And the big banks just have a bigger pool of “talent” to draw from.

Douglas R. Tengdin, CFA
Chief Investment Officer
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(Un)healthy Games

Someone asked me what I think about health care reform. I’ll respond with a story.

An economist’s young daughter had been potty-trained, but it didn’t “take.” The child was having accidents and frustrating her parents. The economist thought he could solve the problem with incentives. He offered an M&M for every time she went to the bathroom properly. Within hours, the young lady was perfectly regular. Problem solved, he thought.

Only, a couple days later he noticed that every 10 minutes or so his daughter was going to the bathroom just a tiny amount and earning loads of M&Ms. Within days this 3 year-old had learned to game the system. She now had the power to earn enough chocolate to make herself sick.

That’s what worries me about changing the incentive structure for a vast swath of the economy with millions of producers and consumers. Even if we get the incentives just right, there’s a lot of smart people who will figure out how new system works and game the rules to earn more M&Ms. That’s not the intent of the new law, but that doesn’t matter. The rules are the rules.

This kind of thing is usually small potatoes. But not this time. That’s why I’m worried.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Healthy Unknowns

So what can we expect from the new health care legislation?

After all the hoopla, what really has changed in health care? Tanning salons will be charging a 10% Federal tax, and Medicare recipients will begin receiving “donut hole” rebate checks. But what else has changed?

For right now, not much. Most of the public policy changes don’t kick in until after the next presidential election. Part of that is smart policy; after all, you need to give people time to plan for the changes. Part of that is politics; allowing voters a chance to consider the bill during the next election cycle.

But some of the provisions—eliminating lifetime or annual insurance benefit caps, or mandating coverage of pre-existing condition—will begin in September. And many people will see the results of these mandates in the cost of their insurance next January, just in time for the mid-term elections

And there lies the rub. No one really knows how voters will react. It’s unlikely that the economy will be a lot better. But higher premiums could kindle voter anger against the insurance companies—or against Congress.

Whatever that outcome, one thing is certain. More change.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Not Counting (Part 3)

So if the numbers don’t count, how do you invest?

After all, stocks and bonds depend on a company’s ability to generate cash to pay interest and dividends and grow its business. The financial statements are the report card, and accountants are supposed to tell you how reliable that report card is. If you can’t trust the statements, how do you put your money to work?

One way is to use index funds to invest in an entire economy. Most people are basically honest, even in a crooked system, and the law of large numbers says that if you invest in thousands of companies, the inevitable accounting errors will cancel each other out and the average price will be fair—except when we go collectively insane, like we did during the internet and housing bubbles and the subsequent bust.

Another way is to find solid companies that even a crook would find it hard to steal from: firms in competitive businesses that pay reasonably high and growing dividends. Managers can fudge a lot of numbers, but they can’t lie about the cash they give you. That kind of discipline makes it hard for accountants to get too creative. As a side-benefit, narrow margins are less attractive to the looter-set than cash-cows.

By investing in everything and also in specific, transparent enterprises, you have a reasonable chance of getting your money back. Even if the accounting doesn’t count.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Not Counting (Part 2)

So what turned accounting into the enemy?

Why is the Financial Accounting Standards Board the investor’s enemy? After all, all the accountants I know are decent people who care deeply about their work and love their families and pay their bills. So why has their profession cranked out rules upon rules that seem to defy common sense and leave the educated layman scratching his head?

In a word, interest.

The rulemaking body is dominated by the Big Four accounting firms. Based on the size of the firms audited, KPMG, Ernst & Young, Deloitte, and Pricewaterhouse evaluate 99% of the financial statements in the US. When a new issue comes up, of course these guys influence the body’s ruling. And for some reason, FAS always find a solution that is more complex.

This increased complexity has two effects. First, you can’t boil earnings down to a single number. Maybe you could once, but now the footnotes are just too important. Second, this increased nuance has functioned as a full-employment act for accountants. And an overreliance on financial rules can distort the system, as we’ve seen before.

When no one understands the numbers, the numbers just don’t count.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Not Counting (Part 1)

So who is the new scoundrel in the Lehman fiasco?

Now that the bankruptcy examiner has reported his findings, what can we learn that’s new? Not that Lehman cooked its books. That was evident some time early in 2008, when spreads on their debt ballooned. Not that some politicians had a soft spot for their competitors. Hello? Did anyone notice where Hank Paulson and Bob Rubin used to work?

No, the villain today is the accounting firm Ernst and Young. Not the guys down the street who do your taxes. The high-powered auditors, who, along with the other two big firms execute 99.9% of the dollar-weighted accounting audits in America. If you’re an investor who likes to delve into the fundamentals of the companies that you’re buying or lending money to, I have news for you: these firms are not your friends.

Somewhere between footnote 12 and 23 the company made “materially misleading” statements that the auditors should have caught. But world-class accountants are caught in a web of conflict and complexity that makes it almost impossible for them to be objective.

The result is a byzantine maze of arcane rules that only an initiate of the Divine Order of the Big Three is authorized to interpret. And that’s not in anyone’s interest.

Douglas R. Tengdin, CFA
Chief Investment Officer
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No Exit

Are we really surprised that Google is leaving China?

The company whose motto is “Don’t be evil,” is leaving the home of Tiananmen Square and the occupation of Tibet. Ostensibly, the cause was the official hacking of some Gmail accounts. But the conflict was inevitable.

As long as the Chinese leaders maintain that their immense cash balances and growing consumer population puts them in a special class of market, these conflicts will continue. Organizations that think that they special and that stifle dissent are likely to veer into unsustainable practices. The results are often not pretty.

Google’s exit is likely to be the first of many. As western companies conclude that the compromises required to do business in China are corrosive to their core values, others will follow.

It may be that these high-profile departures will encourage the leaders there to adopt more open and self-critical practices. But we just don’t know.

Douglas R. Tengdin, CFA
Chief Investment Officer
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