Tuesday, May 31, 2011

What Makes a Child Successful As an Adult?

This is the $64,000 question for parents and children. There's no single correct answer for all children. Indeed, there isn't a universally accepted definition of success--a thrice-divorced workaholic who becomes the CEO of a Standard and Poors 500 company but is a stranger to his or her children may be seen by some as obsessive, not successful.

Nevertheless, career success, for better or for worse, matters a lot. A recent article by CNBC about the first jobs of corporate CEOs (http://www.cnbc.com/id/43223409) offers intriguing insights into the roots of career success. Although the article covers only 10 individuals, hardly a statistically significant sample, it reports that many started with jobs that few upper middle class Americans would want for their children--dishwasher, paper boy, lawn mower, restaurant server, warehouse worker, oyster shucker--and a majority started working before the age of 18. Almost none had the resume burnishing, internship intensive experiences that kids from comfortable suburbs today voraciously seek. Volunteering, if done, isn't mentioned in the article. Neither is overseas travel.

The first jobs for these CEOs generally offer dull, repetitive and intellectually unchallenging work that requires conscientiousness and a tolerance for boredom. They reward those who are willing to work hard, and preferably cheerfully. A child so employed learns that doing the job well and getting it done are rewarded. Enjoying the job, or finding it enriching, are secondary. The enrichment the child gets is greater discipline, persistence and reliability. These traits can pay very large dividends later in life. While they aren't the only components of success--ability, education, personality and, last but certainly not least, luck, play critical roles as well--it would seem that starting off with a low paying, low status job may actually be an excellent opportunity to learn how to work. Don't take my word for it. Ask the CEOs in CNBC's article.

Monday, May 30, 2011

What Are They Not Telling Us About the Euro Debt Crisis?

The European Union is scrambling to put together a second bailout for Greece, which would follow the bailout granted last year that everyone now admits isn't enough. See http://www.cnbc.com/id/43219315. The insufficiency of last year's bailout isn't exactly a surprise, since financial markets Cassandras were predicting its failure almost as soon as it was announced. But the celerity of Bailout, Part Deux is notable. Even though objecting conservative political groups in northern Europe have grown more vociferous, there seems little hesitation on the part of Europe's mainstream leaders to gather planes, trains and buses to take more bailout money to Greece. A second, and speedier than the first, bailout only heightens the hazardous morality of the situation. For all practical purposes, every Euro bloc nation is assuming responsibility for all the sovereign and bank debt of all other Euro bloc nations.

What gives? People don't cover the debts of other people they can't control without powerful reasons. Even if Europe's banks have stupidly overextended loans to Greece--and Ireland, Portugal, Spain, Italy and all the other troubled Euro bloc nations--one wonders why they can't take appropriate haircuts on that debt, recapitalize the dumb banks, and move on. The U.S. just largely did that with its banking system to get past the mortgage market morass. While the process was painful and very costly, and left us with high unemployment, the financial system survived. Exactly what is it about Europe's sovereign debt crisis that is so scary?

It may depend on what we don't know. Importantly, the derivatives markets continue to be opaque. Unknown are the size and concentration of credit default swap and currency derivatives exposures that might be affected by a Greek default (which we assume would trigger falling values for Ireland's, Portugal's, Spain's and perhaps Italy's and Belgium's debt). Because derivatives contracts can be traded on a highly leveraged basis, the costs of a Greek default could be multiplied many times over by speculative enthusiasm in the derivatives markets. And because there are no organized exchanges or clearing houses for most derivatives contracts, it's very difficult to find out whether this multiplicity of risk, if it exists, is appropriately dispersed or disastrously concentrated a la AIG, circa 2008.

Even though many European politicians are making noise about soft defaults and other largely symbolic concessions by creditors, the European Central Bank has very firmly stated it will not accept any bailout that involves a restructuring of Greek (or other dodgy) debt. The ECB's resolute refusal to agree to any restructuring whatsoever is another twist in the entrails that indicates something, like a snake pit of derivatives exposures, is mucking up the situation.

We learned from the 2007-08 financial crisis that what we don't know could hurt us. One would hope that financial regulators and other government officials have moved up the learning curve. Perhaps they have. Perhaps they're keeping mum to avoid triggering a run on their banks. It seems that a deep fog has settled over the European financial system, and the costs and ramifications of the Euro sovereign debt crisis might end up gradually emerging, dank and fetid, like a monster from a swamp, except this might be a real swamp and it could be a real monster.

Thursday, May 26, 2011

Claim and Suspend to Maximize Total Family Social Security Benefits

May 24, 2016 Update:  As of May 1, 2016, a recent law has abolished claim and suspend.

The Social Security system allows those who have reached full retirement age (somewhere between 66 and 67 for most people; to determine your full retirement age, go to http://ssa-custhelp.ssa.gov/app/answers/detail/a_id/14) to start collecting benefits, and then suspend them. While suspended, the benefits will increase, either because the person is working and building benefits, the person is getting older and benefits are increasing because the claimant is deferring them, or both. Not that many people claim and defer in order to increase their own benefits. That would happen only in the unusual instance where a person collecting benefits resumes working and earns enough to live without Social Security. So why would anyone claim and suspend?

The answer is to increase family-wide benefits. If, as between you and your spouse, you have the larger Social Security benefit, you might want to claim and suspend immediately, as soon as you reach your full retirement age. That would allow your spouse to begin collecting spousal benefits based on your Social Security record, while your benefits increase because you wait (the increase is about 8% a year even if you don't work and might be more if you do). If your spouse's Social Security record provides smaller benefits than spousal benefits under your record (or no benefits at all), a claim and suspend with the commencement of spousal benefits may increase total family benefits.

In addition, a couple who have both reached full retirement age can be better off if (a) the partner with the better Social Security record claims and suspends in order to defer benefits (and increase them); and (b) the other partner gets more by claiming spousal benefits instead of collecting under his or her own record, at least for a while. Sometimes, the latter partner's own record will provide larger direct benefits if he or she waits long enough, so collecting spousal benefits under a claim and suspend by the other marital partner may serve as a temporary way to increase total family benefits until the latter partner begins to collect under his or her own record. This strategy is allowed only if both spouses have reached their respective full Social Security retirement ages. The marital partner claiming spousal benefits for a while also has to go through the process of doing a claim and suspend with his or her own Social Security record, and then apply for spousal benefits. Note that the partner collecting spousal benefits can keep working and perhaps increase his or her benefits with an enhanced work history as well as by waiting to collect on his or her own record. Because this partner will, by definition, be at full retirement age or older, he or she will not lose any Social Security benefits from working.

Another facet of claiming and suspending is that if you reach full Social Security age and have dependents--something that's possible for grandparents raising grandchildren and late in life parents with kids at home when a parent reaches full Social Security age--the dependents can start claiming benefits if you claim and suspend. (In fact, the dependents can collect benefits earlier if you start collecting benefits yourself earlier, but you can't do a claim and suspend unless you've reached full Social Security age.) The advantage is that your dependents begin to collect benefits while you defer (and increase) your personal benefits. If you are still working or have other income you can live on, claiming and suspending in order to start benefits for your dependents may enhance total family benefits. Of course, you have to think carefully about how to handle your dependents' payments. As minors, the young ones may not have the most highly developed financial skills, so you should think about putting the money in a custodial account and saving it for their college or other post-high school education expenses.

Claim and suspend is available only if you wait until you reach your full Social Security retirement age (and your spouse, too, if he or she wants to first collect spousal benefits and then switch over to enhanced personal benefits). If you start collecting benefits early, you can't claim and suspend. Your spouse and dependents can also start collecting under your Social Security record if you begin collecting early, but their benefits, just like yours, will be reduced. How these alternative strategies might work for you and your family would depend on your circumstances. If you have trouble figuring out what's best for you and your family, contact the Social Security administration for more information (meet with someone at your local Social Security office or call 1-800-772-1213; don't try to do this by e-mail) or consult with a fee only financial planner.

Wednesday, May 25, 2011

The G-8 Meeting: No Aces, Just Jokers

The G-8 meeting on Thursday and Friday of this week will play like a B-grade horror movie. Ghouls--in the form of European debt crises--keep popping out of closets and lunging at the camera to scare the bejesus out of viewers. Greece's debt problems, thought to have been contained last year, are now revealed to be out of control again. All sorts of prominent officials and personages have insisted there will be no restructuring (i.e., default) of Greece's debt. This only reinforces the belief that there will be a restructuring, directly or indirectly, of Greece's debt. Portugal's debt problem recently lurched out of a closet and got a bailout package, making it the third domino to formally fall (Ireland was the second). Speculators are placing their bets as to whether Spain, Italy, Belgium or some other Euro bloc nation will be the next monster to pop up on the big screen. Northern European taxpayers are recoiling at all these horrors. But their leaders drag them inexorably toward more bailouts. The Euro bloc nations have, de facto, assumed responsibility for all sovereign debts of all Euro bloc members, although formal acknowledgement of this reality is less likely than Lance Armstrong admitting to doping.

It goes without saying that all European eyes at the G-8 meeting will turn to President Obama, accompanied by not really subtle suggestions that the U.S. finance a bailout of Greece (then Ireland, then Portugal and then the rest of the EU). The EU, as a whole, simply has too much debt to foster prosperity for the foreseeable future. As German and other northern European taxpayers assume more and more of the burden of the bailouts, their prosperity will suffer while Greeks protest to protect theirs. The Greek government is proceeding with asset sales to raise funds for paying off debt. But, unless it sells the Acropolis, these one-off asset sales won't reduce debt enough to stem the growing tide of red ink flooding over Greece's finances. Hence, European eyes turn westward for another Marshall program.

But President Obama has no cards in his hand. Today's American politics demand repayment of the federal government's debt, not some other nation's debts. Handouts for Europe wouldn't sell in salons in Manhattan, let alone living rooms in Iowa.

The Euro bloc doesn't have other potential benefactors. The BRIC nations are making noise about having a non-European selected as the next head of the IMF, sending a signal that they aren't overly enamored with seeing their capital contributions in the IMF directed toward financing the First World's luxurious (by BRIC standards) lifestyles. And once you get beyond America and the BRIC nations, no one else has enough wealth to help the Euro bloc.

The Euro bloc and America have no aces up their sleeves. They do have a joker--that the Federal Reserve and the European Central Bank print a lot of money. That would devalue the dollar and Euro, and make the sovereign debts of the United States and the Euro bleed away in the form of inflation. Devaluation isn't a strategy of the strong, but of the weak. The end result is that living standards in devaluing nations will drop. Thus, ordinary, taxpaying citizens will pay the price for the debt-fueled profligacy of the past decades.

Globalization, especially with the Internet and other aspects of modern telecommunications, allows ideas to spread really fast. That's good when they're good ideas. But when bad ideas spread, the result can be really bad. Beginning with over-indulgence in bank lending in Japan in the 1970s and 1980s, to the Federal Reserve's increasing reliance on price controls on credit in the 1990s and 2000s, to the Euro bloc's fiscal irresponsibility, the notion that prosperity can be achieved by financing consumption with debt spread like a prairie fire. But debts that finance consumption have an inexorable way of morphing into bad debts. Unlike transactional debts, such as the classic bankers acceptance, which resolve themselves when the transaction is complete, or business investment debt, which (hopefully) finances a productive enterprise, there's no happy financial ending that inheres in debt used for consumption. There are no necessary rational constraints on consumption, so ready access to debt for consumption can and will eventually produce a financial conflagration, immolating everything in its path.

The one thing that neither the Federal Reserve, the U.S. Congress, the administrations of Presidents George W. Bush and Barack Obama, the European Central Bank, or any of the governments of the Euro bloc nations has done is allow losses from the consumption rampage to be fully booked by the big banks. The institutions at the heart of the First World's financial system still hold vast amounts of dodgy debt that they aren't being forced to write down. Thus, accountability as a concept has died, and moral hazard is the order of the day. Governments no longer look to get rid of the problem; that would--horror--ruin some bankers. They just sneak around, scrambling for any way not obvious to taxpayers to brush the bad news under the carpet or kick the can down the road. This is costly.

The still extant stinky loans clog the financial system by restraining new lending and compelling central banks to print shiploads of money. The Fed's money printing is obvious--zero interest rates and QE2. The ECB's money printing is more subtle--it takes Greek and other sick countries' debt as collateral and lends against it, in essence giving more credit to yucky collateral than private lenders would extend. That's money printing by another name. Thus currencies are being devalued, and living standards in America and Europe lowered.

Expect upbeat pronouncements from the G-8 meeting. While differences between participating nations will be noted, they will also be downplayed while all national leaders put a rose tint on a debt dilemma with no exit.

There is in fact a way out--spurring economic growth and then taxing some of it to pay down the plethora of debt. Spending cuts large enough to close the gap aren't politically feasible nor are they sound public policy (unless one believes we should deprive the elderly of Medicare and close up the Defense Department). In America, growth has returned, albeit with high unemployment. The Republican majority in the House won't allow the only parts of the economy with the capacity to help more to pay down the debt--corporations and the wealthy--to bear an increased burden. So ordinary Americans are condemned to financial stagnation and high unemployment. And the Euro bloc's governance-by-panicky-crisis management precludes any logical continent-wide policies. It can only lurch from bailout to bailout, trying to confine the next ghoul popping out of a closet. The problem is, this isn't just a movie.

Saturday, May 21, 2011

Are the Social Networking Companies Approaching a Peak?

The frenzy over LinkedIn's IPO a couple of days ago, in which its stock more than doubled in price during its first day of trading, is reminiscient of the tech stock mania of the late 1990s. In those halcyon times, companies with no profits, scant revenue and highly optimistic business plans were going public with enthusiastically received IPOs. The stock market was pushed up to levels that it hasn't, on an inflation adjusted basis, since regained. Of course, we all know the tech stock craze went the way of leisure suits, although the financial consequences from stocks were much more painful.

Leisure suits have made a comeback of sorts in the past year or so. And so have tech stocks. The craze du jour is social networking, which proponents claim to be the grand future architecture of the Internet. Maybe. Something similar was said two decades ago about Microsoft, whose MS-DOS operating system was virtually ubiquitous among personal computers. But Gates & Co. didn't get the Internet, which was then struggling to organize itself around a concept called the World Wide Web. Then, a decade ago, portals were seen as the behemoths of the 21st Century. Today, only Yahoo is left as a major albeit struggling portal. A half dozen years ago, Google was expected to be heir to the Internet throne. Today, it is a growing and prosperous company whose vision thing is flagging. Google once was going to become the library to humanity. Legal squabbling over copyright ownership of large numbers of books has bogged down that initiative. Google is a leader in cloud computing, but Amazon will offer formidable competition. Goggle had to play catch up in the browser battles against a nonprofit that puts out Firefox. Google's failed attempt last year to buy Groupon was a signal that its ascendency to the throne of the Internet is no longer seen as inevitable. If Google is a sure fire winner, why wouldn't the Groupon folks want to associate themselves with Google?

But no matter that previous innovators have matured and shrunken to mere mortal companies. Social networking is hot, and investors pant for shares. Logical analysis fell by the wayside with LinkedIn. It had $15.4 million of earnings last year yet has a current market cap of around $8.8 billion. Its 95 million shares outstanding are worth $93 or so each at current market prices. Earnings per share are about $0.16, resulting in a price-earnings ratio of 581 to 1. Considering that the p/e ratio for the S&P 500 index based on trailing earnings is around 17, it's fair to say that investors are, at a minimum, extremely optimistic about LinkedIn.

Facebook, the big prize among anticipated IPOs, has dallied in the not very private private placement market, where transactions reportedly imply a valuation of as much as $70 billion. While the absence of solid public information makes Facebook's valuations somewhat amorphous, it's clear that public investors are getting whipped into a frenzy by all the press coverage of Facebook's private offerings. Facebook has indicated it might go public in the next year or so. When it does, that's likely to be a major signal of a peak in social networking stocks. A lot of really savvy Wall Street insiders huddle around the corporate insiders at Facebook. Those folks surely won't sell until they believe they can maximize the price they get, which by definition minimizes the bargain public investors will get. It's possible for public investors to make money from an IPO (Google is one example). But the IPO is a moment when the odds may well be stacked against the little guy. Invest carefully.

Tuesday, May 17, 2011

Lessons from AIG for Derivatives Clearing Houses

AIG's struggles to sell its $9 billion stock offering as a first step toward becoming a privately held company again remind us why the rather obscure lobbying battle over derivatives clearing houses is so important. AIG was Grand Central Station for high risk mortgage-related derivatives exposure at the time it was nationalized in 2008 in order to prevent its collapse and, with it, the collapse of the international financial system. Major banks that wanted to offload crappy tranches from mortgage-related CDOs and the like managed to persuade AIG to take a firm grip on the bag. When the mortgage market swooned, AIG was left holding the bag.

Almost no one, if one is generous with the benefit of the doubt, outside AIG--and perhaps even inside AIG--appeared to have realized until too late that the fate of the world's financial system and the world economy rested in the hands of an AIG subsidiary, AIG Financial Products Inc. This blog would become unduly lengthy if we detailed how incomprehensibly stupid shockingly large numbers of prominent people--inside AIG, among its counterparties, at its regulators, in Washington, and elsewhere--were in letting this situation come about. But one key consideration is that they didn't know in real time what was going on.

Much of the value of derivatives clearing houses is that they would collect information. With such information in hand, one could, comparatively quickly and easily, figure out where things might hit the fan. Although the question when things might hit the fan could depend on less predictable factors (such as the direction of the financial markets), we need to know if risk is again concentrated onto a single flimsy foundation capable of blowing up the world. Without clearing houses, that determination is exceptionally convoluted and time consuming. Examiners from the banking agencies, the SEC, the CFTC and myriad foreign regulators would have to fan out among numerous large financial institutions, each with a computer system that may well be incompatible with the computer systems of other major financial systems, and try to piece together where among untold numbers of attenuated or overlapping or circular derivatives transactions the hot potatoes have landed. The answer may well, as with AIG in 2008, come too late, from counterparties urging that taxpayers be dunned for yet another Wall Street bailout.

In the late 1960s, the stock markets had a record keeping crisis (the so-called "back office crisis"), where archaic paper-based systems couldn't provide the quality of settlement and clearance required for rising volumes of stock trading. Reputable brokerage firms collapsed or had to be merged with stronger firms, because their records were too messy to establish their financial viability. The SEC instituted a much more comprehensive regimen of improved settlement and clearance, record keeping, capital adequacy and examinations. Since that time, no large brokerage firm has collapsed or been forced into a shotgun merger because of back office problems.

Derivatives clearing houses could offer similar improvement to the markets. Detractors argue that they may present systemic risk themselves, by centralizing risk. But that is misleading. Because clearing houses would provide easily accessible information about the levels of risk they hold, either they and/or regulators can increase margin requirements (and required capital contributions from clearing house members) to provide a buffer against the centralized risk. That, in turn, would deter the taking of risks. While free market theorists (and bank executives at institutions that profit handsomely from their derivatives trading desks) shrink with horror at the notion of deterring risk, it was precisely the creation of too many mortgage-related derivatives, involving the origination of myriad exceptionally moronic no doc, no income, no asset, and no ability to repay loans, that fueled the inferno at AIG-FP. There is such a thing as too much risk, and we experienced it just a few years ago. Clearing houses would put a major barrier in the way of another such debacle.

Although hard core Soviets would blush at the way Wall Street today is revising history to blot out any mention of the 2008 derivatives catastrophe, we would invite history to repeat itself if we leave ourselves in ignorance again.

Sunday, May 15, 2011

Did Dominique Strauss-Kahn Just Mess Up the Derivatives Market?

In the arrest in New York yesterday of Dominique Strauss-Kahn, the managing director and head of the International Monetary Fund, on charges of attempted rape, unlawful imprisonment, and a criminal sex act, the financial press got a rare tabloid-quality story. Financial reporters may be gleeful now, having an opportunity to step back from EBITDA, NAV, SIPC, CDO, and MERS, and turn to allegations of an international financial leader, buck nekked, lying in wait to ambush a hotel maid, chasing her down a hallway and generally behaving like he follows Attila the Hun on Twitter. All reporters need to be good writers, but the truly successful ones have the hunter's instinct for knowing when to pounce. Strauss-Kahn, who might have thought he was the hunter, surely has no trouble hearing the howling of the pack closing in on him.

As a matter of law, Strauss-Kahn remains innocent until proven guilty. But the charges seem to have blown up his political prospects--he had a good chance of becoming the next president of France. And his career in finance is impaired. Another consequence is the new, enlarged bailout for Greece that the EU has been working on may be delayed. Strauss-Kahn, an internationalist who was sympathetic to bailouts, will have trouble getting bail for himself, let alone Greece. He was arrested four hours after the alleged crimes, while seated in a jetliner at JFK International Airport minutes away from leaving for Paris. That's a prosecutor's wet dream (whoops, sorry) for arguing against bail. And it's kind of hard to organize an EU-wide sovereign bailout if you're sitting in jail, eating baloney on white, WWII surplus canned fruit, and week-old brownies. A day of that and never mind haute cuisine. A Croque-monsieur and a demi de biere would seem pretty good.

The IMF says it will soldier on with work on the bailout. And surely it will, because international financial organizations don't justify their existence by saying no. But one can't help but wonder whether some players in the derivatives market who bet on a bigger Greek bailout are wondering if they're going to get margin calls. Even if the arrest of Strauss-Kahn doesn't move credit default swap prices a lot, most traders who play with derivatives mainline margin credit. A little price move can sometimes f . . . foul things up. Strauss-Kahn's arrest by itself won't trigger a financial crisis. But it's something that everyone dealing with the EU sovereign debt morass really didn't need.

There is no derivatives contract covering the risk of the head of an international financial organization being charged with acting really sexy in a wolfish way. No matter how much Wall Street's financial engineers churn and crunch data, there will always be some risks that won't be accounted for. That's why banks and other financial institutions need to be well-capitalized. Even if the next head of the IMF is already well on the way to beatification, you can never completely know when the elephant that is the real world is going to plop a heap of dung on your head.

Wednesday, May 11, 2011

Hedge Funds: Is the Sun Setting on the Raj?

It's not surprising the jury today found Raj Rajaratnam guilty of 14 felony counts stemming from accusations of insider trading. After all, the government had him on tape. Prosecutors love tapes. What the tapes show is that: (a) the defendant and alleged tipper actually had a conversation--it wasn't just chit chat with a secretary; (b) the conversation took place at a time when the defendant could have taken advantage of any nonpublic information he received to trade profitably; and (c) the conversation wasn't just about the Mets, or the best recipe for mac and cheese, or the latest on the width of ties; and (d) the conversation involved the company whose stock the defendant allegedly traded on the basis of inside information. Defense lawyers can and will strenuously argue about what the parties to the taped conversations meant when they said whatever they said, and whether or not that information was already public, etc. But the tapes remove a lot of the doubt prosecutors need to overcome in order to get a guilty verdict.

Rajaratnam has promised to appeal. Apparently, he's going to argue something along the lines that the government can use its wiretap authority to nab old guys who walk around Brooklyn in bathrobes, but not Wall Street guys who live at fancy addresses in Manhattan. At least, that's how the argument on appeal might end up sounding. Would the judges in the appeals court be seen as traitors to their class if they uphold the verdict? Rajaratnam reportedly is rolling in dough, so he has little to lose by appealing ad infinitum. But convicted criminal defendants don't have a high rate of success on appeal. Maybe Bernie Madoff will some day have a neighbor with whom he can talk shop.

More importantly from a systemic standpoint, this verdict may contribute to a downturn for the hedge fund industry. It's not an accident that the current wave of insider trading cases, and the last big wave of insider trading cases, both took place during eras of market stagnation. The Dennis Levine-Ivan Boesky-Michael Milken string of cases had its origins in the insipid stock market of the 1970s and early 1980s. When a market is devoted mostly to flatlining, buying-and-holding and other such investing-for-Main Street mantras don't work. They need a rising market to provide returns. What can be highly profitable in such circumstances is insider trading. Dennis Levine, one of the first high-profile Wall Streeters to be nabbed, turned about $40,000 into $12 million in some eight years. Even if you don't adjust for inflation, that's impressive. (The inflation adjusted figures are an initial investment of about $137,000 becoming roughly $24,467,000.) Insider trading pays, as long as you're not caught.

Since the spring of 2000, the stock market has, adjusted for inflation, dropped. Okay, it's bounced down and up and down and up again. But adjusted for inflation, it hasn't returned to its 2000 peak. In such circumstances, with investors having high expectations for hedge fund results (appropriately so, given the steep management and performance fees they face), hedge fund managers are under the gun to deliver. But things haven't been like the 1990s, when a cow that bought and held would have made a lot of money. Thus, the temptation to seek out and trade on inside information.

The recent spate of insider trading cases, most of which seem to involve wiretaps, confirm that the allure of inside information remains strong. For quite a few defendants, it's proven to be a siren call. Hedge fund managers, whatever they may have been up to, will probably cool their jets. Some phone calls may not be answered; others not returned. Swapping tips to make some money today isn't worthwhile if the true price is you end up a guest at a federal facility, swapping tips with Bernie Madoff. Hedge fund returns could droop.

Hedge fund investors may start to yank their money. Most don't want to be associated with even a whiff of scandal. Moreover, if a fund they invest in is caught up in insider trading, they might have to return some of the distributions they receive so other investors, injured by the insider trading, can obtain recompense. This is what happened to some of Bernie Madoff's investors, who received distributions exceeding their investments and had to return some of the money.

Even if a hedge fund hasn't been charged or isn't rumored to be under investigation, its returns might diminish because managers stop having some of the edgier conversations they've had in the past. Not to say that they were or will do anything illegal, but not all risks are worth having to bunk with Bubba. The lower returns, though, may lead their investors to seek greener pastures elsewhere.

Money has surged into the hedge fund industry during the past year, with investors trying to recoup losses from the recent financial crisis. The hedgies have done well, since the Federal Reserve keeps shoveling shiploads of cash off its loading dock to boost stock and commodities prices. Hedge fund managers have reigned supreme while investment banks battled increased regulation. But the Fed is being circumspect about how long it will keep its money printing presses rolling. Inflation is rising. Asian and European economies are slowing. Commodities prices have suddenly ebbed. There are plenty of market-related reasons to think that asset prices may have peaked. Then consider that federal wiretapping is probably cutting off the flow of inside information to some of the more brazen hedge fund managers, and chances are growing that the sun may be setting on the hedge fund industry, at least for another market cycle.

Monday, May 9, 2011

Slow Mo Euro Woes

High ranking Greek officials have several times in recent days strenuously denied that Greece is considering leaving the Euro bloc. The strength and frequency of their denials leaves the distinct impression that Greece is thinking of leaving the Euro bloc. Although bailed out last year, Greece is still struggling. Maybe it's all just a wink and a bluff, but the Greeks seem to have gotten somewhere. Late last week, high level Euro bloc finance officials conceded that Greece would likely get a sweeter bailout.

The Irish government, fresh from being bailed out just six months ago, has put in its claim for more porridge if the Greeks get more. Seems that when it comes to bailouts, the bailees expect most favored nation status as a matter of course. The Euro powers will be hard put to deny the Irish equality in handouts, as an Irish departure from the Euro bloc could be as damaging as a Greek withdrawal. And it seems likely that Portugal, which just signed up for a bailout, would get an improved package along with Greece and Ireland.

The Euro crisis is pretty much playing out as predicted last year--the bailouts were inadequate and the bailees would return to the trough for more. Germany, France and the other wealthy EU nations will pony up. Their own banks hold large amounts of Greek, Irish, Portuguese and other funky EU sovereign debt, and a dissolution of the EU, even partial, could trigger big losses.

At the same time, however, the political waters in Europe have become more treacherous. A recent election in Finland, of all places, signaled that the anti-bailout interests are growing in influence. One might dismiss that as due to something in reindeer milk, except that anti-Euro groups through Europe are rising in the polls. The pro-EU politicians are drawing out the bailout process, apparently hoping that doling out the pain gradually over time will make the bailouts easier to swallow. But that also brings the problem back into the headlines time and again. The EU is bogging down in repetitive bailout syndrome. Whether its strategy of rationing pain slowly works, or becomes the death of a thousand bailouts, remains to be seen. The keys to EU prosperity--balancing the union's economic imbalances and spurring greater growth--seem consigned to the back burner. That gives the political scalawags room to dance, and they'll choose a danse macabre for the EU if they can.

Thursday, May 5, 2011

Silver Nosedives. Is the CME Doing Better Than the Federal Reserve?

In the past week, silver has dropped more than 25% in price, from close to $50 to around $35 or so in overnight trading this evening (May 5-6, 2011). Other commodities have done their own recent swan dives, with oil falling about 10%, gold falling around 5% and copper 3%. These are big and very big price drops for a week's worth of trading. The plunge in the silver market is a crash, to be precise.

Silver prices began their swan dive after the CME (formerly known as the Chicago Mercantile Exchange or the "Merc") started to raise margin requirements on April 25, 2011. Since then, margin requirements have risen about 84%. In other words, contract holders who maintained just the minimum amount of margin required would have had to add 84 cents per dollar down to their accounts in order to avoid liquidation (and that's not counting losses from the market drop, which would have increased their margin requirements). Those contract holders who bought a while ago at much lower prices may still have enough equity in their accounts to avoid having to send in more cash or acceptable collateral. But contract holders who bought recently at or near the peak are likely to be facing margin calls and the potential loss of their holdings. The price swoon in the silver market indicates that a lot of players have been cleaned out of the poker game.

The CME apparently raised margin requirements in order to quell the speculative frenzy that more than doubled silver prices over the past year, with most of the increase in the past six months. By taking this action, the CME implicitly acknowledged that markets can be irrational, and that speculators can do stupid and potentially destructive things. By stopping the insanity now, before prices popped up to, say, $75 or $100 an ounce, the trading losses incurred by a return of prices to a not completely gonzo level may be relatively confined. This is very important, since limiting losses reduces the potential for systemic impact. Some gamblers may have lost their shirts. But as long as taxpayers don't have to lose theirs bailing out market insiders who risked so much as to become a systemic threat, things aren't so bad. Indeed, a stern woodshedding by the CME may be just the sort of character building experience that the wilder market players need to acquire an appropriate appreciation of the virtues of prudence. And, as the sell off spreads to other commodities, the growth in market wisdom may be well worth the short term losses sustained (as long as taxpayers aren't selected for service as bailers again).

Students of monetary theory will not avoid wondering if the Fed's easy money policies contributed to the speculative lunacy in commodities. After all, if you're one of the Wall Street pros who has access to the zero or near zero interest rates imposed by the Fed (retail credit card customers need not apply), borrowing cheaply and using your almost free money to speculate in commodities is a pretty obvious play. There aren't many other places for cash to go, so a little spark in this market could produce some nice price action. And the traditionally lax rules of leverage in the commodities market made speculation a breeze. Fed officials have acknowledged that they'd like money to move into risk assets. Indeed, they've admitted to hoping to foster consumer spending by boosting asset values in order to trigger a wealth effect. This is a most dangerous game, because if the Fed boosts asset values too far, too fast, it creates a bubble. And, as we know from repeated experience with tech stocks, real estate, and financial assets, bubbles eventually burst. If those bubbles get really big before they burst, taxpayer assets are seized by the government and turned over to the well-off and well-connected. Quite a few Americans seem to think this is bad policy.

The CME made the right move by popping the silver bubble before it became a hydra that would spawn numerous painful consequences in the financial markets. It's a shame the Fed has never had the gumption to pop an asset bubble before it rendered huge amounts of collateral damage. The Fed's rules of engagement seem to require massive casualties among innocent civilian and taxpaying bystanders before the central bank will intervene. Maybe there's no elegant economic proposition, statistically established to the 99% confidence level, that allows unequivocal identification of an asset bubble. But a little bit of common sense might go a long way.

Tuesday, May 3, 2011

Is the Federal Reserve Following Germany's Example?

Germany is Europe's economic engine. Its recent recession wasn't Great, like America's. Its unemployment levels didn't rise as sharply as America's. It has a trade surplus and a strong manufacturing sector at the core of its economy. Considering that West Germany had to absorb moribund formerly Communist East Germany during the past 20 years, one has to wonder how the Germans did it.

Part of the answer is they concentrate on producing high value added goods, taking advantage of their technological know how. The vaunted German machine tool industry makes highly specialized equipment, and constantly seeks to improve, which makes them hard to compete against.

But a crucial part of Germany's success is that wages have been held down. German workers are paid less than French workers (although both nations are well above the EU average). And, surprise! The French economy is weaker. German unions have gone along with wage restraint, in order to promote employment. German workers accepted limited income growth for the sake of fostering national competitiveness in export markets. The American image of Germany is a swirl of Mercedes, BMW, Audi and Porsche logos. The truth is more modest--a nation whose GDP per capita, disposable income per capita and other measures of economic well-being are lower than America's.

The U.S. Federal Reserve is, by all appearances, on a quiet, not for attribution mission to devalue the dollar. Although paying lip service to the sanctity of the Almighty Greenback, the Fed has relentlessly pushed down the dollar's value with a two and a half years and counting zero interest rate policy. Even now, as inflation is rising and central banks in many other nations are raising their rates, the Fed continues to believe that a free dollar is the best dollar (but free only for the financial institutions eligible to borrow at the ultra low rates available in the fed funds market; credit card borrowers can look in the mail for yet another interest rate or fee hike). The free dollar is, on the international currency markets, a falling dollar. That, in turn, raises the costs of imported goods. With the world economy now tightly integrated--some "American" cars have more foreign content than some Hondas and Toyotas--a falling dollar means higher costs for American consumers. This is most evident in the oil markets, where the rising price of gasoline and other petroleum products is the leading factor in pushing up prices. But price pressures are gradually spreading across the spectrum of consumer goods, and the Fed may have to narrow the definition of core inflation if it's going to keep prices down. As prices rise, real wages fall.

By weakening the dollar and, in effect, lowering American wages, the Fed makes America more competitive in the world economy. U.S. exports have been gradually rising, boosting employment (although at 8.8% of the labor force without jobs, we're still a long way from full employment). The price of "recovery" in this manner will be Germany's compromise: more jobs but constrained wages. And American consumers will have to become more like German consumers--tighter with the nickels, making do with last year's model, darning socks, mixing liquid soap with water to make it last longer, and, ugh, saving. Saturday afternoon at the mall will be replaced by Saturday afternoon in the kitchen home canning tomatoes grown in the back yard. The Model T in grandpa's barn will have to be fixed up and put back on the road. But it was and can still be a great car.

The Fed now prescribes America's economic policy. Congress and the Administration manage only to offset each other in a bipolar tango between partisan confrontation and distasteful compromise. Fiscal policy is virtually nonexistent. Only the limited tools available to the central bank are being put to use. And we will have to live with the consequences, because there are no other options.

Monday, May 2, 2011

The End for Osama Bin Laden

The Chinese have a saying: a gentleman's revenge takes ten years. Thus it was that America administered a just ending to Osama Bin Laden's life.

Sunday, May 1, 2011

Penalty-Free Early Withdrawals From a Retirement Plan

As the Great Recession rumbles on and on for just about everyone except those in the top 10% of income brackets, people are increasingly tapping into their IRAs. If you're not 59 and 1/2 or older, you'll pay a penalty of 10% of the amount withdrawn, on top of applicable federal and state income taxes. There is a way, however, to dodge the penalty: substantially equal periodic payments plans (SEPPs). These plans let you withdraw IRA funds without penalty, although regular federal and state income taxes will still have to be paid. SEPP plans can be complex, and you may want the assistance of a tax accountant or financial planner if you're going to use one. Here's a general picture of how they work.

A SEPP plan runs for a minimum of five years or until you reach age 59 and 1/2, whichever is longer. If you start a SEPP plan at age 57, you have to stick with it until you reach age 62. If you're younger than 54 and 1/2, the plan has to continue until you reach 59 and 1/2. So, if you start a SEPP plan at age 45, you'll have to stick with it for 14 and 1/2 years. If you don't stick with the plan and complete it, the IRS will assess a 10% penalty on everything you withdrew before the time you dropped the plan. Since you presumably instituted the SEPP because you were short of cash, that penalty could be painful.

During the time the plan is in effect, you get payments each year (which can be monthly, if the plan is set up that way). The distributions are calculated one of three ways: the amortization method, the annuitization method, and the required minimum distribution method. The first two are somewhat like what you would get from a commercial annuity purchased with the amount of money in the SEPP plan (although this is just an approximate description). You have a fixed amount that is paid out each year, and that amount never changes over the life of the plan. But, unlike a commercial annuity, this payment is not guaranteed and if the investment performance of your IRA lags, you could drain off the balance faster than you expected. (In fact, you can run out of funds before the plan is over; but the IRS won't penalize you for inability to complete the plan because of investment losses.)

The third method, required minimum distribution, is like the formula used for regular required minimum distributions from IRAs (i.e., those for people 70 and 1/2 or older). You take the SEPP account balance and divide it by the owner's life expectancy as estimated by the IRS. The resulting number is paid out. But the distribution has to be recalculated each year (using the owner's ever shortening life expectancy). So the required minimum distribution method is likely to pay out different amounts each year. It also tends to result in smaller payments than the first two methods. But the nature of the required minimum distribution formula means that you'll never run out of the money. You just won't know for sure how much you'll get every year--potentially more after a year of investment gains, and possibly less after a year of investment losses.

If you start with either the annuitization or amortization method, you can make a one-time switch to the required distribution method. This would be advisable if the original method is depleting your account balance faster than you feel comfortable with. Thus, you can reduce the impact that investment losses have on your account balance, but you'll get much lower periodic payments.

You can use some or all of the funds in an IRA for a SEPP plan. If you're going to use less than all the funds, transfer part of your IRA into a separate IRA that is used for the SEPPs. If your retirement money is in an employer sponsored retirement plan like a 401(k) or a 403(b), you cannot do a SEPP plan--it's allowed only for individually owned retirement plans. But if you're no longer employed at that employer, you can transfer the funds to an IRA and do a SEPP plan from the IRA.

A SEPP plan isn't useful for making one-time withdrawals, such as getting a downpayment for a car or house. It's a long term proposition, with a measured payout for each year of the plan. If you need a short term boost in cash flow, look elsewhere, or make the one-time withdrawal and pay the 10% penalty along with income taxes.

The amount you can take out at any one time through a SEPP plan is limited to whatever you can get per year under one of the three permitted methods of withdrawal. You can't use a SEPP plan to take out half the balance of your retirement account at once, or some other ad hoc amount that suits your needs at the moment.

Don't do a SEPP plan unless it's really necessary. You'd be burning up retirement resources earlier in life, which means your golden years may be less golden. Of course, sometimes life isn't kind and you need access to the money in your retirement account. The fact that a SEPP plan avoids the 10% penalty may be significant if you have to make long term withdrawals. For more information, you can visit the IRS website at http://www.irs.gov/retirement/article/0,,id=103045,00.html.