For Your Consideration

“What we anticipate seldom occurs; what we least expect generally happens.”- British prime minister and novelist Benjamin Disraeli.

Risk managers understand that there is a price (or cost) to uncertainty. For example: money spent on a loss which did not occur was still spent. But you don’t have to be a “risk manager” to understand this, we know this from our own daily experience. Almost any variety of insurance expense incurred that went “unused” such as life insurance (because you didn’t die yet) or auto insurance (for a loss which did not occur during the policy period) was still spent. It is gone, ostensibly to pay for someone else’s loss (plus a portion for the insurer’s operating profit). This doesn’t nullify the need for the coverage, it just means it wasn’t “your turn” at the insurer’s trough.

Similarly, anticipated (projected) future losses may be worse than projected. They can be better (meaning “lower”) than expected but this seldom occurs in the wild. This usually occurs when a loss that happens today is not paid out by an insurer for years, which usually occurs with liability exposures. For example, take a situation where someone is injured severely in a car accident you caused and litigation ensues. The litigation process alone can take years to resolve. In the meantime, the prudent insurer has to put aside the money that it expects to pay for the loss, or hold it “in reserve” until the claim is resolved and the loss is ultimately paid.

As you can imagine, the process of reserving losses is just as much art as science. Most of my actuary friends (very, very smart numbers people) agree as these are the folks who are brought in to review these future losses regularly and to make sure the entity has the money to pay for the loss at that future date.

One of the factors used in their quantitative loss analyses is called an “uncertainty factor“. Think of it as (to paragraphrase ex-Defense Secretary Donald Rumsfeld), the “unknown unknown“. Most people know this term from their daily lives as the “fudge factor”, used when a variety of outcomes could ensue from a single event. Because all types of activity entails a certain level of risk, (including getting out of bed this morning to go to work), we can deduce that all activity contains an element of uncertainty.

I strive to keep political discourse here to a dull roar, except where it directly intersects the discussion and application of risk management techniques. For the past two days, the pundits are wondering why our financial markets have dropped about 10% since the results of the election. It’s uncertainty in action, folks. No one knows how President-Elect Obama will govern and perhaps a sense of buyer’s remorse is in play.

Added to this, is the stark realization that the $850B bailout isn’t necessarily going to help in the near term and that the federal government (that’s us guys!) may soon be in the business of bailing out individual state governments, instead of forcing them to live within their means. Of course, these events will only continue to destabilize and debase our currency because all we have left to do is print more money to “pay” for these bailouts, since no foreign government seems to be interested in buying our debt today.

We also don’t know the rules of the bailout lottery, as in why do some companies get bailed out (AIG, Bear Stearns) and some don’t (Lehmann Brothers)?  We had a perfectly good remedy for companies that could no longer operate, it was called bankruptcy. It was messy, it took time, but it worked and we as a society understood it. Now we’re in unknown waters as no one can explain to us how the rules of the bailout lottery work. This apprehension breeds more uncertainty.

And as uncertainty grows, our economy, financial markets and society weaken.

Back in 2002, I was spending my time full-time educating myself as to the academic underpinnings of markets. I was uncomfortable investing with alleged financial experts without having a basic understanding of the language of and the basis for their investment ideas and techniques.

One of the very first things I learned was that according to academic research, over 95% of all investment returns was determined by your asset allocation. It should not surprise that a portfolio of 80% stocks and 20% bonds has a greater *EXPECTED* return over time than a portfolio constructed of 60% stocks and 40% bonds, yet this simple illustration eludes many.

Of course, because the 80/20 portfolio has higher EXPECTED returns, (by most commonly used risk measures) it is also more “risky” than the 60/40 portfolio.  One can slice and dice these portfolios (US vs. International Stock, Large vs. Small Stock, Growth vs. Value Oriented), but that is not the subject for today.

What I wanted to share was some insight and assistance in choosing an equity percentage from some of the finest academic-oriented financial authors, both of which I have listed in the Reading Room.

Authors William Bernstein (WB) and Larry Swedroe (LS) have published some guidelines relating to this issue. Both agree on two major points:

1. Determine your maximum tolerable percentage loss from the following tables,
2. Use the LESSER of the amounts shown to determine your maximum equity exposure.

Maximum      Maximum
Tolerable      Equity
Loss             Exposure
———- ……  ———-
5% …………….. 20%
10% …………… 30%
15% …………… 40%
20% …………… 50%
25% …………… 60%
30% …………… 70%
35% …………… 80%

This first table deals with a “stomach acid test“. If your heart starts palpitating at a 10% stock market loss, according to the first table, your maximum equity exposure should be no more than 30%. However, the “stomach acid test” is only the first gauge- we need to think in terms of time.

Accordingly, a person needs to consider the time horizon as to when funds placed in the stock market need to be “repatriated back” for use as originally intended. Both authors have a slightly different take on this issue as shown in the following table:

.                     Max Equity
Investment     Allocation
Horizon           WB … LS
———- ………. —– … ——
1 year ………. 10% .. 0%
2 years ……… 20% .. 0%
3 years ……… 30% .. 0%
4 years ……… 40% . 10%
5 years ……… 50% . 20%
6 years ……… 60% . 30%
7 years ……… 70% . 40%

So, if you need the money that you’ve invested in the stock market in four years, William Bernstein recommends no more 40% allocated to the stock market. Larry Swedroe is much more conservative, advising no more than a 10% stock allocation.

My personal belief is that Swedroe is right, as four years is simply not enough time for the stock market to recover ground in the event of a severe downturn. You may need to sell at a most inopportune time (like today), negating the market’s historical long-term benefits. Of course, you would lose the opportunity for gain if the market trends higher over that hypothetical four year period.

So when you hear/read about those people “soon to retire” who now have to postpone retirement due to the state of the U.S. stock market today, ask yourself: Were these people getting the “right” advice on asset allocation?

It appears they were not.

Regulatory risk is usually considered as a change in laws and/or regulations that will materially (negatively) impact a business or a business operation. In some cases, it can also refer to noncompliance with governmental regulations, such as in environmental liability exposures. But today let’s consider the soon to be announced $700B “Wall Street” bailout in terms of regulatory risk.

Many view the economic circumstances we are suffering through today as the natural culmination of events which started in 1977 with the passing of the federal law entitled “Community Reinvestment Act” and will end in the crescendo of debt our grandchildren will not have finished paying off.

The CRA was drafted as a high-minded and well-intentioned regulation intended to encourage banks to “help meet the credit needs” of the communities in which they operated and were to include low and moderate-income neighborhoods.

The CRA worked as intended for the most part until 1995, when the Clinton administration enacted certain updates to the Act which, in part, included a provision allowing the securitization of sub-prime mortgages (which were then “guaranteed” by Fannie Mae and Freddie Mac). These revisions further required the banks to offer “equal access” to lending and essentially forced the banks to make loans they, in all probability, would not have made absent these new requirements.

*As a minor historical footnote, it is ironic to note that in 1997 Bear Stearns became the first company to securitize the subprime mortgages and sell them to other financial institutions. As you probably recall, they were the first domino to fall.

So viewed through this historical lens, our economy is now bearing the cost of regulatory risk.

I found (an admittedly politically charged) video to help with following the “bouncing ball” if you have 10 minutes to spare. After about 4:00 minutes, the video digresses into more politics than explanation…

What began as a well-intentioned government mandate has unhinged our economy in ways we have just begun to experience. And as we stand on the precipice of another government mandated “solution”, I am justifiably concerned that while well-intentioned, this new legislation will contain some new regulatory risk that will rear its ugly head in the future.

Good day, boys and girls!

While the stock market is trying to figure out what it wants to be when it grows up and the media is hyping the panic game as shown in the graphic below, it might be helpful to close your eyes, take a step back, a deep breath and relax. (Double-click on it twice for a better view)

Many people have asked me how I have my personal investment portfolio constructed. I usually defer the answer, explaining that each portfolio must be put together on an individual basis and what is right for my circumstances and risk tolerance will most assuredly not be correct for theirs. As you can imagine, that answer, while true and correct, is not that helpful.

I recently came across a posting at Vanguard Diehards Investment Forum in which financial author and advisor Rick Ferri introduces a sample portfolio called the “Core Four”, which I think is probably the best starting point for new and seasoned investors alike. It is especially helpful for seasoned investors who might’ve lost their way and have a mish-mosh of inappropriate investments hodge-podged together that they have acquired though the years.

The “Core Four” outlines a 60% stock / 40% bond strategy and, as financial author Taylor Larimore has noted, has the following characteristics:

• It is globally diversified;
• It is very low cost;
• It is very tax friendly (tax efficient); and
• It is very easy to understand.

For those of you interested in percentages the “Core Four” strategy outlines the following:

• 35% of the total invested assets in the U.S. stock market (not individual stocks);
• 15% of the total invested assets in world stock markets (excluding the U.S.);
• 10% of the total invested assets in U.S. commercial real estate trusts (not sub-prime); and
• 40% of the total invested assets in the U.S. bond market (typically investment grade or “better”).

While my personal portfolio differs in some areas (for example, I take on more small equity and value risks than what’s present in the “Core Four” because I understand the risks I am taking), this is a superb launching point. You would be well-served to take the time and read the four pages of posts contained in the link above.

So, before you spend another night up worrying about your financial future, take some time to educate yourself. If you have any specific questions about the “Core Four” strategy, let me know and I’ll try my best to answer them.

Recalling a prior post (which recalled the “Death of Equities” from a prior era) is instructive if you can keep your wits about you. While pop psychologists and new agers repeat the oft seen “Danger + Opportunity = Crisis” it isn’t quite so. Risk is real. Market risk is real. And what we are seeing in the markets these last few days is the repricing of that risk.

“These are the times that try men’s souls” a phrase written over 200 years ago by a founding father, Thomas Paine, who knew a thing or two about risk. In his December 23, 1776 discussion of the our recent declaration of independence from Britain, he wrote about panics:

“Yet panics, in some cases, have their uses; they produce as much good as hurt. Their duration is always short; the mind soon grows through them, and acquires a firmer habit than before. But their peculiar advantage is, that they are the touchstones of sincerity and hypocrisy, and bring things and men to light, which might otherwise have lain forever undiscovered.”

Yes, our world is changing below our feet, but that doesn’t mean the end result is ruin. The market is gripped in panic, but it appears our final capitulation bewitching hour is nigh. I suspect this because the media has finally called the bottom with this gripping headline: ‘The World As We Know It Is Going Under‘.

Which to my eyes looks like this headline from AUGUST, 1979:

OK, as of today, the Fed has said to Lehman, “NO SOUP FOR YOU!“, and they are now at the mercy of a bankruptcy court. Merrill Lynch ceases to exist as an independent investment bank and will be swallowed up by Bank of America.

Now, we are witnessing the potential of the bankruptcy of AIG, American International Group. This potential collapse is so breathtakingly overwhelming it is difficult to find the words to express its impact.

As of the moment of this writing, the Fed is trying to help orchestrate a $100 BILLION DOLLAR “bridge” loan package to give AIG time to sell assets to stave off bankruptcy and it is EXACTLY this moment that we come to understand the magnitude and utter failure of AIG management who should not have allowed things to escalate to this point. I think in the future there will be entire business management classes and curricula devoted to the study of events surrounding this epic failure.

But the talking heads are missing the point. It doesn’t matter if/how financing for AIG gets arranged today or tomorrow, the damage is done. Credit analysts in the bond markets have marked AIG’s bonds to junk status and the rating agencies have put AIG on “credit watch negative”, which is a precursor to severe ratings downgrades. In essence, perception is reality and many smart people do not expect AIG to survive as it exists today.

But the biggest problem doesn’t rear its ugly head until January 1, 2009 when AIG’s reinsurance treaties expire. Reinsurance is essentially insurance for insurance companies. If the company cannot negotiate renewal of its reinsurance treaties, it  cannot survive as an insurer and will be forced to terminate all in-force policies, citing loss of reinsurance. This is the insurmountable issue as I see it today.  The question of the day is: What reinsurance companies will be willing to “belly up to the bar” for AIG?

Prudence dictates that individuals AND businesses review their exposure to AIG. This is not just an academic exercise. I would urge a review of insurance policies in force as soon as practicable. For individuals that may mean annuities provided by American General, life insurance policies and/or auto policies with 21st Century or AIGDirect. These matters and questions should be reviewed and discussed with your agent. For corporate risk managers or financial controllers: I would direct your insurance broker(s) to provide an assessment of exposure and immediately begin the remarketing of coverage in the event the unthinkable occurs.

That being said, there probably is only ONE person alive who has the gravitas with regulators, capital markets, and reinsurers to “right” the AIG ship: the deposed ex-Chairman of AIG, Maurice “Hank” Greenberg. I believe that only his direct stewardship will assuage these parties. Let’s see if the AIG board has the brass b@lls to bring him back.  Of course, that exposes another long term personnel risk management issue for AIG: life after Hank. But that is an issue for another day. Today is the day AIG needs its Chairman back.

These are truly momentous times. I, for one, will keep my eyes on January 1, 2009 and hope for best (but plan for the worst).

Quick Update as of 4:45PM EST: It appears that Mr. Greenberg has been rebuffed by AIG management (video in link). In this interview today, Mr. Greenberg (who was ousted from AIG over 3 years ago) was asked what “went wrong” and from his perspective, “what happened?”

Mr. Greenberg replied, “I think several things. I think risk management controls either disappeared or were weakened. There wasn’t attention being paid to the accumulation of risk. I felt there was a determination to grow without the right controls in the financial sector of the business. Many things went wrong.”

Now that the US taxpayer is now bailing out Fannie Mae, Freddie Mac and the home-debtor speculators (not to mention all the banks that are being liquidated by the FDIC) it might be a good time to ask this question: Who’s going to bail out the US taxpayer?

But wait, there’s more!  Why not bail out Lehman Brothers as well?

It just wouldn’t be “fair” if Lehman is denied the bailout status Bear Stearns, Fannie Mae, Freddie Mac, the banking industry and the home-debtor speculators have been afforded by our elected politicians from *BOTH* sides of the aisle.

It’s absolutely laughable that after 18 years at the Fed, ex-Chairman Alan Greenspan is warning not to use the Fed as a “magical piggy bank“. There apparently is no shame left in America.

In fact, why don’t we just nationalize the entire financial pornography services industry like our pols want to do with our health care industry? I’d wager there’s more fraud and wrong-doing in the financial services biz than in health care.

The US taxpayer might get a fairer shake then.

In a prior post, I mentioned that the US government debt is not $9 trillion as is most commonly reported by the main-stream press, but $53 trillion. Some of you asked for an outline of the difference:

It’s ugly. And it doesn’t include the most recent bailout numbers. Perhaps it would be better if Congress took off the next 4 years so we could catch up with the damage done.

Five short minutes containing audio of the late comedian Bill Hicks, video of Carl Sagan, and some Hendrix against a down-tempo, ambient dub music backdrop. Enjoy.

The game is to find out what you already are.

Today, the New York Post ran a story that simply mystified me. It was entitled, “Samaritan Trucker Fired” and tells the story of a man named John Acheson who was fired from his job at Sid Wainer and Son  a Massachusetts based specialty food purveyor, for essentially being a good samaritan.

According to the news report:

1. On August 4, Mr. Acheson witnessed a fatal shooting and was delayed after assisting the NYPD in tracking down four suspects in the shooting; and

2. On August 19, Mr. Acheson witnessed a woman strike a livery driver with a hammer and flee. He called 911, chased the woman into an alley and assisted police in arresting her.

3. On August 20, Mr. Acheson was fired from Sid Wainer and Son. His boss (who is unidentified in the story) is quoted as saying, “John, I gotta let you go. You don’t know how to mind your own business”

Simply astonishing.

I’m not sure the founder, Sid Wainer, would’ve approved of Mr. Acheson’s firing. According to the company website, Sid Wainer’s “code of ethics, his strength of character and his resolve to be a positive influence on all those around him” were ideas and concepts Sid Wainer taught his son and current President, Dr. Henry Wainer.

I’m not beating up on Sid Wainer and Son the company, I just think they missed a heck of a marketing and publicity opportunity by not parading the courage of one of their own in the media. They also missed a great human resources potentiality. In an industry where it is difficult to find quality help (truck drivers), Mr. Acheson could’ve become a symbol of “the type of quality employees the company hires”, and used that good-will to attract more and new employees.

Listen, any company that has it’s roots in the depression-era (it opened in 1914) that survives today has my awe and well-wishes, but unless there’s something to Mr. Acheson’s story as reported that we don’t know, they blew it on this one.

That being said, I believe Mr. Acheson has the opportunity to parlay this unfortunate situation into something better for himself. It is obvious that he is special in some way. Perhaps these incidents were cosmic tests of some sort. Perhaps he should consider driving for a paramedical organization or a hospital. This would fulfill his obvious need to assist others in distress and plays to his vocational skillset. Perhaps in doing so, if he has the smarts for it, it will lead him to a career in medicine, or as an EMT.

It is obvious to me that Mr. Acheson is meant for something more. I hope he realizes it too.

“Ursus Head” would make a great name for a garage band, wouldn’t it?  The name’s from a small cape located in the bucolic Kenai Peninsula, near Iniskin and Pile Bay Village in southcentral Alaska. (If you click on the link, “zoom out” about 8-10 times and click on the “satellite” button for full effect!) It’s where I’d be right now if I had my druthers…

For those of you who have been wondering as to my whereabouts, I offer (in my own defense) a quick update on the progress of my studies:

1. I’ve passed 3 of the 5 Certified Risk Manager (”CRM“) certification exams, and am awaiting for the results of my third examination. Based upon the timing of the required courses, certification completion should be achieved in the first quarter of 2009. Each course is 20 hours of intensive instruction followed by a 2 1/2 hour short answer, essay examination. These institutes are by far the most rigorous and doing well on the exams requires the most thorough and complete understanding of risk management concepts. The CRM material also provides the most useful “real-world” information and is pretty much all hands-on. Insidiously, I like these courses the most!

2. As of November 1, 2008 I’ve passed all 3 of the Associate in Risk Management (”ARM“) certification exams and now am authorized to use the ARM designation. Each part of the material is tied to a 400 - 500 page academic text for which proficiency in the material is required to pass. While you can (theoretically) take classes on the material, I did this certification completely self-study. It’s heavy on theory, which is why I can’t get too excited about most of the material. That being said, it’s fundamentally a good thing to explore and understand the theoretical underpinnings of risk management and is a great adjunct to the CRM material. However, being exposed to both the CRM and ARM material at the same time, the ARM material alone feels incomplete.

3. I’ve passed 3 of the 5 Certified School Risk Managers (”CSRM“) certification exams and based on the timing of the remaining required courses and exams, the time frame for completion of this certification is the 1st quarter, 2009. I usually get the question, “Why school risk management?” Because it’s entree into the issues and complexities of public entities. As compared to for profit enterprises, public entities have vastly different capitalization issues and legal liability exposures which affect risk control activities and risk financing options. So basically, I want to take what I learn about school risk management and apply the concepts to other disciplines- doing this forms the basis of the sparks of creativity!

So, assuming all goes well on the timing outlined above, there’s a bit more education I have planned for myself. The “ARM-P” designation is the “Associate in Risk Management for Public Entities” designation and is earned by completing one additional course/exam in addition to the ARM material. Late 2008 is my planned completion date for this certification.

Reaching out to more traditional educators, New York University has 2 risk management programs I’ve found of particular interest: one is a “Certificate in Financial Risk Management” program and the other is a “Graduate Certificate in Enterprise Risk Management” program. Both provide the “meaty” risk management graduate level material I’m looking for without having to suffer through the entirety and hellacious expense of a “formal” MBA program.

The only remaining question is what I’ll wind up doing with all this… Till next time, enjoy what’s left of the summer!

UPDATED RESULTS AS OF 11/14/08.

To borrow from Nancy Sinatra (of “These boots were made for walking” fame), “These times were made for new business startups!” It’s absolutely true: Ironically, times of economic slowdown are some of the best times for starting up a new business. I know it sounds counter-intuitive, but let me make my case with the following “big-picture” points:

• 1. Competitors are generally weakened
• 2. Employee supply pool is large (and scared)
• 3. Vendor payment terms are much more flexible
• 4. Office lease/rental costs far lower than average
• 5. Many initial startup expenses can be had on the cheap

If we accept the premise that business and economies have predictable cycles, then the above should be “obvious”. Right now, our economy and businesses in general are in “contraction mode” and we are struggling through a very difficult time of burning off the excesses that were “built up” over the last 6-7 years. Despite what you hear in the media, it’s not only normal, but a good thing for us all. This process thins out weakened competitors and strengthens those companies that are and have been managed well. It positions our economy for the next cycle of expansion, which brings us the goods and services we want and need at competitive price points.

Which brings me to point number one above. New businesses can take advantage of weaker competitors and those that are ill positioned for growth going forward in the near-term. They do not suffer from excess “weight”, baggage or balance sheet deterioration. They are nimble and can act fast and react smartly to the current economic reality. They do not fear losing market share.

Point number two: Wow, are people scared about their future, their jobs, etc. I think it would be more fascinating to explore what people *weren’t* afraid of! This mindset can be advantageously by the new business owner. Those owners that can foster a sense of security for their employees will have fruits of their efforts returned several fold over time. Right now, not only is talent easier to find, but it costs less. A win/win for the business owner.

Point number three: Vendors of all types (all other businesses that are not your direct competitors) are weakened by a one-two punch of loss of quality business and bad debt write-downs. Those new businesses that can establish a good working relationship with their vendors quickly will reap the rewards long term. Remember, good “terms” from your vendors are not necessarily just financial, they can (and should) be on the service side as well. A vendor may well pay better attention to a new business relationship where future growth potential lies than a long-standing one that is stagnant.

Point number four: Office space is *cheap* and a properly constructed lease can be written to provide the new business with not only a very low initial rental cost (relative to a few years ago), but can (and should) take into consideration at least a five year rental plan. I personally prefer a one year lease with 4 successive one-year renewal options, for a total of 5 years. This way you are locking in a lease cost lower than market average rates, but not locking yourself into the space should it no longer meet your needs. Oh, and one more thing: no personal guarantees! If the landlord insists on a personal guarantee, find other space.

Point number five: I love a good bargain. I can’t remember a time when so much technology can be purchased for so few dollars. Whether it’s computer equipment, office equipment, office tables, chairs, cabinets, etc., deals can be found as companies liquidate to generate cash. Setting up the infrastructure for your new business will cost you far less today than it would’ve just 2 years ago.

So, anyone got any good ideas on our next new business?

People tend to see the world in a “half-empty” way, tending to focus on the negative rather than the positive. I suppose that’s just a human nature thing and it’s not going away anytime soon. And we’ve all got good reason to feel this way right now: we’re in a political and financial malaise and if you listen to most of our major media outlets, America is “in decline” and not relevant in the 21st century, in essence “talking us out” of recovery.

Quite frankly, it’s easy to see their “point” as there are many signposts indicating decline:

• The loss of our manufacturing base, the economic engine of the 20th century;
• Pictures and video of people living out of their cars in defacto barrios after losing their homes;
• Energy and food products costs (the costs of our basic living) rising exponentially;
• Recent freefall of our financial markets;

…among other things….

I submit to you that while the threats are grave, we hold the keys to our own recovery and prosperity. That doesn’t mean it will be easy; quite the contrary, it will be hard. It will be hard to fix the problems that our parents left us with and that we ourselves helped create. It will be painful to “fix” our broken systems be they governmental, health, economic, or energy. In some cases, the broken system will not be able to fixed, it will have to be scrapped. The pain will be broad-based, but since I live in the real world, I know that some will feel the pain more than others. 

But I don’t subscribe to the theory that our problems are insurmountable. I’m not willing to give up that ghost yet. It’s true that we as a society will be forced to change, and it will change. Our economy will change. Our government will change.

To turn a phrase from a well-known song, what the world needs now is not love, it’s courage. Courage to make the hard decisions about what we want our future to look like and then the courage to face the trials and consequences of our decisions. Indecision is not an option, as there are grave consequences for indecision.

Perhaps most of all, our expectations will need to change. The general sense of “entitlement” we exude must (and will) erode. We are not “entitled” to anything in this world, except for those rights prior generations fought overwhelming tyrannical forces for. Those same rights, quite frankly, we have begun to take for granted. 

I’m sure it’s been a long time (or maybe the first time), so go read our Bill of Rights and thank a vet.

We have limited time on this earth and some of us see fewer years than others.

It’s comforting to know that no matter the “anguish of the moment” we are going through and how insurmountable it all appears, this too shall pass. But it’s also a warning when the inverse of that proposition is analyzed: No matter how *well* things are going at the moment, no matter our glory, no matter our earthly status, this too shall pass. It’s how we balance these two “swings of the pendulum” that creates the tapestry of our lives.

You have a choice. It is obvious and distinct. You can either choose to create chaos in your life and in the lives of others, or you can create harmony for yourself and in the lives of others. This is no tree-hugging hippie-crap, it’s the nature of the universe. 

It takes as much effort and energy to act selfishly as it does to act selflessly. Nature abhors a vaccuum: If you do not choose to act on your own accord and create a harmonious reality for yourself and those around you, others will define you by your inaction and you’ll likely be cheated out of great joy.

We live in a universe of creative destruction. If Einstein is right (and science has yet to prove him wrong), then matter and energy cannot be destroyed, only converted from one form to another. This reality is temporal and we need to consider the effect of our choices when building a life. A positive change needs to be made today in order to “live the benefit” tomorrow.

No one ever regrets being nice. No one ever regrets feeling genuine empathy for others. Being nice does not make you an idiot nor does it indicate that you need medical attention or pharmaceutical aid. But most people are afraid to drop pretenses, because they believe it gives them power- power over others and others’ circumstances. 

You can buy into that load of manure if you want, or you can smile knowingly and opt yourself out. It’s all a facade and one day it all evens out. This is evidenced by the fact that the hearse is never followed by the armored car.

If you’re concerned about your place in the world, change it. God (or whatever deity, higher power or “source” you believe in) does not take cash, checks or credit cards. And for those of you who believe in “nothing” or “an absence of anything”, this must also logically be true.

OK, today let me drop a little insurance strategy on you to help you “evaluate your insurance premium savings quantitatively by increasing your risk retention”.

Got that? That’s a real “fancy-pants” way of saying, “save money by increasing your deductible”, but now you can sound important-like and impress your insurance-geek friends. Just one word of caution: don’t try that one at a party unless you’d rather be alone.

OK, bad insurance humor aside, it’s commonly known that by increasing your deductibles will generally lower your cost of insurance. But today, I’ll give you a strategy to analyze the premium savings to see if it makes sense to take on more risk.

It’s important to understand that insurance is provided by an insurance company on a “cost plus basis“. What that means is that very smart mathematics types (known as “actuaries”) figure out the dollar amount of the frequency and severity of losses that the insurer is likely to have to pay for the risks they assume. Think of this number as just the “pure” loss amounts, without any expenses associated with them. Let’s call that number “X”.

Once that’s done, the financial bean-counter guys and gals get together and add in the costs the company must bear to administer their customers’ losses, such as employing people and costs of adjusting and paying for the losses. Let’s call that number “Y”.

Then finally, once that’s done, the management types (you know, the one’s dressed in suits) add a cost which represents the percentage of profit they want to make. Let’s call it 10%. So the cost of insurance is figured like so: (X + Y) * 1.10.

Sounds too simplistic? It’s closer to reality than you think.

OK, so let’s go back to our generally misunderstood actuary friends (they need love, too). They know that if you take a $100 deductible instead of a $1000 deductible, their frequency of loss will increase, because you’ll be tempted to put in that $250 loss claim now. If you had chosen a $1000 deductible, they’d never see the claim. So, what do we learn from this?

By choosing low deductibles, you are trading today’s insurance premium dollars for future potential claim dollars.

The reason and logic should be clear from the example above: the company has to charge more to pay for its increased likelihood of loss, which also includes the very real and expensive loss adjustment expenses. And because you are paying premiums on a “cost-plus” basis, this is generally speaking a bad deal for the consumer because you are not only “prepaying” your small claim but you’re also paying for the insurance company’s costs and profit-margin targets.

If I haven’t lost you yet, here’s a very simple method of evaluating whether or not increasing your deductibles is a good “buy” for you. It assumes that you have the financial capacity to pay that deductible if/when the loss occurs- Remember: the fundamental rules of personal risk management dictate that we do not take on more risk than we can handle and we never risk a lot for a little.

So with those caveats aside, here it is: If today’s premium savings can “pay for” the difference in deductibles within 3 years, it’s probably a good idea to increase the deductible (assume more risk) and take the premium savings.

Say you have a policy with a $250 deductible that costs you $1000 per year. Your agent advises that the premium would decrease to $750 if you chose a $1000 deductible. So your out of pocket premium savings is $250/year (nice!), but your out of pocket risk has increased $750 (not so nice). Since the annual premium savings of $250 * 3 = the difference in our deductible ($750), it’s generally a good strategy to increase the deductible.

Of course, if you do have suffer a loss within 3 years, you’ve “lost the bet” so to speak, but it’s sting is tempered by your retaining the first year’s premium savings. On the other hand, any loss 3 or more years in the future has paid for itself. Actually, and then some, since premiums tend to rise more or less, every year. The percentage rate increase will be less with a $1000 deductible for example, than a $250 deductible, in keeping with our example.

Now that you got this down, call your agent, save some money (if appropriate) and then go treat yourself to something nice (some chocolate, an ice cream, maybe a new car…) because you’re now a much more savvier purchaser of insurance than you were mere moments ago.

Can’t get enough of this scintillating material, don’t forget to click here for more fun.

Just because something is simple, does not make it simplistic, which almost always is used to connote something negatively. And just because you like to keep things simple, does not make you a simpleton. I am amazed at how some people want to overdo the simplest of things, as if by employing the complex strategy the outcome will be better than if a relatively simple strategy was utilized.

It’s kind of like writers using “five-dollar” words, when using “one-dollar” words are sufficient to get the point across. Perhaps it’s an ego thing: the writer feels superior when their audience is forced to use a thesaurus (!) or google an unknown word.

Recently I was asked by one of my friends to help him deploy a financial strategy for a short term goal (which I’ll generally define as one that is less than 5 years away). In this case, the “goal” date for using the money was 4 years away. If you remember this previous post, I commented that it’s absolutely necessary to consider the time-frame for when the funds will be needed.

Failing to do this very basic concept can lead to poor (or disastrous) results.

Monies allocated to equities for short term goals are generally considered *unsuitable* as you may need to liquidate at the “wrong” time, say in a declining market. The inverse is also true, if money is allocated too conservatively for a longer term goal, you run the risk of not having “enough” money after the effects of inflation are considered. It’s these type of issues that the so-called “financial professional” world uses to prey on an financially uneducated populace.

The (unstated but essential) message: You *need* them to figure this stuff out for you because you can’t do it on your own.

It’s not true, of course: anyone with a high school senior math education can follow the basic concepts “along at home”. And despite the pleadings of the financial planning community to the contrary, financial planning is *not* an exact science. Heck, I’m not even sure it’s an “art”; more of a *discipline* than either an art or science.

…zzzzZZZZZzz…

… oh no, there I go again… Sorry about that. Let’s get back to the issue at hand: How did we decide to deploy capital for a 4 year time horizon? Bonds. Absolutely *not* sexy, but they get the job done and are appropriate and suitable for the task at hand.

First, we have to make sure that the investment is low-cost as every dollar confiscated in fees by the investment “professionals” reduces the investment’s total return. (Stunningly simple concept, isn’t it?)

Second, we have to make sure that the investment is internally diversified, meaning we want to hold many bonds to reduce the default risk of any one bond issuer defaulting on its obligation to repay.

Third, the bonds have to be of the highest quality, reflecting the bond issuer’s ability to repay. We need to preserve and protect capital, so “junk” (also known as “high-yield”) bonds were not suitable.

Fourth, we’d like to match the average duration (which is essentially, a measurement of how long, in years, it takes for the price of a bond to be repaid by its internal cash flows) to the goal time-frame: in this case, 4 years.

So, following the 4 steps above leads us to the obvious answer: we were looking for a low-cost, mutual fund of high quality bonds with an average duration of 4 years.

Checking out Vanguard Group, my favorite mutual fund family for DIY investors, two bond mutual funds were reviewed: Vanguard’s Short Term Bond Index and their Intermediate Term Bond Index. As of today, the Short Term Bond Index holds 900 bonds and has an average duration of 2.5 years. Intermediate Bond Index holds 968 bonds and has an average duration of 6 years. Both funds have an overwhelming majority of their holdings in bonds that are rated “A” or better and both have an expense ratio of 0.18%, making them *very* low cost.

So, let’s recap:

1. Low-cost? Check.
2. Diversified? Check.
3. High quality holdings? Check.
4. Duration of 4 years? Uh-oh.

Darn. Everything was going so well until we got to #4.

Fret not, here’s the easy solution: We can “blend” the two funds together to get to our desired average duration of 4 years. The math worked out like this:

1. Short Term Bond Fund duration is 2.5 years * 60% (0.6) of the total invested = 1.5 years; and
2. Intermediate Term Bond Fund duration is 6 years * 40% (0.4) of the total invested = 2.4 years.

By investing 60% of the money in the Short Term Bond Fund and the remaining 40% in the Intermediate Term Bond Fund, we essentially have created a portfolio that has an average duration of 4 years. (Actually 3.9 years, if you want to get “technical” on me!).

One more thing: please be aware that bond fund durations are subject to change over time. You may need to adjust the “blend” as circumstances dictate.

But using this “simple” solution to invest for a short term goal, you’ll achieve better results than many of your friends. Of course, there is the possibility I could be wrong

Have you been to the grocery store lately? Erosion of the value of the dollar is not only present in the increase in the cost of energy, but also in the dramatic increase in the cost of our basic family food needs since late last year, as our economy started to unwind.

Like almost everyone I know, I’m trying to stretch the value of every dollar available. I’m still a net buyer of equities as my investment policy statement dictates- while most are unnerved (panicking?) by the gyrations of the stock market, I believe that our current economic slowdown is *temporary* and not representative of a systemic breakdown. But my family cannot eat future stock market performance today.

So I’ve been considering taking some short-term emergency fund savings (where we’re earning about 2.25% annual yield and losing money after the effects of inflation) and stocking up on non-perishable food and related supplies as a hedge against what is reasonable to expect: higher prices tomorrow.

It’s not a grand plan, but today every little bit counts; and it’s less about “math” and more about logic: The idea is based on the premise that I *expect* food prices to increase at a rate greater than 2.25% over the short-term. There’s limited downside if I’m wrong:

We’ll always use the toilet paper.

P.S.: Remember, there’s more literary goodness to read on the main page here.

This post marks the end of my trilogy of modest proposals dealing with our oil dependency.

This morning I was reading new forum posts on brokeroutpost.com. This website is a for mortgage professionals - it’s very enlightening to see the mortgage crisis from the mortgage broker perspective.

One of the forum posts was on the topic of the prices of gasoline at the pump around the country: As expected, prices ranged from $3.75 to well over $4.50. The posts then drifted to alternative fuel sources: veggie oil, plug-in hybrids, etc.

Then, one of the posters calling himself “neo-logic” chimes in with the following suggestion: “Someone should make a car that runs on b.u.l.l.s.h.i.t. That’s a renewable resource.”

True dat!

It’s been a while since we’ve added a new state to the union (Hawaii in August, 1959). Lately I’ve begun to think that maybe we should start thinking about the political process of adding Iraq as our 51st state. Let me plainly state my case:

1. It would solve the “pesky” and on-going problem of the Iraqi’s having to set up their own government.

Our military leaders tell us that Iraq suffers from *political* issues, and not necessarily military ones, which is why we have to stay there “for the forseeable future” (Which I think we can loosely translate to 50-60 years, like Germany and Japan, places we still maintain a military presence after WWII). Well, we can fix this problem: our constitution has worked well for us for over 200 years, so no need for the Iraqi’s to continue to try to start from scratch.

2. It’d be a heck of a solution to our current oil woes.

Instead of us continuing to pour money into Iraq (that we’ve stolen-borrowed from our children and our children’s children without asking, I might add) without reward, we could now monetize our investment for our children. It would be like adding Alaska to the union (with its huge oil reserves), only in one of the most geopolitically sensitive areas of the globe. As I said, we’re going to “be there” for a generation anyway!

3. Having $1.00/gallon gas in the U.S. for at least a generation would sure silence the anti-war crowd.

I don’t think this requires any explanation. Oh, and don’t forget to “short” the oil company stocks…

4. Our enemies would be forced to stop accusing us of being “imperialist”.

Sure this proposal would peeve the Islamic extremist jihadists, so I say let the Iraqi’s vote on it. And no rigged elections this time: if they honestly want us to leave, we should. If they want to be Americans, they should be allowed to be Americans. And this gift keeps on giving- a “free” Iraq as a state of the United States would be Syria’s and Iran’s worst nightmare. Not to mention China, who competes with us for every barrel of oil available to support their burgeoning industrial economy.

With oil prices currently at around $125 per barrel, it is difficult to believe the US government’s calculation that inflation is currently at 3.98%.

It occurred to me that if our wages were indexed to the price of oil, perhaps it wouldn’t be so bad. So, imagine if you will, that you were making $100,000 when the price of a barrel of oil was $100. (which happened “way back” between February and March of this year).

The cost per barrel has increased 25% in roughly 3 or so months. Now imagine, if you will, your salary increasing by the same percentage. In our hypothetical example, you are now being paid $125,000 today for the same job you were doing in February.

Sweet!

It could almost make you wish for $200 per barrel pricing.

To be very specific, what happens to a life when it ceases being a relentless pursuit of money? I think back to my church confirmation classes and remember being taught that the “love” of money is the root of all evil. But we’ve learned that money is nothing more than a storehouse of value and a method of exchange. In today’s world, it’s nothing more than ones and zeroes contained in a computer database/ledger. It also begs the question: Who’s in charge or control of the “ledger”?

Our money can “disappear” at any time- as it has in America before. Does anyone remember confederate currency? Because it was a fiat currency (meaning it had no intrinsic value, just like our current dollars) and was backed by a government that ceased to exist, confederate currency collapsed and had no value at the end of the Civil War. Those who were “rich” by confederate currency standards were left penniless. I guess the moral of that story is having “more” shouldn’t necessarily make you feel more secure and that you should never assume the unlikely is impossible.

Actually, the disappearance of money doesn’t even need to be so draconian or dramatic as followed by a governmental collapse. Inflation is a hidden danger and stealth destroyer of monetary “wealth”. Inflation is the general level of prices over time. I like to think of it as a general *increase* in the cost of a “basket” of goods and services over time. For example, I would need $661.92 in 2007 dollars to buy what $100 could buy in 1965, the year I was born. A loaf of bread cost a whopping 21 cents then- compare that to today!

Reasonable people ask why this is. It’s because our money supply is manipulated by a financial cartel in the form of the Federal Reserve. As more dollars are injected into the money supply and “made available”, the value of the dollars already existing in circulation *falls*. Therefore, you need increasing amounts of dollars to buy the same amount of goods and services over time.

Recently I was referred to a 60 Minutes segment about David Walker which was broadcast originally back in March, 2007. Don’t know who David Walker is? Don’t feel bad, neither did I. Up until March of this year, he was the US government’s top accountant, the Comptroller General of the Government Accountability Office. He pegs our national debt at $53 TRILLION dollars, not $9 TRILLION and paints a picture of our country’s economic future so grim, it’s as compelling as it is utterly chilling. I consider it a “must see”.

I’m left pondering whether the “endgame” plan is the bankruptcy of the United States (with its corresponding debt default and monetary collapse) to “make way” for something new- I believe George Herbert Walker Bush (41) called it a ” New World Order”.

Wouldn’t that be a hoot? I wonder how the people who spent the entirety of their lives in the sole and relentless pursuit of money are going to feel?

Well, just a flurry of activity today, isn’t it? I’m going to be away on vacation until late April/early May so I wanted to commit a few ideas that I’ve been mulling over lately to the site before I either forget them or get caught up in other things. Some concepts I have “in development” as of today that’ll have to wait for my return:

1. A line item breakdown of variable annuity costs - OUCH!

2. Why stock market timing is a bad (but pervasive) idea;

3. A discussion of “senior” seminars and the art of the “sale” - beware the siren call of the “free” steak dinner!;

4. The allure of fixed index annuities and when they are suitable;

5. Long Term Care Insurance Objections (and rational responses);

6. Within every small business owner lies the soul of risk manager;

7. Moral and ethical obligations of a fiduciary;

8. Legal considerations of the sale of securities by “captive” financial advisors/insurance agents;

9. Exploration of the concept of “Personal” Enterprise Risk Management;

10. How to reduce health insurance premiums through exposure analysis;

11. Matching bond fund durations to meet a 1-5 year financial need;

12. “If investing *isn’t* boring, you’re doing it wrong”; and

13. An exploration of personal risk control techniques.

Just a little “light” reading, huh? Also, if you haven’t already done so, please consider registering your email address (or send me an email at md at marcd.com and I’ll register for you!) so that the site updates will be forwarded automatically to you by email. Consider referring a friend to the site - we need more friends! Thanks again for your support and I’ll see you in about a week.

Small business start-up capital financing is notoriously tricky. Even in the best of economies, banks won’t lend to start-ups without significant collateral. It shouldn’t be surprising then that in the vast majority of cases, a business’ initial capital financing comes from an owner’s personal savings. In fact, I cannot think of one of my businesses that *wasn’t* initially funded primarily by my personal bank account. It’s the ultimate in “putting your money where your mouth is”.

Self-financing of the initial capitalization of a company is a relatively easy (and subsequently dangerous) course. That being said, I find it prudent for a prospective owner to consider self-financing start-up expenses where all other sources are inadequate (either in amount available or in terms offered) or simply unavailable. It forces the owner to carefully consider whether or not to start the business and can save the owner from a financially ruinous affair.

Unfortunately, where I often see “trouble ahead” is when the owner starts using personal assets to cover the on-going monthly operational expenses of the company. Monthly expense items such as payroll, taxes, insurance, rent, etc. need to come from the company’s generated sales and revenues. If there is a consistent monthly shortfall that is being financed by the owner to keep the small business going, warning lights should be flashing!

I know all the rationalizations because I’ve been a victim of them at one time: “Things will get better”. “Next month will be a big month”. “If this business fails, I’m a failure”. Etc.

Here’s what I’ve learned from my own past mistakes: There is something fundamentally “broken” in either the operation or focus of the business if it experiences a consistent monthly income shortfall for 90+ days. The business is in obvious distress and most likely the owner is in denial.

Decisions will have to be made at this point. Line item expenses need to be reviewed objectively in order to reduce or eliminate unnecessary costs. Operations need to be objectively reviewed for redundancies and efficiencies. Income deficiencies need to be objectively addressed to determine the nature and extent of the product or service “saleability”. Indeed, some very difficult activities need to be undertaken to thwart dissolution and ensure survivability.

Keep an open-mind. There is a solution to almost every business problem. Unfortunately, as we all know, sometimes the rational decision is closure, but that should be a last resort only after exhausting all other options.

Let’s first get this out of the way: flood insurance suffers from what the insurance industry calls “adverse selection”, which means that for the most part *only* those people that need to buy flood insurance coverage (as required by their lender), in fact do. Some (closer to “most”) people assume that it’s already covered under their homeowners, renters or condo policies (it isn’t) or figure the risk of flood too remote to affect them. Accordingly, the law of large numbers cannot work properly. I’ve outlined 5 forgotten (or unknown) flood insurance concepts that everyone should know:

1. The primary supplier of coverage is the federal government.

It’s true- it’s called the NFIP, which stands for the National Flood Insurance Program. The government contracts with insurers to provide the coverage to you, but the costs (including claims paid) are funded by the U.S. taxpayer.

2. The definition of a flood zone: EVERYWHERE

There’s *nowhere* in the United States where a flood cannot occur. Just because your home is not in a designated flood “zone” should not give you any comfort. In fact about 30% of all flood losses occur OUTSIDE a designated flood hazard area.

3. Flood coverage includes losses from mudslides or mudflow.

If I had a dollar for everyone who told me, “I live on at the top of a hill (or on a hill) - I don’t need flood insurance”. Ask people who live in the hilly areas of California who’ve lost their homes to mudslides if they don’t need flood insurance. Remember, land subsidence (which is for the most part a fancy term for a mudslide) isn’t covered under a standard homeowners/renters/condo policy.

4. There is VERY-limited coverage for basements.

Contents of a basement is NOT covered, nor is any improvements such as finished walls, floors or ceilings. What *is* covered are things like: foundation elements, utility connections, heaters, A/C units, unfinished walls and clean-up. That big screen TV and stereo system you have in the basement is there at your own risk only!

5. Increased Cost of Construction is included (sub-limited).

This is a nice addon and automatically included for most regular flood policies. Basically, the government (through the insurer) will help you pay for building upgrades (post-loss) to reduce the likelihood or severity of a future loss. Amount of coverage available: $30,000. It’s a shame we don’t pay enough attention to prevention or mitigation pre-loss!

Being tax time, I’m reminded of a piece of sage advice I’ve acquired along the way that I’ll share with you. At one time many years ago, there was an ice cream parlor in my town called “White Mountain Creamery”. It made some of the best ice cream I ever tasted and was always packed with people. By all outward appearances it was a thriving small business. Until one day, that is, when it closed without warning.

I always wondered what happened behind the scenes. Was it the sudden death of the owner who lacked a buy/sell agreement? Was it a lease renewal negotiation that soured? But if that was the case, why didn’t the business move and reopen at a new location? What would cause a seemingly very successful business to shutter “overnight”?

I came to learn it was simply a matter of too much money going out and not enough money coming in. And it simply doesn’t matter how much you’re earning, whether it’s $30,000 a year or $30,000 a month. It’s not what you make, it’s what you keep.

So remember the lesson of White Mountain Creamery whether you’re evaluating new business opportunities or simply living your life. It’ll never let you down.

Now that we’re conversant with the 3 general types of risk, it’s instructive to understand the basic tenets, or “truths”, of risk management. They may seem simple in concept but you’d be amazed at how many people don’t stop to consider, forget, disregard or plainly ignore them in their daily lives.

• Don’t take on more risk than you can handle (afford to lose);

• Don’t risk a lot for a little gain;

• Consider the odds of the risk you’re taking; and

• Don’t confuse, mistake or substitute insurance for proper risk management and risk control.

Remember that many of the pure risks (risks where there only is a chance of loss) we face in our daily lives are easily handled by insurance. When I consider these tenets, I think back to an experience I had with a trucking company owner who operated a small fleet. During my initial meetings with him and review of his current insurance plan, I noticed that most of the vehicles were being insured for liability only. He explained that as a matter of policy, he took off collision and comprehensive coverages once the loans were paid off and he was no longer required to maintain the insurance coverage.

Seemed reasonable enough, but it’s important to know that many of these trucks (he had about 8 at the time) were still worth in excess of $20,000 *each* and I think we can all agree that a very large financial loss would be suffered should even a *single* truck get totaled in an accident. So, I asked the owner to explain his thought process. He shared that it was his experience that none of his trucks were ever totaled in an accident and he had saved a substantial amount of money in insurance costs throughout the years.

We got to talking more about this. I asked about where the vehicles were kept overnight. He explained that he would back them up into the warehouse dock at night and over the weekend. I asked if he considered what would happen if he woke up one morning to find that the warehouse suffered a fire and 6 of the 8 trucks were destroyed because they were so close to the building itself. He thought about it for a moment…

“I would probably be out of business“, was the response.

The owner never considered that possibility/peril and it changed the whole equation and perception of risk in his mind. Well, I don’t know about you, but I consider going out of business for a peril we can prevent or reduce to be an undesirable and wholly unacceptable outcome.

Premiums on truck collision and comprehensive coverages are *heavily skewed* to the collision portion, meaning the cost of collision coverage was about 4-5 times more expensive than the cost of comprehensive coverage. I explained that for about $300 per year, per truck, we could add on comprehensive coverage only which would cover the vehicles for “just about” every physical peril, including fire- with the exception, of course, of colliding with another object. He said his current insurance broker never had this kind of discussion with him or offered comprehensive separately.

So how does all of this relate to the basic risk management tenets? Clearly, the business owner was unwittingly taking on more risk than he could afford to take and was risking a lot for a little premium savings. He didn’t consider the odds of the risk because he didn’t even *consider* the risk! But once presented, the responsible action was clear.

And no, tenet #4 was not ignored: We discussed moving the trucks away from the building as a loss control measure, but he was concerned about vehicle theft issues and the lighting in the truck-yard was sketchy. Since it was a leased building, there were landlord issues which did not allow him to add more lighting. So, while we didn’t confuse insurance with controlling the risk, we *used* insurance as a risk transfer technique because it was economically reasonable to do so given the circumstances.

The business owner was also happy to learn that comprehensive coverage would also pay in the event one of his trucks was stolen. He said it was always a concern, but one “he lived with”. As you can imagine, his warehouse wasn’t exactly in the best part of town.

It is no small feat to operate a small business successfully today. The risks faced by the business owner seem in many ways more formidable now than every before. Many new entrepreneurs are in some small way naive to the risks they face. And perhaps that’s a good thing, otherwise many new startups simply wouldn’t. No new small business owner *expects* that their business will be a party in litigation, but every seasoned owner knows the truth: it is a *virtual certainty* that the business will be sued. How these risks are managed can and will sometimes be the determiner of corporate survival.

Which leads us to the “Risk of the Day”: E-Discovery.

When litigation commences, depending on the circumstances of the stated complaint, the parties to the lawsuit engage in a process called “discovery”. Basically, this is a form of “You show me yours and I’ll show you mine”. During the process each party is required to provide documentation that it has in its possession to the other side for review. In complex corporate litigation, the documentation to be reviewed can be absolutely voluminous- (I know this from personal experience!). But what happens when the documentation requested doesn’t “exist” in the physical world and is “electronic” evidence?

Some estimates suggest that greater than 90% of all evidence is electronic evidence. To instruct parties in litigation of their responsibilities under the law as it relates to electronic evidence, Federal Rules of Civil Procedure have recently been amended and can be found here if you’re willing (or daring).

E-Mail is an easy example of electronic evidence, but it is far from the only one. I have heard attorneys on both “sides” (whether defending or prosecuting) state that even if one was to print out every email, it might not necessarily be “enough” because your adversary (and the court) might not be convinced that *every* email was in fact printed and that you may have ‘inadvertently” retained certain emails that you think might hurt you. Even if you do not use email with customers (this is why many financial advisors will not utilize email, not to mention it is inherently insecure), attorneys are going to want to review internal emails between staff to get a flavor of the discussions “behind the scenes”.

“Legacy” computer systems is another area of concern. When systems are upgraded, many times “old” data is not imported into the “new” system. And even if some is, it is not uncommon that not all of it is. As litigation can deal with multi-year issues, this can be a particular problem area.

Your head spinning yet?

It’s probably helpful to boil down E-discovery risks into three basic trouble areas. Briefly, they are:

• Documentation Over-Production: Costs of legal review can be enormous if you produce *everything* and more often than not, documents that should not have been produced are now released into the public domain;

• Documentation Under-Production: Court sanctions and fines may be substantial for failure to produce documents that should be produced;

• Spoliation of Evidence: Spoliation is essentially actively destroying or modifying documentation or evidence, but it can also be a failure to avoid a destruction of evidence. So, in this case, the sin can be one of omission or commission.

The best general advice is to discuss e-discovery issues with competent legal counsel well before you *need* to. And, as a brief reminder, I am not an attorney and this post is not (nor is it meant to be) legal advice, but just a general overview and discussion of E-Discovery risks.

My father was a small business owner. As I think back, I suspect this happened out of necessity and not by choice. You see, at the age of 14, he was forced to start working to help support his family after a construction accident took the life of his father at a young age. My father was first generation “off the boat” that came through Ellis Island in the early 1940’s.

His family was very poor and no one had the benefit of a formal education. As I understand it, my dad was exceedingly bright and well-liked at school and despite receiving several offers to go to college, he started work full-time straight out of high school to continue to help support his family. At the time, I don’t think he gave it any thought. He just did “what he had to do”.

Before he died, he told me that he had 2 regrets, one of which I will relay here. He said that looking back, he regretted not being able to stay in school and always wondered what the tapestry of his life would’ve been had the circumstances allowed him to go to college after high school.

I think all of us can look back to specific moments in our life and see the proverbial “fork in the road”, where life offers us choices. They seem so clear in hindsight. I view them in terms of “IF…THEN…ELSE” computer language programming branches. “If I make choice “A”, then the likely result is “X”; If I choose “B”, I’ll likely end up in a completely different place.

In short, I try to explain to my kids that each successive choice we make leads us to different possibilities and (accordingly) to different successive choices (If, then, else branches). Some are small choices, and some large. It’s how our futures flow.

We all live with our previous choices, the choices that were made for us and the choices of our parents. All of these accumulated and conspired over time to bring us to our current “place”. Now comes a point of decision: If you want a different “place” (result) for yourself today, you will have to actively make some new and different choices. You cannot “undo” what has been done, but you can take that experience and change your future. It’s like “hacking” your own life.

Sometimes I wonder if our founding fathers would recognize their country. Why is it that government officials, be it local, state or federal, always announce major new directives on Friday afternoons? No need to answer - the answer is self-evident.

Yesterday the Bush administration announced a proposal that would give sweeping new regulatory powers to the Federal Reserve, (which is not a government agency despite its name), according to this AP wire.

Is everyone asleep?

Most rational explanations of how the credit crisis evolved includes the Federal Reserve as a major factor. The concept is that when the Federal Reserve lowered interest rates and infused cash into the monetary system (increasing liquidity) in the days and months after September 11, 2001, it made money “cheap” and plentiful. These decisions at the very least, helped create the current monetary environment.

Banks were encouraged and expected to make loans available (to both businesses and individuals) who may have been affected by the 9/11 event. People were encouraged to “go shopping” to keep the economy afloat. And as it turned out, many people, in fact, did just that. A good question to ask at this point is how exactly did we finance this?

Many used their homes as an ATM, because it was “easy” money.

Banks were lent “easy” money by the Federal Reserve, and then in turn re-lent this “easy” money to others. Loan underwriting standards were lowered dramatically. People who couldn’t qualify for a Discover Card were given new mortgages, which in turn fueled the housing boom. People with current mortgages were encouraged by banks, lenders and mortgage brokers to take equity “cash-outs” because their home equity was just “sitting there”, not doing them any good.

Is there any other way this could have ended?

And now, we are asked to give the Federal Reserve more power. While I understand that the American people want a solution and a “quick-fix”, I think that this proposal is taking us in the wrong direction.

We all know the answer to that one: the stork (oops, right answer, wrong question). Really, have you ever considered where money comes from? Got visions of the US mint printing dollars or pressing coins? You’re not alone. I needed a legitimate resource for this question in preparation for my upcoming “Money and Investing” Girl Scout workshop.

Online research leads to many unsubstantiated conspiracy theories- not very helpful. And then I found a copy of “Modern Money Mechanics: A Workbook on Deposits, Currency and Bank Reserves”, originally written by Dorothy M. Nichols of the Federal Reserve Bank of Chicago in May, 1961. Now we were getting somewhere! I was able to obtain a pdf of the February 1994 revision and have made it available for download here. Sadly, this workbook is currently out of print. I would *love* to see the original 1961 edition for comparison purposes.

Without question, “Modern Money Mechanics” is a remarkable document. As a resource, it is “pure” and conspiracy-free. It quite adequately explains the basics of money creation and our modern fractional reserve banking system. It explains that money can be viewed “simply a tool used to facilitate transactions” and that in the US “paper currency nor paper deposits have value as commodities” and that, “Intrinsically, a dollar bill is just a piece of paper, deposits merely book entries” (Emphasis mine).

In what makes money “valuable”, the text explains: “Money, like anything else, derives it’s value from its scarcity in relation to its usefulness” (Emphasis found in the original text). That makes sense: the more money that’s available, the less “scarce” it is and therefore the less “valuable” it is.

It further explains that “Control over the quantity of money is essential if it’s value is to be kept stable” (Again, the emphasis found in the original text). This is because “Money’s real value can be measured only in terms of what it will buy.” This time the emphasis was mine.

One can begin to understand why this document might no longer be available.

So where *does* money come from? According to “Modern Money Mechanics”, the “actual process of money creation takes place primarily in banks“.

Each time a loan is made, new “money” is created. Essentially, it is conjured into existence by the borrower’s promise to repay the loan and his/her pledged collateral. Taken to it’s logical extreme, if there was no debt, there would be no money.

You know, I *really* don’t have an obsession with the Bear Stearns implosion, but it’s so chock-filled with cautionary tales I just can’t resist! For those who want to know the basic financing “hows” of the Federal Reserve - JPMorgan Chase deal, this is a nice, easy to understand one page illustration:

Bloomberg graphic

In a recent issue of the “Journal of Indexes” (January/February, 2008), author Burton Malkiel (who’s book “A Random Walk Down Wall Street” can be found in the Reading Room) discussed the importance of culture on developing economies. He recalls that Nobel Laureate Sir W. Arthur Lewis used to tell him that “if you want to know why some countries develop economically and some don’t, look at the culture.” The four characteristics that drive economic development outlined in the interview?

• Reverence for education
• Entrepreneurial Spirit
• Risk Taking
• Hard Working

Malkiel’s point was that China, as a culture, fits this profile and is likely to be the “largest economy in the world in the 2020’s”. Of course, we don’t know what we don’t know and there are many possible outcomes. I would have liked to ask him if he felt the same way about the United States today. Thinking back 200 years, when the US was an “emerging market”, I think we fit the profile very well.

Today, however, I think well-reasoned arguments can be made that we don’t fit the profile quite as well as we did then. The entrepreneurial and risk-taking spirit remain, in large part, intact. Our workforce is, on the whole, very hard-working. Where I see a potential issue is in the “reverence for education” department.

But there exists a fifth issue that affects economic development: a country’s regulatory environment. We live in a country that includes the “pursuit of happiness” as an inalienable right, specifically enumerated in our Declaration of Independence. To the best of my knowledge, ours is the only country in the world that provides for and includes such a right in one of it’s founding documents. There is simply no other place in the world that offers individuals the opportunities this country provides daily.

What plays out in China’s relationships with Tibet, Taiwan and Hong Kong will be instructive, each for a different reason. It cannot become the world’s largest economy without trading partners. The world is looking for a normalization of relations with Tibet and Taiwan, not more violence. One can reason that Hong Kong’s capitalist roots will be helpful in tempering old habits.

In large part, if China *does* become the largest economy, it will *only* happen because the world has allowed it to happen. But I’m not ready count the US economic engine out just yet.

It would be instructive to know what “counterparty risk” means since it’s the reason the Federal Reserve decided on the unprecedented act to lend $29 Billion dollars to JPMorgan Chase so that it could buy Bear Stearns. Counterparty Risk is the answer to the question, “Why did the Federal Reserve do this?”. I danced around this topic in a previous post.

OK, so what exactly is counterparty risk?

Let’s set the stage: Two large, competent and experienced organizations enter into an agreement (contract). Let’s say, as an example, Bear Stearns and a major national bank. The bank has no reason to believe that Bear Stearns won’t be able to fulfill its duties under the contract. And Bear Stearns has no reason to believe the bank won’t be able to fulfill its duties under the contract. In this example, so far, both parties are fairly confident in each other’s abilities to “perform” their contractual duties. Now let’s imagine for a moment that Bear Stearns had thousands of such agreements. All based, in part, that Bear Stearns was a financially able organization valued in the marketplace at about $19 Billion dollars. Until one day, it wasn’t.

Very simply, counterparty risk is the risk one party in a contract has that the “other” party in the contract will not be able to fulfill its obligations as outlined in the contract. I have mentioned previously that there is a crisis of confidence present in the markets today. At the core, the problem is that we can’t trust the numbers. A corollary to that is that we can’t trust the companies providing those numbers because it seems that *they* don’t even know the value (or lack of value) of the holdings on their books.

The Federal Reserve had to be concerned that a Bear Stearns failure might intensify the confidence crisis further. I am not alone in thinking this. Meredith Whitney, a bank analyst at Oppenheimer, as reported in the NY Times, had this to say: “The rescue was absolutely all about counterparty risk. If Bear went under, everyone’s solvency was going to be thrown into question. There could have been a systematic run on counterparties in general”. The emphasis is mine.

Remember the stories of the 1920’s depression “runs” on banks? Things are a lot more complex today. Back then we only had to worry about banks. How about a “run” on every financial institution: banks, credit unions, savings and loans, mutual fund firms? Only history will tell if the Federal Reserve made the “right call”, because right now, I’m not so sure.

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UPDATE April 2, 2008: Well, we just heard from the Federal Reserve Chairman himself on the previously unprecedented Bear Stearns bailout plan: “With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions ….and could have severely shaken confidence.” Doesn’t t