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A ‘Flawed’ SEC Program [A Retrospective “April Fool’s Day” Analysis]

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SEC Failed to Rein in Investment Banks [April Fool’s Day – 2015]

By Ben Protess, ProPublica – October 1, 2008 5:01 pm EDT

Editor’s Note: This investigative report was first published ten years ago. And so, we ask you to consider – on this April Fool’s Day 2019 – how [if] things have changed since then?  

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Flag MOney

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The Securities and Exchange Commission [SEC] last week abolished the special regulatory program that it applied to Wall Street’s largest investment banks. Known as the “consolidated supervised entities” program, it relaxed the minimum capital requirements for firms that submitted to the commission’s oversight, and thus, in the view of some experts, helped create the current global financial crisis.

But, the SEC’s decision to ax the program currently affects no one, since three of the five firms that voluntarily joined the program previously collapsed and the other two reorganized.

The Decision – 18 Months Ago

The decision came last Friday, one day after the commission’s inspector general released a report [1] (PDF) detailing the program’s failed oversight of Bear Stearns before the firm collapsed in March. The commission’s chairman, Christopher Cox, a longtime opponent of industry regulation, said in a statement [2] that the report “validates and echoes the concerns” he had about the program, which had been voluntary for the five Wall Street titans since 2004.

The report found that the SEC division that oversees trading and markets was “not fulfilling its obligations. “These reports are another indictment of failed leadership,” said Sen. Charles Grassley (R-Iowa) who requested the inspector general’s investigation.

The SEC program, approved by the commission in 2004 under Cox’s predecessor, William Donaldson, allowed investment banks to increase their amount of leveraged debt. But, there was a tradeoff: Banks that participated allowed their broker-dealer operations and holding companies to be subject to SEC oversight. Previous to 2004, the SEC only had authority to oversee the banks’ broker dealers.

Longstanding SEC rules required the broker dealers to limit their debt-to-net-capital ratio and issue an early warning if they began to approach the limit. The limit was about 15-to-1, according to the inspector general report, meaning that for every $15 of debt, the banks were required to have $1 of equity.

But the 2004 “consolidated supervised entities” program revoked these limits. The new program also eliminated the requirement that firms keep a certain amount of capital as a cushion in case an asset defaults.

Bear Sterns

As a result, the oversight program created the conditions that helped cause the collapse of Bear Stearns. Bear had a gross debt ratio of about 33-to-1 prior to its demise, the inspector general found. The inspector general also found that Bear was fully compliant with the programs’ requirements when it collapsed, which raised “serious questions about whether the capital requirement amounts were adequate,” the report said.

The report quoted Lee Pickard, a former SEC official who helped write the original debt-limit requirements in 1975 and now argues the 2004 program is largely to blame for the current Wall Street crisis.

“The SEC gave up the very protections that caused these firms to go under,” Pickard said in an interview with ProPublica. “The SEC in 2004 thought it gained something in oversight, but in turn it gave up too much public protection. You don’t bargain in a way that causes you to give up serious protections.”

Pickard, now a senior partner at a Washington, D.C.-based law firm, estimated that prior to the 2004 program most firms never exceeded an 8-to-1 debt-to-net capital ratio.

The previous program “had an excellent track record in preserving the securities markets’ financial integrity and protecting customer assets,” Pickard wrote [3] in American Banker this August. The new program required “substantial SEC resources for complex oversight, which apparently are not always available.”

Asked if he believes the 2004 program was a direct cause of the current crisis, Pickard told ProPublica, “I’m afraid I do.”

The New York Times reported Saturday that the SEC created the program after “heavy lobbying” for the plan from the investment banks. The banks favored the SEC as their regulator, the Times reported, because that let them avoid regulation of their fast-growing European operations by the European Union, which has been threatening to impose its own rules since 2002.

SEC Spokesman

A SEC spokesman declined to comment for this article, referring inquires to Chairman Cox’s statement. In the statement, Cox admitted the program “was fundamentally flawed from the beginning.” But Cox, a former Republican congressman from California, offered mild support for the program as recently as July when he testified before the House Committee on Financial Services. The program, among other oversight efforts, Cox said, had “gone far to adapt the existing regulatory structure to today’s exigencies.” He added that legislative improvements were necessary as well, and has since told Congress that the program failed.

More Questions

So why did the commission not end the program sooner? Some say that the program’s flaws only recently became apparent. “As late as 2005, the program seemed to make a lot of sense,” said Charles Morris, a former banker who predicted the current financial crisis in his book written last year, The Trillion Dollar Meltdown [4]. The SEC “didn’t know it didn’t work until we had this stress.”

And leverage does not always spell trouble. In a strong economy, leverage can also be attractive because it can increase the profitability of banks through lending.

In his recent statement, Cox said the inspector general’s findings reflect a deeper problem: “the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.”

Secretary of the Treasury Henry Paulson has called for a refining of the regulatory structure to reflect the global and interconnected nature of today’s financial system. In any case, the program’s failure can be seen in the disappearance of the participating banks: Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs.

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Assessment

Merrill Lynch’s leverage ratio was possibly as high as 40-to-1 this year and Lehman Brothers faced a ratio of about 30-to-1, according to Bloomberg [5].

The Fed and Treasury Department forced Bear Stearns into a merger with JPMorgan Chase in March. And the last two months, Lehman Brothers went bankrupt and sold their core U.S. business to British bank Barclays PLC, and Merrill Lynch was acquired by Bank of America. Morgan Stanley and Goldman Sachs, the two remaining large independent investment banks, changed their corporate structures to become bank holding companies, which are regulated by the Federal Reserve.

As these banks have folded or reorganized over the last several months, the Federal Reserve has largely assumed the SEC’s oversight responsibilities, though the commission will still have the power to regulate broker dealers.

Original Essay: http://www.propublica.org/article/flawed-sec-program-failed-to-rein-in-investment-banks-101

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Does the FED REALLY Matter?

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Does the Fed REALLY matter?

eric

By Erik Kobayashi-Solomon

[intelligent option investor]

Does the Fed REALLY matter?

This is an update to research done in the fall of 2015.

Common wisdom holds that Federal Reserve interest rate policy changes have a large effect on equity returns. The Fed represents, many believe, the ultimate market traffic light.

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NY Fed Reserve Bank

[FEDERAL RESERVE BANK OF NEW YORK]

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And, everyone takes this mental model for granted, but is it really true?

Read more

Was the 2008 Financial Crisis Caused by the Big Banks?

Assessment

The conclusions should be compelling to all ME-P readers, physician-executives and intelligent investors!

Conclusion

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Ben Bernanke: Buy One Suit, Get Three Free

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Linear thinking is dangerous

vitaly[By Vitaliy Katsenelson, CFA]

Linear thinking is dangerous. It is the easiest form of reasoning, lying on the path of least resistance. The simpler the path, the more readily people will march along it. Linear arguments are easy to make, as they require the least amount of evidence — past data points with a straight line drawn through them.However, the larger the crowd that follows the wrong line of reasoning, the more people pile in, and the greater the consequences if they are proved wrong.

A lot of things in nature, and thus in investing, are not linear. A past trend may or may not persist into the future. Events don’t happen in a vacuum; they are observed, studied and capitalized on — which in the case of investing may preclude a company’s future from resembling its past. As I write this, I think of successful companies whose achievements attracted competition, which then marginalized them.

Some things are inherently nonlinear, their behavior reminiscent of a pendulum’s: The further they swing in one direction, the harder they’ll go in the opposite direction. It is very dangerous to default to linearity with such nonlinear phenomena, as the more confident we become in the swing (the more linearity we observe), the closer we are to the pendulum’s reversing course.

Price-earnings ratios often follow a pendulum behavior. If you look at high-quality dividend-paying stocks — the Coca-Colas and Procter & Gambles of the world — they are now changing hands at more than 20 times earnings. Their recent performance has driven linear thinkers to pile into them, expecting more of the same in the future. Don’t! These stocks were beneficiaries of a swing in the P/E pendulum as it went from low to average and then to above-average levels.

Pattern recognition is an important contributor to success in investing. Mark Twain once said that history doesn’t repeat itself, but it rhymes. If you can identify a rhyme (that is, see a pattern) relating to the current situation, then you can develop a framework to analyze and forecast it. But what if the current situation is very different — if it doesn’t rhyme with anything in the past? This is where the ability to draw parallels becomes helpful. It allows you to overlay rhymes (patterns) from other companies, industries or even fields. Building analogous frameworks is a cure for linear thinking; it helps us see nonlinearity and facilitates the creation of nonlinear mental models.

Then there is pseudolinearity: things that seem to be linear but are forced into linearity by extrinsic factors. This was a subtopic of my presentation at the Valuex Vail investing conference in June. I drew a parallel between two entities that suddenly looked analogous: Jos. A. Bank Clothiers, a Hampstead, Maryland–based retailer of men’s apparel, and the Federal Reserve.

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Jos. A. Bank

Jos. A. Bank has always been a very promotional retailer. It would jack up prices, then run sales for consumers happy to be deceived — a typical American retail tale. But sometime in 2008, Jos. A. Bank went promotional on steroids. You could not watch CNBC for an hour without seeing one of its ads. The company started out by encouraging you to buy one suit and get one free. Then you got two free suits. Finally, it started giving away Android phones with suit purchases. For a while this past March, Jos. A. Bank offered consumers the opportunity to buy one suit and get three free.

There are several problems with the strategy: It does not emphasize the quality of the suits or the company’s great service, and the ads aren’t helping to build a brand but are intended just to pimp sales at Jos. A. Bank, as if it were a grocery store with USDA choice beef on sale.

This brings us to the latest quarter. Jos. A. Bank’s same-store sales dropped 8 percent, but what really piqued my interest was this explanation by its CEO, R. Neal Black, during its earnings call in June: “Since 2008, at the beginning of the financial crisis and the recession, the overall sales picture has been one of volatility, and strong promotional activity has been consistently and effectively driving our sales increases. This strategy was designed with 18 to 24 months of effectiveness in mind, and we stuck with it for more than 60 months since — as the economy remained weak. Now the strategy has become less effective.”

What Jos. A. Bank has really been doing since the financial crisis is running its own version of quantitative easing. The company had a temporary strategy that was supposed to get people into its stores during the recession — much like the Fed’s original QE, which was designed to provide liquidity in a time of crisis — but the recovery that ensued was not to Jos. A. Bank’s liking. So just as the Fed implemented QE2, and then QE3 when the economy did not improve to its satisfaction, the retailer followed with more QE.

It is understandable why Jos. A. Bank’s management did what it did. The company was being responsible to its employees — it didn’t want to close stores or have layoffs — and it had to report quarterly to shareholders. The focus shifted from building a long-term sustainable franchise to using short-term measures to grow earnings the next quarter and the quarter after that.

There are many lessons that one can draw from the parallels between Jos. A. Bank’s behavior and the Fed’s handling of our economy. First, it is very hard to challenge someone who has a linear argument. Let’s say that a year ago you talked to Jos. A. Bank’s management and raised the question of the sustainability of their advertising strategy. They’d have pointed to four years of success, and they’d have been right, at least up to that moment. They would have had four years of data points and a bulletproof linear argument, and you would have had your common sense and little else.

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suit-869380__180

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Ben Bernanke

Right now Ben Bernanke looks like a genius. He can show you all the data points in the recovery, but so could Jos. A. Bank, and this leads us to a second lesson: Pain is postponable, but it is cumulative. During Jos. A. Bank’s quarterly call, its CEO also said: “The decline in traffic is because existing customers are returning slightly less frequently. . . . It makes sense when you consider the saturating effect of our intense promotional activity over the past several years.”

With every sale Jos. A. Bank stole its future purchases, because when you buy one suit and get three for free, you may not need to buy another one for a while.But there is also a snowball effect that you cannot ignore: Every ad chipped away at the company’s brand. Now when you show someone that you wear a Jos. A. Bank suit, they don’t think about its quality, just that you have two or three more suits in your closet.

There is a cost to our recovery — a bloated Federal Reserve balance sheet and our addiction to low interest rates. Of course, we spread that addiction globally.

According to Hugh Hendry, founding partner and CIO of London-based hedge fund firm Eclectica Asset Management, rising U.S. bond yields have driven global yields higher. “In Brazil for instance, the biggest emerging debt market, no company has been able to raise debt abroad since mid-May as borrowing costs soared to a four-year high in June, at 7.1 percent,” he wrote in a recent investment letter.

The Fed is betting on George Soros’ theory of reflexivity, in which people’s biases and actions can change the economy: Instead of the wagon being towed by the horse, the wagon, in expectation that it will be towed by the horse, starts moving on its own, thereby motivating the horse to start towing the wagon.Lower interest rates drive people to riskier assets, and as asset values go up, people feel confident and spend money, and the economy grows. But this policy puts us on very shaky ground, because reflexivity cuts both ways: If asset prices start to decline, confidence declines — and so will the economy. Now there are a lot more savers owning riskier assets than they otherwise would have, and their wealth is at risk of getting wiped out.

The third lesson from the parallels between the Fed and Jos. A. Bank: We are in the midst of a game of musical chairs, and when the music stops, no one wants to be left standing around holding risky assets. Everyone is focused on the Fed’s tapering, and they are right to do so. Just as we saw with Jos. A. Bank, economic promotions cannot go on forever. With every sale the company had to increase the ante, giving away more and more to get people to come into its stores. The Fed may continue to buy Treasuries and mortgage securities, but the purchases will be less and less effective. And the music may stop on its own, without the Fed doing anything about it.

Last, pseudolinearity eventually leads to high uncertainty and thus lower valuations. Put yourself in the shoes of an investor analyzing Jos. A. Bank today. Before buying the stock, you’d have to answer the following questions: What is the company’s earnings power? How much did its promotional strategy damage the brand? And how much in future sales did that strategy steal?

Assessment

In the wake of Jos. A. Bank’s own five-year, nonstop version of QE, it is difficult to answer these questions with confidence. The company’s earnings power is uncertain, and investors will be willing to pay less for a dollar of uncertain earnings, thus resulting in a lower P/E. At some point, when U.S. economic activity weakens, investors will have to answer similar questions about the U.S. and global economies. And as they look for answers, they’ll be putting a lower P/E on U.S. stocks.

ABOUT

Vitaliy N. Katsenelson CFA is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of Active Value Investing (Wiley 2007) and The Little Book of Sideways Markets (Wiley, 2010).  His books were translated into eight languages.  Forbes Magazine called him “The new Benjamin Graham”.  

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Eye on the Economy

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The Federal Reserve Resists Change

[By staff reporters]

DJIA: 16,330.47  -179.72  -1.09%

What to watch

The Federal Reserve [FOMC] announced last week that it will leave the federal funds rate unchanged. Unease concerning the domestic implications of international weakness, particularly with regard to inflation, contributed to the Fed’s decision to delay changing its policy right now.

Why it’s important

The Fed’s decision to stay put indicates that policymakers are not as “reasonably confident” that inflation is heading towards their target of 2% as they’d like to be.

For example, Core Inflation [CI], one key economic measure the Fed is watching, is heading into a third year of running below the Fed’s long-run 2% target rate. While the labor market portion of the Fed’s dual mandate appears in good shape, in part indicated by an unemployment rate within their estimate of full employment, policymakers decided to postpone a decision to raise their policy rate for the first time in nearly a decade, citing concerns around the impact that global economic and financial developments could have on domestic conditions.

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Assessment

According to the Vanguard Group, despite the attention given to the timing of when the Fed starts raising rate, some believe the more important questions are how quickly rates will go up and where they stop. Whether liftoff happens in the coming months or even next year, we expect the Fed to make more measured, staggered rate increases than in previous tightening cycles, especially given the fragility in global economic growth.

This “dovish tightening” will gradually normalize policy in a global environment not yet ready for a positive real fed funds rate.

Conclusion

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The Modern US Monetary System

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On Modern Monetary Realism

By Rick Kahler MS CFP® ChFC CCIM www.KahlerFinancial.com

In a previous ME-P column I explained why any currency-issuing country, like the US, will never default on its obligations or run out of money with which to purchase goods and services priced in its own currency. Sovereign nations that are currency issuers have no solvency constraints, unlike currency users such as individuals, corporations, and government entities that don’t issue currency.

Why the Government is Not-Like Medical Professionals

On Modern Monetary Realism

To follow up, let’s look at what has become known as Modern Monetary Realism (MMR).  Economist Cullen O. Roche describes it in a 2011 article on his Pragmatic Capitalism website titled “Understanding the Monetary System.”

This theory came into existence in 1971 when President Nixon eliminated the gold standard and allowed the government to print money at will. This was a paradigm shift in our monetary policy that’s gone largely unnoticed for decades by many educators, economists, and politicians.

Guiding MMR Principles

The principles of MMR are:

  • The Federal Reserve works in partnership with the US Treasury to issue currency. All other units of government, private entities, and individuals are users of the currency.
  • The government creates money by minting coins, printing cash, and issuing reserves. The private banking sector creates money by creating loans and bank deposits.
  • The Federal Government cannot “go broke.” It is inaccurate to compare it to households, companies, and local governments, which all are users of money and can go bankrupt.
  • The major constraint on currency issuers (sovereign governments like the US) is inflation. It behooves governments to manage the money supply prudently in order to avoid impoverishing their citizens through devaluing the currency.
  • Floating exchange rates between countries are a necessity to help maintain equilibrium and flexibility in the global economy. Nations that unduly inflate their currency suffer the consequences of devalued currency, shrinking purchasing power, and contracting lifestyles.
  • The debt of a sovereign currency issuer is default-free. The issuer can always meet debt obligations in the currency which it issues.

Cullen O. Roche Speaks

Roche suggests that a functional government supports the country’s financial system in four ways:

  1. The US government was created by the people, for the people. “It exists to further the prosperity of the private sector—not to benefit at its expense.” Roche argues that when government becomes corrupt by obtaining too much power or issuing too much currency that results in high inflation, it then becomes susceptible to a revolt and dissolution.
  2. Government’s role is to be actively involved in regulating and helping to build an infrastructure within which the private sector can generate economic growth. Roche views regulation as not only beneficial, but necessary to temper the inevitable irrationality that can disrupt markets. Still, he emphasizes that it is the private sector, not the public sector, which drives innovation, productivity, and economic growth.
  3. Money, while a creation of law, must be accepted by the private sector while prudently regulated by the federal government, keeping in mind that the purpose of the regulation is to maximize private sector prosperity.
  4. “Because the Federal government is not a business or a household it should not manage its balance sheet for its own benefit,” notes Roche, “but in a way that most benefits the private sector and encourages private sector prosperity, productivity, innovation and growth.”

Assessment

Like me, you may need to re-read this a couple of times to begin to grasp the concepts. Once you throw off the outdated pre-1971 model of the monetary system, understanding the basics of MMR isn’t difficult. Knowing the basics of how our monetary system works will help physicians, and all of us, frame the important issues in the turmoil unfolding in Europe and in our own upcoming elections. 

Conclusion

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Physician’s Update on Dividend-Paying Stocks

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But Some Doctors Ask – Why All the Hype?

By David K. Luke MIM CMPcandidate [www.CertifiedMedicalPlanner.com]

www.NetWorthAdvice.com

In an effort to help the US economy recover, the Federal Reserve has lowered interest rates to historically low levels. Furthermore, the Fed has announced its intent to keep interest rates low until 2014. Classic income-producing investments such as savings accounts and certificates of deposit pay next to nothing.

Borrowing Good – Saving Bad!

Borrowers are being rewarded, but savers are being punished. Low interest rates may have spurred the economy somewhat, but they have been devastating for retired people who have a low tolerance for risk. Physicians, other investors and their advisors are turning toward alternatives that pay higher returns, but these vehicles necessarily carry more risk. Among these alternatives, some investors are considering the purchase of stocks that pay reliable dividends.

Assessment

But, is this an appropriate strategy for mature doctors and similar retirees? What are the potential benefits and drawbacks?

Conclusion

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Fed Chair Bernanke Defends Bond Purchases

Before House Budget Committee

By Children’s Home Society of Florida Foundation

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Federal Reserve Chair Ben Bernanke appeared on February 9 before the House Budget Committee. He defended the plan by the Federal Reserve to purchase another $600 billion of government bonds. This would bring the total holdings of the Federal Reserve to approximately $2.6 trillion. Previously, the Federal Reserve lowered interest rates close to zero and purchased $1 trillion of bonds to support the financial markets.

Rationale

Chairman Bernanke pointed to four factors that in his view justified the additional bond purchases.

First, the unemployment level continues to be approximately 9%.

Second, he expects unemployment to remain high and inflation to remain low “for some time.”

Third, it is likely the federal funds rate will remain quite low as long as there is high unemployment and low inflation.

Fourth, the initial purchase of $1 trillion of bonds and the proposed additional $600 billion bond purchase are both appropriate and manageable. He suggests that there will be opportunity “to tighten monetary policy when needed.” The Federal Reserve has sufficient capability to sell the bonds and reduce its holdings as needed.

Fiscal Policy

Chairman Bernanke also addressed fiscal policy. He noted that it is important “to put the budget on a sustainable trajectory.” Chairman Bernanke spoke approvingly of the plans advocated by the National Commission on Fiscal Responsibility and Reform. He suggested that there is now a “much-needed conversation” on the deficit.

Paul Ryan

House Budget Chair Paul Ryan (R-WI) agreed that it is important to address the deficit. He observed that the projected $1.5 trillion deficit this year would increase the publicly-held debt. That public debt was 40% of the economy in 2008 and will rise to 69% of the economy by the end of the year.

Chairman Ryan stated, “Endless borrowing is not a strategy. We must restore the foundations of economic growth – low taxes, spending restraint, reasonable regulations and sound money – to help restart the engines of economic growth and job creation.”

Chris Van Hollen

The Ranking Member of the House Budget Committee is Rep. Chris Van Hollen (D-MD). He indicated to Chairman Bernanke, “I commend you and your colleagues at the Fed for using various forms of monetary policy to promote maximum employment and stable prices.” However, Rep. Van Hollen also agreed that it is important to create “a responsible plan to bring down and then eliminate the primary budget deficit.”

Conclusion

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Chairman Bernanke Advocates Tax Reform

Reform Coming in 2011?

By The Children’s Home Society of Florida Foundation

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Chairman of the Federal Reserve [the FED], Ben Bernanke met January 7th 2011 with the Senate Budget Committee. He spoke on the topic of tax reform during 2011. According to sources, Mr. Bernanke noted, “Greater clarity and certainty is obviously beneficial, and to the extent you can create more certainty about where the tax code is going to be over the next couple years, that would be helpful.”

Budget Committee Seems to Agree

Chairman Bernanke and the Senate members of the Budget Committee all noted that with the current weak economy and high level of unemployment, it is a very key year for potentially reforming the tax code. Sen. Ron Wyden (D-OR) joined with Sen. Judd Gregg (R-NH) to introduce the bipartisan Tax Fairness and Simplification Act of 2010. Sen. Wyden noted, “The big idea for economic growth in our country is fundamental tax reform, where you go in there and clean out this job-killing, thoroughly discredited mess.” Senate Budget Chair Kent Conrad (D-ND) agreed that the tax code “is just completely out of date.” He responded, “It does not take account of the world that we live in today.”

Assessment

In the House, the new Chairman of the Ways and Means Committee, Dave Camp (R-MI), also showed interest in tax reform during 2011. He suggested that it will be necessary to “streamline the tax code that today is too costly, too complex and too burdensome for families and employers.”

Editor’s Note: Both House and Senate Finance Leaders will be holding hearings this year on tax reform. Because 2011 is not an election year, it is a potentially good year for major tax reform. As was evident from the tax bill that was signed in December 2010, tax reform will require compromise between the Senate, the House and the White House. However, with the unemployment rate currently at 9.4%, there is now a growing consensus on the need for continued improvements in the tax system in order to reduce unemployment.

Conclusion

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On Stock Market [Mis]Timing Strategies

Do They Come Up Short?

Dr. David Edward Marcinko MBA CMP™

www.CertifiedMedicalPlanner.com

[Publisher-in-Chief]

Stock market investment rules are notorious for showing profit when tested on the same sample period from which they were developed, and then failing when applied to a new period. According to Professor Roger C. Vergin, it’s dangerous to use the same data to both discover and test the rules.

Of Marty Zweig

Using the “Zweig Strategies” developed by Martin Zweig and published back in 1986 in Winning on Wall Street (WOWS), Professor Vergin shoots some rather sizable holes in Zweig’s indicators by testing them against the 10-year period since WOWS was published. Zweig’s models are applied to various periods from 19 to 33 years, ending in 1985, and they claim to outperform a buy-and-hold strategy with annual rates of return as much as eight times as large, according to some measures. When the author ran these strategies for the 10-year period ending Dec. 5, 1995, not only did they not outperform a buy-and-hold strategy, but they trailed the market averages by a significant amount—9% vs. 14.4% for buy-and-hold.

The “Z” Indicators

Zweig’s indicators include a prime rate indicator, a Federal Reserve indicator, an installment debt indicator, a 4% indicator (market momentum), a monetary model, and a “super” model, which Zweig referred to as “the only investment model you will ever need.” 

Vergin corrects for inconsistencies in the evaluation criteria from one strategy to the next in WOWS and runs the numbers for the original test period first. Zweig’s strategies still outperform buy-and-hold. But, when run against an independent time period, as the author has done, the wheels fall off. Vergin runs the Zweig Strategies against the S&P 500, the Value Line Index, and an index developed by Zweig called ZUPI (all NYSE stocks).

Assessment

Over the 10-year period, none of the six Zweig Strategies outperformed a simple buy-and-hold strategy when compared against any of the three indexes mentioned above. They produced an average return of 9% compared to 14.4% for buy-and-hold.

In fact, Dr. Burton Malkiel’s [personal communication] conclusion in his book A Random Walk Down Wall Street, was that: “market timing is likely, not only to not add value, but to be counterproductive” seems to have borne out again.”

Note: “Market-Timing Strategies: Can You Get Rich?” by Roger C. Vergin. The Journal of Investing, Winter 1996, pp. 79–85, Institutional Investor, Inc. [212] 224-3185)

Conclusion

And so, your thoughts and comments on this ME-P are appreciated. By trying enough patterns against past events, one can always find simple rules that “would have” worked well in the past. But, do they hold up against differing periods of time; like say 2008-09? … At least not yet! What do you think?

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Behind the Financial Reform Push

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Of Worries on Warring Regulators

By Jeff Gerth, ProPublica – April 14, 2010 12:07 pm EDT

Backers of financial regulatory reform are gearing up for the final stretch in a yearlong effort to construct a new, streamlined architecture. But, recent reports and testimony about the financial crisis suggest a crucial ingredient in any new structure is in short supply: cooperation among the watchdogs.

Office of Thrift Supervision

A proposal to eliminate one regulator seen by many as particularly weak—the Office of Thrift Supervision—could alleviate some friction. A soon-to-be-released federal examination of the Washington Mutual collapse found that OTS resisted efforts by a more skeptical regulator, the Federal Deposit Insurance Corporation, to take a closer look at WaMu, according to an account in The New York Times [1].

Reform legislation pending in the Senate [2] (PDF) would also create new agencies, including a financial stability council to assess risk and a consumer protection watchdog. To work as envisioned, the agencies would need new levels of information sharing and decision making. By contrast, history suggests agencies can be stingy with what they know and eager to point blame at sister regulators.

Fall of the House of Lehman

Lehman Brothers, the investment bank that collapsed in September 2008, presents a case in point.

A lengthy examiner’s report [3] for the judge overseeing Lehman’s bankruptcy found that the Federal Reserve Board and the Securities and Exchange Commission kept crucial data from each other even though they had “overlapping” functions. The heads of the Federal Reserve and the SEC reached a formal sharing agreement in July 2008, but the two regulators “did not share all material information that each collected about Lehman’s liquidity.”

SEC Queries

The SEC, asked by the Federal Reserve Bank of New York to provide data on Lehman’s commercial real estate exposure and liquidity, “affirmatively declined to share” the information because it was still in draft form, the bankruptcy report found. The reserve bank never turned down an information request from the SEC, but bank officials “did not perceive any duty to volunteer” information about a $7 billion shortfall in Lehman’s liquidity they uncovered in August 2008.

The reason? The report says it was “because the SEC did not always share information” with them. One official at the Federal Reserve Bank of New York told the examiner “there was not a warm audience” for information sharing between the New York Fed and the SEC.

Lehman fell under the scrutiny of the Fed after it was allowed to tap Fed lending facilities, normally reserved for banks, in the spring of 2008.

Oh … the Irony

Ironically, examiners at the Office of Thrift Supervision, which regulated Lehman’s bank subsidiary, concluded in July 2008 that Lehman had violated its own risk limits by placing an “outsized bet” on commercial real estate. But, the OTS appears as a bit player in the autopsy of Lehman’s collapse; top Federal Reserve officials “considered the SEC to be Lehman’s regulator,” the bankruptcy report found.

One of those officials, Timothy Geithner, was president of the Federal Reserve Bank of New York from 2003 until early 2009, when he became secretary of the Treasury. Shortly after he joined the cabinet, Geithner was asked by a senator about the Fed’s supervisory responsibility [4] in connection with the collapse of institutions like Lehman and the insurance giant AIG.

“I just want to point out,” Geithner told the Senate Finance Committee, “the Federal Reserve was not given responsibility for overseeing investment banks, insurance companies, hedge funds, non-bank financial systems that were a critical part of making this crisis so intense.”

networking_0

Fed Responsibilities

The Fed is responsible for supervising bank holding companies, such as Citigroup. Those holding companies include investment banks and, as a sister regulator quietly pointed out last week, the Fed shared responsibility with the SEC for overseeing the risky practices of Citigroup’s broker dealer.

John C. Dugan, who oversees nationally chartered banks as comptroller of the currency, told the Financial Crisis Inquiry Commission [5] (PDF) last week that most of the problems that led to a massive bailout for Citigroup took place under the umbrella of the weaker holding company regulated by the Fed—not at Citibank, the banking subsidiary under Dugan’s authority.

Most of the losses, Dugan said at the end of a lengthy report to the commission, were in subprime lending, leveraged loans and the structuring and warehousing of CDOs (collateralized debt obligations) that are supervised, either all or in part, “by the Federal Reserve.”

Geithner has acknowledged [6] that he could have done a better job of supervising Citigroup during his tenure at the New York Fed.

Assessment

If the Senate bill becomes law, Geithner would sit atop the new financial stability council, whose members will include representatives of several different agencies—including the Fed, the SEC and the Office of the Comptroller of the Currency.

Conclusion

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How One Hedge Fund Helped Keep the Bubble Going

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On the Magnetar Trade

By Jesse Eisinger and Jake Bernstein, ProPublica – April 9, 2010 1:00 pm EDT

In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates. Subprime mortgage company shares were falling. Investors began to balk at buying complex mortgage securities. The housing bubble, which had propelled a historic growth in home prices, seemed poised to deflate. And if it had, the great financial crisis of 2008, which produced the Great Recession of 2008-09, might have come sooner and been less severe.

Precise Timing

At just that moment, a few savvy financial engineers at a suburban Chicago hedge fund [1] helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages.

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When the crash came, nearly all of these securities became worthless, a loss of an estimated $40 billion paid by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers.

Yet the hedge fund, named Magnetar for the super-magnetic field created by the last moments of a dying star, earned outsized returns in the year the financial crisis began.

The Magnetar Trade

How Magnetar pulled this off is one of the untold stories of the meltdown. Only a small group of Wall Street insiders was privy to what became known as the Magnetar Trade [2]. Nearly all of those approached by ProPublica declined to talk on the record, fearing their careers would be hurt if they spoke publicly. But interviews with participants, e-mails [3], thousands of pages of documents and details about the securities that until now have not been publicly disclosed shed light on an arcane, secretive corner of Wall Street.

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations — CDOs. If housing prices kept rising, this would provide a solid return for many years. But that’s not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Chance Enhancement

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.

Magnetar says it was “market neutral,” meaning it would make money whether housing rose or fell. (Read their full statement. [4]) Dozens of Wall Street professionals, including many who had direct dealings with Magnetar, are skeptical of that assertion. They understood the Magnetar Trade as a bet against the subprime mortgage securities market. Why else, they ask, would a hedge fund sponsor tens of billions of dollars of new CDOs at a time of rising uncertainty about housing?

Key details of the Magnetar Trade remain shrouded in secrecy and the fund declined to respond to most of our questions. Magnetar invested in 30 CDOs from the spring of 2006 to the summer of 2007, though it declined to name them. ProPublica has identified 26 [5].

Independent Analysis

An independent analysis [6] commissioned by ProPublica shows that these deals defaulted faster and at a higher rate compared to other similar CDOs. According to the analysis, 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs. The study [6] was conducted by PF2 Securities Evaluations, a CDO valuation firm. (Magnetar says defaults don’t necessarily indicate the quality of the underlying CDO assets.)

From what we’ve learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn’t cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.

Major Players

Magnetar worked with major banks, including Merrill Lynch, Citigroup, and UBS. At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses [5], the banks didn’t disclose to CDO investors the role Magnetar played.

Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.

Assessment

Of course, some bankers involved in the Magnetar Trade now regret what they did. We showed one of the many people fired as a result of the CDO collapse a list of unusually risky mortgage bonds included in a Magnetar deal he had worked on. The deal was a disaster. He shook his head at being reminded of the details and said: “After looking at this, I deserved to lose my job.”

Magnetar wasn’t the only market player to come up with clever ways to bet against housing. Many articles and books, including a bestseller by Michael Lewis [7], have recounted how a few investors saw trouble coming and bet big. Such short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding.

Magnetar’s approach had the opposite effect — by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

Conclusion

Several journalists have alluded to the Magnetar Trade in recent years, but until now none has assembled a full narrative. Yves Smith, a prominent financial blogger who has reported on aspects of the Magnetar Trade, writes in her new book, “Econned,” [8] that “Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder.”

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Tim Geithner’s Letter Shows Opposition to Fixed Capital Requirements for Banks

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In Financial Reform Bill

By Marian Wang, ProPublica – April 2, 2010 2:10 pm EDT

Remember how earlier this week, in a post about financial reform and liquidity requirements [1], we noted how vague [2] Treasury Secretary Tim Geithner was being with The New York Times about setting hard and fast rules about how much cash should be required to hold?

Here’s what we excerpted from the Times on Tuesday: Mr. Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.

Bank

Pinning Down Geithner

But try pinning down Mr. Geithner, or anyone else in the Beltway, on how much capital banks should be required to keep, or even how the word “capital” should be defined, and certainties disappear.

Turns out he had a lot more to say on the subject than what he told the Times. Mike Konczal [3], blogging for Ezra Klein, unearthed a letter Geithner sent to a lawmaker in January, explaining his hesitancy—really, his opposition—to setting fixed capital requirements in current financial reform proposals. From the letter [4]:

Although the Administration strongly supports imposing a simple, non-risk-based leverage constraint on banks, bank holding companies, and other major financial firms, we do not believe that codifying a specific numerical leverage requirement in statute would be appropriate.

Assessment

So when Geithner said, “We have not made a judgment yet on the number,” what he really was thinking—if this letter is any indication—is that as far as financial reform legislation itself goes, he doesn’t want a number, period. And when it comes to actually imposing tighter capital requirements on financial institutions, he wants the Treasury, the Fed or some combination of regulators to have a free hand to pick and change the number. In other words, pretty close to the way things are now.

Conclusion

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Data Show Little-Known Bank Regulator Goes Easy on Enforcement

Office of the Comptroller of the Currency

By Marian Wang, ProPublica – March 29, 2010 12:51 pm EDT

The New York Times business section had a piece recently about a little-known bank regulator [1] called the Office of the Comptroller of the Currency. It points out that while the Federal Reserve has shouldered most of the criticism directed toward bank regulators, because of its relative obscurity, the OCC [2] has escaped much of the scrutiny.

[picapp align=”none” wrap=”false” link=”term=John+C.+Dugan&iid=5559429″ src=”b/6/1/5/House_committee_examines_a74a.JPG?adImageId=11861248&imageId=5559429″ width=”380″ height=”500″ /]

John C. Dugan

The Times piece focuses mostly on John C. Dugan, the former bank lobbyist who heads the agency. It highlights criticism that Dugan is too pro-bank, and goes back and forth between criticism and Dugan’s response. Mr. Dugan bristles at the notion that he is too easy on banks and says his agency’s record on consumer protection has been “vigorous and sustained.” He says it is a “cheap shot” to suggest that his lobbying years color his viewpoint and that it demeans his employees and his years of public service. In point-counterpoint situations, what’s often helpful is hard data [3]. The Times brings it into the story later on, with statistics on the OCC’s formal enforcement orders against banks.

Assessment

The OCC has both formal and informal enforcement orders against banks. The Times’ chart shows that the agency rarely takes formal enforcement action against banks, and even more rarely doles out actual penalties to the banks in the form of fines, restitutions or refunds to consumers. The agency defended its small number of enforcement actions, saying it works closely with banks [4] to fix problems while they’re small, so as not to require stronger measures.

Conclusion

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Medical Risk Management: http://www.jbpub.com/catalog/9780763733421

Healthcare Organizations: www.HealthcareFinancials.com

Health Administration Terms: www.HealthDictionarySeries.com

Physician Advisors: www.CertifiedMedicalPlanner.com

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