For Your Consideration

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.

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.

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

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

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

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

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

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

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

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

OK, so what exactly is counterparty risk?

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

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

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

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

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

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.

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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?

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.

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.

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.

Ain’t macroeconomics grand?

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.”

(Emphasis added by me). The direct source of the quote.

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.

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.