Credit Where Credit is Due

Who elected the credit rating agencies?

It turns out that the credit downgrade of MF Global is what sparked its death spiral. S&P downgraded the company on October 24th. On October 25th the company reported a $200 million loss. Moody’s and Fitch followed suite shortly thereafter. As a result of the downgrades, MF Global’s repo counterparties demanded more capital, and on October 31st MF Global filed for bankruptcy—one of the largest filings in US history. The company has listed some $40 billion in assets and liabilities.

We’ve seen it happen before: a ratings-agency downgrade sparks demand for more collateral. If the debtor can’t fulfill these requests the creditors reduce their exposure and the borrower fails for lack of liquidity. In many cases, it’s the credit agency reports that initiate the death-spiral. Their ability to destroy a company is powerful. Who gave it to them?

The short answer is the Federal Government. In the ‘30s regulators wanted to stop banks from buying junk bonds, so they restricted bank investments to highly-rated bonds. Congress went along, and credit ratings acquired the force of law. Over the years insurance companies, pensions, and other regulated entities were included. Now it’s almost impossibly to conceive of financial life without ratings agencies.

What’s to be done about them? First, we need to understand that tighter regulation will only raise the cost of credit. But given that, perhaps improving financial disclosure—requiring issuers to improve reporting of their risk factors and financial exposure—and requiring the agencies to focus on these publically available reports would be most effective.

This wouldn’t have prevented MF Global’s demise, but it would have made their $12 billion leveraged bet on European sovereign debt more visible. In a complex world, expert advice will always be needed. But in the world of credit, the best surprise is usually no surprise.

Douglas R. Tengdin, CFA
Chief Investment Officer
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A Nation of Mercenaries?

Is conscription becoming less common?

In a celebrated exchange, General William Westmoreland testified in favor of the draft, stating that he did not want to command an army of mercenaries. Milton Friedman challenged him: did he prefer rather an army of slaves? He was a mercenary professor; he used a mercenary dentist; he employed a mercenary accountant, and so on.

Around the world conscription—mandatory military service—has been in decline. When Napoleon Bonaparte imposed the draft in1793 and then went on to conquer most of Europe, the other European powers quickly followed suit, raising large armies that could be commanded by a professional officer corps. Before that time, conscription was fairly rare.

But by the late 20th century many countries began to look at the economic costs and benefits of a draft. In 1970 80% of the world used military conscription; by 2009 that number had fallen to 45%..

Much of the reason is economic: mandatory military service ignores the fact that some people are better at farming or teaching or entrepreneurship, and thus reduces a country’s economic potential. Also, it harms the productivity of the military, as high personnel turnover requires significant training, and gains from specialization are lost.

Finally, abundant, cheap labor distorts the incentives of military managers. When Napoleon was told that a planned attack would cost too many men, he replied that that was nothing—that he had more than he could use. Such a statement ignores the cost to society of that loss. An honest assessment of true costs encourages managers to use better equipment, improving efficiency.

In a free society some will choose military careers, and for that we should all be grateful. But let’s also thank the economists and policymakers who showed how inefficient the draft is. Our military is stronger as a result.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Super Failure?

Was the deficit Supercommittee’s failure a fiscal disaster?

On the face of it, no. Their failure to come up with $1.2 trillion in tax increases and spending cuts over two years will simply trigger an automatic sequester process that will begin in 2013. There’s no risk from this of a government shutdown or a debt default. All three ratings agencies affirmed the US’s credit rating.

But on a deeper level it illustrates that our political system is broken. The fiscal path the nation is on is unsustainable. Government expenditures are running at 25% of GDP. Revenues are 15% of GDP. You can’t run a 10% gross deficit for long before debt service consumes the economy. The Supercommittee was designed to shield its participants from normal political pressures—things like speaker privilege and filibusters. Its demise means any attempt to change the terms of debt ceiling deal must pass these hurdles.

But it’s clear that we need to get our fiscal house in order. If we want government spending equal to 20% of the economy—a naïve, half-way compromise—we need to design a tax regime that meets this goal. The current system is filled with special provisions and gimmicks that distort the economy and make it less efficient. Tax reform is on the table.

But it will have to run through the normal process in an election year. Many doubt whether this is possible, but a looming disaster—as we see brewing in Europe—has a wonderful way of focusing the mind. Let’s hope it does, this time.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Giving Thanks

What do we have to be thankful for?

We can be thankful that we have free markets and free capital, where we can invest where we want and when we want without many restrictions. If I want to buy shares in a Chilean airline or a Chinese oil company, I can do that. And they’re obligated to provide audited financials.

We can be thankful that we have an open and deliberative political process. Sure, it can be chaotic. The failure of the Supercommittee and the upcoming dust-up over funding the government on December 16th are evidence of that. But the alternative to a messy system is often a closed system, where no one knows what’s going on but a few insiders, and they’re not talking. Japan had that. No thanks.

We can be thankful that it’s not 2008. I know there are rumblings in Europe; that Greece could be Europe’s Lehman; that Italy is now the lynch-pin of the Euro. But the Lehman bankruptcy was the most intense marker of the sub-prime mortgage debacle that started in 2007, and it came after the failures of Bear, Fannie and Freddie, and AIG. For all its import, the European debt crisis doesn’t have the same impact as the mortgage crisis over here.

And we can be thankful for the extraordinary wisdom and insight that the Founders showed some 224 years ago when they framed the Constitution that still governs our republic. It was a singular coalescence of talent, initiative, and opportunity that enabled leaders like Madison, Franklin, and Washington to lead a raucous convention to a happy conclusion. Our nation has survived wars, depressions, invasion, insurrection, and assassinations as a result.

We have a lot to be thankful for.

Douglas R. Tengdin, CFA
Chief Investment Officer
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The Revenge of the “Yeti”

There’s one weasel-word that can immunize any prediction: “yet.”

Talk to an inflation hawk about price stability and he’ll concur that prices haven’t risen much…yet. Complain to an unreformed Cold Warrior about how Russia seems to be much more market-oriented she’ll agree…for now. Challenge mega-bears or uber-bulls with the 10-year do-nothing nature of the stock market and they’ll smile and say, “Not yet.”

“Yet” is the universal acid: it indemnifies anyone who uses it. I once read a market analyst who, after predicting a market meltdown that didn’t come, started off his discussion by stating that he couldn’t tell the difference between being wrong and being early.

Well I can tell you that my clients know. They don’t want to be early, they want to meet their financial objectives. They don’t’ have extra money to pay for weasel-worded advice, or doctrinaire positions. Markets are immune to ideology. They don’t’ go up or down on command. They do embody the collective expectations of millions of independent investors.

It’s hard to change your mind when your predictions don’t work out. But it’s essential when you’re dealing with the real world. Because the one of the first principles of investing is not to fool yourself—and to also recognize that you’re the easiest person to fool. But if we’re honest, we recognize how little we really know. Yet.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Small is Beautiful?

Could Little Rhody show the way?

Up until now Rhode Island has been a bit player in the financial crisis. The State suffered tremendously during the recession: unemployment is currently 10.5%; almost double New Hampshire’s 5.4% and the worst level in New England. In addition to cyclical issues, Rhode Island’s economy has been beset by structural challenges for some time.

When the headline bankruptcy of Central Falls hit the tape, many municipal investors decided to avoid the State entirely. Their yields rose, exacerbating fiscal challenges. A death-spiral seemed possible. But a funny thing happened on the way to Armageddon: legislators decided to get serious.

One of the major issues facing Rhode Island (along with many other States) is their retirement system. By current accounting standards, the Rhode Island has funded less than 58% of its projected pension cost—8th worst in the country. But late last week the Rhode Island State Legislature enacted a pension reform bill that raised the retirement age, reduced cost-of-living adjustments, and enacted a hybrid 401(k)-like structure along with the traditional pension.

Many of these changes affect current retirees as well as future ones, so the courts will have to weigh in. But with the stroke of a pen the bill improves the funding level by 14%, and wipes out $3 billion in projected costs. The fiscal savings amount to 5% of the State’s General Fund.

I’ve said before that pensions are promises, and if the money isn’t there, those promises will have to be changed. By enacting the most sweeping pension reform of any state in recent years, Rhode Island may be able to show a way forward.

Douglas R. Tengdin, CFA
Chief Investment Officer
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57,000 Questions

Something is wrong.

Something is wrong when GE employs an army of accountants to file a 57,000 page tax return in order to pay no taxes. Something is wrong when our 35% marginal corporate tax rate nets a 20% effective tax rate. Something is wrong when a country like Finland–with a 26% marginal rate–collects corporate taxes equal to 4% of its economy, while the US, with a 35% marginal rate, only collect taxes equal to 1.8% of its economy.

And this isn’t just a result of the downturn. Sure, GE’s zero tax-burden from last year is. When it hit the news earlier that they paid no taxes in 2010 my reaction to the story was, “Duh.” They lost tons of money in ’08 and ’09. So because they could carry the losses forward, that wiped out their profits for the next couple years: no profits, no tax. Seems fair to me.

But corporations in the US are subject to taxes on money they earn anywhere in the world. If IBM’s Japanese subsidiary provides consulting to Toyota in Japan, the US Treasury wants some of it. So IBM just keeps the money safe over there, where our tax authorities can’t get at it. And large companies employ thousands of accountants and tax attorneys to minimize payments to Uncle Sam—thousands of intelligent, skilled individuals whose gifts and training surely could be put to a more productive use.

High rates, worldwide taxation, and a complex tax code are a poisonous combination. It would be great if we could simplify things.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Counting on Trouble (Part 3)

So how do we fix accounting?

Someone once said that free elections are meaningless as long as the politicians control who counts the votes. In the same way, accounting reform is meaningless as long as management controls the accountants. At present, audited financials are the responsibility of the firm. You can’t list a company without hiring an auditor to look at your books.

But the independence of such audits is a fiction. If the auditors come up with an opinion that differs dramatically from management, they risk getting fired. It’s a lot like the “issuer pays” model with bond ratings. When the rated entity hires the rater, there is an inherent conflict of interest. And in both cases, you have an oligopoly: there are three major bond ratings firms, and only four major accounting firms.

At least bonds investors have the option of hiring an investor-paid rating agency like Egan-Jones or Kroll Ratings. Auditor independence can only be assured if auditors are paid by investors. Issues like adopting European accounting standards or pushing for more market prices in the balance sheet are just academic side-shows. The real issue is testing management’s performance.

Accounting should focus on whether management is providing an appropriate economic return for investors, but there needs to be a way for investors to call the shots. You get what you pay for, and as long as management pays the accountants, the accountants will serve—not test—management.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Counting on Trouble (Part 2)

So what is wrong with accounting?

I know. As soon as I mention accounting, most people’s eyes glaze over. It’s like those dreadful, interminable Algebra 2 classes: the teacher talked to the board and went on and on and on while everyone else got to go outside and you were stuck with this boring class forever! Or that’s what it seemed like. And accounting seems like that.

The problem is there are these really strange rules in Accounting-land. It’s like Math-world, only it pretends to be part of our everyday life. For example, people in business are always trying to control risk. One of the big risks in international commerce is currency fluctuation. So companies purchase or sell foreign currencies on a forward basis, or even enter into long-term swap agreements.

But some firms have used these contracts to speculate. (I know: you’re shocked, shocked.) When things went wrong, they hid their losses temporarily in some hedging reserve or deferred payment bucket. Eventually, though, the truth came out and investors got hurt.

So the accounting board has set up elaborate regulations governing when a contract is a hedge and when it’s a speculation. There’s even a small sub-industry to help firms deal with the mystical world of swap-land, so that they don’t fall afoul of the rules.

The problem with accounting is people want simple answers when life is too complicated for simple answers. What gets measured gets done, and we need to figure out how to put investors back in charge of the measurement.

Douglas R. Tengdin, CFA
Chief Investment Officer
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Counting on Trouble (Part 1)

Is accounting part of the problem?

At its heart, accounting is an attempt to translate the economic reality of an enterprise into a set of standardized reports. Accounting’s high-point was captured in a statement by Larry Summers in 1999 while Deputy Treasury Secretary. He stated that General Accepted Accounting Principles were perhaps the most important financial innovation on the American landscape. Talk about overreach!

Accounting is in many ways a disaster. For example, accountants now mark much of a bank’s balance sheet to market. Perversely, this means that when a bank’s credit standing deteriorates—and its own bonds sell off—that becomes a gain on the income statement. Academic accountants want banks to be more like mutual funds, with frequent statements of the net market value of the enterprise. But they set up perverse incentives for executives to game the system in order to maximize their own returns.

In the name of transparency, GAAP gives enterprises various optional accounting treatments that make it easy to smooth income, create hidden reserves, and just plain hide relevant information. Auditors are powerless to stop determined managers from making two and two equal five—when you add back the deferred tax reserve, the deferred comp reserve, and prepaid expenses.

In the past several years we’ve seen solar companies (and executives) get rich by trading tax credits; wood processors go out of business when the subsidy for a pulp by-product was ended; and financial shenanigans at MF Global and Lehman be blessed with clean audits.

Accounting isn’t science, and it isn’t art. It’s a language subject to political and social pressures. GAAP is an equation, and only rarely does it truly balance. Pretending otherwise just makes things worse.

Douglas R. Tengdin, CFA
Chief Investment Officer
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