Folks, get ready to hear more about the McCarran-Ferguson Act in the coming days and weeks as it is now in the crosshairs of our elected representatives in Congress and may quite simply become a casualty of the health care “reform” push. I’m going to try to briefly separate fact from fiction and address some of the “spin” I’m reading in the current misguided push to repeal this federal law.
What you absolutely need to know about McCarran-Ferguson is that it allows each of the states to regulate the insurers that write business within their state. So, instead of one regulator in Washington looking at the industry, there are 50 regulators! McCarran-Ferguson also grants insurers a VERY LIMITED exemption to federal anti-trust laws. The law’s Wikipedia entry is here and if you’re particularly adventurous, here is the text of the law itself.
Now, the general effect of McCarran-Ferguson on insurers is that it allows the sharing of statistical loss data and loss experience (usually called “prospective loss costs”) over the entirety of the industries they serve. So, for example, a health insurer writing business in Washington, DC can review an amalgam of all losses of all health insurers within that jurisdiction.
McCarran-Ferguson does not allow insurers to get together in smoke-filled star chambers and price-fix the cost of coverage for the ultimate consumer. That, friends, is completely untrue, utter nonsense and political spin. Federal laws such as the Sherman Act (and other such anti-trust laws) were enacted to prevent this type of illegal activity and McCarran-Ferguson does not supercede these laws. So, to reiterate, collusion to fix prices and so called “tying” arrangements are illegal and McCarran-Ferguson does not allow them to occur, no matter what you read on the internet.
It does allow (in concert with certain legal decisions in the 1980s) insurers to share actual loss data in the aggregate.
Why this is important is because the accuracy of an insurer’s prediction of losses increases as the size of the data sample increases. In essence, the sharing of loss data increases “credibility” (both statistically-speaking and in the real world). In fact, it’s this mathematical concept, commonly referred to as the “Law of Large Numbers“, that allows insurance to be viable.
So, to the extent that losses are forecast more accurately, the premiums charged better reflect the actual exposure to loss. In plain language, fairer and more accurate pricing of coverage is possible because the insurer has a larger, more credible sample of loss data to draw upon, rather than trying to price coverage based upon its own (very limited) loss data/experience.
Further, in political parlance, one can see how McCarran Ferguson actually promotes “choice and competition” as it allows insurers which do not have experience in certain lines of coverage to offer products with more relative certainty of the losses they are likely to see. Without the relative certainty large loss data samples afford an insurer, it may simply decide not to enter new markets, thus depriving consumers of a potentially competitive choice.
Also, the sharing of loss data promotes stability of insurers, reinsurers and society as a whole as it offers greater relative certainty that pricing is adequate for the exposures to loss assumed. The singular benefit to the consumer and society is that these stakeholders can be reasonably assured that the insurer will be “there” when losses occur and are required to be paid.
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Repeal of McCarran-Ferguson will undoubtedly have many unintended negative consequences. It is not difficult to envision that restricting an insurer to its own loss data will likely cause a contraction in not only the availability but also the scope of coverage provided by insurers. Many carriers may simply cease offering certain types of insurance or cease offering insurance to certain classes of business as they cannot assess their risk adequately.
If the above occurs, it will likely increase the cost of insurance, not only becase insurers will less credible loss data to base their pricing decisions upon (and have a greater cost of uncertainty) but also because there will be aggregate less competition amongst insurers, both of which ultimately results in fewer choices for consumers.
It is said that truth is the first casualty in war. In this war of words, at least understand what the truth is.
Late September UPDATE: Apparently quite a few Americans believe as I do. According to a recent Rasmussen poll, 78% support the idea of allowing all Americans the option of purchasing the same health plan that Congress enjoys. So with support for the current incarnation of the health care “reform” at 41% approval, the question you must ask yourself is why Congress keeps pushing a plan on a populace that clearly doesn’t support the effort. I maintain that the answer lies in the concept of a “scheme of control” and fundamental loss of individual liberty.
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Few days go by that I’m not drawn into a conversation relating to the health care debate. And today, I got an email from a friend and attorney asking my thoughts on the subject. Politically, he and I are generally diametrically opposed, but he is a great guy with a sharp and inquisitive mind. We laugh a lot when we’re together. I consider it my honor to spar with him.
His position: [It] “seems to me the big issue that has been alluded to but not really spoken expressly is shifting the health economy from a finance and profit based model to a care based model. The reliance on insurance companies and their place in the financial sector is what has to be addressed, as well as the fact that the consumer is not choosing the provider.”
I share with you now, my complete response:
For the sake of brevity, I think the President could go a long way to “ensure choice and competition”, by the adoption of a one-page bill: one that would give the general public access to the 300 or so insurance options that the federal government employees currently enjoy. The positives should be immediately recognizable: complete portability, affordability, lack of a employer-mandated solution, no waiting period for pre-existing conditions, etc. Some great progressive ends, wouldn’t you agree?
If paying for the insurance is still an issue for some, a solution like the Earned Income Tax Credit might be appropriate- in which the federal government, either by direct payment to the provider or via the 1040 form, can help subsidize the expense. Don’t misunderstand me, I am concerned about the constitutionality of these programs, but I’m also a realist.
I am also aware of the “creeping incrementalism” social programs generally exhibit, and think there are reasonable concerns over the increasing cost of the social compact of 3 generations ago, one which has not kept up with medical advancements. In short, my opinion rests on the following posit: there can be no social programsif we’re bankrupt.
Further, I have grave issues with what amounts to “generational theft”, as I see it as immoral and unethical. It does not matter how much our government requires, it is never enough. I agree with the progressives in one specific way: a revolution is occurring and cultural battle-lines drawn. I’m not suggesting that the revolution will be one of violence, but it certainly is being televised!
Hope I haven’t offended, I’m merely relaying the truth as I see it. You deserve nothing less. I would appreciate your candid thoughts. It’s only through rigorous examination of our positions can we be certain of their value.
Should national health care be a reality soon, we will see the most important (R)evolution in a generation rapidly unfold before our very eyes: the EXTINCTION of the corporate employee and the EMERGENCE of the independent contractor. I’m sure this is not what the President and Congress have in mind of course, but while a free-market exists for human capital, it is this end that strikes me as most plausible.
Which ever version of health care scenarios wins out in the end is not at all relevant. In the end, they all rely upon workers to be classified as “employees” in order for this thing to “work”. Whether the new national health care “premium” comes in the form of new taxes, surcharges, fees or penalties, no business will stand blithely by and be gutted by legislation. Accordingly, an interesting question comes to light: what happens when the business employs a relatively few number of “employees” and contracts their work out to independent contractors?
Everyone (including the IRS) has a slightly different definition of what makes a person an independent contractor versus an employee. They all converge around the same issue, that one being the issue of control. Who controls the work product? Who controls where the work will be performed? Who control when the work will be performed? Who provides the tools in order to process the work? Does the “independent contractor” have their own telephone number? Their own insurance? Do they invoice regularly or are they paid weekly? Is there an “arms-length” business transaction between the parties?
Think of what this kind of (R)evolution could do to all levels of local, state and federal government! And what it could quite easily do to unions…
The progressive fascination with tinkering with 17% of our national economy will have its consequences. Some can be foreseen and some cannot. Here’s one possible consequence which future generations may hail as our President’s greatest unintended accomplishment.
There are mornings I wake in a “Groundhog Day” grip. The clock blithely reads 4:45am, the parking lot spot: 2278; familiar faces greet me as I pass them on the side streets of the city. I count how many times I’ve seen each and marvel as the numbers reach 5, 10… 15.
I wonder if they find my regular presence in their world at all unusual. In a place of over 8 million souls, it’s remarkable to view the same ones so consistently. It draws me to a question: are these moments a lucid dream of my sole creation or do I reprise a recurring role in theirs? Is the notion of free choice a sadistic joke or something real? With each morning eerily similar to its predecessor, I do not pose these questions lightly. I fear the answer.
As acts of defiance, I walk different paths to change the view. I steal moments to read new periodicals, smell new smells: Halal mixed with urine and steamed subway ventings. To break monotony’s hold, I change travel timings: an earlier train in and a later train out. I am iced coolly and a kid for today.
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We choose the cage of our own desires and perhaps I am opening my eyes. Perhaps others are doing this in their own way as well. Perhaps I stand changed. Perhaps an end is in sight and the latest challenge will present. Perhaps everything will work out in the richness of time. And perhaps, just perhaps, as I breathe deep, slow my pulse to mentally mark the moment, this late evening in the city is warm and calm just for me.
Since “in the long run we’re all dead”, I’ve been wondering lately if I’ve been letting my “bad-attitude” get the best of me. You see, it’s getting increasingly difficult to see the proverbial light at the end of the tunnel. Forget the economic stats, there is a sense of unease and general “un-wellness” in people that’s positively unsettling.
My work has had me in Manhattan daily for months and the arduous commute is a ritual that almost must be shared to be endured. To that end, I’ve made some “single-serving” friends, nice people that I talk to regularly during the commute to help pass the time, but whose relationships are limited in time and space. A woman I’ll call “Aural” is worried about President Obama’s seeming naivety and the possibility of what she calls, “another 9/11″. We swap stories on where we were and how we felt on that fateful day. It’s hard to tell her not to worry.
“Mike” sees the twisted humor of it all but worries about what kind of future awaits his kids. I can relate. It is hard to have confidence in our leaders when the person third in line to the presidency alleges that the CIA (and impugns the entire intelligence community in the process) has misled her and Congress about “enhanced interrogation techniques”.
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I see this as a binary expression: either the Speaker has made a false accusation and should be removed from office or it’s the truth and we should bring those responsible to justice. I can’t get anyone to take odds on either one happening. As of yesterday, Madam Speaker stands by her accusation.
“Earl the Hip” is trying to make it to the end of his middle management career working for a large quasi-public entity. His tired and vacuous eyes are periodically punctuated by staccato rumblings about ineptitude people at work and the relentless uselessness of time spent there. He figures if he can eak out a few more years without getting “right-sized”, he’ll bail with his pension. I see in him the present and future of many. He counsels me on “being in cash” but I counter that I’ll “see his cash and raise him” via inflation. I explain that he may feel safe being in cash, but he’s likely to lose on a real, (post-inflation) basis.
I find it palpably ironic that the person to whom the “long-run” quote is attributed, British economist John Maynard Keynes, is most well-known for his work on the theories of interventionist government policies. The central theme of his work is that “modern capitalist economy does not automatically work at top efficiency, but can be raised to that level by the intervention and influence of the government.” (From Wikipedia). So essentially, anything a free-market economy can do can be outdone by government. Certainly from a spending point of view that is true.
I find it both humorous and sad that it’s the foreign press that’s beginning to see through the “news-speak” passed as journalism which we are spoon-fed from an adoring media. The main idea in this article from the U.K.’s Guardian, is that political risks usually relegated to third-world countries, are now present in the United States. This was once unthinkable as the most stable nation of laws, but the capricious and arbitrary nature of the intervention of the federal government in private enterprise cannot help but be a chilling pall over the stimulation of investment in America. Who wants to play a game when the rules not only can, but are now expected to, change as the political winds blow?
There will come a day when the interventionist party will be over, the guests will be left to recover from the proceedings and the property owners will be left to salvage what remains. The landscape will have been irreparably changed.
For many years, I have wrestled with the idea of working for a Masters degree. Many things kept me from this pursuit: work needs, lack of time, family needs, you name it. There also was that nagging “value-proposition” problem…. I couldn’t find a Master’s program that qualified me for more than a $75,000/year middle management position. As an owner of my own business, the idea of spending the time, energy and money to obtain a Masters for a position I was over-qualified for seemed rather silly.
Fast forward a quarter of a century….
In my risk management studies, I met an individual (hat-tip to George) who turned me on to the possibility of using the graduate credits earned from my ARM and ARM-P coursework towards a Masters degree. I began investigating this possibility and found the Salve Regina University willing to accept at least 12 graduate credits towards the 36 needed for the conferment of a Master of Science in Management with a Risk Management concentration. I will be petitioning the Dean of Graduate Studies to accept 6 additional graduate credits once I complete my Associate in Commercial Underwriting (”AU”) designation, scheduled (if all goes well) for June 1.
Almost all of the work is online and much of it self-study: right up my alley! To that end, I decided to apply. My first assignment: “Provide a detailed statement which describes academic and professional experiences which will make a contribution to your pursuit of a graduate education at Salve Regina University. Include in this statement any unique aspects of your experience relevant to your intended course of study.”
My graduate admissions statement follows:
I find it humorous that as I sit here wrestling with an appropriate application statement, I am transported back 25 years or so wrestling with my USC and NYU application statements as if it were yesterday. In that sense, my experience is circular, with everything old being new again! I am smiling because it’s “interesting” to try to sift through a quarter century of life trying to figure out what experience should be highlighted in such a statement. And by “interesting”, I mean “pointless”!
Every thing I’ve done and every person I’ve met and every experience experienced has led me to this point in time, the “here and now”. Every person helped, every person counseled, every life touched is a part of what constitutes me as me. For me to attempt to judge which experience was more important than another strikes me as folly. So let’s recap…!
NYU days were hectic. I worked full time in the family’s trucking business my junior and senior years and took night courses and summer sessions to keep up. I did not do this by choice but the family business was struggling and I needed to pull my weight. I paid for my own education and therefore understand its value. Soon after my Bachelor’s conferment, the family business failed. Shortly after that, I was married to my bride, moved and started a new job all in the span of 30 days. It was during this time that I consciously learned and accepted that the only constant in this world is change.
And many things did indeed change: I “fell into” the insurance sales business by accident and with my first home and daughter on the way, I had to figure things out very quickly. One thing I figured out quickly is that insurance sales producers could be broken down into two groups, one being so-called “social” producers, relying upon who they knew and not what they knew to make a living, or “technical” producers, those relying upon what they knew rather than who they knew. Since I didn’t have an effete, “social” background, you can pretty much guess which group I was relegated to!
I have yet to meet the person that grew up wanting to be in the insurance industry. A policeman, a fireman, an astronaut, yes, but not one insurance actuary, underwriter or risk manager. I think that this is the reason why there is such a lack of empathy, compassion and passion associated with the insurance industry. Its members think in terms of insurable risk,insurance contracts and how much the commission is going to be on the policy they just sold. After 20 years of practicing, I can tell you that the best insurance practitioners listen to people and find creative solutions to the problems faced.
At his trial for heresy, Socrates is acknowledged to have spoken “The unexamined life is not worth living”. In times of quiet, I close my eyes and allow myself to relax. In these moments of introspection, I listen and allow myself to hear what my heart is telling me. And what I’ve heard are the most important things, things that have shaped the tapestry of my life. Among these “important things” is that I need to be a life-long learner not just to expand knowledge for its own sake or for personal hubris, but to deploy this knowledge to better the lives of others. Willingness to assist others is not enough, as it must be matched with commensurate ability.
Which is why, after 17 years from the conferment of my first professional insurance designation, I decided to listen to what
my heart was telling me and have dedicated two or so years to a remake, a refresh, a re-do. I chose the study of risk management in all its forms because it was the most natural progression from insurance. With it, I took my first steps into a much larger world. What I soon learned is that for all these years I had been applying risk management techniques and risk control mitigation in solving problems, I just never knew the language and could not articulate the ideas and solutions as well as I can now. I became aware, that despite its vast nature, just how small the world of insurance was.
Since January 2008, I have formally studied risk management at the AICPCU/IIA and National Alliance for Insurance Education and Research and have attained many acknowledged advanced technical designations. Conferment of a Masters degree in Risk Management will break down many walls to understanding, and give those whom I meet and help added comfort in my ability to adequately address the pressing problems they face.
I do not know what the future holds, but when the time comes to stand before my Maker, I do not want Him to think I’ve wasted my life, after all He’s given me.
The current credit crisis, how it affects the global marketplace and why it’s important to our entire economic system. Made so simple that a fourth grader can understand it.
This is a massive post for which I apologize in advance. Hope you have some time.
To my eyes it seems that society’s perception of risk is getting closer and closer to the actual risks we face. I have been a staunch proponent of markets ’self-correcting” and I have not minimized or sugar-coated the “pain” likely to be felt during this process. But my cautious optimism has in large part been based upon the political and regulatory processes of our country not radically changing.
But it’s right that we should expect change. The political wonks will tell you that it’s what the majority of voters “voted for” in November. While many can lament that more people didn’t ask for details of the proposed change, the reality of the situation is palpable.
Today, U.S. citizenry is faced with a dizzying array of emerging, high severity risks:
Surveillance Risks
Access to Information
Taxation Risks
Inflation Risks
Social Engineering Risks
Financial Risks
Regulatory/Political Risks
Class-Warfare Risks
Job and Home-Loss Risks
Loss of Liberty Risks
Probably not since our country’s founding have such a confluence of ideas and issues been thrust to the forefront for society to work out. Some thoughts on each risk follows:
Privacy and Surveillance: Advances in technology has made it possible for government to surveil hundreds of thousands, even millions of people at relatively low cost. Whether the surveillance takes the form of monitoring computer searches or through security cameras the result is the same. I am appalled by the disingenuous nature of “marketing” these programs, using the guise of “protecting the public” by “helping fight crime” or “making the streets safer”. Privacy is a linchpin of liberty and the more we relent to intrusive surveillance, the more liberty is lost.
Access to Information: In 1989, the modern internet was born when “Tim Berners-Lee invented a network-based implementation of the hypertext concept” (which we now call the world wide web). It is hard to imagine modern life without the internet. But our growing dependence upon “easy” access to information is a risk in and of itself as information may be withheld or corrupted to serve the needs of those who control not only the information itself but its flow and availability. The growing rate of loss of print media is also an alarming trend as we can envision a time when information is only disseminated through the internet.
Taxation: The recently passed “Stimulus Package” at its heart is morally corrupt, as it makes future generations financially responsible for our folly today. Higher rates of taxation and new taxes not yet devised are a virtual certainty. Monies surrendered to a government means that it cannot spent in the “regular” economy. Taxation however, has a potentially dark underbelly as well. It can be used as a tool in social engineering, where taxed activities can be monitored. A recent idea of taxing people on the basis of the number of miles they drive rather than on how much gasoline they burn is only one step away from monitoring the who, what, where and when of such usage. See Privacy Risks.
Inflation: A cousin to Taxation Risks. A natural consequence of “inflating” money supply in an economy is inflation, which is the loss of purchasing power over time. We intuitively understand this concept as the cost of goods and services tend to increase over time. However. as a result of current monetary policies, we can expect much higher rates of inflation in the near term future. The good news is that a little inflation is better than deflation, which is commonly defined as a “persistent” decline in the costs of goods and services.
Social Engineering: For those unfamiliar with the term, social engineering can be thought of as those “efforts to influence popular attitudes and social behavior on a large scale”. Social Engineering is glaringly apparent in a bill currently circulating in the Illinois General Assembly, (HB0687). The bill, if passed, would amend the current Illinois Firearm Owners Identification Card Act to require firearm owners to provide proof of liability insurance in the amount of at least $1,000,000 specifically covering any damages resulting from negligent or willful acts involving the use of such firearm while it is owned by such person. As of today, lawmakers sense that they will not be able to suspend the Second Amendment to our Bill of Rights, so we can look at this proposed litigation as an attempt to circumvent it. Issue #1: the proposed law will require an insurance policy that covers “negligent and willful acts” of firearm usage. Good luck finding that today. Issue #2: if such a policy is not obtained, the owner’s firearms are subject to seizure. If something cannot be banned, there are those that seek to control it.
Financial: A picture is worth a thousand words. As of this writing, the Dow Jones Industrial Average is shown directly above, which as of this writing is down more than 16% YTD. The basic problems? Lack of trust, lack of transparency, and lack of ethics. Increasingly, we do not trust our elected officials to get it right. Changing rules of the game “while the ball is in play” is particularly troublesome and does not assuage the people that make up the markets. The Fed’s refusal to disclose the recipients of over $2 TRILLION dollars that not one American citizen or his designated representative voted on is completely unacceptable. In an information vacuum, trust suffers. In the “lack of ethics” department, think Madoff, Tom Daschle, Tim Geithner or Rod Blagojevic, all involved in some violation of trust. Simply speaking, without trust (which flows naturally from open and ethical frameworks), financial markets will continue to exhibit weakness and society will bear the brunt of its full force.
Regulatory/Political: More and more, this is aligned to Financial Risks as New York and London cede financial power to Washington DC. So long as we delude ourselves into thinking that Washington has the answers to all our problems, the higher the frequency and severity of risks CAUSED by the political process. I promised a friend I would not mention that the “cult of personality” of some of our leaders today poses its own set of risks.
Class-Warfare: a cousin to Taxation risks and an increasingly closer cousin to Political Risks. Societal unrest is an increasing possibility as battle lines of class-warfare are being drawn. There does seem to a bubbling sense of unease between recipients of governmental programs and those tasked with “paying the freight”. I sincerely hope this doesn’t rip us apart.
Job and Home Loss: Simply speaking, the rock upon which our modern society stands (or falls). Job losses can cause an “infinite vicious regress” of home losses, which results in tax-base erosion, which results in lower tax amounts to government, which further strains government resources, which has to increase tax rates, which may result in further home losses and so on. (I’ve always wanted to use the term “infinite vicious regress” and now I have!)
Loss of Liberty: By far, the risk that concerns me the most. Without blatant political commentary, I ask that you remember and consider this one risk as time goes by and events unfold. It is likely that this will take the continued form of “incrementalism“, where small liberties are asked (or demanded) as a “reasonable” trade-off for perceived safety. This is a close cousin to Privacy/Surveillance Risks, but be aware that the more power we relinquish to our government, a commensurate loss of liberty results.
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While our future is uncertain, being aware and thinking carefully of the emerging risks we face will put you ahead of the curve. As always, I look forward to your comments!
Given our recent proclivity to nationalize financial “pain”, it seems that it’s only a matter of time before those very well-heeled hedge funds (and their very well-heeled investors) taken in the $50B Bernard Madoff ponzi scheme will formally request a bailout of their own. I suspect it will happen very shortly after January 20, 2009 and just might be one of the first national policy “tests” of our new President, Treasury Secretary and SEC Chairperson.
From this recent Newsday article, “There’s no doubt that hearings will be held on this, and some government aid is a very logical request,” said Robert Schachter, an attorney with New York-based Zwerling, Schachter & Zwerling, which is representing several Madoff victims. “If we’re bailing out Wall Street and the auto industry, maybe these individuals should be bailed out too.”
When the time comes, will you blame them for making this, using Mr. Schacter’s own words, “very logical request”? Especially in light of the SEC’s own press release on the issue which reads in part…
“The Commission has learned that credible and specific allegations regarding Mr. Madoff’s financial wrongdoing, going back to at least 1999, were repeatedly brought to the attention of SEC staff, but were never recommended to the Commission for action. I am gravely concerned by the apparent multiple failures over at least a decade to thoroughly investigate these allegations or at any point to seek formal authority to pursue them.”
Well if that isn’t a prima facie admission of negligence, I don’t know what would qualify….
In fact, read for yourself the SEC “Case Closing Recommendation” which plainly states that the SEC staff “found no evidence of fraud” as of November 21, 2007.
Luckily for the SEC, like most government agencies, it operates under the doctrine of sovereign immunity, which means that for all intents and purposes, “the king and queen can do no wrong” and cannot be sued under most circumstances.
But such claims against the SEC will provide “cover” for the politicos who’ll support the notion of a Madoff claimant bailout. And thankfully for them, they don’t have to look very far for the potential sponsor of such a bill: Senator Frank Lautenberg of New Jersey, who entrusted his family’s charitable foundation to Madoff. According to the Senator’s attorney, Michael Griffinger, the extent of the foundation’s losses is not known as yet, but “that the bulk of its investments had been handled by Madoff.”
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Still, I am struck by some of the most basic and glaring risk management deficiencies as the facts of this matter emerge…
In the risk analysis phase of the risk management process (once risks have been identified), assessments of potential impact on the firm are reviewed. If done comprehensively, both quantitative AND qualitative analyses are performed. Quantitative analysis deals with so-called “hard numbers” and includes a review of things like projections of loss, cost/benefit analyses and net present value calculations.
Well-trained financial “quants” on Wall Street get paid “the big bucks” to do these type of analyses, and their reports are usually quite impressive on paper. The problem is that too many financial and business decisions are made on the basis of these “impressive” reports/projections alone.
Without a concurrent review of the qualitative risks undertaken, the risk analysis is INCOMPLETE and can lead to unforeseen and financially disastrous results as evidenced by the recent collapse of so many financial services firms.
Qualitative risks are by definition, difficult to define as they are not “hard number-oriented” and rely to a great extent on the experience, judgment and intuition of the members of the risk management team.
I think the primary reason I see almost no discussion of qualitative risk analysis undertaken is because IT IS HARD TO DO. It is also time-consuming. It requires a thorough understanding of the business, its processes, and its place in the physical, organizational and socioeconomic environments the business operates in. It requires people who are TRAINED IN RISK MANAGEMENT TECHNIQUES, not just financial wizards who can make a report read however management wants it to read. Finally, it requires corporate management support, which is notoriously difficult to get (and keep).
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Despite the political grandstanding that is likely to happen when this matter is undertaken by Congress, we cannot legislate greed out of existence and scams like this will come to light in the future.
In Errol F. Moody Jr.’s discussion of “Investment Malfeasance and Breach of Fiduciary Duty” (which is an excellent read and is VERY highly recommended reading), he makes the case that for all intents and purposes, matters such as Madoff all come down to the same issue: “a failure to gauge risk”.
Clearly, the risks posed by Madoff were either not identified or analyzed properly by investors and a price for failing to properly manage risk shall be exacted.
It’s 2013. Governments around the world continue to struggle to keep social and financial order, but with clever and well-intentioned legislation, things are getting better all the time.
The nationalization of certain companies at one time had their non-nationalized competitors at a distinct disadvantage. Because these nationalized organizations (the “NO’s”) had an unlimited source of funds at their disposal, they didn’t have to worry about the pesky problems of raising capital much less the “cost of capital”, like their non-nationalized competitors had to.
So long as the NO’s continued to do what Congress mandated them to do, things were good for the NO’s. Social and financial engineering through a myriad of regulations has continued unabated.
The credit markets never recovered and disappeared entirely. No bank was willing to lend their capital to a non-nationalized company and the NO’s didn’t need them. When reviewing business plans, it asked a fundamental question: How can this entity compete against an unlimited-funded NO?
The previous “lender of last resort”, the Federal Reserve, is now the *only* authorized and needed lender. This really doesn’t have an impact since private ownership of business was outlawed in one of the better provisions of the Business Users Satisfaction Tax of 2010 (affectionately known in the beltway as the “BUST”).
Other provisions of the BUST forbade future home foreclosures (allowing people to stay in “their” homes even though they didn’t pay for them) and granted ownership of all currently-encumbered homes to the Fed. The BUST also eliminated the word “bailout” from our language and substituted it with “loan”. The penalties for using the “B-word” in print or verbally are severe.
To take advantage of Congress’ vast business experience, the President created a cabinet-level position “Office of the People’s Business” to ensure the NO’s compliance with Congressional mandates. Funding for this new office was easily obtained from the former Small Business Administration, which was disbanded due to lack of interest. Unions have also been legislated out of existence with the recognition that we all work for the Homeland now.
So much so that the budget for “Department of Homeland Entitlements” now eclipses that of the Department of Defense, as created by the “Fairness Tax of 2011″. The good news is that we all now have access to “affordable healthcare”, due to the nationalization of all health care providers. This was absolutely brilliant, as it completely bypassed the need for nationalizing the health insurance industry altogether.
The good news does not stop there, though! The Medicare, Medicaid and Social Security programs (which now take full effect at age 61!) are now well-funded due to the mandatory “age 60″ individual liquidation provisions.
The ownership stake of AIG taken in 2008 was fortuitous as it now “insures” all General United States Auto Worker Motors Company’s automotive products, which we are now mandated to buy. However, it appears its time as an insurer is limited. Legislation recently passed will amend tort laws in 2014 so that private collection of civil losses will be eliminated. All monies will now be automatically transferred to Department of Homeland Entitlements for compassionate redistribution.
The trial lawyers fought a good fight, but the fix was in. They now turn their attention to “The Happiness Act“, a really swell piece of legislation making its way through Congress which would eliminate five of the “least used” rights contained in the Bill of Rights, which is by any measure now “just a piece of paper”, a complete anachronism in our modern times.
But the Happiness Acts’ goodness doesn’t stop there. This bi-partisan proposal would also “update” the Constitution to mandate economic equality and correct the unalienable rights of “Life, liberty and the pursuit of happiness” enumerated in the Declaration of Independence to the much more compassionate “Loving government, wonderful life and guarantee of happiness”.
I mean really… How can anyone be against happiness?
Oh, and if you don’t know the meaning of the word “irony”, go look it up (and have a nice day)!
The stack of stuff I want to share seems to be growing by the day… too much stuff and not enough time! So instead of writing fewer/longer pieces, here are a few succinct words of advice/counsel on each subject in one “omnibus” post. Hopefully, you’ll find a “nugget of joy” that’s of use to you and I can start to cut through my growing stack of stuff. So, let’s get to it…
1. Putting money in bank CD’s may seem like the safest choice today, but it might not be. You’ll be told that these things are “riskless”. They’re not. The one primary risk they don’t tell you about and that you retain (and it’s a biggie!) is inflation risk. Very simply. when the inflation rate is higher than the CD’s APR, you’re losing money. Historically, the one asset class which has a real return ABOVE inflation is equities. With stocks “on sale” at about 40% off, you might consider “buying low” today if you have the time to wait until the market recovers. I suspect that 10 years from now, you’ll wish you put every dollar you had in now.
2. Every personal insurance policy should be reviewed annually to make sure it still meets your needs. Take some time to do it. You might find that coverages can be eliminated, deductibles can be increased, insurers can be changed, etc. to reduce your insurance cost.
3. Every small-business owner should review their insurance program annually as well. If your business operates on a 10% operating margin and you save $10,000 in premium, the savings was not just $10,000- The real savings is $100,000 in gross sales you didn’t have to make just to pay the insurance premium.
4. The “annuity vultures” are out in full force. They usually take the form of “investment advisors” working for insurance agencies and especially prevalent in poor economic times, such as today. They prey on your fears that you’ll run out of money before you die which they cryptically call “longevity risk”. There’s 3 main reasons you should shun: 1. These are extremely complex insurance contracts. Most come with a 200-300 page prospectus. Unless you read and understand all those terms and conditions, be ready to get hurt. 2. Annuities are guaranteed by the issuing insurer- want to make any bets on which insurer(s) are going to survive? 3. COSTS. Depending on the insurer and the particular product being promoted du jour, the underlying costs of the annuity are outrageously high. Remember, the agent needs to be compensated for selling you this complex contract. You’re the one paying the freight.
5. If you have a private disability (DI) policy, look to increase your “elimination period” (which is a essentially a deductible measured in time, not dollars) to decrease your cost. I recently changed the elimination period on one of my DI policies from 30 days to 90 days. When the policy was originally written, I could barely afford to be without an income for 30 days. Blessedly today things are a little bit different. I saved over 25% in making this one change.
6. Our preconcieved notions and the media shape perceptions of risk. Do you really think that Congress knows how to “fix” the economy? Do you really have faith in their stewardship? Should we allow government to grow or would you prefer that industrious, entreprenurial Americans be tasked with our economic recovery?
7. Turn off CNBC. Stock market-timers have to be right not only once, but twice. Even Warren Buffett can’t do it. The stock market-timers “Hall of Fame” is an empty room.
8. Remember, it’s all relative. All assets are being repriced. Globally. There’s no place to hide. Forget U.S. Treasuries with their 0.01% interest rate. Invest in your own education. You want security? Look in the mirror. It’s the only place in this world that you’ll find it.
9. Worry only about the things you can DIRECTLY control. Everything else will take care of itself and you’ll save yourself a lot of heartache.
10. Continue to fund your 401k. If enough people opt-out, these tax deferred programs will go away and that’s not a good thing.
11. If you’re in business (or work for one), don’t forget to advertise and market the goods and services you provide. Your competitors aren’t and it’s a great time to steal market-share from them.
12. You may have noticed the increase in advertising by gold sellers, I know I have. Before buying, understand that gold has a ZERO expected rate of return, as it produces NOTHING. Gold has no intrinsic value, only the value we ascribe to it. You’re also going to need to buy A LOT of it to make it “worthwhile”. Where you gonna put it all?
13. Taking medications (legal ones, that is)? Want to try to save some dough? Live in NJ? Try www.njdrugprices.nj.gov for an online prescription drug registry. Prices for a one month supply can vary widely, even within the same zip code. It works surprisingly well.
14. According to John Montgomery, Founder and Portfolio Manager of Bridgeway Funds, there have been nine bear markets since 1940. The average time for the stock market to “recover” to its previous high is 13 months (excluding this current bear market). 13 Months- a little over 1 year. Of course, this time may be different but know that historically speaking, if you can keep your head when everyone has lost their’s, you’ll be well-rewarded.
15. THIS IS NOT THE GREAT DEPRESSION, PART TWO. We do not have 25% unemployment and the only thing we stand on lines for are HDTVs, not bread! Don’t “buy” the doom and gloom the media is “selling”. It’s all meant to manipulate.
“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:
Determine your maximum tolerable percentage loss from the following tables,
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?
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.
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.”
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.
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. UPDATE: Got it and am currently waiting for my diploma!
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!
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 premiumsavings quantitativelyby 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.
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:
Low-cost? Check.
Diversified? Check.
High quality holdings? Check.
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:
Short Term Bond Fund duration is 2.5 years * 60% (0.6) of the total invested = 1.5 years; and
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 increasein 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.”
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.
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.
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:
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.
My wife gently ribs me from time to time, saying that I view the world as if the “sky was falling”. Well, blessedly the sky almost never falls (but the risk is there that it might), and sometimes it actually does. Well, it *feels* like it, anyway. I try to remind my children that life is messy business and no one gets out alive.
So, I promised some info related to my CRM Principles of Risk Management course that I recently attended. The instructors were bright, articulate and engaging and as a result, the 20 hours of instruction went by fairly quickly. As you may deduce from a “Principles” class, the essential focus was the basics of risk. The class was a fairly large one, with about 90 people. It was also a very highly credentialed group, with about 120 designations granted to these folks. Definitely no slouches here.
The first risk concept explored is an identification of the three generally accepted types of risk, each with their own unique characteristics. They are:
Pure Risk;
Speculative Risk; and
Gambling.
Pure Risks are those where there’s a chance of loss *only* with no possibility of gain. An example of this might be an airplane falling out of the sky wiping out a city block or the death of a loved one. With respect to individuals, insurance does a good job of protecting against many pure risks we face in our daily lives.
Speculative Risks are those where there is a chance of a loss OR a gain. These risks include a *variation* of outcomes where profit is possible. An easy example of this is investing. We invest money in stocks, bonds, commodities, etc. with the hope of a positive result (profit), but where exists the possibility of loss. To spin this concept to financial academia, having the majority of your investments in one company or one industry group, is called “speculating” (and not investing), and we all know how dangerous that can be!
Starting and operating your own business is another form of speculative risk. For my money, this is, for most individuals, the most “risky” speculative financial risk. Since I have been a “serial entrepreneur” (stop me before I start another business again!) all my adult life, I guess this is why stock market investing seems nowhere near as risky as the commitment and deployment of capital in my own business.
The last risk group is gambling, where there is the chance of loss or gain, but the probabilities strongly favor a loss. I highly doubt this type of risk needs any explanation. Anyone who has ever been to Las Vegas or Atlantic City (or watched CSI: Las Vegas on television) understands this type of “risk”. In the real world, I’m not sure that gambling is really a form of risk. I don’t consider shooting craps or “putting it all on red” to be forms of risk, as I think it’s a virtual certainty that a loss will occur.
I think it’s fair to say that one of the areas traditional risk management gives short-shrift to is the area of “personal” risk management. Sure, major corporations employ risk managers and teams of experts to assist them survive the myriad of risks present to the “enterprise” but where’s the love for individuals?
Even the risk management educational material I’ve reviewed focuses almost entirely on corporate risk management (I guess it’s because that’s where the money is). This lends credence to my point of view, but my position isn’t set in stone. If there is a wealth of personal risk management educational material available that I’ve somehow missed, let me know. When the data change, so do I.
Let’s face it, the general public depends on insurance salespeople to act as risk managers because:
A. The general public (and most insurance salespeople) thinks “risk management” is the same thing as “insurance”; and
B. Most people, who are busy living their lives, don’t consider risk management concepts and techniques.
Professional risk managers wince and take a real dim view of the perception that “risk management = insurance”. They’ll tell you that insurance has a role to play in risk management, but as a financial tool to be used, nothing more. If you can only solve risk management problems with insurance, you ain’t much of a risk manager!
There’s a problem, though - insurance salespeople aren’t particularly versed in risk management techniques. (There, I said it.) They can talk to you all day about life insurance, car insurance, house insurance (you get the point), but to have an intelligent discussion on how to apply risk management techniques to *your* LIFE is not one you’re likely to be engaged in any time soon.
There are exceptions of course, but not many. While a person can obtain a Masters degree or Ph.D in insurance, they’re usually relegated to academia (or locked away, somewhere far away!). These are not your garden-variety insurance salespeople types. The industry attempts to compensate for this education gap, in part through designations such as CPCU, CLU, CIC and CRM. Admittedly, it’s a confusing alphabet soup for the general public.
I would urge you when choosing your next insurance broker or representative, strongly consider those people who have passed the rigorous education and testing requirements required to obtain the designations shown above. You’re much more likely to be able to have a conversation on risk management concepts and techniques if you do.
Want to keep up with updates to this site easily (and really, without even trying)?
Click on this cute little box:
A new page should open. Press the button “Subscribe Now” to add this site to your Bookmarks Toolbar Folder. This works in Firefox and theoretically, it should also work in IE versions 7 and 8, but since I don’t use either, I can’t verify that for you. (Maybe you can let me know!)
Anyway, if all went well, you’ll be able to see the updates in your browser automagically. (You’ll still have to remember to turn on your computer, fire up your browser and look at the monitor, though).
Go ahead and do this now. Don’t worry about me, I’ll wait here ’till your done. Let me know if you have any trouble.
I first considered an insurance career in the months between 1987 -1988. Like 99.999% of all insurance industry workers, I didn’t grow up *wanting* to be in the insurance industry. Perhaps that’s the reason why so many in our industry are so seemingly dispassionate, they’re not in it ’cause they love it. But that is a subject for another day.
In the late 1980’s I was running several trucking companies: a messenger service, an airfreight cartage operation and a hazardous materials hauler. (No wonder I was tired!) During that time the transportation industry was in the midst of severe regulatory change and I wasn’t sure we were capitalized well enough to keep up. I also wasn’t sure if I wanted to dedicate the next 20 years to the industry. I was burned out and run completely out of ideas. To stagnate is to slowly die. So I started talking to my insurance agent, Richard Augustyn, about his business.
By the end of October, 1989 I started my insurance industry career in sales (on a $450/week draw against commissions) with a small retail agency on the cusp of great things. I was able to leverage my transportation industry and small business ownership experience for the benefit of my new customers immediately. Those were fun days, but I was dangerous by what I *didn’t* know. A new insurance license can be roughly equated to a motor vehicle learner’s permit. I was so “sure” of everything in those days and it is only in hindsight that I understand how much incomplete (not necessarily “wrong”, just incomplete) counsel I gave.
I learned how to run an insurance agency: operational aspects, the special accounting methods, premium finance, policy marketing, sales and service (they are all different skill sets) and the absolute importance of renewal business to agency survival. It was a brave new world for me and I enjoyed learning *everything*.
Then the agency opened an insurance “program” division, writing inland marine business countrywide. I learned about program and broker administration, managing insurer expectations, policy creation and insurer underwriting guidelines and standards, the “why’s” behind the insurance contract.
Well, all heck “broke loose”. Staff grew from 7 to about 35 in less than 12 months. My role had morphed from operational VP and sales to what amounted to being “mother-hen” and “fireman”, keeping tabs on all my chicks and responsible for putting out all the fires in the office.
That’s how I felt. Within 2 years, the small business ownership bug had bitten me again and I had the *audacity* to open my own retail insurance agency in July, 1991. The parting of ways was not amicable as I recall. It’s always been a regret, although in hindsight there was probably no way to avoid it. I must admit I was amused and flattered (in a really weirded-out way) when I found out my ex-boss went through the trouble and expense to put me under surveillance after I left. That being said, I am especially grateful to Richard Augustyn for being my friend and guide in those years. It is not an overstatement that without him I would not be where I am today. That experience laid the foundation for all that was to come and is today.
There is no formal definition of the term “financial pornography” (FP) but like the Supreme Court has written, “I know it when I see it”. The term commonly refers to the depiction of financial or investment material in such a way as to arouse or elicit an intense, emotional response. The cure for FP addiction, as you might expect, is an understanding of how capital markets work.
In some cases, FP is just annoying, like having to sit through incessant TV ads for “this” investment company or “that” investment company, each expressing how their method of investing is the way to go. These ads all play on one of two (and sometimes both) simple human failings/traits, fear or greed. True securities analysis may have at one time been able to give one investment company a *sustained* advantage, but the tragic irony is that there are so many of these very smart, very qualified people doing this type of work that they are unable to sustain an advantage, because they have to consistently beat all the other very smart, very qualified people doing the same work.
Passive investors paradoxically benefit from their toil. Because they are so good at what they do, the stock market is an “efficient” one, meaning that at any one given moment, the value of the market is likely to be the “correct” one. There are moments, like the one’s we are experiencing, that mis-pricings can occur. It does not mean the market is inefficient. We are emotional beings and accordingly, gross mis-pricings (if they exist) are due to behavioral reasons.
But FP addiction can be very hazardous to your wealth. Kindly note the video above. It is Jim Cramer on CNBC’s Mad Money show advising people not to sell Bear Stearns last week (when they could’ve gotten out at around $60/share). Now, I am not blaming Jim Cramer for this, he’s got an entertaining show to provide. That’s his job! Whether he was wrong because of a bad call or you think something’s “fishy”, is a question I’ll leave to you.
The blame for following this advice rests solely on the shoulders of people who equate investing to entertainment.
Financial advisors are not responsible for setting investment policy - you are! The corollary to this is that we don’t set investment policy from entertainers playing financial advisors on TV.
True financial advisors are those that are responsible for building appropriate portfolios that help meet your financial goals and match your willingness, need and tolerance for risk. They assist in fund selection, placement, and perhaps a little assistance in tax planning as it relates to tax loss harvesting. Can they *assist* in setting investment policy, OF COURSE, but the ultimate responsibility is yours.
Setting an appropriate investment policy in writing will save you from yourself.
I don’t usually care about what happens to an individual stock, but there is an important lesson to be gained from the short story of this one…
In case you missed it, over the weekend Bear Stearns was sold to JPMorgan Chase (using money loaned to it by the Federal Reserve). A very short stock price history:
Within the last year, Bear Stearns shares were valued at just shy of $160 per share.
Within the past week, it’s share price, which had fallen sharply, was still hovering at about $60 per share.
Over the weekend, Bear Stearns was sold in an apparent “fire” sale to JPMorgan for $2 per share.
GULP.
About $19 BILLION in market value is gone. Vanished. The company was sold for the “bargain basement” price of $236 Million dollars. The answer to why this happened is the subject of another post. My immediate concern is for the company’s employees.
Today there are about reportedly about 14,000 Bear Stearns employees that have seen vast sums of their retirement and pension savings completely wiped out. Apparently, the lessons of Enron and Worldcom have not been learned because Bear Stearns employees figured it couldn’t happen to them. But very unfortunately for them, the risk has “shown up”.
When you hold a single security you are taking on what the financial academics call “specific risk” which includes within its very definition, the most extreme form of “business” risk, the risk of complete failure.
Author Charles Ellis, in his book “Winning the Loser’s Game” (the link to which can be found in the Reading Room) discusses this concept at great length. He explains that specific risk and “extra market risk”, which is the risk taken by holding related stock groups, cannot be diversified away, and therefore should be avoided. Investors are simply not rewarded or compensated for accepting specific and extra market risks. Because these kind of risks can be eliminated, they should be. Mr. Ellis calculates that about 75% of the risk associated with holding a single stock can be attributed to specific and extra market risks.
It’s important to understand that even if specific and extra market risks are eliminated from a portfolio by means of diversification, what remains is market risk, or in academic parlance, systematic risk, which can be managed. Market risk represents the overall risk of holding stocks and is the only type of risk that an investor has been rewarded for taking historically.
The best financial tool devised for the average investor to manage market risk is an index fund or ETF that tracks the Wilshire 5000 index, which is a composite of the entire US stock market. It shouldn’t be your only holding, but it is considered by most financial authors to be one of the most appropriate core investments for long term investing.
Here’s one silver lining: Today (March 17, 2008) Bear Stearns stock closed at $4.81, so JPMorgan has already seen a 240.5% return on its investment (using borrowed money, no less!). So, if anyone doubts the ability of Wall Street to make a buck, look no further.
———–
UPDATE: March 20, 2008 Stock Price: $5.96 - JPMorgan’s return on original $2 (borrowed $$$) investment: 298%; Don’tcha wish all your investment returns could be like this?
One of the best ways for people to conceptualize the benefits of passive investing is a game called “Outfox the Box”, created by author Bill Schultheis and found in his book entitled, “The Coffeehouse Investor”, a link to which can be found in the Reading Room.
The game is deceptively (and almost deviously) simple. There are 10 boxes from which to choose from. Which box do you want?
$1000
$2000
$3000
$4000
$5000
$6000
$7000
$8000
$9000
$10,000
It’s not that difficult to figure out. Everyone wants the $10,000 box.
OK, let’s change the rules just a little. You are now asked to choose a box from here:
$8000
??
??
??
??
??
??
??
??
??
Now what do you want to do? Is it worth risking a lot to gain a little?
In other words, do you risk getting less than $8,000 for the prospect of $9,000 or $10,000? This is when most people opt to take $8,000. Passive management/indexing works as a strategy, as illustrated by the fact that 75% - 80% of all mutual funds do not beat their benchmark indexes.
“Outfox the Box” is a game I intend to share with the Girl Scouts to help make our workshops together a little fun.
A short note (that needs to be said): I have borrowed heavily (okay, stolen) from Mr. Schultheis’ website here and claim no ownership of his brilliant idea. My intent is to help make this game and his book more well known, *not* to steal his work. If asked, I will remove this blog entry.
John Montgomery is the manager of Bridgeway, a no-load mutual fund family (like Vanguard). One of their funds that is most interesting to investors (and that is still open currently for investment) is their Ultra-Small Company Market Fund (BRSIX), which is a passively-managed fund of the smallest of the small publicly traded companies. It’s benchmark index is one that you’ve probably not heard before, the CRSP Cap-Based Portfolio 10 Index, which is an unmanaged index of about 1670 smallest publicly traded stocks.
Small cap stock funds, like this one, is not for the faint of heart. Small companies are subjected to business and capital risks most large companies are not subjected to or at least to the same degree.
First there is the issue of access to capital. On whole, smaller companies have limited access to capital as compared to their larger cap cousins. Also, when it is made available, it is at a much higher cost. The reasons for this should be relatively clear. Smaller companies are subjected to much higher business risk, risks to the entire enterprise that may “take down” the whole ship. Again in relation to much larger companies, smaller companies tend to have immature product or services lines of business, less experienced management, greater costs (access to capital to grow) and a greater exposure to losses to net income from losses of primary supplier(s) and primary customer(s).
John Montgomery, in his February 25, 2008 investment management team letter stated that their examination of the data between 1926 and 2000 revealed that “ultra-small stocks fell an average of 35% more than large stocks during the average calendar year market decline” and that their “best generalized advice is not to have more in these funds than an investor means to have for the long haul, nor more than investor can afford to hold through a downturn.” He goes on to say that this generalized advice is good advice when considering one’s own stock market risk tolerance, i.e. what percentage of your total investments will be in stocks.
So why hold the stocks of small cap companies? Higher *expected* returns. Please note I did not write “higher *guaranteed* returns”. The evidence suggests that the longer the time period held, the more likely the higher expected returns of smaller cap stocks will show up. Investors in small companies demand (and historically have received) what the academics refer to as a “risk premium“, a premium for buying higher-risk investments.
Author Larry Swedroe gives an illustrative example of 2 companies: Wal-Mart and K-Mart. He asks readers to consider which is the “better” company. Most people would consider Wal-Mart the “better” company of the two. He then asks readers to consider which stock would make a better investment? Again, many would answer Wal-Mart, in large part because it is perceived as the “better” company. Mr. Swedroe’s argument is that K-Mart would likely be the better stock to own because of its risk premium. In a big picture sense, investors can allocate and deploy their capital as they see fit. They don’t *need* to invest in K-Mart. So, investors that actively choose to invest in K-Mart over Wal-Mart demand (expect) a higher rate of return over what they would get if they invested in Wal-Mart.
We can apply this example to smaller cap stocks. Investors (that can deploy their capital in any manner) that choose to invest in smaller companies demand (expect) that their investment returns in this risky asset class will be higher than large cap companies as the stock market has historically rewarded risk. If the expected returns were the same, there would be no reason for an investor to choose a riskier investment over a “safer” one!
Mr. Montgomery further noted in the investment letter cited above, “in ten of the last eleven recessions, stocks rose an average of 24% after the low”. He is referring to the average stock market gain (of all stocks). Because small cap stocks have a higher expected return, investors in small companies expect an even higher post-recession increase.
Again, not every expectation of gain materializes. If there were no risk, there would be no risk premium. But the longer the holding period time frame, the *more likely* the expected returns materialize.
In getting ready for the “Got Money?” Girl Scout workshop, I thought it might be neat for the girls to look at stock market volatility and returns in action. I chose (at random) six NJ publicly traded companies: Campbells, Bed Bath and Beyond, Commerce Bank, Johnson and Johnson, A&P and Prudential Financial.
I’ll ask the girls to “team up” for each company and tell me why they think the company is a good stock “pick”. Should be illuminating to hear the thought process. After we go through a little discussion, we’ll take a look back to 12/31/2005 where they’ve been “given” $1000 to “play” the stock market. We’ll chart the progress of each stock through March 12, 2008. This simple chart will illuminate the way:
Volatility: What’s the likelihood of them holding Bed Bath and Beyond past 2006 (where the decline in value was of over 22%);
Uncompensated Risk: Buying one stock or a few stocks is very risky as you do not get “compensated” by the stock market for holding a non-diversified portfolio; and
Returns: Only 1 of our 6 stocks beat the Wilshire 5000 (Campbells) during this period. All others lost. How likely is Campbell’s out-performance likely to continue?
After about a decade of trying to get me involved in Girl Scouts, my wife can *finally* claim victory! She has been a troop leader, “nut” and “cookie” mom, service unit manager…. Ugh! I had valiantly evaded previous attempts to get involved due to other pressing involvements, but I couldn’t in all good conscience evade any longer. I had the time, the knowledge and the inclination. Recently I was asked by the Girl Scouts to teach 2 workshops for teen girls, one on money and investing and the other on business ownership - topics I am no stranger to and I believe we are not adequately teaching young people.
This lack of financial education has far-reaching effects. One of the problems of course is that parents (at least of my generation) lack basic financial literacy themselves. The learning has all been “seat of the pants” and it isn’t always pretty to watch. Consider the increases not only in credit card usage but in average credit card balance amounts. Consider our appalling low savings rates. Consider that once America was the world’s largest creditor nation and are now it’s largest debtor nation.
I think one of the answers is financial literacy.
The Girl Scouts have 2 workbooks for use in these workshops entitled “Got Money?” and “Mind Your Own Business”. While they provide a good overview of the topics, they’re awfully dry. I have a couple of ideas on ways to make the topics more interesting so I don’t lose my “victims”, oops I mean “students” and I’ll share them here in the coming days. Maybe they’ll be of help to you.
According to this Los Angeles Times news article, UCLA economists are standing firm on their prediction of no U.S. economic recession. Doesn’t mean that it doesn’t “feel” like one. One look at our investment statements or at the breathtaking drop in the financial markets and we all know how it “feels”. But essentially, this is a crisis of confidence. We’re seeing panic selling now, which I believe is a good and healthy thing.
Panic selling, which is a factor in depressing stock prices, means the future holds higher *expected* returns. That is the terrible mathematic truth. For those that have 10-20 years of market investing, this drop in prices is (as Martha would say), a “good thing”. It just doesn’t feel like it.
What’s also happening is our perception of market risk is changing. This is also a good and healthy thing. When perceptions of market risk are high, so are returns. Of course, the inverse is also true. Investing in stocks is risky and should not be undertaken lightly no matter what pretty color filled brochure you’ve been given. People who bought in to the market near market highs in 2001 and around August of last year had, generally speaking, a very low perception of market risk. Of course, market risk was there all the time, it’s just that our *perception* of it was not very high.
So, does this mean it’s all a bed roses from here? Absolutely not. Business cycles and societal trends don’t work like that. But as risk premiums rise, so do returns. So, if your investment policy statement is mandating that you sell some of that cash and fixed income you’re holding to buy equities and you’ve been resisting, reconsider your market risk tolerance.
Remember, it’s not very often that you get to buy equities while they’re on sale.
This brief comic video reminded me of one life insurance sales call I made years ago on a junior executive and his wife.
Despite his wife’s protestations, the guy was convinced life insurance was a waste because he wouldn’t “get anything out of it”. This type of response, while being ridiculous on its face, is a fairly common objection to owning life insurance. Not rational, but common. Of course, life insurance is not for the person being insured, but for the survivors. I explained that it was for his wife and 5 minor children, to help take care of them financially when he wasn’t around to do it. Not a particularly difficult concept to grasp, but he wasn’t having it.
I then reminded him that he had just taken a $685,000 mortgage and I was curious as to how he thought it was all going to work out for his family if he should die during the mortgage term. He answered that he never thought about it because “it wasn’t going to happen“.
It then hit me. He felt the coverage was worthless because he rationalized in his own mind that he wasn’t going to die anytime soon. Not really worrying about the sale at this point, I forced him to verbalize this more and called him on it. I told him I understood his perspective. I said, “Ray, I get it. You’re not going to die” and smiled wide. He leaned back in his chair and smiled back at me as if he won something. He responded, “That’s right“.
Since there’s no use arguing with the wind (or a cat), I could only tell him that he’d “be the first“.
Liars figure and figures lie. Watch John Bogle, founder of the Vanguard Group discuss “financial engineering” and offers a reasoned argument on why many corporate pension plans are failing. He takes a very dim view of finance managers manipulating earnings and how it will effect us all. It’s only 2 minutes in length but a must-watch for anyone that has to work for a living.
Contrary to what some believe, I was not born with a particular math aptitude. Knowledge comes by study and commitment. For those who are interested in how to become better students of personal investment studies, I offer the Reading Room. The books contained provide a great foundation for learning more about personal investing. They are hype-free and easy to read. There is also a “nerd-gasm” section of the Reading Room for those who like more challenging math. Enjoy.
Yes, I updated the site’s “look and feel” to make it a little more easy to read. I also tweaked a few words here and there. Sorry for the lack of posts, I’ve been busy attending at my first Certified Risk Management professional designation course in Windsor CT last week. I look forward to sharing some of that experience in the coming days.
I think I know how you feel: everyone wants a piece of you and you can’t trust a soul. I bet you’re not feeling like you’re in a good place.
It struck me recently that while you make news for just walking down the street and everyone says “they hope you get better”, no one to my knowledge has ever offered a plan to help you. Except maybe Dr. Phil, but that just smacked of being self-dealing. Well, that struck me as a bit unfair, really. The other day my wife and I were doing a little shopping and this subject came up as a topic of discussion. I had been thinking of ways you could take control of your life again. It will take time. It will take work. I outlined my plan to my wife over a hotdog and coke lunch. Perhaps you could consider the following:
1. Sell one hour blocks of your time to all the media outlets willing to pay $250,000 per hour for a print interview. If they want to videotape it, the cost would be $500,000 per hour (No limit!). Have them make the checks out directly to your favorite charities. I look at it this way: They’ve been making all this money off of you for years, it’s time to make them pay up. I figure this is good for several million dollars in a very short period of time.
2. Invite the press to cover you hand-delivering each of these checks as you receive them. Spend at least a day or so with each charity, doing additional fund-raising on-site. You’ll not only get positive press for each check, but you’ll be turning their industry on itself, using that machinery to generate more positive publicity! Even better, invite your kids and ex-husband as well! You’ll gain continued strength and the press will lap it up.
3. Advise the court through your legal representatives that you will not fight your father for conservatorship of your estate. Cease any current or planned litigation. It’s a time, life-force energy and money waster which is why you’re not likely to get this advice from the attorney handling that aspect of your legal issues. Listen, your Dad has a legal obligation to “conserve” the money in the estate so you need not worry that he will blow any of your hard earned wealth. Consider that it might be better in the long run while you get other things in your life sorted out. You’ll be sending a strong message to the court that you’re starting to “get it” and most people will begin to believe that your growing up. Make sure your publicity people get this out the press. Let the paparazzo know that they could get an exclusive to discuss this issue with you for $250,000. See #1 and #2 above for what to do with the money.
4. Advise the court through your legal representatives that at this time, you accept the terms of present parental visitation situation. Your antics are making people believe your ex-husband Kevin is the father of the decade! Have the good sense to stop giving your enemies ammunition to use against you. Popular opinion and consensus says you’re not well enough to take care of your kids at this time. I’m not saying they’re right, but at this point, you’ll have to prove them wrong. It’ll take time and effort. I promise you this, it will be worth it.
5. Get up to date with any outstanding legal issues. It’s a noose around your neck and time to get rid of it. If the court asks that you attend counseling, attend counseling. If they ask you to appear for deposition, appear for deposition. Again, it’s not going to be easy, but in order to get control of your life, you’ve got to give in. In time, these issues will disappear. Stop feeding the frenzy around you.
6. Cautiously and adamantly guard your privacy. This may seem to be in contradiction to what I’ve previously written, but it’s not. You have a personal life and it’s time to reclaim it. Your path is a public one and it was created at your choosing. You cannot expect that the industry that’s been built up around you to suddenly go away because it won’t. But you can start the process. After the media outlets have paid their millions for exclusives with you, send out a press briefing that for the foreseeable future, you will live in a local Southern California hotel (with a large enough meeting hall) and invite them to an 8 hour press conference every work day (less one hour for lunch) for the foreseeable future. That’s right: 5 days a week, 7 hours per day. It’s your new job: making them sick of seeing you. Britney, at it’s core, it’s supply and demand theory. Now that you’ve made them pay for access to you, give it away now! Nothing will make you less attractive for the paparazzo than access to you for 35 hours a week! Put no timetable on how long you will continue this. Basically, keep it up until they get tired of being there. It is in doing this that you begin to control your image and through it, your life. Few things will be as empowering.
7. Make certain you make clear in this time with the media, that you are looking forward to reconciling with the loved one’s in your life: your parents, your kids, even your ex-husband. As you begin to look like you’re regaining your balance, it will soon become a self-fulfilling prophecy. You will begin to regain the balance you’ve lacked in your life.
8. Begin to understand that we all have a role to play. Yours is unlimited access to media. With that, you can make a difference in many people’s lives. Instead of fighting against it, embrace it. Enjoy it. Accept it. Use it to make other people’s lives better. You can do it. It will make you stronger, it will make you feel better about yourself.
9. After the paparazzo have grown weary of you in your hotel meetings, tell them you’re going to travel abroad for awhile. Invite your kids and ex-husband along. Maybe even your parents - Invite them to join you, too. Gain strength from your family. Be forgiving to the point of selflessness. You can arrange it so that additional fund-raising can be done. You’ll see the world like few have ever seen it. Take your time. No one owns you and over time you’ll learn to be focused on the moment.
10. Consider additional creative outlets. Return to music and acting. You will be in a different place than where you started. You’ve changed, you’ve grown in experience and in life. Embrace the changes. The well of goodwill you’ve filled is important and no one will be able to take it away from you. You’re wiser and will be better equipped to tell the difference between those that care about you and those that are inclined to use you.
11. Consider learning about your own finances. Be mindful of your abilities but lessen your need for alleged financial professionals. It’s not all that difficult and you’ve already attained “critical mass”. You don’t need to worry about getting it all correct, you just need to make sure you miss the big mistakes.
If you’ve followed this bouncing ball to this point, your legal issues will be minor and manageable. By this point, you’ve understood that it is a “process” to be completed so make the best of that meat-grinder with the knowledge that in terms of a lifetime, it’ll be over soon.
Well, this is a harbinger of things to come. As outlined here in the Wall Street Journal, the FDIC is looking to ramp up employment in preparation of an increase in the number of bank failures in the near future. That means we can look forward to more media “doom and gloom” about the economy and continued talk of “recession”.
In case you’re not familiar with the definition of “recession”, you can learn more here. In plain terms, a recession is 2 or more successive quarters of negative economic activity. Just so you know, the US economy hasn’t been in recession since November, 2001! Of course, you wouldn’t know that by the way the media talks about “how bad” the economy is.
Here’s how it ties together: our economy is completely reliant upon consumer spending, with about 70% of our economic activity tied to it. There’s a good reason why our economy is called a “service” economy! When people continue to hear “how bad things are” they stop spending because not spending is completely rational based upon what we hear on the news and read in the papers or online.
When people stop spending, economic activity slows (duh!) and it becomes a self-propagating, negative feedback loop. Why else would a government give us back our own money via a “stimulus package“? They’re hoping we spend the money because spending it lowers the risk of recession.
Look, before we begin understand that a homeowner’s policy is a complex document. Remember, an insurance policy is a legally binding contract, so of course, it’s complex and not easy to read. It’s designed that way.
And just so we’re clear, I’m not your agent and I have no idea your particular coverage or circumstance. But writing the post just prior to this one got me thinking: Many people who bought their homeowners coverage in the last 48 months are in all likelihood paying for coverage they’ll never get to use - but think they will. Here’s the skinny, but a point of clarification first:
One of the coverages included in your homeowners policy covers the “dwelling”. In fact, in all probability, your policy declarations page will show just that: “Dwelling” and then a dollar amount indicating the limit of coverage purchased/provided. Assuming you bought replacement cost coverage (you *did* buy replacement cost coverage, didn’t you?), this limit is there (in the best cases) to accurately and adequately reflect the cost to replace the “dwelling” (or “structure”) of the home in the event of a total loss.
In many cases over the last four years, however, people had been forced by their lender(s) to purchase a dwelling limit in an amount that equaled the purchase price of the home. This amount has no bearing to the amount of coverage available under the policy. You see, the “fine print” of most homeowners policies states that the insurance company will pay the dwelling limit amount shown on the policy, but only up to the actual loss sustained! Let’s look at a brief example to help illustrate:
A hypothetical NY/NJ metro single family home, 2000 sf, owner-occupied, would currently have a dwelling replacement value of about $250,000 to $350,000 (anywhere between $125 - $175 per square foot depending on age and build quality). Let’s split the difference and go with $300,000 replacement value. The market value (pre-August 2007) of this home is: $650,000.
Here’s where the lenders missed a turn in the road and their borrowers are paying for it: The policy dwelling limit should reflect $300,000 and not $650,000, even though the mortgage amount is greater than $300,000! (It’s probably around $585,000, assuming a 10% down payment). Because the premium on a homeowners policy is based in large part on the dwelling limit, the homeowner is paying about TWICE what he should because he/she was forced into buying a $650,000 dwelling limit instead of $300,000.
AN IMPORTANT POINT: a homeowners insurance policy does not pay off the mortgage in the event of a loss- it pays the replacement value of the home ONLY, irrespective of your mortgage amount! So, don’t bother torching the home, it won’t pay off your mortgage unless the mortgage amount is LESS than the replacement value of the home - then you’ll get what’s left over after the mortgage is paid.
If you think about it (and who does, unless you’ve got much too much time on your hands), this all makes sense. You don’t want the value of the land to be included in the dwelling limit, that’s just silly. Remember, the land will still be there, even if the home isn’t. It’s doubly silly when I tell you of another “fine point” you’ll find in most homeowners policies… “Land” is EXCLUDED from coverage! Ah, those insurance company types.
In my years as a retail insurance agent, I can’t tell you how many times a lender strong-armed the borrower to insure the property to the purchase price (or at the very least, the mortgage amount). They simply would not fund the loan unless this was done. Well, times are a little tougher for the lenders these days and you just might be able to get them to see it “your way” now.
Talk to your agent and see if you can reduce your cost of insurance today.
This is great quote. Read it and just let it sink in for a moment….
“The entire real estate debacle is the fault of everybody that was involved. And it was all about greed and speed,” said Rachel Dollar, a Santa Rosa attorney who represents lenders in fraud and other cases. “The brokers wanted their commission. The lenders wanted their premiums. The borrowers wanted their homes.”
I love the way Ms. Dollar (sometimes this stuff just writes itself!) uses the word “everybody”…. Let me add some more people who need to be included in the “everybody” category…
Real estate attorneys received payment for their closings;
Newspapers received increased real estate advertising revenue;
Home appraisers received payment for their (ahem) valuation reports;
Home inspectors received payment for their services;
Homeowners insurance companies received premiums (and still continue to get paid) based on inflated real estate values (which were required by the lender to fund the loan);
We can add insurance agents/brokers to the line above as commissions in large part are based on the gross premium paid by the homeowner;
Many local and state governments benefited (and continue to benefit) from inflated real estate values;
I could go on, but you get the point. In short, it’s turned out to be a big turd sandwich in which we will all now have to take a bite.
Double click on the chart above (it’ll open up a new window) and you’ll understand that home prices have a long way to fall before bottoming out. Ouch.
Almost every investor has a money market account (MMA) or a bond fund. Almost everyone knows these accounts are not ordinary bank accounts and thus are not insured by the FDIC. Of course, FDIC “insurance” is a bit of a canard, as there is nowhere near enough money in reserves to pay everyone who has an FDIC insured account in the event of a sufficiently large enough U.S. banking crisis.
What most people are blissfully unaware of is that a MMA is essentially a very short term bond fund. A bond is essentially a “promise to pay” a certain sum tomorrow (over time) for a certain sum today. There are many websites that explain bond funds in hyper detail (go here for a great primer) - this is the most stripped down explanation I could think of! Bonds can be offered by many entities (corporations/governments, etc.) and are used for many purposes (capital expenditures/cash flow/reserves, etc). “Short term” refers to what is essentially a bond’s duration (which is essentially it’s “repayment period”). The duration of a MMA is usually less than 1 year. Short term bond fund duration as of this writing is about 2 years. Intermediate term bond fund duration is about 5-7 years and long term bond fund duration is 7+ to 3o years.
Let’s consider ABC Company, which needs money to manufacture a new plant. It decides to sell bonds (backed by its ability to repay) to meet its needs. It becomes the bond’s “issuer”. It will pay the bond owner interest for the use of the bond owner’s money today over the duration of the bond. But consider that ABC Company is not in the best of financial shape and would have to pay an interest rate much higher to attract an investor (who is concerned with ABC Co’s ability repay its debt, which is commonly referred to as “default risk”).
So ABC Company decides to pay to have its bonds insured with a monoline bond insurer for a fee, essentially “lending” its own credit rating to ABC Company’s bonds. Without the bond insurance, ABC would (in this hypothetical example) have to pay 8% interest on its bonds, but now that the bonds are “insured”, an investor might only be able to get 5% interest from ABC Co. since the risk of default is (allegedly) far less. ABC Company “pockets” the 3% difference, less the cost of the fee to the bond insurer.
So far, everybody’s happy, right?
ABC Company is happy, it’s paying 5% interest instead of 8%;
The investor is happy because the bond is “guaranteed” by a triple AAA rated bond insurer; and
The bond insurer is happy because it charged and collected the bond insurance premium.
So what happens when the bond insurer goes belly-up? It’s a reasonable question these days and while it hasn’t happened (yet) don’t mistake the improbable for the impossible.
You see, the bond insurers have taken a bite of the sub-prime mortgage mess and the losses in this market segment may cause these insurers to lose their AAA rated credit status and even worse, may bankrupt them.
So in answer to my own question, very bad things would happen. Existing bonds would lose their insured status. New bonds would not be able to become insured, increasing borrowing costs for issuers. Investors would, in many cases, lose money (principal) on existing bonds that go into default. The shockwaves are so vast that it’s difficult to get your head around it. Our economy relies so heavily on credit that almost every industry will be effected by this in one way shape or form. Of course, as businesses are negatively impacted, employment will be as well.
The best primer I’ve found to help explain this potential meltdown can be found here. You can’t put your head in the sand on this one.
From wikipedia, “The yield spread premium (YSP) is the cash rebate paid to a mortgage broker based on selling an interest rate above the wholesale par rate that the borrower qualifies for”. What that means in plain language: YSP is a mark-up on the interest rate charged to you over and above the rate a lender would be willing to receive.
Lenders provide rate sheets to mortgage originators (including mortgage brokers). If the originator closes your loan at a rate higher than shown on lender’s rate sheet, the lender pays a percentage of that amount (overage) back to the originator. This is over and above any other fees the originator may charge such as appraisal fees, underwriting fees, etc.
In a prepared statement to Congress in 2002, Professor Howell E. Jackson of Harvard Law School noted in relevant part that the “study indicates that the vast majority of borrowers pay yield spread premiums - on the order of 85 to 90 percent of all transactions” and that “the average amount of yield spread premiums is quite substantial, on the order of $1,850 per transaction, making these payments the most important single source of revenue for mortgage brokers.”
It’s reasonable to suspect the “substantial” YSP amount of $1,850 in the Professor’s study is woefully antiquated. Since this testimony was prepared before the housing bubble, let me give you an updated example for your review, using some reasonable NY/NJ real estate values.
Hypothetical loan amount: $400,000
Lender’s par rate per their rate sheet (the rate the lender would accept): 5.50%
The rate you closed at: 6.25%
YSP paid to originator: $12,000
Difference in the total amount of interest paid by borrower on 30 year loan: $69,016.61.
The rule of thumb is for every 25 basis points (0.25) paid by the borrower over the par rate, 1% of YSP is created. So in the example above, about 3% YSP is created. Following the math, $400,000 X .03 = $12,000 would be paid to the loan originator.
As I understand it, there currently is no legal obligation to disclose the loan YSP to borrowers except on the final settlement statement at closing, when it is often too late to do anything about. I believe it is a moral and ethical dutyto disclose prior to closing, but since greed trumps morality almost every time, I would urge you request this information before the closing date on your next mortgage.
Further, with many borrowers who bought homes in the bubble years 2003 - late 2007 looking for someone to blame, I wonder what would happen if they looked at the mortgage originator and lender as a prospective target? Perhaps an argument could be made that the lender/originator was “unjustly enriched” for failing to disclose YSP prior to closing. I have to believe that insurers writing mortgage brokers and lenders professional liability (malpractice) coverage are concerned with this. It wouldn’t take many of these actions to start an avalanche of litigation, especially for those in the most “bubbly” real estate markets of California, Nevada, Florida and New York. I’m certain there are litigators who wouldn’t mind trying.
Of course, where the YSP was disclosed and agreed to by the borrower prior to closing, I have no issue. I wonder just “how many” disclosures occurred prior to closing…
I do have one final question, but it is admittedly rhetorical: How can we objectively review borrowers’ legal counsel’s role here? While the closing documents are in preparation, this information is available. What action(s) did borrower’s counsel undertake to explain YSP to their clients? Yes, I know. This line of questioning is a slippery slope with no answer.
Think this post is over the top? Check out this link.
I’m not going to try to talk you into it. I’ve heard all the objections and reasons for not buying private disability insurance. None of them any good. If you don’t mind NOT having an income when you’re not able to work, you’re right, you don’t need disability coverage.
If however, having a ready income stream when you can’t work is important to you (heck, maybe it’s even a necessity with that mortgage you have and car payment and let’s not forget the insurance and …), you’d be wise to consider it. Premiums are about 3% of gross income per year.
But this post isn’t about buying disability coverage. It’s about buying it BEFORE you start your own business.
You see, no one thinks about disability insurance before they start their new business. Truth is, it’s next to impossible to get it once you begin self-employment. This is due to the financial underwriting process the company will undertake, where you will have to prove the financial “need” for the coverage by providing copies of your W-2 (or similar documentation) for review.
See the problem already? You won’t be able to prove financial “need” because you probably will not have a salary at opening day- OR you will have a greatly reduced salary at start-up, which will severely limit the amount of coverage you will be able to qualify for.
There’s also the bit about employment history. Disability underwriters want to see 2+ years at a job (or at least job function). You won’t have that at start-up either. It’s not difficult to understand why. Offering a policy to someone in a new business has the very real increased potential for claim written all over it. Not doing well in your new venture? No problem! You’ve got a disability policy that’ll pay!
So, before you leave that cushy job (with group long term disability coverage), budget for a disability policy on yourself while you can qualify for it!
About once every decade or so (as the economy dictates) the scam artists come out to prey upon people who’ve fallen into the very bad situation of possibly losing their home in a foreclosure event. Well, it’s that time again…
The web is replete with companies that promise to be able to “save” the home from foreclosure. Some even promise they’ll be able to keep the foreclosure off your credit report. In essence, they’ll say anything to have you buy one of their “kits” for anywhere from $995 (cheap!) to over $2500.
It’s snake oil.
Don’t trust this situation to anyone but yourself. Accept responsibility. Talk to your lender - they do not want your home. In most cases they will try to work with you to avoid taking back your home. If this doesn’t work, speak with a licensed attorney to protect your legal rights.
A quick video from Freddie Mac for your viewing pleasure.
Many people, myself included, like hybrid technology in theory. We like the idea of saving money every time we fill up and there’s a bit of thumbing our noses to the oil industry as well. I’ve been considering a new car purchase (my current vehicle is “only” 13 model years old - my wife chuckles every time I say that) and I’ve been thinking maybe it’s just getting time for a change.
So, with the lure of saving money at the fuel pump, I’ve started to consider vehicles with hybrid technology. Aesthetics aside, the Prius is the fuel economy champ, no surprise there. But my current interest is more in how much more is this technology going to cost me up-front and when will it (if ever) start paying for itself?
We need a few data points to calculate a good guess. With that in mind, consider the following:
The average person drives 15,000 per year. Yes, I know many people drive much more than that but let’s use it as a starting point, shall we? Many new cars average (including some of the ones I’m considering) about 20 miles per gallon. The current cost of gasoline (where I am in NJ) is about $3.00 / gallon. So you can calculate your annual total cost of fuel to be about: $2,250. The math is: Total miles / Miles per gallon (15,000 / 20 = 750 gallons consumed) * Cost per gallon ($3) = $2,250.
Now, let’s say that the hybrid vehicle you’re considering averages 30 mpg but costs $3,500 more than the non-hybrid alternative. When do we break even? Well, plugging in 30 mpg into the calculation above lowers our total annual fuel cost to $1,500 because we’re only consuming 500 gallons per year instead of 750 (15,000 / 30). That’s a savings of $750 / year at current gas prices. Our break-even period is about 4 1/2 years at this rate. Of course, that’s assuming that the cost of fuel will stay the same and not increase over that time period. Yeah right, how likely is that?
So let’s try increasing the cost of fuel to $4.00/gallon, shall we? Annual fuel cost, non-hybrid: (@ 20 mpg/$4) = $3,00o. Annual fuel cost, hybrid: (@ 30 mpg / $4) = $2,000. Annual fuel savings - $1,000. So, looks like the hybrid will pay for itself in about 3 1/2 years under this scenario. (Yes, I am ignoring the time value of money calculations to keep this relatively simple!) At $5.00/gallon gas, the annual savings is about $1,250 - but let’s hope we don’t see that too soon. The one thing, however, I think we can all agree on is that the cost of fuel will continue to increase over the next 5-10 years.
For outside sales people who spend their lives in their car, the savings can be dramatic. Consider: 30,000 miles per year, 20 mpg, $3/gallon represents a $4,500 annual fuel cost. Substitute a hybrid alternative (30,000 miles,30 mpg, $3): $3,000 annual fuel cost, savings of $1,500 per year. If the hybrid alternative is $3,500 additional up-front, it will pay for itself in fuel savings in a little over 2 years. If you update the cost of fuel to $4/gallon, the annual savings is: $2,000 and the hybrid break-even point is essentially 18 months. If you like to keep your cars a long time, the annual savings are almost staggering. Happy car shopping!
Many people forget that the sole object of investing is the allocation of current money to provide funds for future consumption.
As such, it might be helpful to think in terms of separate “buckets” or “pools” of money for each future need. For example, you might have one bucket for emergency use needs - say a 4 to 6 month pool of money in the event of a job loss, another bucket for higher education needs, and one more for retirement needs. Maybe there’s a bucket set aside for your dream home on the beach!
The point is is that each of these future needs has a different expected time horizon of when the money will be called upon for use. All should be considered separate buckets when determining suitability for a particular investment.
Before doing anything else, click on the picture above (twice) and note the date of that headline. On such an “interesting” day in the US and foreign equities markets, it’s important to remember that “The Death of Equities” wasn’t true in August of 1979 and is not true today. The very wise and noted financial author, Larry Swedroe, has recently written that “Bear markets are periods that transfer assets from those without strategies and weak stomachs to those with strategies and the discipline to stay the course”. Very important words to remember on a day like today. It’s simple: if you sold or felt compelled to sell, your asset allocation did not pass the stomach acid test. Time to rethink your strategy and risk tolerance.
My good friend Phil has always said that a very smart insurer could make a killing by offering “End of the World” coverage. The idea is that people would buy insurance to cover themselves from the peril of Armageddon and the “End of the World”. In case you weren’t aware, insurance policies as a general rule specifically exclude the peril of war (there are some exceptions). In the event of a claim, people could send in their proofs of loss to a mailbox or post office box for review (and prompt payment, ostensibly).
If any underwriter at Lloyds of London thinks this is a good idea for a new product and can get 100% subscription, call me.
Some subjects just lend themselves to exciting writing: politics, religion and of course, the current media-created sensation du jour, Britney Spears. Let’s face it: writing about insurance is kind of like trying to make paint drying exciting and inspires as much enthusiasm as the thought of watching grass grow.
Well, no argument here. In fact, after spending close to 20 years in my chosen profession, it’s absolutely true that people want to know about their coverage exactly on two occasions: when their premium is due and when it comes time to file a claim. This should not exactly surprise anyone.
The industry is vast and complex and it’s not surprising to get (at least) 2 different answers to any one question asked. Even alleged “experts” disagree on fine points of coverage (ask a victim of Hurricane Katrina if their loss was a result of a flood or wind damage) and in many occasions, the court system is relied upon to tell us what the definition of is is. And so goes the insurance industry’s delicate dance with the legal system. It’s sometimes impossible to imagine one without the other.
Personal financial risk management is not for the timid or weak of heart. The best insurance people find reasonable solutions to the very real risks faced by their clients. When things go well, the work goes mostly unnoticed, due to the intelligent risk management design of an insurance professional.
There is a subtle, yet real difference between the terms customer and client – they are not interchangeable. Essentially, a customer is a Wal-Mart shopper: the active party in a transaction. A client is generally defined as one who is “under the protection of another”. Usage of the term “client” conveys an active professional standard and duty of care, which may be why the term has fallen out of favor.
Over the past decade, insurers have come under increasing pressure to become more a “financial services firm that happens to do insurance” than what most people think of as the traditional financial risk transfer role of insurers. With this subtle transition, and much to my dismay, insurers have been quietly exiting the “client” business.
Of course, the insurers are not solely to blame, as they will stress that they are only reacting to consumer demand. There’s truth to it: One cannot get through an evening without seeing at least one TV commercial with an animated character espousing the ability to quote, bind and print auto insurance policies online within minutes.
The subtext is clear: The burden of being “correct” has shifted to you from the insurer (or its representative) . Regrettably, the choices made will not be known to be adequate until AFTER an incident. Let’s be careful out there!
