The “Madoff twist”

How do Wall Street insiders, smart brokers, and big investors get caught by Ponzi schemes like Bernard Madoff’s?

According to John Kay in the Financial Times columnist, “the fraudster hints at impropriety, but implies that the target will be the beneficiary rather than the victim.” Kay calls this the “Madoff twist.” (FT 3/18/09 p. 9)

I doubt Madoff invented this twist. This kind of trap is set by a lot of unscrupulous people, whether or not they are actual “con men.” The idea is to sell the victim the idea: “we’re smarter than that poor dope.” This works by creating a sense of belonging, superiority, and being privileged to have inside information.

The “having inside information twist”

The “having inside-information twist” was noted by John Gapper, another Financial Times columnist, in his article” Wall Street insiders and fools’ gold.” (FT 12/18/08 p11). Mr Gapper was writing about Henry Blodget, a Wall Street analyst charged with issuing fraudulent research in 2003. Mr. Blodgett had an opinion about fellow con man Madoff’s scam.

Gapper summarizes Blodgett’s opinion: “Wall Street veterans thought Mr. Madoff was up to something. But he [Blodgett] adds, They did not think he [Madoff] was recycling client funds…they suspected that he was using inside information … to “front-run” trades for his clients. That would have explained his oddly consistent high returns.”*

Blodgett’s reasoning about Madoff is an example of another way smart people get caught in scams.

The “human need for explanation twist”

This is a psychological mechanism everyone in the Bay Area knows, but we have no common name for it. During the Loma Prieta earthquake, Californians had thoughts like these.

“It’s sure windy on the bridge today.”
“Wow, I think I drank too much coffee”
“My tire must have blown out”

My own thought was that the BART train over my head was going off the tracks. I decided that was what was causing the cement columns around me shake. Of course, while looking up to see where the train was, I had no explanation why the concrete under my feet felt like it was turning into jello.

Seconds later, all the car alarms underneath the BART station went off simultaneously. A passing cabbie yelled at me over the din, “Was that an earthquake?” I finally got what had really happened.

If we run into a new or rare experience, we explain it with whatever familiar idea seems reasonable. Somehow, I think humans need explanations, no matter how valid or invalid, to keep our primal fears at bay.

Unfortunately, our own good explanations are often what get us into trouble. Even con men get deceived by other con men because of our human tendency to make up explanations for new things using erroneous analogies with familiar old things.

Copyright © 2010 Nancy K. Humphreys

*Front-running is an illegal action by a broker when they buy or sell their own shares before filling their obligations to buy or sell the shares of their clients. That way the broker gains more or loses less money than clients whose transactions to buy or sell are put through later. Clients get burned when the front-running has caused the market price of a stock to rise or drop.

Wall Street has coined the name for retail investors: ‘dumb money‘. And, as headlines like “Investors resist the siren call of equities” suggest, Wall Street is now surprised that retail investors are fleeing the market in droves? Who’s dumb?

Retail investors have lost confidence. They feel manipulated by brokers and betrayed by the market. Clearly the government hopes that more regulation will help. It won’t.

Regulation doesn’t build confidence; regulation prevents confidence from slipping away. It’s a bit late for that! What builds investor confidence is success. Success cements an “I can do it!” attitude.

What pari-mutuel betting means for investor confidence

Parimutuel betting is based on confidence in one’s own opinion. Investing isn’t like games of chance. There are no fixed “odds” in investing. Investing is a game of outwitting your foes. So what happens when people keep losing at the track? The obvious happens. It’s no longer fun to bet. So they stop betting.

Those retail investors who are still betting on the “race” are jettisoning their old ways of thinking. For example, right now, the P/E (price/earnings) ratio is being dumped in favor of reports about the US and global economy. They’re even latching onto new indicators like the ‘Hindenburg’ omen.

What the Hindenburg omen indicates

The Hindenburg omen is a technical indicator of when to get out of the market. It has a 25% success rate. That means the market has declined only one out of four times when the Hindenburg predicted it would go down. The Hindenburg omen indicates retail investors are desperate for new measures of the market.

What market indicators measure

The problem with any measure or “indicator” of the trend of the market (or of a company or industry) is that retail investors have reified (i.e., concretized) indicators into facts in and of themselves. Investment indicators mean nothing in and of themselves.

Understanding that investing is a parimutuel betting game means realizing that indicators of the market, to be useful, must actually measure investor sentiment. It’s investor sentiment, and not “chance” as in probability theory, that shapes the odds for the whole market or for any given part of the market.

To be useful, there has to be an explanation of sorts underlying why indicators should work. Otherwise, when their indicators fail, novice investors, like ancient tribes who worshiped deities, run from the old ones to the new ones.

For example, knowing all the factors of a horse race (the horse, its parentage, its trainer, its jockey, the condition of the track, the weather, and the horse’s competitors is like knowing the fundamentals of investing. Those who know companies, industry sectors and markets have a “reality check” to alert them whether market indicators are likely to be accurate or not.

Right now experts are skeptical of the low p/e rates. And rightly so. A Wall Street analyst quoted in the Wall Sreet Journal article, “The Decline of the P/E Ratio” says, “The market is worrying not just about a slowdown, but worse. People want clarity before they  make a decision with their money.

The article’s authors assert “The P/E ratio tends to fall as uncertainty rises and vice versa.” They underscore  this opinion by pointing out the fall of P/E ratios during the Depression in the 1930s, after WW II, during the 1970’s, and in 1980.

About a week before the above WSJ article, the Financial Times warned about dangers of trusting any “spurious accuracy” of p/e ratios. In particular they point to one type of p/e that  “awards undeserved authority and accuracy to something that is an educated guess.” In its brief item, “P/e multiples,” the FT advises “Treat a p/e as shorthand for what the market might be thinking; not a short cut to serious investment decisions.”

The problem with the FT’s opinion is that in the end investing is just “an educated guess.” Because of this, there is a danger that investors seeking to use global economic indicators to measure the markets will create a self-fulfilling prophesy of doom from bad news.

What retail investors need now

What retail investors really need are (1) solid market indicators that will build their confidence, and (2) regulation that prevent confidence from being lost due to the machinations of Wall Street brokers, traders, and con men like Madoff.

Can solid indicators of the market(s) be found? I wouldn’t know, but I suggest experts on Wall Street and the universities start digging for some good market indicators soon, and that regulators begin leveling the playing field.

If not, I can’t imagine how Wall Street will get retail investors to bring their “dumb money” back into the market. Not after we’ve all become wise to what Wall Street has been doing with other peoples’ money.

Copyright © 2010 Nancy K. Humphreys

There is cheating in all kinds of gambling. But cheating in pari-mutual betting is different than cheating in gambling games of chance. Investing is pari-mutual betting. Investing is based on skill not luck. Investment scams work differently.

Market manipulation, insider trading, front-running, and banging the close. Why are all these things illegal in investing? We’ll see shortly.

Cheating and winning in probability gambling

The law of probability applies to totally random acts. When statisticians repeat a random act over a long time, they find out the odds for any result of that act. Many, many tosses of a coin are needed before the results of all the tosses average out to 50/50. And over time, the odds of a coin toss always do seem to average out to 50/50. For any particular toss of the coin, the outcome could be either heads or tails. Each side has an 50/50 (equal) chance of coming any time you toss a coin. Other random acts have different probabilities that can be known ahead of time.

In probability betting, because you know the odds of an outcome, an event can be rigged to change that outcome to one you can count on. A coin with one side heavier than the other is going to come up the way you want. The same goes for your loaded dice. These devices contravene the odds that everyone knows are set by the law of probability. These scams let you win without relying on “chance” or “luck of the draw” That’s why they are illegal.

Your best bet to win legally at pure probability betting comes from knowing the odds of your game. Different games have different odds. In craps, for example, there are different probabilities for the outcome of a 6 versus a 10 when two dice are thrown. (The 6 is more likely to happen because there are more ways two dice can add up to 6 than 10). Here is a table of craps odds. Using a strategy in craps (such as betting different amounts of money on different numbers) can help you, at least to lose less money if not to win more often, in this probability-based game.

Compare this to roulette. In roulette, knowing the odds means you will disregard those boards showing recent results that are hung near the roulette table. The odds of any color or number coming up in roulette are always the same no matter what numbers or colors just came up. The odds are 50/50. Your number/color either will come up or it won’t. Winning at roulette is just pure dumb “luck” on your part. Strategy won’t help you in this probability-based game. Those recent results boards are not information; they are devices to get you to spend more money.

Cheating and winning in pari-mutuel gambling

Pari-mutuel bets, on the other hand, concern events that aren’t purely random, and you can’t repeat them. Instead, bettors, or in this case investors, study the past trying to find similarities or trends that might be continuing, but there are no odds that can be set on the probability of the market going up or down at any moment. The likely outcome of the market can’t be calculated, only guessed at.

As a result, strategy is always a vital and big part of the game of investing. The stock market is a different entity every day. You have to figure out for yourself what is likely to happen.

At a racetrack, doping a horse doesn’t change the odds of any other horse winning. It changes the amount paid out to any winning horse. Cheaters may get more money by ensuring that one of the  horses does not finish the race. Because the race winners get everything in the betting pool (except what the track takes out for itself first), one less horse at the end means that more money gets split among the winners of a rigged horse race.

But doping a horse doesn’t guarantee that you’ll be one of those winners! It only guarantees that you’ll get more IF your horse wins. if your horse wins, you’ll get a portion of the bets the losers made on the horse that was doped. If your horse loses, doping the other horse didn’t do you a bit of good (unless you made a private bet that the doped horse would lose).

Deciding which horse to dope is based not on its “probability” of winning, but on which horse the doper believes most bettors will be putting their money on to win. As a result of the expected winner being eliminated during the race, the horses that now win, show, or place in the race will each pay out at a much higher rate than the odds on them would have indicated. This is why doping in racing is illegal.

In pari-mutual betting, cheating doesn’t rely on contravening the law of probability and changing the odds already given on an event (e.g., changing 50/50 on the coin toss to 100% heads); it relies on figuring out ways to get a bigger chunk of the pari-mutuel money pot for yourself. And this is exactly what scam artists in investing do.

Cheating in Investing

“Front running” lets a broker get more money than you do by investing their own and your money at different times. The broker buys shares of a stock before investing their customers money’ in that stock. Brokers invest customers’ money a little bit later. When all that money hits the market, it drives up the price/value of the broker’s shares. The broker then turns around and sells their own shares at a profit. The same trick works when the broker sells their own shares first when they know many of their customers will also be selling that stock.

“Market manipulation” aims at manipulating investors’ expectations to artificially push up prices. Manipulators might buy a small futures contract for a commodity at an unreasonably high price. This can get everyone else to start buying and selling at a higher price. When that happens the broker can sell their previous contracts at a much higher price than the market would warrant. Day traders in Norway were charged with manipulation recently for “outwitting the electronic trading system of a US broker.”

“Insider trading” is like horse doping. The winners use secret information to get a bigger piece of the pie. And “banging the close” (aka “tape painting”) is used by futures traders to make last-minute trades that influence the market just before futures contracts are settled.

Even the famed VIX indicator (‘the Fear Gauge’) is sometimes rigged by last-minute moves called “carpet bombing.” This is done by the big players to try to influence perceptions of investors about the amount of volatility in the market.

Investing is a game that is all about perceptions rather than probabilities. It’s about “smarts” not “luck.” It’s important for you to remember that. Winning at pari-mutuel betting requires learning as much about the game as you possibly can, even if, perhaps especially if, you entrust your money to someone else to invest it for you.

Copyright © 2010 Nancy K. Humphreys

Investing is an example of pari-mutuel betting. I discussed this topic in my last post, “Investing is Not the Kind of Gambling You Think! “  Pari-mutuel betting is based on human intelligence, not on probability or mere chance. This means the more you know about investing, the better your “odds” are for winning.

Economists and financial writers often are blissfully unaware of this difference.

They use the word “gambling” in relation to investing in inappropriate ways. They also refer to probability betting as if it applies to betting on the outcomes of activities involving living beings. It doesn’t. Probability betting applies only to inanimate objects like dice, cards, or spinning wheels. It doesn’t apply to the hand or mind that manipulates those objects.

So that you can see what I mean by this confusion, here’s an example from a recent issue of the Wall Street Journal. It’s from Sam Mamudi’s article on August 2, 2010 (pages R1 and R6). Mamudi’s title is “Try as Investors Might, So Much Depends on Chance.”

Use of the word “chance” is not the only wrong thing about this article. Right away we see images from probability betting in the two clever, professionally-shot, photos that accompany this article. One photo shows a bird on top of a pile of dice in a bird’s nest. The other photo shows coins being flipped by human hands.

Investing as rolling the dice

Investing as coin tossing

As you’d imagine, Mamudi’s article addresses investing as a form of probability betting rather than a form of pari-mutuel betting.

Mamudi’s main point is that  “chance” outcomes each year in the mutual fund market can greatly affect one’s retirement earnings. Depending when you accumulate your retirement funds, you might get less than you would have if you invested over a different time period.

Most of us can see that mutual funds don’t return the same amount every year. We also learn the hard way that funds that did well last year usually don’t do well this year. But this isn’t due to chance or luck.

There is a better explanation for the lack of consistency in fund returns. Mutual funds are managed by experts who know the most about financial markets. And these experts are competing to win the race every day. Yet these experts don’t know everything. They don’t know when company accountants are lying. They don’t know when or how a political event might affect a stock. They don’t know what the sentiment of other investors in the market will be in the morning.

Human fallibility is the reason we don’t have many winners in the mutual fund race who excel over time. Fund managers lose and have to learn from their own and each others’ mistakes. Fund managers win, and things change. The challenges they face then are new ones.

Mamudi’s title really should be, “Try as Investors Might, So Much Depends on Lack of Knowledge.” Now I’m not saying we can ever have perfect knowledge of everything. We’re human. I’m simply saying that our odds of success in pari-mutuel gambling are based on educated guesses not on chance. The stock market is complex. It’s affected by numerous and varied factors. Nobody can get it right all the time.

Investing is like betting on horse or dog racing

It is the same in investing as it is at the track. At the track, those in the know begin betting on the horses they think are most likely to win. The horses people bet the most money on to win are given the best odds of winning, e.g., 2 to 1. If a dark horse wins, (a horse with high odds of losing, e.g., 31 to 1), the payout to each of the winners is a lot bigger.

That’s because everyone put their money in the kitty, but only the few winners who chose the dark horse will need to split the money in the kitty among themselves. In a race where everyone put money on the same horse to win and that horse won, everyone would get only their own ticket money back – less a tiny amount taken out of each “tote” by the “track” to pay for its expenses. This is how pari-mutuel odds and payouts differ from odds and payouts in games based on chance.

With pari-mutuel betting, there is a fixed amount of money in the investing pot at any given time. This means at the end of the day, after the buying and selling stops, what one investor loses, another gains.

But the track itself never loses in pari-mutuel betting, and neither do mutual fund managers. They get their share of your bet no matter what happens to you. The only reason a mutual fund goes out of business is from poor financial management of the money it makes. Any business that doesn’t bring in customers and/or spends more than it makes over the long run, fails.

Fund managers who can’t compete with their peers will lose customers. Fund owners will either throw those managers out or demand they try harder to win the next year. That is the essence of competition in investing. Keen competition explains why individual funds will do well some years and not in others. Anyone who follows or bets on sports teams will see this phenomenon in action there too.

Luck is not the lady who oversees investing

In his article, Mamudi quotes Shlomo Benartzi, a business professor at the University of California, Los Angeles about the idea of “luck.” Says Benartzi, “We have an asymmetric view of good and bad luck. It’s well established that people attribute bad luck to randomness, but then attribute good luck to their own skill.”

The professor is correct. Ironically, Mamudi’s article makes this same mistake. Mamudi attributes bad luck in investing to chance. Mamudi claims that “chance” causes returns in the stock market to vary from year to year. He is well-intentioned. He’s warning you that you can get less than you expect for your retirement. Which is true. But his mistaken notion this is due to “chance” or “luck” leaves you feeling utterly powerless to change the outcome of your investing.

While the outcome of probability betting games does depends on “luck” rather than skill, this isn’t true for pari-mutuel betting. (This confusion about probability betting comes mainly from casino-type gambling where there can be an element of skill as well as luck involved- more about this in a future post). However, investing is a pari-mutuel “betting game” where investors pit their knowledge and skill against each other. Skill trumps luck in investing.

For example, those investors have an edge who know about studies which show mutual fund returns tend not to outperform “the market” (i.e., the returns of a major stock market index such as Standard & Poors 500.)

If sensible, these investors won’t waste time and money repeatedly chasing after vanishing phantoms of huge returns from mutual funds. They will plan for retirement with an investing strategy based on knowing the average fund return they can expect to get over the long haul.

For example, if the S&P is returning an average of 6 or 8 percent a year over the long-term, investors in S&P-type companies and mutual funds should assume they’d being do well to get that percentage on the total of their investment and compound interest upon retiring.

That means really watching those fund fees! (See my previous three part series “Fees in a Mutual Fund Prospectus.“)  If your fund and/or broker fees leave you with a 3% return over 30 years, you will indeed find you haven’t made anything like what you hoped. You’ll barely have managed to keep up with inflation!

Copyright © 2010 Nancy K. Humphreys

Next time: Why Investment Scams Work

They’re closing down the textile mill across the railroad tracks
Foreman says these jobs are going boys and they ain’t coming back to your hometown (“My Hometown”)

Part 2 “The End of the American Empire?” (Click here for Part 1)

What does the de-leveraging of the middle-class credit bubble mean?

It means we’re caught between a rock and a hard place. Middle-class Americans aren’t paying down debt because we’ve all caught a sudden case of conservative financial management. We’re paying down debt because the credit card companies and banks are turning the screws on us if we don’t. Many people as well as small businesses are going underwater and/or bankrupt.

Larger companies have cut jobs and inventories; sold bonds to rich investors; and hung onto their cash because they know there are no new buyers for their products. The US dollar is about as low as it can go to encourage sales of American made goods abroad. Americans themselves can’t afford those goods. Increasingly, the middle class is going broke.

A secondary change that’s happening in America is a shift of income from the States to the Federal Government. The new financial reform bill is necessitating the hiring of thousands of federal civil servants. Meanwhile state and local-level civil servants are being laid off, furloughed, payed in IOUs, and vilified as “special interests.”

Will the new hires in the federal government balance out the losses of income by state and local government workers? Or will unemployment keep rising as more and more government employees too wait at home for unemployment checks?

The government is the last bastion between us and total economic stagnation in this country. Almost one-third of all jobs lost since the crisis began in 2007 were connected with the mortgage market. No one likes Fannie Mae or Freddie Mac, but their extinction will not resurrect the private mortgage market if American workers (private and government combined) cannot afford to buy houses and if the foreign investors from Asia who fueled the US mortgage bubble do not return.

The third factor affecting America is the loss of corporate headquarters to other countries. More and more American companies are being bought out, taken over, or simply out-competed by foreign corporations. (Click here for my posts about the book manufacturing industry.)  It’s happening in other sectors too. Even the mortgage industry in America has European banks like Switzerland’s UBS now moving in on American banks’ territory.

It’s clear the American empire is entering into a waning phase. Unless the United States gets out of costly wars, takes on the challenge of developing new technologies, and embraces the rising information industry with better education and training of workers, there won’t be much hope for us regaining what we had before the crisis. Wealth from corporations in traditional sectors like manufacturing and finance is moving abroad. And it’s taking American jobs with it.

Where’s the hope?

The hope is in knowing that neither “the free market” alone nor the federal government alone can be expected to solve a problem that is not merely a short-term aberration. “Monetary or fiscal” arguments are useful in looking a short-term crises. They’re not so useful when facing long-term declines.

We’re looking at a growing imbalance that has been going on for over a half-century. The huge private debt of individuals has now become the gigantic public debt of our federal government. There’s really nowhere else to keep “passing the buck.” The dis-ease we’re suffering from now is not being able to see that we’re all in the same boat. And we’re sinking together while the captains keep on arguing about which way to sail the ship.

The nature of capitalism’s global dominance (in all except a few patches of the earth, like China and Cuba, where national economic planning takes place) is that wages everywhere will keep decreasing (or in poor countries, increasing) until wages are relatively equal around the world. The current crisis is a long-term crisis within all developed capitalist economies.

Something has to give when it comes to banks and corporations hoarding cash, the wealthy few gambling on extremely risky investments while brokers grow rich of their fees, and a vast number of other Americans watch their pipe dreams going up in smoke, never to return.

The question is, will we cling to an old dream of past glory that can’t ever come true? Or will we commit ourselves to a principle of true entrepreneurship and caring, and make them work for the benefit of all people, not just a few?

Copyright © 2010 Nancy K. Humphreys

Blow away the dreams that tear you apart
Blow away the dreams that break your heart
Blow away the lies that leave you nothing but lost and brokenhearted
(“The Promised Land”)

Part 1 “What cased the financial crisis?”

I’m an optimistic person. I see a lot of things in life to love. And I also know that sometimes you have to face unpleasant realities. The more I read about the financial situation today, the more I see a  situation that can’t be fixed unless there’s a major change.

People blame various things for the financial crises:

• Banks
• Subprime Mortgages
• Fannie Mae and Freddie Mac
• Investment Banks
• Insurance Companies
• Derivatives
• The Shadow (private) Banking System
• The Global Conspiracy of The Rich
• The World Bank
• Sovereign Debt
• National Deficits
• Republicans
• Democrats
• Ignorance
• Greed
• Corruption

Pick your favorite one!

Maybe it’s time to look at what we can agree on. We can all agree that there was a mortgage bubble in the United States. But that mortgage bubble is also attributed to various things:

1. banks that lent without doing due diligence about the property and/or buyers
2. subprime mortgage lenders who misled homeowners about what they were getting into
3. home buyers who should have realized they didn’t have enough money to afford a home
4. ineffective and/or nonexistent government regulation of the mortgage and banking industries
5. property market imbalances due to GSEs (government subsidized entities) like Fannie Mae and Freddie Mac
6. the selling of mortgages to companies who bundled them into derivatives that were sold by the slice

Pick your favorite one! They’re all irrelevant. Because there’s a deeper question.

Why did we have a mortgage bubble in the first place?

For decades there has been a shift of wealth from the pockets of the middle class into the pockets of the rich in America.

This shift has occurred through several vehicles:

1. erosion of the “real” (as opposed to “nominal”) value of wages via inflation
2. aggressive anti-labor actions that have hobbled unions with laws and pushed unions out of workplaces,
3. shifting from defined-benefit plans (pensions) to defined-contribution retirement plans (401k, 403b and 457b plans)
4. tax structures on all levels in the United States.

Oh yes, and one more thing:  5. easy credit.

The credit card bubble

National credit cards came into widespread use in the 1970s. Before that, a few businesspeople owned gasoline credit cards. Then came department store cards, replacing the old “layaway” system where the store held your purchase until it was paid for in full. Then came Visa and Mastercard.

The lobsters in the pot didn’t notice the boiling away of their real purchasing power in terms of dollars earned. That’s because we had lots of new purchasing power in the form of credit cards. Then came home equity loans, and some of us had even more purchasing power. Can you really blame homeowners, now underwater, who wanted that home equity credit to use as their real wages shrank?

It doesn’t matter if you blame those subprime homeowners or not. The fact is that even prime loan home buyers are increasingly getting into trouble. They too do not have the earning power to pay for their homes. Because of the the five wealth-transfer vehicles that I named above, plus the current recession, the American middle class is now broke.

Economists call it “median wage stagnation.” They’re talking about “real” wages, wages that take into account the effects of inflation. The bottom ninety percent of U.S. families have had a total increase in earnings of only 10 percent since 1973. That’s a wage increase of about one quarter of one percent per year. The top one percent, however, have watched their wages triple over that same period. Just before the financial crisis the median household income dropped by $2,000 over a six year period (2002-2007).

The mortgage bubble was the tip of a bigger middle-class credit bubble. When middle-class credit became too highly leveraged, the bubble began leaking. Bank-credit froze up, while the mortgage- and mortgage-backed securities markets melted down.

Next time: what does the de-leveraging of our middle-class credit bubble mean for our future?

Copyright © 2010 Nancy K. Humphreys

Yes, a face can launch a ship, but it’s words that cause wars.

Example 1: Nature means two mutually exclusive things

A conflict between PETA and Park Service rangers can be traced back to a 19th century British philosopher, John Stuart Mill. Mill wrote a book called On Nature. In it Mill noted that we use the word “Nature” to mean two mutually exclusive things: (1) everything except “man” and (2) everything including man (i.e., we too have a human “nature” so we’re a part of Nature).

The confusion begins, said Mill, when people using the word switch back and forth between meanings of the word “Nature.” The conflict starts when people use the same word, “Nature,” to mean two mutually exclusive things.

PETA clearly believes that nature means definition (1). Nature to PETA is exclusive of man. PETA feels we should all butt out and let nature alone.

The U.S. Park Service believes in definition (2) – that man is part of Nature. However, taking the biblical saying that God gave “man” dominion over the earth and all of its creatures, the Park Service sees its role as being responsible for balancing the needs of other living creatures so that species extinction doesn’t happen to any of them.

Thus, a few years ago the California Park Service and PETA came into conflict over those principles in the San Francisco Bay Area. A predator was wiping out a bird species. The Park Service stepped in to protect the bird; PETA stepped in to protect the predator, arguing that humans should leave “Nature” to run its course.

No doubt you’re thinking “OK, Nancy, interesting story, but what on earth does this have to do with investing as gambling?”

Example 2: Gambling means two mutually exclusive things

Gambling is a similar type of word. It means two mutually exclusive things. There are two types of gambling: (1) gambling games based on the “law of probability”, and (2) gambling based on human intelligence (i.e., pari-mutuel betting).

The confusion between these two meanings is similar to that of the debate about Nature. Definition (1) of gambling, i.e., the law of probability, excludes “man”. It doesn’t matter whether a person picks out the marked balls that lead to a cry of “bingo” or if a machine mixes up marked balls and spits them out for the weekly state lottery. In both cases the law of probability rules. The law of probability applies to all of the things that people gamble with: marked balls, dice, coins, cards, etc.

Definition (2) of gambling includes human beings; in fact it is based on the existence of human beings. Pari-mutuel betting is a form of gambling where human beings pit one opinion against another in advance of the outcome of some kind of event. Usually these events are based on the activities of living beings: athletes, bulls, gamecocks, greyhounds, horses, etc. Those who make the best “guess” based on what they know about the kind of race or contest being bet on are the winners.

It’s vital that we all understand how these two types of gambling differ.

The importance of understanding that investing is pari-mutuel gambling

Investing is an example of pari-mutuel betting. There used to be things called stock certificates that one kept in safety deposit boxes, but no more. Now, you only know the value of your investment when you gain or lose money at the moment of selling your stock or your stock mutual fund in the market. No object is involved in the “sport” of investing.

Instead, the underlying event that investors in a stock are betting on are the human activities of those who control, manage and work at a a corporation, as well as the human activities of those outside that corporation that somehow impact that corporation during the period of the “race,” i.e., the period of the individual’s ownership of that stock.

Investing is not similar to games of chance where events are random and governed by the law of probability. The law of probability says that repeated testing shows that the things involved in games of chance have a certain percentage, or “chance” to occur each time the object is used e.g., there’s a 50/50 percent (or chance) for heads or tails on a flipped coin regardless of who or what flips the coin.

For any particular flip of a coin, toss of the dice, or roll of the wheel, lady luck rules. And for sure, past performance is absolutely no predictor of future performance.

This isn’t the case with investing. In investing, past performance can indeed be a predictor of future performance, but often it isn’t. That’s not due to the law of probability though; it’s due to human fallibility. Much like weather forecasting, investor forecasting takes account of complex factors, not all of which can ever be known at the time.

Investing is similar to games where human sweat and ingenuity play a big part in the chance of either team to win, and in the chance that someone gambling on those games will win or lose. Those who know the game well will have better odds of making the right bets and winning.

Sure, luck might cause you to lose occasionally when betting on pari-mutual events. After all, who can predict a horse that trips or a “flash crash”? But to win repeatedly in the contest of investing, you need to be more knowledgeable than your opponents, not just luckier.

Copyright © 2010 Nancy K. Humphreys

Money, as Karl Marx spent thousands of pages in his book titled Grundrisse trying to convince us, is not a “thing.” In modern economics this idea is expressed more succinctly. Money, we are told, is “a medium of exchange.” But an exchange of what for what?

Even though they say money is about exchange, economists usually talk about things in connection with it. “You sell me one thing. I give you money. You take my money and buy another thing. That person takes your money and buys more things, etc.”

Marx’s view of money as an medium of exchange was quite a bit more profound. Marx viewed money as a “social compact.” When the society that created and agreed to use a certain kind of money no longer functioned, neither did its money.

You can see “social compact” money any day of the week in Berkeley, California and other cities in the U.S. and the world. Merchants, even farmer’s market sellers, accept “local” or “community” currency as payment. There are no government resources behind this printed money, but it’s legal. It’s a way local businesses use to keep their local economy thriving.

Money is a sign of relationships among people. This is the true value of money. When those relationships break down, money as a medium of exchange, does too. The night they “drove old Dixie down” was also the night the Confederate dollar became a worthless collector’s item rather than a medium of exchange.

Many people think gold is a tangible kind of money that will protect them in a crisis. But like other forms of money, gold is only as good as the relationships within a society at the time it’s used. If we’re all starving, who is going to take gold in exchange for food?

Many people think too that a dollar is something that can be made as easily as it can be lost. “Easy money,” or as John Dos Passos called it in his 1930s book, The Big Money, has been the downfall in the U.S. economy during many periods before our latest crisis of 2008. Behind every financial bubble is a whole slew of people believing in “easy money,” and an even bigger number of con men just waiting to take advantage of that belief.

There are always a few people with exceptional talents for whom, at times, making money can happen easily regardless of their personal relationships with others. But time and money invested by members of society as a whole when societal relationships aren’t strong yield heartbreak in the end. To become wealthy in the final run, all of us have to be able to rely on others to deliver what is promised when paid our “good money,” the money we put our honest labor into.

This is why even a despised nineteenth-century “godless communist” could see that the present penchant of our financial system for betting customers’ currency on its own investments rather than making good on its promises to help local businesses, workers, and consumers is nothing short of self-destructive lunacy.

Our financial system has “evolved” to become a giant global gaming parlor. As John Plender of the Financial Times remarked on June 30, 2010 in “Fragile state of banks means recovery is still precarious” the banking system has become “the political equivalent of a leper colony,” and governments do not wish to get further involved with it.

So now we’re requiring banks to keep higher capital reserves so banks can “more safely” risk losing their customers’ dollars. What a brilliant non-solution! Both banks and large companies are hoarding their cash. They won’t spend their cash on entrepreneurial projects (the supply side). And working people do not have cash to buy consumer goods (the demand side) because many are underwater with their mortgages and/or out of work. And so, we’re still stuck.

It’s a truism of macroeconomics that if the private sector has a surplus, the public sector has a deficit. The private sector has a big surplus right now because it isn’t spending the cash reserves it has. And no surprise, the public sector, which has been futilely pumping money into banks and the auto industry to try to jump atart the private sector, is now deeply in debt.

The biggest crisis in America and elsewhere in the world is stagnation of businesses and joblessness. There HAS to be a way to get banks and large companies to invest their money in the growth of our economy and more jobs. If big businesses keep hoarding their cash and banks go on pumping their funds into risky investments that yield no tangible benefits to anyone but a select few who love money only for money’s sake, we’re violating the essential social nature of money itself. We’re sacrificing our all for the benefit of a few.

To grow, we need an economy based on community and mutual honesty in financial exchanges. We need an understanding that circulation of money is essential to preserving the vitality of our nation. We need to see that the morality of money requires creating real value with it, not just using it to play games where a few “win” at everyone else’s expense.

Next time: What is Investing? It’s a Kind of Gambling Called Perimutuel Betting

Copyright © 2010 Nancy K. Humphreys (All rights reserved. (You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.)

• “Now I don’t know who to trust and I don’t know what I can believe. They say they want to help me but with the stuff they keep on sayin’. I think those guys just wanna keep on playin’ ["Roulette"] (Springsteen)

“Risk” is a word you hear a lot if you invest. Ever stop and wonder why that is?

Risk is key to broker success. Large investment brokers have found ways to transfer risk onto the shoulders of their clients without their client’s knowledge. Some do it for commissions. Some do it so they can profit off their client’s ignorance.

Smaller investment brokers use risk as a way to milk clients for money too.

Financial advisors who sell mutual funds

My first visit as a client to a brokerage was quite long ago. I went to Charles Schwab’s old office near the University of California in Berkeley.

Schwab’s office was a bit plainer than Merrill Lynch’s in Oakland where I’d worked. But like Merrill Lynch, Schwab at that time, had no one at the front desk. I had an appointment. Again I had to go hunting for someone to tell me where to go.

Times have certainly changed since then. Schwab is now very business-like and their Berkeley office looks plush. So maybe what followed in my first visit to Schwab no longer happens, but I suspect something like it still goes on.

The financial advisor I found at Schwab took me into a tiny room with a table and gave me a form to fill out. I was informed I was taking a quiz to determine how much risk I would be comfortable tolerating. I did wonder what in the world this had to do with investing, but the advisor had disappeared. So I picked up my number 2 pencil and dutifully filled out the answer sheet.

The test was supposed to determine if I was in investor able to handle “low,” “medium,” or “high” risk.

Actually that test was intended to do other things too. (1) It set me in the position of “novice” and my financial advisor in the position of “teacher,” ( 2) It showed my financial advisor how much pressure he would need to exert to get me to buy any of Schwab’s products, and (3) it told my financial advisor how he would need to word his sales pitch for whatever products he was interested in selling me.

Face it folks! There is no financial product in existence that doesn’t carry a lot of risk!

Financial advisor as teacher or coach

Financial advisor as teacher or coach is an interesting and ironic idea. Goldman Sachs’ defense against accusations of shafting its clients is based on the idea of a broker as a “partner” instead of a teacher or coach.

Investors at large banks are called “sophisticated.” This means they are supposed to know exactly what they are getting into. “Sophisticated investor” is the excuse used by upscale investment bankers when their clients realize they’ve been sold a “white elephant” while being assured it’s a very valuable antique.

What makes an investor a novice or a sophisticated investor? How much do you have to know to graduate from one to the other? It seems to me that the main distinction between these two categories of investor is not really knowledge at all, but rather the amount of money you have to invest, i.e., over $1 million.

Do sophisticated investors have to go to school, get a degree or even take a workshop to be sophisticated? Do brokers give them a test to see how much risk they want to take?

Imagine that we all (rich and not so rich) were kids again, and we were in high school taking a class on investing. Do you think the teacher would give us a quiz to test whether or not we were afraid to take risks with money? NOT! They’d teach us what the real risks were.

Brokers and financial advisors warn everyone about risks, but they protect no one against risk.

Copyright © 2010 Nancy K. Humphreys

(part 3 of 3)

Risks of Investing

If you’ve ever bought a mutual fund and read its prospectus, you’ve probably seen the section where the prospectus highlights all the kinds of risks attached to that kind of fund. Unfortunately “disclosures” of risks from the financial community are much like disclosures of side effects of prescription drugs in TV commercials for those drugs. There are so many you just tune all of them out.

Is risk a four letter word? No! It’s not a bad thing if you want to live life to the fullest. But only a fool jumps off a cliff without knowing if there are rocks under the surface of the water below.

This blog series aims to reveal the chief risks of ETF’s.

Risks of derivatives in general and ETFs in particular

In Part 2 of Exchange Traded Funds (ETFs): The Safest or Riskiest Investment You Can Make? we saw two risks attached to buying any derivative.

The first risk is that the value of any derivative does not necessarily coincide with whatever investment it is based on. This is why derivatives are popular with financial speculators. They hope to profit off them. But sometimes the value of a derivative is lower than the investments it is based on.

The second risk is the danger of the issuer of the ETF not being able to pay out. This is called counterparty risk.

Other risks of ETF investing

Over the past two years, we’ve all become acutely aware of how interdependent the finances of the world are. At the beginning of the financial crisis almost every kind of investment dropped at the same time. There is “market risk” involved when investing in stocks. Market risk is when the whole market drops.

Recently we’ve seen how shaky whole countries can be. Greece is essentially “bankrupt”. It’s sovereign debt is connected with ours (via Goldman Sachs, its chief advisor), German banks, and the whole Eurozone (countries using the Euro). There is “systemic risk” from sovereign debt involved when investing in some exchange traded funds. Countries and whole regions can fail too.

Now there is another danger so new it hasn’t been defined yet. Some are calling what happened on May 6th a “flash crash” of the stock exchanges. During this record drop in stock market prices that Thursday, ETFs were hit far worse than other investments.

In spite of being a smaller proportion of total trades, over two-thirds of the erroneous trades cancelled after the drop were ETFs. An erroneous trade was one more than where 60% of its value at 2:40 pm was lost that day.) For exchange traded funds that lost less than 60%, the owners were out of luck!

ETFs were a prime victim of a perfect storm that swamped the major stock trading exchanges. Thus, there is now “exchange trading risk” involved in buying and selling exchange traded funds.

Risks unique to specialty ETFs

You have to be particularly sharp about checking into the details about any specialty ETF fund you plan to buy. Some exchange traded funds are managed by managers and their expense fees are high. In addition, speciality ETF funds in bonds, commodities (like gold), currencies, and partnership trusts, may have extra costs. Some additional costs on these investments include special taxes on these types of investments.

Exchange traded funds are sold as if they are simple products, but like other derivatives, they aren’t. Some specialty ETFs are even third-generation products that include multiple synthetic swap derivatives. These are ETFs with more than one counterparty.

Their makers claim synthetic swap derivatives are more secure than a plain-vanilla ETF that has only one counterparty. But are these synthetics really more secure than single market-maker ETFs?

TIP: ETFs are a good deal, fun to own, and an easy way to dip your toe into stock investing. But be sure to investigate the particular market maker and the stock index (or the manager) behind any exchange-traded fund you buy!

If you buy a country or regional ETF, keep in mind that your ETF depends on the particular basket of stocks from that country or region that your ETF is based on, and not on how the whole country or region does.

If you’ve never seen an ETF, check out iShares (formerly owned by Barclays Bank and now owned by private equity company, Blackrock). Click on the name of any ETF to see part of what’s in its “basket.”

Copyright © 2010 Nancy K. Humphreys

(part 2 of 3)

You’ve seen what ETFs are in part one of this series. Now we’ll look at the pros and cons of buying these “poor man’s derivatives.”

The advantages of exchange traded funds

ETFs beat mutual funds when it comes to costs. Even with paying both commissions on buying and selling and fees, ETF costs will usually be lower than a mutual fund.

Besides lower prices, the presumed advantages of ETFs are that they are more diversified than mutual funds. After all, a whole country or even an entire region of the world is much broader than a stock or a mutual fund.

ETFs have an advantage over stocks of being much simpler to invest in. Investment in stocks requires knowledge of companies, industries, and if you’re a technical trader, of all kinds of technical indicators of the health of a company and the industry it belongs in. ETFs only require a basic knowledge of the stock index index that ETF is based on.

ETFs also have an advantage compared to mutual funds in that again, you only need to focus on the stock index that an indexed ETF is based on. Categories of companies such as small cap, mid cap, large cap, value and growth are used by mutual funds to distinguish each from the others. Indexes upon which ETFs are based may fall into one of these categories too. But you won’t need to do as much comparative shopping. There are usually only a few ETF funds based on the same index.

The disadvantages of exchange traded funds

As hybrids, ETFs have a major disadvantage compared to stocks. There is far less trading information about them. You won’t find much news about them either at this point in time. If you own a country ETF, for example, you’ll want to keep your eye on the financial health of that country. This means taking the time to keep up with the news. If you own an indexed ETF you’ll need to keep up with what’s happening to companies included in its index.

The disadvantages of investing in derivatives

ETFs also have a major disadvantage compared to mutual funds. Last time we looked at insurance company mutual funds in retirement plans. We saw they were “derivatives” of mutual funds. One danger of all derivatives, including ETFs, is that they can vary in value from whatever investments they are based on. You learned about this danger as well as one other major disadvantage of derivatives in my post, “Insurance Company 401k Mutual Funds: The Poor Man’s Derivatives.”

ETFs are also derivatives.

The value of an ETF is derived from an underlying “basket” of securities. These baskets of stocks usually reflect an index for a particular market such as technology stocks (the NASDAQ index) or industrial stocks (the DOW JONES Index) or emerging countries (the MSCI index). The baskets are owned by “market makers.” Market makers are investment banks, hedge funds, and other large financial entities. Like life insurance companies, these entities carry “counterparty risk.” This is the risk that the other party in a contractual transaction will not pay up.

Market makers not only are risky because they could fold, but also because they have no obligation to look out for you. As the recent investigation by the SEC of Goldman Sachs revealed, market makers feel they do not have a fiduciary duty to look out for the best interests of their clients. (See my post, My Week at Suze Orman’s Merrill Lynch for more about fiduciary duty of brokers.)

TIP: You must pay attention to who is issuing your ETF. Are they a secure and prosperous bank, hedge fund or other type of company? Are they going to sell their ETF business to another institution? Do they do a lot of ETFs or just a few? Are they being sued or about to be regulated? Are they liked by their customers? Be sure to check our your ETF’s market maker!

Copyright © 2010 Nancy K. Humphreys

Once upon a time long ago in a land faraway, there was a community of successful business people who wanted more books to read. They decided to pool their resources and create a brand new library.

These people founded a beautiful new library building in the center of their city. They sought the best librarian in the land, so they offered the extra incentive of fees. In addition to a salary and bonuses, their librarian could earn fees for services. They instructed their librarian to uphold two of Mr. S.R. Ranganathan’s “five laws of library science”:

A book for every reader.
A reader for every book.

Our industrious librarian immediately began making deals with both book publishers and library patrons, charging each side a fee. These deals were all based on the value of books. So these kinds of deals quickly become labeled “book derivatives,” or “BODs” for short.

Keep in mind that a derivative has no intrinsic value of its own. A derivative is founded on the promises that two or more parties to a contractual deal make to do something for each other.  When push comes to shove a derivative (deal) is only as good as each party’s word. But what about the word of the “broker” of a derivative deal?

Our cutting edge librarian is the “broker” in book derivative deals. This kind of broker matches readers and books in BOD deals. So how good is our librarian’s word? Here’s where our story begins.

Fees from one side

Every week our book broker sends out an announcement to patrons describing the new books they’ve bought. There’s one new book title in particular that’s been attracting readers like hotcakes at a pancake breakfast.

Imagine a patron calls and asks our librarian to hold a copy of this popular new book. Our librarian says, “Sure, we have one in now,” and puts a copy of this book on the back shelf to hold for that patron. Our librarian broker collects a personal fee when the patron fulfills their promise and comes in for the book.

Fees from the other side

Imagine our librarian had a choice of who to buy this book title from. For this title, our book broker chose a publisher well-known for putting together cheap books with “library binding.” This is a special type of binding where the pages tend to fall out more easily after a few uses.

Yes, library binding is real. It’s used for hardbound books that are expected to sit on the shelf in a library or  the bookcase of any book afficianado. Library binding serves a useful purpose. It allows book collections to be more comprehensive in spite of limited budgets. The publisher pays our book broker a fee when when the books are delivered.

Betting on library binding

Our librarian fulfilled their job description by brokering a deal where a book found its reader and a reader found their book. And, our librarian even made their library money on the deal by buying books with less-than-stellar binding. So now their library can afford to buy more books! Naturally, our book broker writes a glowing self-evaluation on how well they did their job.

Meanwhile back in the break room, employees of the library are sitting around with their cellphones out. They, their families, their friends, some of their patrons, the book’s publisher and its employees, and other interested parties have a “pool” going.

They’re all betting on whether or not the patrons of this particular new book title will be happy with the copy of the book they got. Will the copy be intact or will pages fall out over time. Our book broker too is part of this pool. Eagerly they all await to see if the library gets a flood of complaints about this particular book.

Judgment day

When caught out, our book broker librarian insists that users of the library are “sophisticated” patrons. The library’s patrons all use the library regularly. They all know what they’re getting into when they accept the librarian’s offer to hold a book for them for a fee. Our librarian says there’s no need to disclose the kinds of binding used for each title they buy. “Sophisticated readers know that some publishers use library binding.”

Our librarian sees no conflict between taking fees from both sides. Our book broker stoutly insists that under this system of market making between publishers and patrons, “most patrons get what they expect from a book when they come into the library, so all is well.” The publisher of the book in question and our librarian both protest loudly, “Library binding is legal. We’ve used it for years!”

As far as the betting pool goes, our librarian argues that the library and some of its employees have lost a little bit of money on the deal too. “Patrons aren’t the only losers,” our book broker whines.

When questioned by Congress about how their BOD library operates, our librarian bravely asserts that a book broker simply cannot be held to have a duty to each patron. “Our job as book brokers is to match readers with books. The more money we save, the more books we can buy, and the more readers we serve. If such a standard of duty to every patron were applied to us, we simply couldn’t do our jobs!”

What do you think? Do you agree? Is this how a library should work?

Three key issues for market makers of derivatives

Here’s what I see as the primary problems of Goldman Sachs’ as a market maker:

(1) fees – charging both sides of derivatives  fees. How can Goldman always make derivative deals that are in the interests of both sides? Even attorneys know better than that.

(2) disclosure – assuming all clients are “sophisticated investors.” How many investors really know which derivatives are sound or what the intentions are of the particular company that makes the derivatives they buy?

(3) conflict-of-interest shorting – creating inferior products in order to bet against them. It’s one thing to bet against the thrower of the dice in a game of craps. It a whole other thing when you pick the maker of the dice being used in the game!

Copyright © 2010 Nancy K. Humphreys All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.

(part 1 of 3)

In my post, Fees in a Mutual Fund Prospectus: Three Ways A Prospectus Deceives, part 3,  we looked at how mutual fund fees can accumulate and take more than half of the total return on your investments. Over the past seventeen years many people realized this loss on mutual funds was happening. They’ve switched to investing in exchange traded fund (ETFs) instead.

Investors have caused the number of exchange traded funds to nearly double over the past few years.  Should you think about joining them? Well, yes, consider ETFs, but be aware of how complex these derivative products are.

Derivative products have no value of their own. Their value is based on other kinds of investments. Exchange traded funds are based on the value of a “basket” of stocks that are owned by an entity called a “market maker.” You buy rights to part of this virtual basket when you buy an ETF.

In this post we’ll see what an ETF is. In part two of this series on ETFs we’ll look at pros and cons of buying an ETF. In part three we’ll learn about market makers of ETFs and what risks are entailed in buying ETF products from them.

What are exchange traded funds?

Exchange traded funds are a “hybrid” investment. They possess some characteristics of stocks. They share other characteristics with mutual funds.

Like stocks, ETFs trade on exchanges such as the York Stock Exchange (NYSE). You pay a commission (usually under $10 these days) to buy them and a commission when you sell them. You can buy and sell any time you want. They are sold by both mutual fund companies and brokerage firms. And yes, they can be part of your retirement fund.

Like mutual funds, ETFs have fees. But these fees are usually far lower than mutual fund fees. Vanguard has even begun offering low fee exchange-traded funds with no commission charges on buying and selling. Unlike mutual funds you don’t need to wait until the end of the day to see the value of your ETFs. ETFs trade all day just like stocks do.

Exchange traded funds are cheaper than mutual funds because, until recently, none of them were managed funds. Instead of a manager, most of these funds simply reflect a stock index. You’ve heard of stock indexes such as Standard & Poor’s 500. The S&P 500 index, now owned by the McGraw Hill Companies, covers the 500 leading companies in leading industries of the U.S. economy.

There are hundreds of these stock indexes. As a result there are hundreds of “indexed ETFs” based on stock indexes. In this country there are around 900 ETFs available for trade. You can even buy an ETF that reflects a basket of stocks for a whole country anywhere in the world. It’s fun to own “Canada” or “Malaysia” or “Brazil.” But there are risks involved too.

We’ll look next at the pros and cons of buying these kinds of “poor man’s” derivatives. Following that we’ll examine the types of risks involved with trading ETFs.

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.

Along with investment banks, large insurance companies are major providers of 401k and 403b funds for employee retirement plans. Perhaps you have a plan with one of them.

A few years ago, I discovered a shocking secret about the mutual funds offered in insurers’ retirement plans. They are not mutual funds at all. They are proprietary derivatives based on mutual funds. I learned I’d been investing in derivatives!

401k and 403b derivatives: how I discovered I owned them

I had a 403b plan with a major life insurer. Like a 401k, a 403b* is an employer retirement plan, but it’s strictly for employees of non-profit organizations. A few years after leaving employment with a nonprofit, I decided to look into my 403b investments. I wasn’t happy with what I saw.

I’d just taken a financial workshop and learned about NAVs, “net asset values,” of mutual funds. Net asset value (NAV) is the value of an entity’s assets less the value of its liabilities. At that time you could see the NAV for any mutual fund by looking in a major newspaper.

I began tracking my 403b mutual funds NAVs in the newspaper. Prices reported for my 403b funds and those printed in the papers weren’t jiving. And the difference wasn’t in my favor.

My 403b fund only reported NAVs quarterly, so comparison wasn’t simple. Nevertheless, I could see that over time the same funds in the newspaper were paying out a significantly higher amount than I was getting from my 403b life insurance company plan. I wasn’t pleased to discover this. So I called my insurance company.

“Are you charging extra fees on my mutual funds?”

“No, we don’t do that,” said the company rep.

“Then why are all the mutual funds you offer in my plan paying less than what I see in the papers?” I asked.

The flustered woman on the other end of the line hemmed and hawed, then said haltingly, “Well, these aren’t mutual funds, exactly.”

“What do you mean, ‘not exactly’?” I demanded. I was getting pretty agitated.

“Well, our funds are based on all the mutual funds you see named in our prospectus, but our funds contain a slightly different mix of stocks and other assets,” she replied.

Furious, I informed her I was going to roll over my 403b to an IRA and buy the real things. They paid better! She quickly said she’d send me the papers for the transfer.

Transparency concerning derivatives

A derivative is an investment that is based on another investment. Derivatives are “proprietary” products created by investment banks and insurance companies. The failures of some types of derivatives issued by Lehman Brothers and AIG, an insurance company, set off the financial crisis in 2008.

I didn’t know the word, “derivative,” back when I talked with my insurance company about my 403b funds, but I knew enough to know I’d been hoodwinked. As far as I can tell there was, and still is, no “transparency” about mutual fund derivatives included in insurance company 401k and 403b plans.

Dangers of derivatives

Why is it important that these were mutual fund derivatives? Perhaps you  think other derivative mutual funds paid better than mine. Maybe they did. But a derivative carries an extra danger called “counterparty risk.”

Counterparty risk is the possibility the other party to a financial transaction might not be able to come up with the funds to pay. They may default. There is more probability of counterparty risk if an insurance company does not have the capital reserves to pay up on its derivative mutual funds in your 401k.

I recently went online and looked through the current sales brochure from my 403b insurance company. The brochure went into precise detail about different types of mutual funds and their risks. But nowhere did it say anything about the particular funds it offered let alone discuss risk if they were derivatives.

I feel strongly that life insurance companies should be required to disclose all derivatives and proprietary products in their 401c and 403b employer-sponsored retirement plans.

If financial regulators are insisting on more transparent disclosures to protect “sophisticated” investors from losses on CDO and CDS derivatives, surely they should offer the rest of us equal protection from being misled by mutual fund derivatives!

*A similar retirement plan for government employees is called a 457b plan.

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.

(part 3 of 3)

Last time we looked at the list of fees within the “Fees and Expenses” section of a prospectus. There’s another misleading chart in this part of the prospectus. It’s the ten year fee table that purports to show the expenses on a $10,000 investment. You’ll find it in all mutual fund prospectuses. This is what happens in a chart called “Expenses on a $10,000 Investment.”

It’s easy to overlook the impact of fees when they’re divorced from earnings.

This chart shows fees taken out at the end of 1, 3, 5, and 10 year periods. It is required by the SEC. Click here to see the SEC’s tips for reading reading a prospectus.

Here’s an example of this chart based on 5% earnings and a 1% fee:

“Expenses on a $10,000 investment”* (See how amounts are computed below.)

1 year    3 years    5 years    10 years
$105     $344        $625       $1,557

A compounded 1% fee on $10,000 comes to a little over $100. That seems so little compared to $10,000. But that isn’t anywhere close to the actual amount you will pay each year.

Your “actual” fee deduction is the difference between the amount your money makes and how much is taken out for fees during that same time period.

In the SEC ten year fee table example, that’s (5% of $10,000) or $500 minus (1% of $10,000) or $100. That’s $500 minus $100 for the first year.

$100 divided by $500 is 20%, not 1% in fees on your earnings each year.

Your compounded earnings go up by over 5% each year, but you are losing 20% of that amount each year because the annual fees you’re charged are on your total investment. Each year you’ll lose one-fifth of your compounded earnings!

Here’s another way to look at this. Over a period of ten years, assuming your investment earns zero, you’ll lose1% per year in fees from your initial investment of $10,000. That’a 10% or $1,000! Over fifty years, you’ll lose 50 percent of your initial investment to fees. That’s $5,000!

You lose a such large chunk of your investment over the long term because the 1% fee is charged over and over again every year against the same total investment you made at the beginning, i.e., the $10,000.

In order to make anything at all from your investment, your real earnings must make up for the 20% fee that’s deducted annually from the total of your earnings and the compound interest on those earnings. This is why the chart below shows a loss of so much at the end of a period of 51 years.

Thanks to the magic of compounding and the sleight of hand that takes fee deductions out of the entire mutual fund so that they’re invisible to you, after 51 years you’ll pay fees equal to 40% of your initial investment and its total earnings.  After  51 years your $10,000 investment would earn over $120,000. But when a 1% fee is taken out each year, your return will only be $72,000, or 60% of what your money actually earned. You’ll pay over $48,000 in fees at 1%.

Looking at the ten year fee table in a prospectus you’d never guess this!

Why doesn’t the ten year fee table in a prospectus show this consequence of paying 1% in fees? Because the SEC-mandated fee chart is not intended to show you the actual amounts fees will cost you. It is intended merely to let you compare certain types of fees for one mutual fund with the same types of fees at another mutual fund.

What should be in a prospectus?

The SEC’s required fee chart is disingenuous. A prospectus should show the actual cost of fees charged on mutual fund earnings compounded over time.

The difference in expectations about fees versus their reality is outrageous! Many mutual fund investors wind up with a vague feeling after years of investing that something wasn’t right. They didn’t get what they thought they were going to get. Now you know why.

I think prospectuses should be required to include a chart showing both fees and earnings, like the one below. And I feel 1% is way too much! Wouldn’t you agree?

CHART:  Mutual Fund Fees and Earnings over 51 Years at 5%

* To see the the actual cost of a 1% fee on $10,000 at 5% over a ten year period, take the amount over $10,000 in the “no fee” column and subtract the amount over $10,000 in the 1% fee column for that year

For example, for Year 1
$500 – $395 = $105.

For Year 5
$2,762 – $2,137 = $625.

**For fun, compare the above chart to the chart for 8% earnings in my previous post, “Financial Advisors’ Commissions and Fees.” (Be sure to add a zero at the end of each amount in that chart. It’s based on $1,000 instead of $10,000.) You’ll be amazed at how a 3% increase in earnings affects the total amount of fees you’ll pay!  At 8% interest after 50 years, your $10,000 would earn $506,537, but you’d lose $203,198 in fees at 1%.

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.

(part 2 of 3)

This post is about a pit I fell into and stayed in for many years! I overlooked it because fee charts in prospectuses deceive by omission. Not until I attended a financial workshop in 2006 over in San Francisco, did I realize my mistake.

Prospectus fee charts don’t show “a percent of what?”

It’s not uncommon to look at the “Fees and Expenses” section of a prospectus and skim over fees without a thought of what they apply to. The amounts seem so little when you look at them.

As an example of a fee chart in all prospectuses, this table is from “Fund fees and expenses” in the prospectus for SWSCX  Schwab Small-Cap Equity Fund ™)

Management fees    0.81
Distribution (12b-1) fees    None
Other expenses    0.34
Total annual fund operating expenses    1.15
Less expense reduction    (0.03)
Total annual fund operating expenses after expense reduction 1.12

It’s easy to glance at this chart without ever understanding exactly what these mutual fund fees apply to. From there it’s a short step to making the error of thinking you will pay the 1.12% fee only on your earnings.

But the difference between “earnings” and an “investment” is astronomical.

Here’s the difference when a 1% fee is taken out of an investment of $10,000 with annual earnings of 5%.

if you assume you are paying mutual fund fees only on earnings you get:

$10,000 at 5% = $500 in earnings
1% of $500 in earnings = $5 in fees

But, on an investment of $10,000 what you pay in fees is 1% of $10,000 or $100 in fees. And you do pay mutual fund fees on the whole investment each year, not just the earnings each year.

So what you actually pay on $10,000 at the end of year one is $100. That’s twenty times higher than what you might have thought you were paying, i.e., $5. And mutual fund fees keep going up as your earnings on your past investment totals compound each year.

Even very tiny differences in the amount of mutual fund fees charged for various funds can make a big difference in what you get back. This is especially true when you are investing a large amount of money in mutual funds over time.

I feel strongly that mutual fund prospectuses should tell us that mutual fund fees are on the entire investment, not just on its earnings!

Next time we’ll take a look at another misleading chart in the “Fees and Expenses” section of a mutual fund prospectus. This one is even more difficult to spot. And this one can cost you thousands or even tens of thousands of dollars!

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.

(part 1 of 3)

This is the first of three prospectus pitfalls to watch out for.

You may have been thinking of jumping back into the market and buying some mutual funds. You know by now how the value of investments can drop drastically. But you may not know where to find all the mutual fund fees that will also reduce your returns on your investments.

Mutual fund fees are not always found in one place in a prospectus.

In How to read a prospectus, Neal Frankie, Certified Financial Planner, cautions the reader that all mutual fund fees may not be included in the “Fees and Expenses” section of a prospectus.

Frankie addresses the experienced investor who knows enough to avoid mutual funds with load fees and to watch out for penalty fees if the mutual fund is sold within 90 days after purchase:

“Don’t get too cozy yet. Every mutual fund investor in the galaxy is still subject to a second class of fees. These are fund expenses, which are paid out of the funds’ assets — even if the fund loses money. You don’t get a bill for these expenses, but the costs are taken out of the fund and it reduces the value of your account each year.”

Neal Frankie advises readers to read the whole prospectus to find all of these fees. For example, he uncovered an additional fee in the section in a prospectus called “Management of the Funds.” Under a subsection titled “Investment Adviser and Management Expenses” he found a fee for managers’ bonuses.

According to Frankie, some additional fees even show up in a supplemental publication to a mutual fund prospectus called a Statement of Additional Information (SAI).

In his discussion of the “Financial Highlights” section of a prospectus, Frankie also shows how taxable interest, capital gains, and turnover costs also affect the return you earn on your mutual funds

After reading Neal Frankie’s guest blog post on www.getrichslowly.org, I feel strongly that prospectuses should should be required to show all fees in one place!

Next time we’ll zoom in on the “Fees and Expenses” section of a prospectus for a closer examination. It holds two more major pitfalls to avoid.

Copyright © 2010 Nancy K. Humphreys

Broke and Broker (part 2)

This week I received a comment pointing out that broker’s commissions have changed a lot since the time of my week at Suze Orman’s Merrill Lynch.

That’s very true! Over the past couple decades financial advisors have switched to charging general advisory fees rather than taking commissions on sales of financial products to customers. Creators of mutual funds also charge fees now instead of using commissions.

But do you know how much those fees will really cost you over time?

Broker and mutual fund fees – how much are they?

Financial advisors typically charge from from 1 to 2 percent of your total assets per year for providing you with their services.

If you are a DIY investor, you’ll choose to buy mutual funds directly from the fund creator, through a “supermarket” brokerage such as Charles Schwab, or from an online brokerage such as E-trade. But you’ll still pay fees on your fund. The range for these fees is similar to those you’d pay a broker, although a few mutual fund creators, such as Vanguard, do operate at a fraction of this cost.

You don’t usually see fees once you buy a broker’s services or a mutual fund. The fees are periodically taken out of your account. And most investors don’t pay much attention to such fees. After all, 2 percent seems so little.

But it isn’t. Not really.

The magic of compound interest

Most of us have heard of compound interest. We see our savings account grow interest on monthly, quarterly or daily basis. We know that compound interest is interest paid on interest already accrued for as long as you save or invest.

For example: At ten percent over two years, the annual interest paid on interest from one dollar is 1 cent interest paid on 10 cents interest paid on a dollar investment. That totals $1.11 As you keep on earning compound interest for 9 years, according to the Rule of 72 (see *note below) your dollar doubles. You’ll then have $2.

Over the years, the way compound interest “grows” your money seems like magic!

The real cost of a 2 percent broker or mutual fund fee

Most of us have heard about about compound interest. What most of us haven’t heard about is that compound interest can also grow the other way: more and more “minus” instead of more and more “plus.”

Broker and mutual fund fees “earn” compound Interest too. For you that means there’s a “minus” compound interest that’s deducted from your investment account.

Take a look at the chart below. It shows how much an investor makes annually at 8 percent on an investment of $1,000 for over 50 years. The columns show how much you get after three different levels of fees are taken out. The three levels of fees are: zero, one percent, and two percent.

You can see the results. “No fee” taken out results in $50,653.74 in 51 years. That amount is your 100 percent return on $1,000 dollars compounded annually at 8 percent. $50,653.74. Quite a nice sum!

Now take out a “2 percent fee.” That results in a total sum of $18,077.63. In other words, at the end of 51 years, you’ll receive only 36 percent of the whole amount your $1,000 investment earns! Even a puny fee of 1 percent results in your receiving only 60 percent of what your money earned.

Who gets the rest? Your broker and/or your mutual fund company.

CHART: Mutual Fund Fees and Earnings over 51 Years at 8%

* Rule of 72 for estimating how long it will take to double an investment earning compound interest: for $1,000 at 8 percent interest per annum, divide 72 by 8. That tells you you’ll need roughly 9 years for your investment to double to $2,000.

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.

Next time: why a 1 or 2 percent fee seems so little – the mutual fund prospectus

Who really benefits from your financial advisor’s advice? It isn’t always you. That’s a shocking fact I learned from working at Merrill Lynch a decade before Suze Orman did.

Suze Orman’s Merrill Lynch office

A long, long, long time ago I worked at the same place where Suze Orman got her start. That was at the downtown Oakland office of Merrill Lynch.

Unlike Suze who decided to go for an interview for a permanent job as a broker at Merrill Lynch after her investment advisor lost all her money in the market, I was simply broke.

I’d arrived in Berkeley, California with a masters degree in economics from the University of Wisconsin-Madison. I couldn’t even find work as a waitress in an impossible job market in the San Francisco Bay Area. So I signed on with Kelly Girls, a temp agency.

Kelly Girls sent me down to Merrill Lynch to work for a week. I’ll bet I was as excited as Suze was on her first day. In a previous assignment for them, I’d passed daily by a stock exchange in San Francisco. It had a wedge-shaped moving marquee with letters and dollar figures flowing across it in bright lights. This time I was so excited I even arrived early on my first day.

As I stood staring at the solid-looking door, I thought, “wow, this is where the money gets made.” I was sure the scene inside would be traders in shirt-sleeves waving buy and sell orders in a roar of voices. What would it be like to be on the inside? I took a deep breath, grasped the handle, pulled the stout door open, and walked in.

The place felt like a pharaoh’s tomb. There was a spacious, empty, dimly-lit lobby with plush carpet that muffled all sound of my footsteps. In fact, the place was so quiet you could hear a pen drop. But I didn’t hear a pen drop, nor a a voice or even a phone ringing.

So I began timidly poking my head in office doors. Suddenly a white-haired gentleman in a suit appeared from nowhere and asked dubiously how he could help me.

When I’d explained the reason for my being there to his satisfaction, “Mr. White” took me to meet my new supervisor, “Harvey.” Harvey was a young man about my age, but he was much more professional looking than I. He had short blond hair, and like Mr. White, was dressed also in a suit and tie.

Harvey briefly told me what to do and dashed off. With a let-down feeling in the pit of my stomach, I used my great knowledge of economics to begin stuffing and putting stamps on envelopes. For three days nothing at all exciting happened. On the third day, everything changed.

Harvey came stomping into the room. “What are you doing?” he demanded.

I cringed. “Uh,” Mr. White” told me to sort these brochures.”

“Yeah, right! CRAP of the MONTH! That’s the stuff he wants us to push on clients. It’s worthless JUNK they won’t make anything from. But we get paid COMMISSIONS.”

He spat this last word out like it was obscene. I froze in panic. Harvey was working himself up into a rage. Suddenly he turned from his pacing and asked fiercely, “Do you like pot?”

Stunned, I tried to think how I should answer that.

I decided to go with something I’d heard once – if you don’t know, just tell the truth: “well, uh, I guess it’s OK, but it makes me nauseated, so I don’t like being around it.”

Harvey replied, “Well, I LOVE it! I smoke it all the time. I’m a HIPPIE, you know.”

I must have looked skeptical.

Harvey reached up then and grabbed his blond hair. As I watched in shock, he yanked a wig off his head and long brown hair flowed out. “This is my real hair, but I can only wear it ON WEEKENDS. I have to wear THIS THING for WORK, work I have to do for that A..HOLE!” With that Harvey stormed out of his office.

We never spoke of anything personal again. I noticed with envy that Harvey was rarely ever in his office. On my last day of the job at Merrill Lynch I sat, as usual, alone and lonely in Harvey’s office, and filed client cards. It was mindless work that left me counting the minutes left to 5 o’clock. Suddenly I spotted a familiar name.

It belonged to my favorite economics professor back at UW-Madison. Surely it couldn’t be, I thought. Then I remembered a classmate telling me he’d married a wealthy heiress from California. As I looked at his account balance, my jaw dropped. His wife must be wealthy as the Queen of Sheba! I couldn’t believe it. I felt totally distressed: my favorite “economics guru” had just lost a bundle! He lost more than I could imagine making in a whole lifetime.

I left Merrill Lynch knowing I’d learned more from one week at that place than I ever learned in school. I learned truths that still stand me in good stead today. This is what I learned: Stockbrokers are not to be trusted, and economists know nothing about making money.

Stockbroker’s fiduciary duty to clients

What Harvey was upset about was his boss’ orders to ignore loyalty to the client in favor of making profits for the firm and himself. It’s still perfectly legal for financial advisors to do this.

The legal term for putting client’s needs above all others is “fiduciary duty. The “rub” is in how you define the word, “client.”

Only registered investment advisors must show a fiduciary duty to their clients, who are investors.

Other stockbrokers owe their “fiduciary duty” only to their brokers and dealers, i.e, the “clients” who create the financial products these brokers sell to investors. These stockbrokers only have to give “suitable advice” to their customers. Their advice to customers can be “suitable,” even if its not the best advice they have to offer.

To check out whether your financial advisor or brokerage firm is registered and has a good reputation, you can use this website by the SEC (Securities and Exchange Commission).

Large brokerage firms, like Merrill Lynch or Charles Schwab, and investment banks often employ both registered investment advisors who have a duty to investors, and stockbrokers whose duty is to the firm’s financial clients whose products they sell.

Before you buy, be sure to ask your financial advisor if they owe their fiduciary duty to you!

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.

Coming soon: brokers’ commissions and fees

If you can follow the threads of a mystery story and sometimes even figure out whodunit, you can find work in this economy. You can uncover new business opportunities and/or find the best places to look for a new job. You can tell when it’s time to leave a job too. Economics can help you do this.

Be aware of economic shifts

There are two kinds of shifts that take place in an economy. There are long-term foundational shifts such as the one I wrote about in my three posts on the publishing industry. These shifts result in permanent changes. And then there are short-term shifts which may or may not result in long-term changes. Short-term shifts are the results of “business cycles.”

Whether you are an employee or an entrepreneur, you’ll survive better by “following the trail” of both short and long-term shifts in the economy.

Long-term economic shifts

As I discussed previously, employment in the print publishing industry is unlikely to ever expand again. But it is likely that jobs in media will increase. For example, Hearst, the well-known publisher of newspapers, an industry sector in dire straits these days, is now moving into the apps business, particularly into news-information-type apps for the iPhone. Random House, now a unit of Bertelsmann (a German media conglomerate), is moving into creating stories for video games along with writing books based on those video games.

Short-term economic shifts

On the other hand, if you’re looking at short-term shifts in the economy, any change in your work may be ephemeral, a butterfly that flits and disappears. This is why it’s really important to keep an eye out for short-term shifts. These are your signals to quickly move out of a declining sector and into one that’s expanding.

During cycles of recessions and boom-times, businesses have to make shifts to survive. An example is the U.S. export business sector. Here’s what’s happened and the new opportunities that emerged.

Shipping industry example

Container shipping companies were hit hard by the financial crisis. There was a dramatic decline in demand for shipping worldwide. These businesses sold off some of their fleets. They also put a good percentage of their ships into mothballs. They slowed down engine speed to save on fuel costs. As a result, the time involved in shipping rose, costing their customers a lot more.

Meanwhile the U.S. dollar declined. It fell so far that its low exchange value encouraged more people abroad to purchase our cheaper U.S. goods. But U.S. ports and the container ship industry weren’t ready for this change. All of a sudden exporters from the U.S. couldn’t find a boat to save their goods. Costs of shipping skyrocketed as container shipping companies decided to keep on limiting shipping routes from the U.S. in order to drive prices high enough again to expand.

The consequences of this “short-term” downturn (which has been going on for a few years) didn’t stop there. U.S. manufacturing companies that depended on container shipping to and from their outsourced plants in other countries were suddenly slammed with rising costs for shipping. In addition, the high jobless rate in this county enabled them to negotiate much lower wages for American workers.

Reversal of offshoring

Thus began a short-term trend of “onshoring” or “reshoring.” Companies began closing foreign operations and bringing those jobs back to America. Caterpillar, GE (General Electric), and U.S. Block Windows, Inc. are just three companies who have done this. The U.S. auto industry which had expanded from Detroit into Canada, Mexico, and California found itself needing to shrink its operations located the furthest from Detroit as well.

Offshoring is still the main trend among U.S. companies, but because of increased shipping costs, as well as political instability and problems with copyright and patents abroad, more U.S companies are moving back. They are encouraged by local, state, and federal government inducements for relocating here. This is probably a short-term shift. More container ships will again sail the seas again. But it’s still a place to find a new job, promotion, or business opportunity for at least a few more years.

Use economic shifts to look for new opportunities

Employees and entrepreneurs who can figure out the workings of economic shifts have a better chance to pluck a promotion, extricate themselves from unemployment, or launch a new business. It isn’t hard to do this. By following business news, amateur “economy detectives” can uncover which industries are doing poorly. Then determine which other sectors might be doing well as a result.

For example, the winner from the export and container shipping sector dilemma is the air freight carrier sector. Fed Ex and UPS have ramped up considerable new business and profits by going where container ships won’t go. Railways too have picked up new customers. Some agricultural shippers are paying for rail transport that takes days just to get their goods to a port with a ship that’s going where they need it to go. Air freight and railways are the economic sectors where you may find new opportunities.

Tracking economic shifts and their consequences for particular industries and companies is how successful investors such as Warren Buffett make money. It’s how you can make money too. Do it and find a new job or a service that you can provide to clients.

Copyright © 2010 Nancy K. Humphreys  All rights reserved. You are free to use material from Brucenomics in whole or in part, as long as you include attribution to Nancy K. Humphreys followed by a live link to http://www.brucenomics.com.

Murder at the Margin by Marshall Jevons (Princeton University Press, 1978)

Can economics and English ever mix? I switched from English to Economics in graduate school for a purely economic reason. The tenured professors in the English Department were so incensed with their graduate students going on strike for higher wages that the profs abolished the only source of financial aid in the department…awards for teaching freshmen English.

At a mixer for new grad students in Economics at UW, I was teased by an upperclassman, “Oh, you mean English majors can add?” In one of my many classes where I was the only woman, my professor whipped out a poem by an author I’d never even heard of, and looking straight at me, read it aloud. He concluded with a smile and the statement, “Even we economists can appreciate great literature.”

So it was with some delight and skepticism I picked up a copy of Marshall Jevons’ book, “Murder at the Margin,” the first known mystery by an economist. Both feelings were richly rewarded.

This novel is well worth reading not just for its detective’s many wise arguments, usually made to his most forbearing wife, “Pidge,” that use concepts from economics to figure out what’s going on around them. The detective is Henry Spearman an economics professor at Harvard University. Henry is a detective as distinctive as Adrian Monk, Hercule Poirot, or Sherlock Holmes.

The “margin” referred to in the title has nothing to do with investing, as I first thought. It’s a reference to how the addition of lime to a glass of lemonade tips the balance for Henry when deciding whether to spend a dollar for the drink. It’s the place where a “marginal benefit” of some small thing that adds value to a good or service, pushes the buyer to buy it. I sense that “margin” also refers to the fact that Henry and his wife are vacationing at a resort called Cinnamon Bay Plantation on a remote island in the Caribbean. They, and the murderer are on the margin of society in the geographical sense.

The cast of characters at the resort, all diverse and distinctive are amusing, as is the hero. Readers originally thought the book was written by Milton Friedman not only because of similar names but also because of the parallels between Henry’s physical appearance and way of reasoning to Friedman’s. But it was not one of Friedman’s creations. It was written by two less-well-known economists who collaborated and used “Marshall Jevons” as their pseudonym.

“Murder At The Margin”  has lasted 30 years and is used in high school and college classes for teaching students about economics, but I doubt it’s part the curricula of any literature department. The problem with it is that it utterly fails as a mystery.

One of the requirements for a good murder mystery story is that the reader be given all the clues needed to solve the puzzle. “Ellery Queen Jr.” (pseudonym),  Agatha Christie, and Dorothy Sayers come to mind for their skill in using “red herrings” to fool readers while disclosing all the facts needed to figure out the mystery.  But in this book, the authors* were so busy teaching classical economics reasoning that they forgot to reveal the one detail Henry used to figure out whodunit…

This detail is mentioned twice earlier in the book, but without the simple math behind it, the language of the authors is too ambiguous to grasp what was meant by the clue.

The moral of this book, though, is an interesting one. Just as many cops feel that criminals’ stupidity gets them caught, in this book, on at least two occasions, the criminals are caught out because they are cheapskates. Henry employs his sharp eagle eye to dissect their spending habits and ferret out the truth of their actions.

This book isn’t a great mystery book but it will be a hit with anyone interested in mysteries or economics. Personally i can’t wait to read Marshall Jevon’s second book, “Fatal Equilibrium”!

Copyright © 2009 Nancy K. Humphreys

Sales of U.S. Assets

At the end of the post Our Government: A Business Without Assets? I asked, “What next? Will we soon see ads for giant auctions on the lawn of 1600 Pennsylvania Avenue?”

Apparently the answer is yes. That’s the implications of Ana Campoy’s article in the Wall Street Journal on February 26th, titled “Worries Balloon Over Helium:  Experts Say U.S. Is Mishandling Selloff of World’s Largest Stockpile of the Gas” (page A5).

This article says the largest stockpile of helium on earth is located in the Texas Panhandle. We supply one-third of the global demand for helium. Helium is used in high tech products, and as a result, demand for it has skyrocketed. The problem is that the U.S. is selling off all of its helium from its supply depot in Texas.

Concerned parties, which include a government advisory agency, are asking that all of our helium not be sold off by the target date of 2015. They also believe helium should be sold at market rate instead of the exact price Congress set for it in 1996. Congress has been asked to consider the matter, but is pondering the issue of whether it should consider it.

The government has been selling off other useful rare metals too, but China has stolen its market in those.

The reason Congress is so anxious to sell off its whole supply of helium at a price lower than the market price is that the Bureau of Land Management went into the hole to the tune of $1.3 billion to acquire and process helium. In 1996 Congress made a decision to sell all of our helium to repay that debt.

Yes, if we don’t pay attention to government assets, this is what can happen, especially when our government’s debt and deficit are rising.

Sovereign debt crisis

We think of the U.S. government as a lender of foreign aid to others. But we are among the biggest recipients of foreign aid from other countries. This aid comes in the form of purchases of Treasury investment products. These purchases can be used by the Treasury in lieu of printing money.

The problem is:  Treasuries may not remain desirable investments for other countries. If the U.S. government’s debt becomes so high that its sovereign debt credit ratings go down, demand for Treasuries will fall. This is threatening to happen. If it does, we’re looking at higher taxes, and possibly, inflation. The upside is that Treasuries, which are more risky at that point, will pay higher interest rates to any buyer willing to take a chance on them.

In Our Government: A Business Without Assets? postscript I discussed sovereign debt crises due to off-the-balance-sheet debts of governments in the PIIGS countries. This issue is front and center in Europe right now.

The Fed is also said to be concerned about Greece. Why? Because Goldman Sachs, J.P Morgan, and other large financial companies in the U.S. have been providing “foreign aid” to Greece and the PIIGS countries. These financial companies made deals with the governments of Greece and Italy involving derivatives called “currency swaps” and “credit-default swaps.” These deals may have enabled these countries to seem prosperous enough to enter the European Union, when in fact, they were seriously in debt.

The Fed has the authority to examine U.S. financial institutions to see if their pursuit of profits in any way acts to destabilize any countries or companies. But our own country’s off-balance-sheet debts are threatening to destabilize this country. Perhaps the Fed should look closer to home!

Copyright © 2010 Nancy K. Humphreys

Is Your Job Already Outsourced? (part 3 of 3)

(Click here for part 1) (Click here for part 2)

From the start of this century the publishing world has gone in two distinctly different directions.

On the one hand, the number of traditional printed-book publishers has shrunk. American book publishers have been swallowed up by media conglomerates, most of them foreign.

On the other hand, brand-new electronic-book-reader technology from American chain bookstores and computer manufacturers has blossomed. And reminiscent of the “mimeo revolution” of the 60’s and the desktop publishing revolution of the 80’s, downloadable-print-publishing via the Web by self-publishers has exploded too.

Publishing means promotion not production

Up through the 20th century, publishing was classed as part of the manufacturing sector. Publishers typeset, bound, and distributed books. Sometimes books were marketed via publishers’ catalogs and review copies. But promotion was a nominal part of what publishers did.

In the 21st century, almost anyone can publish and distribute a book. Promotion, rather than production, is now key to online bookselling in this era. And publishing is now a part of the Entertainment and Information sectors instead of Manufacturing.

The traditional (i.e., “printed book”) publishing industry charged high prices, yet never paid its workers well. The median return to authors for a published book has hovered around $3,000 for decades. Royalties to authors are often not paid until a year after the book is published and the publisher deducts all costs. Royalties are usually not itemized or ever reported in total on royalty “statements.”

For less than $3,000 an author now can publish and promote their own book and keep 100% of the gross royalties rather than settle for the mere 7-10% net royalties traditional publishers typically pay. Authors can keep their own copyright or creative commons rights to their work. Most importantly, an author can see who is buying their book and even market another book or other kind of product to those buyers.

While media giants scramble for blockbuster print book moneymakers such as the $10 million Springsteen autobiography reputedly in the works, these publishing companies leave many authors out in the cold.

But now authors left out in the cold have many alternatives: they can self-publish their own books; create POD books, books that can be printed-on-demand as readers buy them; or write e-books.

But what do we mean by “e-books”?

As I described above–there are two publishing sectors. The corporate sector aims at “wealth-building” for the few. Simultaneously, there is an economic sector referred to often as “the long tail” [wags the dog] sector. The goal aimed at in this sector is for all in it to “make a decent living.”

So, e-books can refer quite different things, depending on which economic sector you’re talking about.

Electronic-reader e-books

E-books can be books published or repurposed for corporate electronic readers sold by via the Web by large booksellers such as Amazon or Barnes and Noble (i.e., Kindle and Nook). Apple too has jumped into this market with its new iPad, and PC makers are quickly following suit.

These corporate-published “electronic reader e-books” are being made for students in colleges and schools as well as for the general public.  The Financial Times reported on October 26, 2009 (p12) that “A pilot scheme to evaluate e-book technology in the classroom is underway at six colleges and business schools.” Last year governor Arnold Schwarzenegger called for all of California’s public school textbooks to become electronic.

PDF e-books

But e-books can also refer to a booming trend of professionals creating downloadable PDF files for online distribution.

Many of these downloadable e-books, formatted for printing out, are free or low-cost “loss-leaders,” intended to start “selling conversations” with prospective clients for services offered by the professionals who wrote the e-books.

Some of these downloadable e-books are workbooks sold through shopping carts. Others are full-priced multimedia kits one buys online. The word, “e-books,” also encompasses chapters of self-published books that are offered for free or at a lower price to entice new customers to discover an author. Some online “serial” e-books are even supported by reader donations.

Both kinds of e-books are new, but they arise from two very different business models. In their stories about “e-books” traditional corporate media, i.e., newspapers and television, usually are referring to books published by retail book and computer companies for the new electronic readers these corporations sell. PDF e-books, on the other hand, belong more to the blogosphere.

Alternative and corporate and publishing combined

However, these two business models do sometimes overlap. The tail sometimes wags the “master.” For example, a self-publishing writer may use the traditional Hollywood movie “trailer” or a TV appearance to promote their new book.

It’s an individual choice as to what vehicle for promoting a book works best for each author. For example, in the last century Joyce Carol Oates switched back and forth between large American publishing houses and independent small press publishers to get all of her novels out.

Authors today may enter self-publishing with a goal of eventually becoming picked up by traditional publishers or getting their work put out for electronic readers. Other self-publishing authors have no interest at all in getting an agent, publisher, or e-reader book contract. They’d rather be on their own. For all self-publishing authors it’s a brand new frontier out there on the Web!

Be The Media

For a comprehensive look at traditional and new business models on the Web for creative people, providers of services for them, and community-based organizations that use media, see David Mathison’s Be The Media. David was a client of mine, and I’m proud to be an affiliate seller of his book. We have similar work histories and think much alike. David’s book is simply the best coverage of what’s happening with alternative and mainstream media today.

Nancy Humphreys © 2010

National liabilities are the other side of national assets. In my last post, I didn’t discuss this side of things. Governments not only don’t track their own assets; apparently they don’t track their own liabilities either.

Sovereign debt crises are now happening in the “PIIGS” countries (Portugal, Italy, Ireland, Greece and Spain) because of “off-balance-sheet” liabilities. These liabilities includes things like sovereign credit default swaps (CDSs) and securitized investments via banks, as well as private equity deals.

More telling, national off-balance-sheet liabilities also include health and retirement benefits such as our Medicare and Social Security programs. This doesn’t mean those things are intrinsically bad. It just means that someone needs to show the assets that could offset them on the national balance sheet.

And that won’t be taxes. Taxes are just a part of our national government’s assets. Federal taxes will go toward paying only two-thirds of our national government’s projected budget debits in 2011.

Likewise, using our definition of assets as things which bring money into our pockets and liabilities as things that take money out of our pockets, we can see that jobs are liabilities, not assets. It doesn’t matter if those jobs are private or public or how big the numbers of jobs are. What does matter is what kinds of assets for America workers in those jobs produce.

On the other hand, infrastructure improvements are national assets. But while government bureaucrats and Congress point fingers at each other for the failure to make such improvements, the stimulus package has spent very little on infrastructure. The infrastructure our government has spent the most on shoring up is our continuously-eroding banking infrastructure.

So yet again, we’re right back to the key question asked in my original post, Our Government: A Business Without Assets? With Moody’s threatening to lower the United States’ current three-star sovereign credit rating, why aren’t our President and Congress including national assets and liabilities in the discussion about our national deficit and debt?

Copyright © 2010 Nancy K. Humphreys

Before I finish my series on the incredible transition taking place in the publishing industry, I need to comment on the current controversy about our government’s debt and deficit. There’s an important pair of terms related to debt and deficit that aren’t being discussed right now, and they should be.

Clive Crook of the Financial Times asserts that President Obama’s new budget for 2010 is only a “”minutely worded wish-list,” that most likely won’t be honored by Congress. All of us probably agree with that statement. But Crook also  believes the “only remedies [for the US debt/deficit dilemma] are lower spending and higher taxes.” I strongly disagree with that. Only one-third of the U.S. deficit is paid for by taxes, and there IS another way to approach the US government’s debt/deficit problem.

Debt vs. Deficit: What are they?

Debt, as we all know, is what we owe. Sovereign debt, i.e., the debt a country owes, is fast becoming a concern not only abroad, but here. In regard to the US stock market, Uri Landesman, portfolio manager at ING bank’s investment wing told the Wall Street Journal, “Clearly, the sovereign-debt worries are first and foremost for the market right now.”

There’s a lot of agitated talk about our deficit too. But what’s a deficit?

Let’s say you pay all your debts using a credit card. When you receive your statement, your debt is the total amount that you owe to your credit card company. Your deficit on this statement is your credit limit. That’s the total amount that Visa or Mastercard would allow you to borrow.

Many of us have assumed our national government had an unlimited credit limit and could just go on printing money to pay its debts. That isn’t true.

Congress is like a credit card company–it sets limits on the national deficit and the national debt. And it has the power to prevent the federal government from exceeding those limits.

Do you think it’s odd to be discussing our government’s budget in personal terms by comparing it to a household credit card bill? Well, it is. In modern economics, comparing “macro” with “micro” is strictly forbidden.

Comparing macro and micro levels of the economy

The fact is that macro and micro comparisons have to be made, but not, as they were in the olden days of “political economy,” between government and households. Comparisons today have to be made between government and business.

That’s because of the modern Republican Party’s agenda. The Republican Party in the US has long stood on the side of “Business,” large or small. It is still doing so, but with a new twist. In addition to downsizing government and letting business take over many government functions, Republicans aim to give our government a complete makeover. They’d apparently like government to become a business.

What’s missing in the debt and deficit debates

The macro level of our economy is our national government. The micro levels of our economy are businesses, households, and individual consumers. If we compare the federal government with business, we can easily see what’s wrong in Congress.

What’s missing is a serious discussion in Congress of the US government’s debits and assets. At the very least, those who believe government ought to operate more like a business, and produce products, i.e., “results,” that can be measured in terms of cost-benefits, should be asking for debit and asset information. So should Democrats in order to defend their stimulus programs. And so should taxpayers!

Debits vs. Assets: What are they?

What are debits and assets? Roughly speaking, debits (sometimes called “liabilities“) are things that take money out of your pocket and assets are things which put money into your pocket. (If you remember, I talked more about this pair of opposites in my previous blog, “Part I: Banks and People.”)

To go back to the credit card analogy, debits are the items listed on your monthly statement. Debits are what you spent your money on last month. Add up all your debits over time and you get your total debt. But on a business balance sheet (or a household budget), at some point, your debits need to be offset by at least some kind of assets or you’re headed for big trouble. Even if it’s only an unemployment check, you’ll need an asset to offset your debt.

In my previous post, “14 Trillion and What Do You Get? Another Day Older and Deeper in Debt,” my advice was:  “If you do go into debt, it should be for an asset that you are sure will make money for you.” This is true for individuals, businesses and households. But what about our government? What’s it doing about its assets?

Assets? What assets?

We have no idea of the total worth of our government assets. John Rutledge of Rutledge Capital says that financial assets of the US. Government totaled $1,261 billion in the fourth quarter of 2009. State and local governments owned financial assets totaling $2,555 billion. These amounts change, sometimes drastically so, every quarter.

Dr. Rutledge, too, wonders why economists don’t keep track of all US government assets.

But our government doesn’t even know its own assets. An old friend, Bill Murray, who was helping fix up the house I now live in, loves to discuss precious metals as well as tools. One day, out of the blue, Bill mentioned platinum.

“It’s our most valuable metal,” he explained, “because it has so many more practical uses than the precious metals.” Bill told me that the market price of platinum was way off because, “for security reasons, our government owns a lot of it.” He said, “Even they don’t even know how much they’ve got of it.”

Dr. Rutledge states that the Fed only tracks the financial assets owned by our governments. The Fed doesn’t track tangible assets, (things like desks, cars and platinum). And to quote Dr. Rutledge, “… any analysis of the economy that focuses on spending or saving or budget deficits alone, to the exclusion of the balance sheet [assets vs. debits], is almost certain to be wrong…”

When you’re in a financial hole, squabbling over specific items of spending on your credit card without considering if they’re “debits” (things that take money out of your pockets ) or “assets” (things that bring money into your pockets) isn’t how you get out of debt.

But our Congress spends its precious time debating only the size of expenditures and/or whether expenditures are too extravagant, e.g. gold toilet seats for the military. The only time we ever seem to hear about our government ’s assets is when they’re being sold.

A Biggest Loser Auction?

Because of the financial crisis, as well as its own peculiar budget process, in 2009 the government of the State of California was forced to hold a giant auction of its assets. Other states have been doing the same thing.

Government auctions are often described as sales of “surplus” items. But an auction isn’t like a rummage sale where one gets rid of old, useless, junk. An auction is usually a sale of valuable assets that can be used to make money.

Things do look dire when even governments, like companies, households, or individuals, have to sell off assets just to survive. What next? Will we soon see ads for giant auctions on the lawn of 1600 Pennsylvania Avenue?

Copyright © 2010 Nancy K. Humphreys

Source:  Dr. John Rutledge quotes are from his blog article,  Total Assets of the U.S. Economy $188 Trillion, 13.4xGDP

Is Your Job Already Outsourced? (part 2 of 3)

(Click here for Part 1)

Last time, I looked at ownership of large book publishers in 2004. We saw that many large American book publishers were taken over by foreign print book publishing companies. In 2010 the picture is way worse. Those large foreign book publishers have themselves been swallowed up by even bigger media conglomerates.

Let’s look first at what happened to American book publishers and then to big foreign publishers, including Bertlesmann, Thomson, and Taylor and Francis, the leaders in 2004.

If you check recent US stock statistics, the results for “publishers” are quite strange-looking. Top companies in terms of volume of trading are: Ep Global Communs Inc.; News Corporation; Gannett Co Inc.; McGraw-Hill; Thompson Reuters Corp.; Marvel Entertainment; Yellow Pages; Income Trust Units; Mcclatchy Co. Hld.; New York Times; Idearc Inc (a Verizon spinoff).; and Martha Stewart Living.

This is certainly a very catholic group of companies, with McGraw-Hill being the only well-known book publisher. The rest are an eclectic combination of newspaper, magazine, and even phone book and comic book publishers. What gives?

According to Dan Poynter, well-known advocate of self-publishing, the top six publishers by size today are: BERTELSMANN, CBS CORPORATION, HACHETTE, NEWS CORPORATION, PEARSON, and VERLAGSGRUPPE. Many of these companies are privately owned corporations.

The only American-born-and-bred corporation among the big six is CBS CORPORATION which took over SIMON & SCHUSTER. 

So, let’s look at who the other five giants are.

BERTELSMANN, a German company, owns RTL Television along with RANDOM HOUSE, INC., “the world’s largest English language trade publisher.” Bertelsmann’s founder, Reinhard Mohn, died last October. His company is private and family-owned.

HACHETTE LIVRE is the largest book publishing company in France and the second largest publisher in the world. It is a subsidiary of Lagardère Media, the media division of Groupe Lagardère, a limited partnership holding company. Hatchette Livre’s U.S. division, Hatchette Book Group, includes TIMES WARNER BOOKS. Hatchette also took over LITTLE, BROWN AND COMPANY.

NEWS CORP., is a publicly-owned company founded by Australian media mogul, Rupert Murdoch. It is the largest media company in the world. It holds properties all over the world in film, television, cable, magazines, newspapers, book publishing, and professional sports, with Fox TV likely its best known property. News Corp owns HARPERCOLLINS, a combination of American book publisher, HARPER & ROW, and British COLLINS.

PEARSON PUBLISHING is a publicly-owned UK-based media corporation that claims to be the world-leader in education, business information and consumer book publishing. It owns the former leading secondary education publisher in America, PRENTICE HALL, along with the UK publisher, THE PENGUIN GROUP, which previously acquired PUTNAM. PENGUIN-PUTNAM was the second largest trade publisher in the world.

VERLAGSGRUPPE (Bauer Media Group) is a private family-owned media company in Hamburg, Germany that operates in 15 countries in the world and publishes nearly 300 magazines, including Q, a UK music magazine similar to Rolling Stone.

Other book publishing imprints such as ST. MARTIN’S PRESS, HENRY HOLT & COMPANY, FARRAR, STRAUS & GIROUX and MACMILLAN were taken over by the German family-owned media conglomerate, HOLTZBRINCK PUBLISHING HOLDINGS.

INFORMA PLC, a publicly-owned UK conference and event promoter, took over FRANCIS AND TAYLOR in 2004.

Last, but not least, THOMPSON CORPORATION, a Canadian book publishing giant, spun off a number of it’s educational publishing divisions and merged with Reuters to become THOMSON-REUTERS, an “intelligent information” and “technology” company focused on financial news.

Book publishing is not the main business of these giant worldwide conglomerates. They are actually global media companies with a lot of diverse activities under the umbrella. 

The few well-known American book publishers, such as JOHN WILEY and MCGRAW-HILL, who have survived the conglomeration trend can hardly compete with these international behemoths.

McGraw-Hill, however, is trying. Its About page on the Web says:

“McGraw-Hill aligns with three enduring global needs

• the need for Capital
• the need for Knowledge
• the need for Transparency”

This hardly sounds like the mission of a traditional American book publisher!

The reality is, book publishing is no longer a very important medium within the context of media. CBS Corporation, for example, is far more concerned with what’s happening at NBC or Fox than it is with what’s going on with Simon & Schuster. And with the emergence of new media such as Amazon’s kindle, Barnes and Noble’s nook, and Apple’s iPad, “print” may soon become a thing of the past.

Next time: Online Publishing: The New Frontier

SOURCES: http://www.investools.com and Dan Poynter’s site, http://parapublishing.com/sites/para/resources/statistics.cfm

Copyright © 2010 Nancy K. Humphreys

Is Your Job Already Outsourced? (part 1 of 3)

Industry Concentration

In my previous blog series on “Banks and People,” I traced how the financial sector is in the process of becoming “concentrated” as a result of the financial crisis. “Concentration” simply means that the share of the market for each bank still standing has increased. In the past year we’ve lost over 140 banks in the US. We’ve lost 180 banks since the financial crisis began. Many more bank failures are expected this year.

Concentration within any industry brings dangers associated with monopoly or oligopoly power at the top. “Rent-seeking” is also found when economic power is concentrated. Rent-seeking is the act of legally appropriating wealth created by other people. Rent-seeking tends to promote economic inequality among individuals and/or among groups of individuals.

But while our attention has been focused on the financial crisis and bank failures, we’ve overlooked the huge foundational shifts taking place in many other sectors of the US economy.  Concentration isn’t just taking place in the banking industry, and concentration has been going not just for a couple years, but during the whole decade.

In this series of three posts, I’ll trace what’s happened in the publishing industry over the past decade as an example. The same pattern found in book publishing also applies to many other parts in our economy.

Book Publishing Industry Concentration 2000-2004

The entire American book publishing industry is simultaneously growing and contracting. Publishing is going global, yet the traditional publishing market for authors’ writings is shrinking. You probably realize that independent bookstores are closing, and small presses are being sold to bigger presses that in turn are being swallowed up by even bigger companies. But you may not know that more authors than ever are self-publishing their own books.

You’ll find a comprehensive overview about these shifts in all creative fields, including publishing, and the implications for businesses that serve creative people in David Mathison’s Be The Media. David’s book is an epic description of the battle going on for control of creative endeavors on and off of the Internet during this decade.

But here’s my take on the print book publishing industry, having watched it closely for over thirty years. Our publishing industry is no longer “our” publishing industry.

Even if you didn’t lose your job during the financial crisis, you may find it’s not with the same employer you had back in the 1990s! In fact, these days your company’s “boss” is very likely to be sitting in an office in another country. Your job in the United States is the one being outsourced by a foreign firm.

Who Owned Whom in 2004:

Bertlesmann, a German company, owned these publishers:

• Alfred A. Knopf
• Ballantine
• Broadway
• Doubleday
• Pantheon
• Random House

Thompson [now Thompson Reuters], a Canadian Company, owned these publishers:

• Brooks Cole
• Course
• Gale
• Southwestern Educational
• Thompson Learning
• Wadsworth
• Westlaw

Taylor and Francis, a British Company [now owned by Informa plc], owned these publishers:

• Martin Dunitz
• Europa Publications
• Gordon & Breach
• Curzon Press
• Fitzroy Dearborn
• Garland Science
• Bios Scientific Publishers Limited
• Frank Cass
• CRC Press
• Canadian-owned Routledge Group (this includes Routledge, Spon Press, and Carfax)

As you can see, at the start of the 21st century, most large book publishers in the US came to be bought out by foreign companies. Five years later the picture is even more incredible. The book publishing industry has truly re-invented itself. Today it is no longer even the “publishing” industry!

Nancy Humphreys © 2010

Next time:  “Traditional Global Publishing, 2005-2010″

Banks and People (part 3 of 3)

At the start of the crisis, the U.S. government said it wanted banks to switch from making investments back to making loans, loans that were sorely needed by businesses and consumers. Now, with TARP about to end, President Obama is still saying the same thing.

The US government estimates it will make a profit of $19 billion from the big banks it bailed out, but laments that the banks are not using bailout money to make loans. Sheila Bair, head of the FDIC, was particularly critical of the government’s TARP bailout program, noting that bank loans declined by 2.8% in the last quarter, the biggest decline since 1984, the year the FDIC began tracking bank loans.

The pairs of four variables in my previous post,  “Part II of Banks and People,” show why this is happening. During the financial crisis  banks eschewed making bank loans to customers (options C and D) in favor of  selling their own stock and bonds along with making short- and long-term investments in government and corporate bonds (options A and B).

The Role of Government

The US government has only itself to blame for its disappointment with banks not making loans. The Fed has encouraged bank investment by keeping bank-to bank (Libor) interest rates low. Because of the government’s low interest rates, banks can borrow cheap from the Treasury and make higher and safer returns through investing in government and corporate bonds than by making loans and/or by paying higher interest on customer deposits.

Another reason banks aren’t making many loans is the terms of the government’s bailout of big banks in programs such as TARP, and in particular, the government’s mandate for lower bonuses for bank executives. Bank executives want out of these programs quickly. And the government is encouraging them to do this. The government is letting big companies such as Bank of America, Citigroup, and Wells Fargo prepay government bailout assistance. This doesn’t encourage banks to make loans either.

Bank of America sold stock itself to raise $19 billion. Wells Fargo wanted to wait and raise money from business profits, but it’s been pressured to sell stock too. It just raised $10.4 billion by selling new shares in itself to pay back half of its loan from the US government. Blocks to Citigroup’s request to repay TARP funds have been removed by the IRS. and it will pay back it’s entire $20 billion debt through sales of its shares. Meanwhile the FDIC has guaranteed $300 billion of bank-issued bonds.

As you can see from the Liquidity and Solvency of Banks table in Part II of this blog series, neither selling bank stock nor selling bank bonds (options A and B) increases these big bank’s solvency. Selling shares and bonds only increases liquidity and leaves the banks still in debt. Meanwhile, on the other side of the banking coin, the “People,” are suffering. Business failures, foreclosures, and layoffs are continuing to rise. Unemployment in Detroit hit 50% this week.

And while banks pay off TARP rather than make loans to consumers, piles of affluent people’s cash invested in money market funds have nowhere to go. This bank-related problem is severely impacting no- and low-earned income people (including many retired people).

Money market funds rely on short-term “securitized” investments. These kinds of short-term investments, packaged and sold by banks by combining consumer loans (loans for cars, mortgages, and education), began to become unsellable beginning in 2007. The Fed has bought $1 trillion of mortgage-backed securities from banks. But the securitized investment market dried up. As a result, money market funds shifted into investing in short-term (weeks to a few months) government bills called Treasury bills.

People and businesses and other organizations, such as condo associations, who depend on Treasury bills for a fixed income are now out of luck. Because of the huge influx of demand for T-bills on the part of money market funds, interest rates on T-bills are almost as low as the pittance usually paid on money market funds themselves. Money market funds serve large investors who “park” uninvested cash in them. The funds have to pay some kind of interest on deposits, and T-bills are their only choice these days.

Only the US government could be remotely happy with this dismal turn of events. It’s getting lots of money out of sales of Treasury bills (and Treasury Bonds) as well as from big banks’ repayment of TARP loans.

Smaller banks, however, have received almost nothing from TARP or from the FDIC’s program that encouraged big banks to make short-term loans to businesses and consumers. The FDIC’s bank loan guarantee program ended last month, small and mid-size bank failures this year topped 130, and bank loans just dropped by a record amount.

As a result of government policies, big banks are still making profits, but cash isn’t trickling down to smaller banks. They’re failing daily. Nor is cash flowing into the economy. Smaller banks and businesses and individuals, particularly lower-income people, are obviously coming out with the short end of the stick.

A Split within Government

The FDIC and the rest of the U.S. Government do not seem to be in synch while trying to solve the “banking problem.” For example, a recent study shows that 60 million adults in U.S. households lack bank accounts. These people use check cashing services and keep their money on hand. They have no relationship with banks.

The FDIC is researching ways to get these people into the banking system, a goal that would bring “real” cash into banking system.

The FDIC is also scrambling to keep failing banks’ deposits “liquid” and “solvent” by transferring them to other banks. And the FDIC continues to guarantee transfer of toxic assets of banks onto the shoulders of solvent banks, hedge funds, and other buyers who can hold these assets long enough to [hopefully] recoup their purchases and make a profit. In short, the FDIC is pushing banks towards doing the business of banking on behalf of the people.

The Fed, the Treasury Department, and Congress, on the other hand, in the name of “prevention” of another financial crisis, are pushing banks towards raising capital reserves. And now the government is allowing banks to deplete their capital reserves by using them to pay back TARP loans early.

Over the objections of the FDIC head and securities analysts, the US government is driving big banks (and large companies such as GM) to raise a lot of money quickly, even if that’s at the expense of the banks’ capital reserves and their customers. These banks, and especially Citigroup, have put themselves in a precarious place by paying back their government loans early. As a result, TARP has failed the both the banking system and the people.

A Suggestion

The government needs to pay more attention to bank solvency along with bank liquidity. More investments in and by big banks aren’t going to solve our “banking problem.” It’s way past time for government to give the “people,” a break.

I would strongly suggest that The Fed, The Treasury, and Congress think harder about ways to encourage all banks to focus more on bank customers again. In fact, it might even be a good idea for government to consider supporting credit unions, check cashing services, and other institutions who do make loans to business and consumers.

Copyright © 2009 Nancy K. Humphreys

Postscript:
If The Liquidity and Solvency of People table in Part II of this series interests you or the ones you care about most, I highly recommend Robert Kiyosaki’s Rich Dad Poor Dad book series or games for yourself or a gift.

Banks and People (part 2 of 3)

“I’ve been here for three years and never once heard the word ‘people’.” [handwritten note posted on bulletin board in graduate department of Economics at University of Wisconsin-Madison]

Last time we looked at two key pairs of opposites that played a role in the financial crisis.

Liquidity vs Leverage (or “Illiquidity)
Solvency vs. Debt (or “insolvency” )

This time we’ll look at how these pairs of “variables” apply to people and to banks.

Let’s start with the first of two charts. This chart, the People Chart, is based on Robert Kiyosaki’s “Cashflow Quadrant” (in his Rich Dad, Poor Dad book series).

The Liquidity and Solvency of People

(A) Employees and self employed people
Have jobs (paychecks) or clients (payments) + usually are “cash poor” = liquidity + debt

(B) Homeowners
Own houses with mortgages (i.e., outgoes) + usually are “cash poor” = leverage +debt

[Note: "cash poor" usually means reliance on credit cards to stay solvent.]

(C)) Landlords and business owners
Own income-producing property and/or assets + usually are cash rich = leverage + solvency

(D) Wealthy investors and retirees
Own stocks, pensions, Social Security + usually are cash rich = liquidity +  solvency

We say that landlords, business owners (and homeowners) are “leveraged” because their income comes from assets which can take a long time to sell (months to years). Imagine that pile of money being “lever-aged” over your head. You can’t get your hands on it until it comes back down to earth. On the other hand, employees (who sell their own “labor”) and investors can get paid their money relatively quickly (days to weeks). So we call their income “liquid.”

It’s risky to be leveraged. Picture that heavy bundle of money over your head! What if you can’t get it back down? What if it falls? So leveraged assets usually pay higher returns on your investments in them.

Where “logic is deficient in the face of desire,” or more plainly, when the desire to “get ahead” and have some savings or “security” hits, people often leverage and take on more risk. And guess what? Banks do the same thing. Here’s the Banks Chart.

The Liquidity and Solvency of Banks

(A) Banks that sell stock in themselves or make short-term investments + take in deposits = liquidity + debt

(B) Banks that sell bonds in themselves or make long-term investments + take in deposits = leverage + debt

C) Banks that make long-term loans with higher interest rates + take in deposits = leverage + solvency

(D) Banks that make short-term loans with lower interest rates + take in deposits = liquidity + solvency

Deposits are the debt that banks owe to their customers. If a bank can pay back this debt quickly, it is liquid. The liquid assets of the banks bring in money more rapidly. The fastest way banks raise money, other than by encouraging deposits, is by selling stock in themselves.

But leveraged assets of banks are income the bank usually receives over a longer period of time. For example, bank bonds are usually long-term “loans” made by investors in banks. Likewise, long-term loans made by the banks are usually home loans.

Here, as in the People Chart, solvency refers to how able the bank is to pay out deposits at any given moment.

Some things to observe

(1) If you compare charts you’ll see that “cash” belonging to people in the People Chart shows up as “deposits” in the Banks Chart, and vice versa. People and banks are two sides of the same coin. In any “market transaction” between buyers and sellers we need to pay attention to both sides. Instead, the focus these days is on banks alone, and not people.

(2) Rather than blaming any particular parties, the financial crisis can be seen as a whole system where imbalances occurred among people and the banks. This brought about failures for both. In other words there’s no longer:

A bank for every person.
A person for every bank.

For example, let’s look at the banks’ option C, longer-term loans. When banks made long-term loans to landlords, both groups were leveraged, but solvent. Landlords who took out loans at the bank made rent off their property and paid the banks interest on their long-term loans. Both were better off from the deal. But when banks made long-term loans to homeowners or to landlords who were over-extended, the latter became leveraged and being “cash poor” were in danger of defaulting, i.e., becoming insolvent or bankrupt.

Likewise, looking at option B, when banks made long-term investments, particularly commercial loans in large building projects, or sold structured securities created from conglomerations of long-term personal loans sliced into pieces called “tranches,” banks put themselves in the same position as homeowners – they became highly leveraged and deeply in debt. They couldn’t get money easily, and they were obligated to pay their depositors (who have the right to demand money from them at any time).

Banks which went into debt and over-leveraged their investments to make profits during the bubble times are now failing daily. We’re up to 130 bank failures this year.

This “economic model” or “blueprint” with four paired variables (liquidity/leverage, and solvency/debt) has given us a very simple way to look at the problems of banks and people during the financial crisis. Now, in Part III, we can go ahead and use it to look at the “solutions” the government is using for banks and people.

Copyright © 2009 Nancy K. Humphreys

Banks and People (part 1 of 3)

The first laws of library science are:
For every reader a book.
For every book a reader.

The first law of economics, the “law of supply and demand” is:
For every seller a buyer.
For every buyer a seller.

In other words, you can’t have a “market transaction” without both a buyer and a seller.

Keep these laws in mind as we explore the relationship between banks and people.

People put money in the form of “cash” into banks. This cash is called “deposits” by the bank. Banks use deposits to earn more cash for themselves from other sources. This is how they survive. People use banks as long as banks keep their money “safe.” And sometimes people make deposits because banks pay people cash for their deposits. This is called “interest” on their bank deposits.

The relationship between people and banks is that simple. Banks and people buy and sell (i.e., borrow and loan) cash from each other. Where it gets complicated is in how banks use the cash they get from people.

When banks began failing faster, two supposedly opposite reasons for the failures were raised: liquidity and solvency.

“Liquidity” is the ability to get your money fast.
“Solvency” is having money to get–solvency is having enough to pay the bills.

So did the banks lack liquidity? Or did the banks lack solvency? I feel this is a false dichotomy. Taoist philosophy from ancient China shows us a way out of either/or thinking traps such as this one. Liquidity and Solvency are not opposites. They simply belong to two pairs of opposites. These pairs are:

Liquidity vs Leverage (or “Illiquidity)
Solvency vs. Debt (or “insolvency” )

Liquidity typically applies to Assets. “Assets” bring in money, they’re “incomes.”
Solvency applies to Debits. “Debits” cost you money; they’re “outgoes.”

To understand the term leverage, think “lever-aged” Imagine yourself using a lever to slowly raise and lower heavy piles of money that go up and over your head. Consider what happens if something goes wrong and the lever slips.

In Part II we’ll look at how these definitions of this pair of opposites apply to people and to banks. We’ll show what happened during the financial crisis. In Part III we’ll examine the roles our government is playing and show how different parts of our government are working against each other in trying to remedy the financial crisis.

Copyright © 2009 Nancy K. Humphreys

Last night I caught an early show of a new documentary film with the Yes Men.

Who are the Yes Men? Well, they are kind of like the Blue Men, only they don’t work for a corporation; they pretend to represent corporations, government agencies, and other powerful institutions that the Yes Men don’t like.

Unlike Michael Moore who plays a buffoonish bad boy giving the bigwigs a hard time, the Yes Men become the bigwigs. The two of them in this film give everyone they come in contact with an Alice in Wonderland tour of what the world could be if it weren’t so out of whack. They take dry financial concepts such as “hazard” (a bad thing that could happen) and “risk” (the likelihood that the bad thing could happen) and show us through their own experiences what these concepts really mean to us as human beings.

While there are hundreds of Yes Men walking the world, the film shows just Andy Bichlbaum and Mike Bonanno. Wild and wacky while devising their plans to turn reality topsy turvy, they seem to be able to pass as utterly straight when they step out to play their parts on the world’s stage. Then they become completely believable CEOs, government bureaucrats, and corporate scientists who announce some kind of “new world order.”

Within minutes their speeches begin to pull everyone in the drab conference rooms where society is shaped out of their normal bored weekday doldrums and into the excitement of an altered reality. What is this new reality? The Yes men tell you what they hope it is as you watch their film. But another way to view where they’re headed is to go back to the 1980s when Mary Daly, lesbian-feminist Catholic scholar and professor at Boston College, wrote a famous, or some would say “infamous,” book, called Gynecology.

Daly’s focus in her book was on the oppression of women around the world throughout “history”. Tackling taboo topics such as foot-binding in ancient China, genital mutilation in Africa, and the brutality of the Western medical establishment, one of Daly’s main points was “patriarchy’s” reversal of what was previously done in matriarchal societies.

The most striking image I recall from some 30 years ago when the book came out was Daly’s provocative argument that the early Roman Catholic Church replaced the earthly triple goddess of ancient matriarchies, i.e.. the “crone, mother and daughter” with its own heavenly triple god of the “father, son and holy spirit.”

According to Daly, the early Church retained the Virgin Mary as a symbol of the pre-patriarchic mother goddess. The priests replaced the daughter goddess with the symbol a dead son-god hanging on a dead tree. And, said Daly, the leaders of the Roman Catholic Church eschewed their own sexual nature and donned skirts in order to assume power over their male and female followers alike.

The Yes Men, on the contrary, seem hell-bent on reversing reality back to the core of matriarchal values In particular, they reclaim reverence for life instead of death, and they do this by donning professional men’s business suits. Enter their fantasy world and you become dizzy seeing life as it could be rather than it is.

This shift is most explicit in their prank of passing out a fake issue of the New York Times on the streets of Manhattan. On the big screen we get to watch the faces of many of the 1,000 New Yorkers who read, not “the news fit to print,” but the “news you’d hoped to hear” from a date six months into their future.

I don’t know about your view of New Yorkers, but my experience is they don’t go around downtown Manhattan looking shocked, smiling, and then hopeful and happy very often, and especially not while reading their daily newspapers.

The audacity of The Yes Men had me alternately  gripping the edge of my seat in expectations of their getting caught and hauled off to prison, or laughing out loud with the rest of the audience at their antics.

What most amazed me about The Yes Men is how the hidden “glasses cam” one wears while the other plays the speaker, pans their audiences and brings out something rarely visible to the human eye. I was reminded of an episode from the old TV science fiction series, “Flash Gordon.” In this episode Flash and his men were exploring a cave on Mars. As they pass through the cave, creepy figures of clay humanoid beings emerge from the cave walls and begin following them.

It’s fascinating to watch their audiences as the Yes Men stretch what Mary Daly called the “necrophiliac” (death-loving) values of patriarchal societies way past the boundaries of “good taste.” While some members look shocked or even sickened by what they hear, others beam with joy at the whatever new “final solution” that the Yes Men propose for their fields of work.

With the Yes Men’s glasses cam, you don’t need to slice a V in anyone’s neck to see who the reptiles are who would wipe out all of humanity while not caring a whit. Their faces are right on the screen, glowing with glee.

To me these were the most shocking and startling moments of the film. They’re the moments when you can clearly distinguish the hidden psychopaths, or as they are now called, sociopaths, who walk among us and live and work beside those of us who have consciences and care.

On the other hand, some of the most heartening moments of this film are watching a group of developers cheer the idea of poor people regaining their homes in New Orleans. This would cost the developers money they’d lose from not building upscale condo and shopping projects, but they clapped in approval anyway.

Another moment came after seeing the smiles on the faces of those in India who said two hours of “false hope” from a prank by The Yes Men was worth the pain of the let-down when “reality” returned and they found their dreams of restitution were still a fantasy.

Watch this movie and you’ll both laugh, feel pain, and see the world in a brand new way, unless of course, you’re one of the “Visitors” without a human conscience… Even then, you’d probably enjoy it too, just in a very different way from the rest of us.

Copyright © 2009 Nancy K. Humphreys

Believe it or not, this dismal series on banking is going to end with a hopeful note. That’s because “debt” isn’t always a four letter word.

When Debt is Good to Have

Our world definitely turned upside-down over the past year. “Hedge funds” or “private equity” companies used to gobble up companies for profit and spit out the remains. Now they are being called upon to save our banking system. One of them is even financing highway rest stops in the state of Connecticut.

We’ve left the free market far behind too. The Treasury is now in hock for $14 trillion of guarantees in its attempt to stem the blood flowing from the financial crisis. The US government is fast approaching it’s debt limit of $12.1 trillion. Congress will shortly be embroiled in what is bound to be nasty debate over raising the statutory cap on US debt to $13 trillion for 2010.

Another odd thing about these times is that corporations are heading as fast as they can towards debt by selling corporate bonds. Eventually those bonds (or loans) will have to be paid back with interest to the buyers. Companies and banks don’t seem to care. One corporate spokesperson even told a financial reporter his company didn’t have any need for the cash but the company issued bonds because it thought it would be a good idea to have cash on hand.

Here’s where I had an idea about the future. Based on the work of Armen Alchian, it occurs to me we are likely to be in for a bout of inflation, even though the Federal Reserve protests that nothing of the sort is on the horizon. Here’s Alchian’s conclusion from research he did about business cycles in the decades following the Great Depression.

Alchian found that “net debtors” did better in times of inflation than “net creditors.” ["Net" simply means "overall" a debtor or a creditor.] Now remember, because this was true in the past, doesn’t mean it will be true in the future. But right now several financial writers have been suggesting, for various reasons, that inflation is on our horizon.

Inflation Ahead?

One reason given for possible inflation next year is that our cash-strapped, in-debt-to-it’s-hairline, federal government will need to print more money to pay for some kind of support to boost the mortgage market and/or small businesses.

Another reason put forth is that the issuing of so many US government bonds, many of which are being bought by banks, may create a new danger. There may come a time when there is a surplus of government bonds for sale and fewer buyers than now. Banks will again have a financial liquidity problem when they can’t cash in government bonds.

A more compelling argument is one by David Bowers, a strategist at Absolute Strategy Research. Bowers argues that it is businesses, not consumers, who will lead any recovery. When the financial crisis hit, businesses were caught with large inventories. Producers have been selling off these inventories and not replenishing them. In some cases, such as that of Delphi, the biggest car parts supplier, providers of inventories have gone bankrupt over the past year.

Bowers suggests that corporations will eventually use the cash they’ve raised to hire new employees and reorder supplies only to find that supplies are now scarce. And here we have the traditional definition of “inflation” as “too many dollars chasing too few goods.”

Banks as Net Debtors

According to Armen Alchian banks are “net debtors” by definition. This is because banks make money by taking in deposits from customers and loaning out that money in order to earn interest from the loans. Because banks loan out the money they receive from depositors, they’re net debtors. They owe more than they have at any given moment. Which is why we have the FDIC insurance fund in case there is a run on a bank by depositors.

Alchian’s research showed that banks and other net debtor companies did better during periods of inflation than companies that that weren’t in debt. Interest rates tend to rise during a period of inflation because everyone needs more money to pay higher prices. Banks sitting on a lot of cash during inflationary times do well. They can make lots of high-interest loans.

It would seem that any banks that survive the current bloodbath (124 out of approximately 800 FDIC member banks have disappeared this year) and accumulate enough capital reserves will come out winners during an inflation. And this, perhaps is why hedge funds are so willing to sign on when the FDIC comes calling to ask them to help it bail out a bank.

What About Us?

So what does this mean for us? Alchian concluded that the net debtor advantage during inflationary times applied to both governments and individuals as well as to corporations. Is it possible our government has not been certifiably insane in running up such a huge debt in its attempt to keep the economy from imploding from the credit crunch? Could the U.S. come out smelling like a rose in the end?

And what about us? What will happen if we find ourselves in an inflationary period? What do we do?

First, we need to better understand how “debt” is not necessarily a four-letter word. As Robert Kiyosaki points out in his Rich Dad books and classes, entrepreneurs and the rich think differently from the rest of us about debt. For entrepreneurs debt is a good thing as long as it is used in a way that involves assets and creates wealth.

So, am I saying go into debt or into more debt if you see inflation coming? Not necessarily. But you’ll need to learn to think like an entrepreneur, a banker, or a government economist. If you do go into debt, it should be for an asset that you are sure will make money for you.

A house (mortgage) is a large long-term liability. You must pay and pay for it, unless you are a landlord and have renters bringing in an income for you. A truck could be a money pit or it could be an asset if you can make money by using it. The same goes for a computer. It can be an asset if it brings in money for you or your family, but it’s just another expense if it doesn’t.

How can you use your money and/or time to acquire an asset or assets? If you buy a foreclosed house now, will you be able to afford the mortgage if prices for other goods go up? Will you be able to move elsewhere and rent out the house if inflation bites you? Or will you be able to rent part of your house, condo or apartment if times get really tough?

If you don’t have cash or credit, can you eke out enough from your budget to stockpile canned goods or start a garden? Can you trade for a more gas-efficient car or give up driving?

If inflation comes, will you be able to get your cash out of where it is now to use it before its value drops? Where will you spend your money to make money before your cash loses its buying power during inflationary times?

These are the kinds of questions we should all be asking ourselves right now or any time the economy might bounce from an long tiring recession into the beckoning arms of a brand new inflation.

And finally, remember that assets are not just things. They can include intangibles. “Goodwill” in business refers to clients or customers. Family, friends, and community are all assets too. Assets are the bounties we need to remember to be grateful for.

Copyright © 2009 Nancy K. Humphreys

Is Your Bank Safe (part 3 of 3)

The FDIC, which insures virtually every bank deposit in this country, is rapidly digging itself into a $500 billion hole. Here’s how.

Three banks failed in 2007. 25 banks failed in 2008. Two Fridays ago, the FDIC shut down seven banks in Florida, Georgia, Illinois, Minnesota, and Wisconsin, bringing the 2009 total to 106. This past Friday the FDIC shut down nine banks in Arizona, California, Illinois, and Texas. That is the largest number of bank closures ever in one day. This year we’ve reached 115 failed banks.

In September, the number of “at risk” banks rose from 305 to 415. Now, unnamed government officials are saying 1,000 of the 8,100 FDIC member banks could fail over the next three years. According to the Wall Street Journal last week J.P. Morgan/Chase CEO, James Dimon, said he expects “several hundred additional smaller regional-based banks to not make it.”

The FDIC is running out of money to help failing banks, not because it needs to cover customer deposits (i.e., bank “liabilities”), but because it is spending large amounts of money to buy up bank “assets,” many of these, “toxic” assets. The FDIC has entered into “loss-sharing” agreements with surviving banks and with hedge funds to take over ownership of failed bank assets.

Already the FDIC has spent $50 billion on closeouts of around 135 banks since the financial crisis began in 2008. In addition, the FDIC said this past Friday’s closings would cost its insurance fund $2.5 billion alone.

In its latest loss-sharing deal, he FDIC and the U.S. Bank of Minneapolis agreed to share losses on about $14.4 billion of the combined purchased assets of $18.2 billion from last Friday’s nine failed banks.

As a result of all of its takeovers and loss-sharing arrangements for assets of failed banks, the FDIC has fallen below its statutory minimum for holding reserves to cover customer losses.

A Run On The Bank?

While we have not had a bank run yet, other countries have. In September the Dutch government seized DSB Bank NV, one of the biggest banks in the Netherlands after a run on deposits. Depositors were given three days to take their money out via ATMs at other banks. Even ING and four other big Dutch banks could not buy out this collapsing Dutch bank. In fact, ING is now divesting itself of both its US ING Direct bank and its insurance business in order to pay back some of the loans it received from the Dutch government.

Could this happen to us?

The primary causes of bank failures in the US have not ceased. Along with buying toxic assets like derivatives from investment banks and insurers, banks paid out loans, both secured and unsecured, that are now “underwater” or “nonperforming.” Bank failures have come largely from declines in the housing market, credit cards, and commercial loans.

According to CNN Money.com (Oct 15, 2009), RealtyTrac reports that the number of foreclosure filings is at a record high in the third quarter of this year. CNN’s headline blares, “They were the worst three months of all time.”  The statistics:  almost 1 million homes (I.e., one in every 136 homes) received a foreclosure letter during the last quarter of the year.

Many of those homeowners in foreclosure are working people with good credit who have lost their jobs as businesses downsize. Some small businesses even closed because they could no longer get needed loans from banks. Banks are too busy raising capital and writing off bad loans from the past to make many new loans. CIT Group, lender to nearly a million small and midsize businesses couldn’t raise enough capital to cover losses. It just filed for Chapter 11 bankruptcy, leaving taxpayers likely to hold a bag filled with a now-worthless $2.3 billion dollar TARP bailout investment in CIT stocks.

As foreclosures mount up, some banks are trying creative arrangements. One of these is similar to a reverse mortgage except the bank doesn’t pay anything to the underwater owner. The bank simply lets an older owner continue living in the home the bank now owns. When the bank’s customer dies, their heirs can choose whether or not to buy back their relative’s home by paying off the debt owed on it to the bank. In the fiercely competitive world of banking, this kind of losing arrangement is unprecedented.

Bank credit cards are also taking a hit as more and more people stop paying on them. Even JP Morgan Chase is losing money on its cards. Congress is cracking down on credit card fees next year. Calls are coming in for regulation of bank overdraft fees as well. But most worrisome to banks, the Fed, and the FDIC are commercial mortgages. This market is in far worse shape than the home mortgage market. Along with smaller banks that failed from making commercial loans, Capmark Financial Group, one of the biggest lenders for commercial development projects, just filed for Chapter 11 bankruptcy this past week.

What The FDIC Already Tried

The FDIC has taken steps to replenish its insurance fund. Last spring it levied a $5.6 billion emergency fee on member banks. This fall it requested Congressional approval to collect member bank fees in advance for the next few years. These steps have enabled the FDIC to keep up with extraordinary losses to its insurance fund so far this year.

Seeing that the FDIC could be in deep trouble next year, this past March Sheila Bair went to Christopher Dodd, chair of the Senate banking committee, and requested an increase in the FDIC’s emergency line-of-credit from the US Treasury. She got a $500 billion line of credit.

In May FDIC staff estimated that bank failures would run the FDIC a total of $70 billion between 2009 and 2013.

In August, Bair reluctantly set in place a program of loss sharing with hedge funds who buy failed banks. This set a new precedent at the FDIC. Four members of the FDIC board voted to set a new precedent, while the fifth board member remained completely opposed the idea of letting hedge funds buy banks.

Bair wanted hedge funds to agree to keep “Tier One” capital reserves of 15% on hand, but after pension funds from several states as well as the hedge funds complained, the FDIC board lowered the capital reserves rate to 10% for hedge funds. The FDIC also wanted hedge funds to be “a source of strength” for banks and be available to provide extra support, but this requirement was dropped also because of the need to acquire extra capital to support failing banks.

The fact is that hedge funds have also been failing, and now the largest are selling off their investments. Blackstone, a well-known private equity group, is planning to sell five companies and is listing eight others. Many hedge funds will need to raise new capital within the next couple years. A consulting group in Boston is estimating that 20 percent of the largest 100 private equity groups will fail in that endeavor and will simply vanish within a couple years.

In September, FDIC staff estimated the cost of bank failures between 2009 and 2013 would run about $100 billion. Bair briefly considered drawing on her Treasury line-of-credit, but opted for requesting advances of up to $45 billion in fees from FDIC member banks instead.

With the blessing of Treasury head, Tim Geithner, the FDIC also announced its intention to end its Debt Guarantee Program after October. The FDIC began this program under pressure from the Bush Treasury during the start of the financial crisis in 2008. This program aimed to increase the liquidity of banks by having the FDIC guarantee short-term debt that large banks issued. The FDIC reaped almost $10 billion for fees for this guarantee and as of yet had lost no money.

The biggest users of this $310 billion FDIC program are large retail banks such as Citigroup, GMAC and General Electric. In September the three said they were able to issue debt without any more government guarantees. But now these banks are in trouble. The FDIC had to extend its Debt Guarantee for another six months. Today the FDIC guaranteed $7.4 billion of new debt for GMAC, while the Treasury injected $7.5 billion into this tottering bank.

There is a very real danger that larger retail and regional banks that bought smaller banks will themselves fail or need more help from the FDIC. For example BT&T, a regional bank in North Carolina considered to be very stable, entered into a $7.7 billion dollar  “loss-sharing” arrangement with the FDIC for the purchase of the assets  (mostly commercial loans) of Colonial Bank of Alabama this past summer. On October 20th a Wall Street Journal headline reported that BB&T reported a net decline in value of 58% for the bad loans it now owns.

This “house of cards” the FDIC is building with bank and hedge fund partners reminds me of the Thanksgiving/Christmas/New Year holiday season I sat biting my nails. I’d maxed out all my credit cards, taken a loan from my condo board, and borrowed on my insurance to fix up my wrecked home for sale just as the housing market began sliding down into the pit it’s now mired in. When Bair begins using her $500 billion line-of-credit she will be in the same boat. I was lucky in selling my home before it went underwater. But we’ve all seen what has happened to other borrowers recently. How will it go for Bair and the FDIC?

The FDIC’s estimate that bank failures between 2009 and 2013 would cost the FDIC a total of $100 billion looks utterly shortsighted at this point. The FDIC has already spent over $52.5 billion on around 135 failing banks since the crisis began just over a year ago and it’s now looking at losing as many as 1,000 member banks by 2013.

That $500 billion line of credit from the Treasury looks much more likely to be needed by the FDIC and soon!

But here’s the hitch. Unlike TARP bailout funds, the FDIC’s $500 billion line-of-credit has to be paid back to the Treasury Department, which itself going deeply into debt. How will the FDIC repay such a large amount when it has already tapped out its members for years ahead?

Bair, normally a sensible government bureaucrat, has been forced by extraordinary circumstances to assume the kind of risk usually only a private entrepreneur takes on. Will the toxic bank assets Bair is gambling with in her loss-sharing bank deals recover their full value? Or even part of their value? Ever?

Next time:  “The Treasury:  $14 trillion, and what’d do we get? Another minute older, and deeper in debt”

Copyright © 2009 Nancy K. Humphreys

Is Your Bank Safe (part 2 of 3)

Last weekend the FDIC seized three smaller banks. This makes a total of 98 banks that failed this year. The banks were Jennings State Bank (Spring Grove, MN), Warren Bank (Michigan) and Southern Colorado National Bank (Pueblo).

The FDIC is chief savior when banks fail. It monitors the financial health of banks. Whenever a bank collapses, the FDIC moves in to arrange auctions of their assets and debts to other banks and/or hedge funds.

Having been a customer of two early banking failures last year (a bank and a credit union), I can personally attest the FDIC process works well. But can the FDIC keep up it up?

The FDIC Deposit Insurance Fund

The Federal government requires the FDIC to keep $1.15 cents on hand for every $100 of deposits by its approximately 8,000 member banks. At the end of 2008, FDIC members had approximately $4.8 trillion in deposits. But the FDICs deposit insurance fund fell by $16 billion down to $19 billion. The FDIC quickly levied a hefty emergency assessment on its members this spring.

By June 2009 the amount of money in the FDIC’s deposit insurance fund declined to $10.4 billion; down from $42 billion in the previous June. This is the lowest level since the Savings and Loan crisis of the 1980s. As a result, FDIC’s fund had only 40 cents for every $100 of deposits. That’s well below the statutory minimum required.

But bank failures are continuing to grow. Recently, government officials estimated that bank failures between 2009-2013 would cost the FDIC up to $100 billion. Seeing that it was due to run out of funds before the end of the year, the FDIC is now demanding prepayment of several years in fees from member banks.

This, unfortunately, will be likely to have the effect of hastening the demise of some of its members.

How can the FDIC be so broke so fast? Let’s take an in-depth look at the answer and what it means for our futures.

The True Costs of Bank Failures

The FDIC will spend somewhere around $19 billion from its deposit insurance fund this year, but little of that money is going to depositors. That’s because the FDIC has been fairly successful at getting other banks to take over the deposits of failed banks. It is the assets, e.g. property, loans, investments, etc., of failed banks that are costing the FDIC so much money.

The costs to the FDIC for handling the assets from bank failures are mounting up. The FDIC estimated it would pay $293.3 million out of its insurance fund for the three most recent bank failures last weekend. And these are very small banks.

Why is this total so high? In January of this year, the FDIC began using a tool from the savings and loan crisis days. It’s called “loss sharing.” Loss sharing is basically a subsidy to other banks and private equity sources to take over failed banks. It means that FDIC costs for handling bank failures aren’t just bureaucratic ones. The FDIC is taking on the risk of owning toxic assets that may or may not improve in value in the future.

For example, when Colonial Bank of Alabama went under in August it was the sixth largest bank collapse in U.S. history. The FDIC entered a loss-sharing transaction for $14.3 billion of Colonial’s approximately $22 billion in assets. BB&T, a Southern regional bank, took on the remaining $7.7 billion.

When Colonial failed in August, for the first time ever, the FDIC included a clawback provision. The FDIC has agreed to reimburse BB&T for the 80 percent of its first $5 billion in losses (after which the FDIC is pledged to reimburse 95 percent of losses up to a total of $14.3 billion). The FDIC’s clawback provision says if BB&T’s losses from Colonial are less than the first  $5 billion, the FDIC gets some money back. But any return of the FDIC’s funds won’t happen until 2019!

This kind of risk-taking isn’t unusual at the FDIC.

When Corus Bank of Chicago went under in September, the $6.6 billion of its deposits went to another Chicago bank. Regarding the $5 billion in assets (valued now at around $2.5 billion), the FDIC then made a complicated loss sharing deal with a group of private equity companies in a 60-40 split.

The FDIC did ensure that all of the Corus’ debt must be paid off before anyone gets any equity. And the FDIC has an option to take as much as 70 percent of any equity raised from Corus’ assets. Unfortunately, Corus assets were mostly non-performing loans for unfinished building projects.

And here’s the sweetener for the buyers. The winner of the auction for Corus gets a number of goodies from the FDIC. It will get access to $1 billion in interest free loans and a subsidized rate on loans after that. It will also get a revolving line of credit, plus $40 million in management fees.

The FDIC estimates that the Corus Bank collapse will cost its insurance fund around $1.7 billion.

Where’s the bottom line?

At least one WSJ commentator has commented acidly that FDIC loss-sharing deals with buyers of failed banks are similar to the kind of arrangements banks made on subprime mortgages. The FDIC’s deals encourage buyers to overpay, and the results could be just as fatal.

Professor of economics at Boston University, Laurence Kotilkoff, estimates that the FDIC now has more than $6 trillion in contingent obligations against its deposit insurance. By getting prepayment of fees from member banks for up to three years in advance to pay this year’s bills, the FDIC looks to be paying Peter to pay Paul while mortgaging its own future for years.

The obvious questions for our futures? What will happen if the FDIC can’t pay for the equity it’s buying from the failed banks? And what happens when the next failed bank has no buyers?

Next time:  “Who’s The FDIC Gonna Call?”

Copyright © 2009 Nancy K. Humphreys

(part 1 of 3)

Trickle down” bailouts aren’t working for smaller banks.

The U.S. government’s efforts have succeeded in keeping large investment banks out of the soup–for now. The big banks are raising capital reserves by issuing bonds. (These are loans that must be paid back by a certain date.)

The bigger banks are investing their new capital reserves in each other’s bonds and socking some of it away at the Fed. They’re also issuing new, risky, derivatives. All this, rather than return to lending on a large scale.

Larger banks have a huge asset. No matter what they do they’ve been deemed “too big to fail.”

Smaller banks have no way to create and sell their own bonds to raise more capital. Meanwhile the chickens of small bank lending and investing practices of the past are coming home to roost. Regional and community banks are folding at alarming rates.

Last year 25 banks failed. Already, with the last quarter of the year yet to come, the number of failed banks is close to 100. This year we could see a 500% or more increase in collapsed banks.

These banks range from small community banks to large regional banks serving multi-state areas. Some of these banks go back to Civil War times. Two regional bank failures in 2009 were among the ten largest failures (in terms of assets) in the history of U.S. banking.

Why are small banks failing?

Some smaller banks that needed ways to invest capital during boom times bought non-government-backed securities called “private issuer” or “private label” securities. They also bought derivatives called CDOs (collateralized debt obligations), and they purchased “trust preferred securities” (a hybrid investment made up of debt and equity.) These types of investments went sour last fall.

Home mortgages went bust too. The rate of sub prime loan defaults is now slowing, but unemployment is pushing up the rate of prime borrower defaults. According to the banking trade association, the Mortgage Bankers Association, nearly 1 out of 12 mortgage holders are at least 90 days behind on their payments. Colonial Bank (Alabama) is the 6th largest banking collapse on record. It failed in mid-July because of its real estate lending in Florida and other states. Colonial is the largest bank failure since Washington Mutual and IndyMac during the current financial crisis.

But smaller banks’ nemesis is commercial property. The Fed is now looking into banks’ exposure to commercial mortgages. Commercial mortgages and derivatives based on these mortgages are dead weight dragging down the banks. For example, Corus Bank (Chicago) failed after half its condo construction loans defaulted in April. These totaled about $2 billion. In mid-August, Guaranty Financial Group, Inc. (Texas), the 10th largest bank to fail in U.S. history, had $3.5 billion in sub-prime securities backed by adjustable-rate mortgages. The write-downs on these securities in just one month put Guaranty Financial up on the chopping block. These write-downs used up all the bank’s capital.

How bad is it?

Things in the mortgage market have become so bad for smaller banks, they’ve banded together to form their own trade associations to lobby on their behalf. Two new associations are The Community Mortgage Lenders of America and the Community Mortgage Banking Project. Consolidation is driving this move. The three biggest banks in the Mortgage Bankers Association, Bank of America, Wells Fargo, and J.P Morgan Chase, have gone from issuing 15% of new mortgages in the early 1990s to 37% in 2007 to over 52% this year. Small banks feel that the Mortgage Bankers Association can’t always represent their interests in Washington without some conflict of interest over what the larger banks’ want it to do.

Small bank failures are not the only grim statistic. The overall number of banks on the FDIC’s “sick list” has risen dramatically. Out of approximately 8,200 banks backed by the FDIC, the number of banks “at risk” rose from 305 to 416 in the second quarter of this year. Assets of these banks total around $300 billion. This month the Institutional Risk Analyst, a bank watchdog, said that its “F-rated” banks have total assets of about $4.5 trillion dollars at risk.

The only ray of light in this bleak picture is a slight resurgence in the market for “toxic” assets like mortgage-backed derivatives. This may mean banks that survive would be able to “write up” some of the value of their distressed assets. For many small banks this is too little too late.

Coming next: FDIC: Rescuer or Rescuee?

Copyright © 2009 Nancy K. Humphreys

http://twitter.com/nancyuno

As a self-employed cookbook indexer I felt obligated to see the movie, Julie & Julia, even though I never cared for Julia Child or French cooking. I mean, Meryl Streep is wonderful, isn’t she?

When the movie suddenly introduced Irma S. Rombauer, author of The Joy of Cooking, I was as stunned and in awe as Julia was. Irma has long been my heroine for producing the culmination of, and antidote to, all those syrupy Betty Crocker-type cookbooks I grew up with. Like Julia in the movie, I listened to Irma’s litany of  big-publisher perfidy with an equal amount of growing horror.

When Irma concluded her ‘plaint by wailing about the ineptness of her publisher’s indexer in putting “Crispy Chicken” under “D” for “Drumstick” rather than “C,” I probably had the biggest smile in the audience.

That said, it’s no secret that audiences of the movie loved the “Julia part” and hated the “Julie part” of the movie. No surprise! A/B structures are fine for writing and songs, but nearly impossible to pull off in a feature-length film.

We were supposed to imagine that the lives of the two women whose names both start with “J” were parallel with each other. That premise was ridiculous! For me the Irma scene was not only a highlight of the movie; it was a reality check about publishing that made the Julie part of the movie not work at all.

After Irma’s litany, any intelligent viewer probably wondered for a second why Julia and her partners persisted in finding a publisher. The answer is, that unless you had a fortune or family connections, like the early twentieth century American poets Gertrude Stein or Amy Lowell, you had to go out and get a big publisher to manufacture and sell your book in Julia’s day.

Julia’s saga in finding a publisher was one most of us over thirty who call ourselves writers have been through in one way or another. During the movie I even had a palpable memory of exactly what Julia was “feeling” when she bundled up her carbon-copied typewritten manuscript to send out to a publisher. But times have changed, and in more ways than one. Many of us no longer sign with, or even seek out, traditional publishers.

Julie was among that number. Julie hadn’t even finished her “book,” whatever it was about, let alone tried to find a publisher or dealt with one, when she began her blog. Her project really wasn’t about writing as much as it was about being enough of a “foodie” to cook every one of Julia’s recipes from Mastering the Art of French Cooking. For that I honor her cooking spirit.

But I can’t honor the Hollywood studio and scriptwriters who turned Julie’s story into a complete fairy tale of becoming a “real” writer with a big book and movie contract. That’s an increasingly elusive happy ending in this century. Fewer authors are picked up by big publishing houses than ever before, and the average total royalties for a book is still around $3,000.

Unlike the beginning of blogging, today a typical self-publisher with a blog still has to take a number of steps to promote her/his book well enough to get a book contract, if that is their intention. Julie’s path to fame, as the movie portrayed it, was a complete fluke, or worse yet, possibly a fake that Hollywood promulgated for its own profit.

In the movie we hear how much Julia got as an advance, and we know from the context it was piddly. But not a word is peeped on what Julie was paid for her book, just a coy intimation of more money than she had. Movie rights aren’t even given a mention.

Did the real Julie get the millions of dollars that the fictional Julie’s boring, stressed-out peers at Cobb Salad lunches got from their work? Given the statistics on writers’ royalties–doubt it!

Julia’s past will shine like a star for a long time. I’ll never love her like I love Irma for her classic Joy of Cooking. (Warts and all, Joy still has the most well-organized, comprehensive, cookbook index I’ve seen—but yes, “Crispy Chicken” is a bit difficult to find…) Still, I respect Julia Child a lot more than I did before seeing this movie.

But Julie? Julie’s recipe for success isn’t one that most writers will be able to follow. More telling, even for her in this movie, it fell flat at the end. Who could believe in the bittersweet ending of this movie? No one with an ounce of brains—poached, scrambled, or sautéed!

If you’re a self-publisher, or a moviemaker, or a small business owner who works with creative people, or any kind of creator, or a community-media organization, be sure to check out David Mathison’s book, Be The Media. You’ll find a lot more to excite you in David’s stories about Internet entrepreneurs than in Julie’s story.

Copyright © 2009 Nancy K. Humphreys

http://www.wordmapsindexing.com                                                                                                                       “The Best Index for Your Book”

Do you think about becoming self-employed? Do the thoughts in your head go something like this, “I hate working because….”

You know those reasons:

“I detest office politics.”
“I don’t get enough money to do this,”
“No one recognizes how special I am.”
“I can’t stand my lazy co-workers one more minute.”
“This is the fifth time I’ve been laid off. I don’t want to go out and job hunt again!”

Have you ever thought, “I should become self-employed!” Is that how self-employment happened, or might happen, to you?

Or did you realize there was something very different about you–even when you were just a kid? I mean really different. Like feeling happy to go see your dentist?

Yes, that was me. Little Nancy reaching up to grasp the cool metal bar that opened the door, leaning all my weight on it to open the heavy door, and escaping along with the stale air from the corridor in my junior high school. That was I, feeling pure joy as I heard the “clang of freedom” as the steel door slammed behind me for a couple hours.

Mind you, it wasn’t that I hated education. I loved learning. And I liked my friends in school. And sure my dentist was nice, but I didn’t have a crush on him! No, in any structured place, like a school, I just felt trapped, like a weasel in a box.

My favorite job, and the only one I couldn’t do successfully, was cherry picking. I envied guys who worked on highways, even though I knew I’d be bored out of my mind with such a job. I dreamed of becoming a forest ranger or postman. But I never qualified for an outside job.

I was on time every night to my first job in an electronics factory because someone gave me a ride, and the company docked our pay if we missed even a minute. But left to my own devices I always arrived late to my jobs. As I worked my way up the career hierarchy to more freedom in the workplace, I only felt more and more trapped. Even when I could roam a whole university campus at will, I didn’t want to go to work.

I didn’t realize it, but I was born to be a feral.

Only after a tiny black and white cat came into my life and refused to be confined to human habitation, did I figure that out. Torn or scratched carpets, blinds, and windowsills had to be repaired or replaced for years until I got the message. He’d always come back, but only if I let him go.

So one day I let myself go too.

Yes, I had had some of those negative thoughts I mentioned above too. And you know what? They just went right along with me when I went into business for myself. Now I was muttering:

“I’m not making enough money.”
“I can’t stand that annoying client one more minute.”
“No one even knows what I do, let alone how special I am.”
“How am I going to deal with that other independent contractor who keeps messing up my client’s project?”
” I used to have to job hunt once every few years. Now I have to do it every week. Why oh why did I become self-employed?”

But deep down I didn’t really care. I was a feral worker. I was free.

And I’ve learned some really important lessons through being self-employed. If I worked with someone I didn’t like, I could actually experiment and find a way to deal with it without the risk of having to hit the unemployment line. If I didn’t make enough money, it wasn’t someone else’s fault. It was my responsibility now.

And some things changed for me because I needed them to change. I learned to enjoy selling my services because it enabled me to really connect with people. I was finding out what people needed and telling them I could give it to them. I liked that. And I finally got recognized for my hard work. Many of my clients gave me appreciation my coworkers or bosses didn’t.

And the biggest payoff of all from working feral? I learned I could feel freedom and joy at work…without having to go to the dentist. For that, I’ll be grateful to self-employment [and one fierce little black and white cat] forever.

ferals enjoying a walk

Copyright © 2009 Nancy K. Humphreys

Once upon a time, a professor with a degree from the prestigious London School of Economics offered myself and another librarian extra employment to put together a resource list for his students.

We were thrilled. Then the professor let slip to me that he was also hiring an English professor to edit his workbook. My reaction, as someone who had all but three courses needed for a PhD in English, was to think (a) you didn’t need a PhD to edit, and (b) many English professors had no idea how to edit writing.

Then the economist dropped the real bomb. He told me that he had to pay his English professor buddy twice a much as the other librarian and me.

When I asked why, the economist said, “Because he can get a lot of work editing. But you girls’ opportunity costs for outside work are far less than his.”

I was stunned. I knew what an “opportunity cost” was. It’s the cost of foregoing the “road not taken.” I was outraged at this excuse for paying two women less than a man. When I explained what happened to her, so was the other librarian.

Here’s the thing about economists. Economists tend to draw a rigid line between “work” and leisure.” They learn that wages are payment for “giving up leisure.” To economists, leisure is mainly of interest when studying consumer-buying preferences. That’s not a glamorous part of their field.

So it’s understandable that the economics professor forgot there’s always an alternative to work. That alternative is leisure. One can just say “no” to a low-ball offer of a job.

And that’s exactly what the other librarian and I did. The “smart” professor wound up compiling his resource list in what would otherwise have been his own leisure time, but for no pay.

So, does the economists’ definition of wages as a reward for giving up leisure time mean anything for self-employed people? I think not.

Self-employed people are self-directed. We have the opportunity to mix and match personal and work life at will. For many of us, it can be hard to draw a hard and fast line between work and leisure the way a factory shift or a 9 to 5 schedule at the office does for those who work for a single check from an employer.

And self-employed people do much that is not directly compensated by our clients. To survive, a good chunk of our time has to be spent on thinking about our work and designing better and more efficient ways to do it. No one pays us while we improve our skills. No on pays our benefits like health insurance, and retirement. We have to take care of those kinds of things ourselves.

So, for self-employed people, opportunity cost often boils down to choosing to do one thing over another, period. Something that may seem like leisure or fun may well turn out to be invaluable to our business. And something that may feel like work may be an utter waste of time.

As self-employed people we have to:

Not accept the things we’re used to,
Have the courage to try something new,
And find the wisdom to know when to do what.

Each of our decisions about what we’ll do and what we won’t determines how much we profit from our businesses.

The money we get is not a wage. It is not payment for giving up leisure. It is not even for the work we do. It’s for our talent, expertise, and experience.  Leisure isn’t something we give up. It’s something we gain from putting our talents to better use.

Copyright © 2009 Nancy K. Humphreys

Recently an acquaintance of mine at a California state agency complained about independent contractors at his workplace.

“They come in when they please, sit around, don’t do anything, and I get stuck with all the work. AND they’re falsifying their results to look bad when in fact things aren’t that bad. They’re getting federal monies they shouldn’t so they can keep getting their fat salaries. Oh, did I mention they make a lot more than I do even though I’ve been there for years. What do you think Nan, should I blow the whistle?”

I pointed out to my acquaintance that in spite of so-called protections, most whistleblowers get fired, and if they appeal, they wind up losing. But I missed the real reason why he should be wary of complaining.

Traditionally, independent contractors were white-collar women and blue-collar men hired by private employment agencies such as Manpower or Kelly Girls rather than state employment agencies. These “temps” were hired on a short-term basis to fill-in for regular staff at other companies. Companies paid a lot for these “temporary employees,” but the temps earned below market rates and received no benefits.

With the rise of “Silicon Valley” type companies this changed. These companies needed technical specialists, innovators, and management experts. The independent contractor of the 1990s was often a computer or scientific research consultant with special expertise. These experts weren’t temporary replacements for existing workers. They were brought into a company to solve problems the regular managers and employees of the company couldn’t. Some were even brought in to “reorganize” companies, i.e., layoff employees.

The jig was up at the end of the last century after Microsoft Corporation created “dummy employment agencies” and hired droves of “independent contractors” in lieu of computer-savvy employees at its headquarters in the state of Washington. This put Microsoft in violation of federal employment laws that protected employees. After that, the IRS cracked down hard on private employers who hired independent contractors as a way to avoid paying employee benefits.

During the Bush administration of the past eight years, the use of independent contractors by government agencies escalated dramatically. Often these independent contractors were retired workers on pensions, and the government had the same motives as Microsoft—to save money on salaries by not having to pay worker benefits. In other cases, outsourcing of government jobs was seen as an effective way to bring innovation into the bureaucratic government workplace. More than that, many politicians assumed uncritically that any effort to replace civil servants with private labor would be beneficial. Even your mail deliverer could now be an independent contractor.

Recent scandals at the federal government level have created some doubts about this practice. First, it was revealed that contract workers in Washington, DC had released private records of celebrities and politicians. But the government could not discipline these workers. They could only be fired after the fact. Doubts arose too in cases where private soldiers, not punishable under military law, were accused of killing civilians in foreign countries.

But the biggest issue for everyone, regardless of political philosophy, is why some of these “private civil servants” are being paid more than their government counterparts. How is this reducing the size of government bureaucracy or government costs? And when charges of indiscriminate killing or unethical research falsification are raised, doesn’t it make you wonder what is going on?

My acquaintance went awry when he assumed independent contractors were additional help brought in by his state agency to do the same job as he was at a higher salary. Clearly the “hired guns” were given a different mandate by his managers than he was. Those temporary contract scientists were probably hired because they were willing to “bend their statistics” so the government agency they were at could get more funding. Civil servants with scientific credentials couldn’t have been persuaded to do that at any price.

Highly paid independent contractors are paid more because they have some form of “expertise” that an agency or organization believes its own managers cannot or will not provide. Because of their special talents they have to be compensated for their special abilities at a higher level of salary, and they get additional perks, such as the right to come to work whenever they feel like it.

The main problem with independent contractors is that they allow management to bring in personnel to easily circumvent the publicly accepted goals and rules of an agency or organization for some particular individual or group’s private benefit. This can result in a tremendous, and even dangerous, waste of resources. We all, as taxpayers and donors to charitable organizations, deserve better when we pool our resources so that our government and nonprofit agencies can bring about some kind of “public good.”

And as far as my friend’s dilemma goes, unless he goes to the news media, whistle blowing will rarely be effective while higher management is involved and covering up.

Copyright © 2009 Nancy K. Humphreys

Brucenomics: why I’m writing this blog

Most active investors eventually become interested in “economics.” They believe they can see how the economy affects the financial market they are trying to make money in. I’m an investor who is interested the opposite thing. I want most to understand how investing and investments affect the economy, and how in turn the economy affects each of us, especially those who are self-employed.

Even though I have a Masters in Economics from the University of Wisconsin, I’m a babe in the woods when it comes to understanding the connections between investing and economics. But here goes one brief observation and an example.

Forecasters and Fixers

Before you listen to anyone’s “forecasts” about markets or the economy, especially to the rosy ones, think again. There’s no guarantee the United States economy will ever return to what it was. The financial crisis has exacerbated global shifts in wealth. It’s even possible that the economic indicators everyone relies on so much to predict a return to to the way things were may not be accurate anymore.

And before your accept proposals for fixing this or that aspect of government, just recall how little anyone really knows about how these things work. There’s a reason for that. It’s all very complicated and interconnected.

For example, there are those now who want to get the Federal Reserve under more Congressional scrutiny. Could they be people who want to weaken the Fed in order to shrink the size of the federal government? Indeed they could be. Ron Paul is one example.

And then there are those who want to increase the powers of the SEC and other federal regulatory bodies. But stop and ask yourself, aren’t these the same agencies, even the very same people, who just missed the boat? Mary Shapiro, 29th Chair of the SEC, for example, was the one who investigated Bernard Madoff and didn’t smell a whiff of anything wrong.

Besides the fact that the horse is out of the barn already, here’s one core issue I see with all this rage to regulate government agencies right now.

If we have strong congressional oversight of administrative agency officials, then won’t policy for those agencies just keep swinging back and forth every time elections put a new party in power? And what about the immense power of lobbyists who are providing money and pressure in Washington?

I spent about a year in federal civil service. It was all I could stand. Since then, the closest thing I’ve experienced to working in our federal government is working in our state university systems. I spent fifteen years of my life working as a librarian in two of them.

The University of Wisconsin system seemed well organized and fairly rational. But the humungous University of California system, and UC Berkeley in particular, is the most labyrinthine, political, nonprofit “corporation” you could ever imagine.

In the UC system whole departments of study disappear overnight or find themselves relegated to the worst building on campus. Similarly, in Washington, departments, offices, and bureaus of this or that regularly disappear or are eviscerated. Federal and state civil servants may have “security,” but their actual work and working conditions sure don’t.

To me there seems no way to get any kind of stability in a workplace when politics dominates an organization.

So what about letting “the market” run the financial system instead of politics? First off, there isn’t any such thing as “the market.” There are many financial markets not only in the U.S., but also in the world, and they have complicated interrelationships and strong effects on each other and on our government.

Investing, Markets, and Government

In the news you’ll see all kinds of contradictory “forecasts” of where “the market” is going right now. No one can agree on whether “bull” or “bear” is the word. So let’s clarify the issues. When they say “the market” they usually mean equities, and more specifically, they mean corporate stocks.

But we all know there are other kinds of financial markets: bond markets (state, municipal, and corporate), commodity markets (from corn to diamonds), money markets, currency markets, mortgage markets (residential and commercial), and lots of specialty markets like art and auction markets.

In addition, the financial crisis uncovered a whole host of previously little-known  “off-exchange markets” for rich investors. These market investments bypass traditional exchanges for stocks, commodities, and currencies like The New York Stock Exchange, Chicago Board of Trade, or Forex. I’ve been writing about these unregulated off-exchange investments for almost a year now, and I’ll be posting more about them on this blog.

So here’s my example. The news is full of stories about the U.S. government and how it’s handling the financial crisis among the banks.

The first problem for understanding what the news is saying is that there are two kinds of banks: regular “banks” like the ones where most of us make deposits and write checks, and “investment banks.”

The latter type of banks include the ones who spectacularly failed, e.g., Lehman Brothers, or were bought out, e.g., Bear Stearns and Merrill Lynch, or are being raked over the coals for surviving this past year, e.g., Goldman Sachs.

One thing that gets confusing is that both institutions are referred to as “banks” in the news. But they aren’t the same: the rules for each are not the same, and they don’t even serve the same functions or types of customers.

Investment banks do a range of things most regular banks don’t do. One of them is to sell “securitized” loans to “institutional investors.” Institutional investors are big investors such as mutual funds, private pension funds, and public employee retirement plans. Securitized loan investments collapsed during the financial crises.

Likewise many institutional funds’ investments in and based on commercial real estate developments also tanked and are still in the toilet. California’s employee pension fund, Calpers, is a notable example of an institutional fund that got burned badly by the financial crisis.

I suspect that hidden “dark pool” (private exchange) and off-exchange investments sold by investment banks and other large lenders are affecting corporations, the stock market, and the economy much more than what happened with regular banks and their customers.

In short, there are actually two markets when it comes to investing: the institutional-investor market and the individual-investor market. Clearly the biggest force affecting the economy is the institutional-investor market. Investment banks and other “shadow banking” institutions, such as insurance companies and hedge or private equity funds, serve investors in this market.

Thus, to my eye at this point it seems that the FDIC is focused largely on regular banks and their customers. The Treasury Department and the SEC seem to be most focused on the investment banks, insurance companies, and off-exchange investors and their customers.

The Federal Reserve seems to have a finger in every pie, which is perhaps why conservatives are targeting it for reform, so we can all return to an era of smaller government and letting the “the market” rule our economy

I’m keeping an open mind, but right now, to me it seems ridiculous to talk about “the market” as either a solo entity or as something separate from “the government.”

All kinds of financial markets as well as all kinds of government entities that regulate and support those markets heavily influence our economy. Under the word “economy” lays fascinating panoply of investments and government activities that can affect each and every one of us in a major way.

For more examples of how various markets and government actions affect us personally, drop by Brucenomics.com again soon.

Copyright © 2009 Nancy K. Humphreys

A teenage Morgan Stanley intern is ringing bells on London’s version of Wall Street. The teen, Matthew Robson wrote a market study about what his peers like. The word “free” was a prominent note in his piece.

Teens don’t like regular TV or advertising. Nor do they prefer print. They don’t favor Twitter. Forget radio! Forget phones! No!

Their time and money is spent on cinema, concerts, and video game consoles. The latter are used in lieu of computers or phones for texting friends.

“Wait a minute, Nancy. Where do you get the word “free” in all this?”

If you read David Mathison’s new book, Be the Media you’ll see. The theme of David’s book is the battle between traditional media forces and the new Internet media way of doing things. The latter is what Matthew Robson was telling the financial moguls in London about.

In traditional media, the idea is to “hook” consumers with “free” or low-cost “come-ons” to become subscribers. You subscribe because there seems to be little alternative among the big corporations offering you media services. Then you watch in horror as your bill goes up and up and up each month.

Burned by offline giants like Comcast, AT&T and Verizon, you tread carefully on online giants such as Google, MSN, Facebook and other “free” sites, perhaps recalling the furor on MySpace after Rupert Murdoch, owner of Fox News and other mainstream media bought it and began changing its TOS (terms of service).

When it comes to traditional and online mogul media, “free” comes with strings attached. You are going to have to pay in one way or another: more money for less services as your subscription costs rise; less privacy; charges for things you used to get for free; or having your time wasted by advertising, some of which (my last paid email provider as one example) is downright disgusting and/or nauseating

In the new media model, also called the “10,000 fans” or “the long tail,” free stuff, such as music downloads, is given away in order to promote personal services, like concerts or music instruction or other experiences, for which you do pay. The deal is out in the open. You sign on as a fan instead of a subscriber. When you do sign on, you get more when you pay more, not less.

The new media model is described in detail in Mathison’s book, Be The Media, along with all of the new media tools, Internet sites, service providers and community organizations that support it. This is why I have an affiliate link to it. I feel everyone, and especially authors, musicians filmmakers, graphic artists, digital tv and radio shows, and independent news writers, needs to know what’s in this book.

In my view, what Matthew Robson’s peers are doing is going for the free-est versions of media they can find. They like commercial-free radio, films and concerts (where the performers they like do earn a living by charging for tickets or selling branded merchandise), and video consoles where they can chat—on devices their parents no doubt supply them for their birthdays and pay the Internet charges for.

The downside of this is the fact that most teens aren’t going to have a lot of disposable income in the current economic climate. The upside is that they’re managing the money they do have exceedingly well. For “creatives” and small businesspersons who are in the creative and digital production and distribution service fields, this new business model is a boon to earning a living.

But have no fear about this being an easy road.

First, there are the traditional media who are trying desperately to hang onto their best-seller profits through use of what Robert Kiyosaki, author of the Rich Dad, Poor Dad series, calls “business systems.” These systems are government and legally-enforced monopoly rights to ownership through contractual vehicles such as copyrights, royalties, patents, and franchises.

Be The Media is filled with horror stories of how these “rights” have often been used to leave creatives with next-to-nothing while ever-consolidating giant producers and publishers walk off with trillions. These companies will not give up without a fight.

Second, with the collapse of traditional speculative markets, there are risk-loving investors entering the “intellectual property” field. Under the new investment fad of “securitization,” the big money-players are looking to buy up song rights and branded merchandise and other “intellectual property” from mainstream artists and others from whom they plan to profit.

Securitization of intellectual property is different than the act of flipping intellectual property.  “Flipping” traditionally involves a house that is bought at a low price, fixed up and sold at a higher price. But on the Web it means a blog or social network is bought, improved in content, function, and appearance, and then sold for more money.

In this case there is a measurable improvement in the media property being bought and sold. That’s the number of subscribers. Not so in bankers’ and brokers’ securitization markets. Those are the markets that brought us the asset bubbles (e.g., the largely now-defunct SIVs or “structured investment vehicles”) popped by the last economic downturn.

Securitization of intellectual property is a big-money gambling game where there are expectations of huge rewards from “arbitrage,” or price differences, based on everyone’s lack of information about some unknown kind of inherent value underlying the royalty cash flows from media property. In other words, no work is involved: there’s just a “hunch” that prices will go up. Sound familiar?

Personally I think we ought to listen to Matthew Robson and David Mathison’s Be The Media. It looks to me like today’s teens aren’t about to support giant media or big money arbitragers’ hopes for the future.

Copyright © 2009 Nancy K. Humphreys

I don’t know about you, but I feel my money should be working as hard as I do. Right now it’s not. I converted my investments into cash back in early 2008 when I saw the financial crisis coming.  It’s pretty much just sat there since then.

Microinvesting, the practice of supporting the businesses of small entrepreneurs in other countries, sure seems a lot more inviting than investing in anything in the U.S. securities markets these days.

An economist promoting this idea is Dambisa Moyo from Zambia. She’s ruffling white male feathers in Europe and America by suggesting that foreign aid to Africa and other less-developed areas of the world is hindering rather than helping things.

This isn’t a new idea. I proposed it in 1973. But unlike Moyo, I didn’t have a PhD in economics from Oxford and an MBA in Finance from Harvard along with a decade of experience at the World Bank and Goldman Sachs. My 1973 article, “Ethiopia: Trapped by Foreign Aid” in The Nation was merely based on research for my masters thesis awarded at the University of Wisconsin-Madison.  It’s at http://sn.im/ethiopia

My article was a “case study” that supports the theory of Dr. Moyo’s new book, Dead Aid, that aid from foreign governments and the World Bank isn’t helping Africa. It’s at http://sn.im/kqqjp

According to the The Financial Times and others, critics of Dr. Moyo use words like “unscientific,” “reckless,” and “naïve.” Critics say she has no proof foreign aid is not working. But where is the critics’s “proof” that “the hundreds of billions of dollars poured into Africa over decades” by governments of developed countries and the World Bank actually could cause any overall decrease in poverty?

My research indicated the main beneficiaries of aid to Ethiopia were the U.S. military and multi-national corporations. The corporations benefited by displacing masses of indigenous communal farmers so that they could grow and mechanically process coffee on large plantations. As a result, we got something new to drink. The children in Ethiopia got nothing.

The real issue, in my opinion, is the purpose, not the amount of foreign aid.

Foreign aid, by ignoring the needs of the people who live there, also appears to promote dictatorial governments and bloodshed in Africa. As long as economic diversity, self-reliance, and competitiveness in developing nations are stifled by foreign aid, there will not be a reduction of poverty abroad; only a massive wealth transfer via cheap exports and interest payments back to developed countries.

No amount of charity can offset that loss. Microinvesting, as a bottom-up solution may be a drop in the bucket in comparison with foreign aid, but at least the benefits to all parties are equal.

Since the 1970s microlending institutions have sprung up all over the less-developed areas of the world. As little as $25 can be invested through a financial institution in another country to help solo proprietors get on their feet with an idea for a product or service. In return you receive interest on the loans you make to foreign entrepreneurs in support of their dreams.

Some microfinance programs offer support to entrepreneurs by requiring them to sign up for regular meetings with groups of other entrepreneurs in their local geographic area. They all act as mentors for each other as they grow their businesses.

(1) Kiva.org is a well-known group endorsed by Dr. Moyo.
(2) MYC4 at myc4.com is another group established in Africa.

Recently PBS had a special on microcredit projects in India and other countries. Organizational names I pulled from that show include:

The three oldest ones:

(3) ACCION  at www.accion.org
(4) Grameen Bank at www.Grameen-info.org
(5) SKS at www.sksindia.com (guarantees 100% return)

More specific or newer institutions:

(6) Yehu Bank at www.yehu.org (includes 3% men borrowers)
(7) FINCA (Foundation for International Community Assistance) at www.villagebanking.org
(8) Pro Mujer at www.promujer.org

Microcredit Summit lists more microinvesting projects around the world at www.Microcreditsummit.org/microfinance_links/

Check out microlending. If you believe as I do, in the value to society and the world of true entrepreneurship, here is where you may get the best return ever on your funds.

Copyright © 2009 Nancy K. Humphreys

Apple’s ads with Bill and Steve are cute, but oh, how they miss the point!

I began computing on a giant gray metal, wall-sized machine with toggle switches. Then I learned BASIC programming on a dumb terminal at the University Library. As soon as I got a job I bought a politically incorrect PC from IBM. It was a $2,000 PC with 64K of memory, one floppy drive and green monochrome monitor. How I loved that DOS machine!

Or rather how I hated using typewriters. Since jobs for women tended to include them, and I’d taught myself on an electric typewriter when I was 14, I was stuck!

When Windows 3.0 and 3.1x arrived, I did like the graphic interface, but it was downhill from there. In 2008 when my Dell started deteriorating one program at a time, apparently from a problem with a part of the Windows operating called “Winsock,” I began seriously considering a Mac. I didn’t need the commercials. I had over 25 years experience with Microsoft operating systems driving me out the door.

Make no mistake. I knew DOS and Windows. I was a Novell CNE. But each version of Windows got progressively worse, IMHO. Winsock was the last straw.

Here’s what I think the Apple ads should be telling everyone. (1) The MAC Is Fun! (2) The MAC Does Everything You Need It To.

Let’s take each of those two points all together, OK?

I opened up my new Air. It was so cute and light. As soon as it went on for the first time it talked. Yes! It talked. “Hello,” it said, “Would you like me to show you around?” I nearly dropped it in surprise. But then I answered. “Indeed I would,” so it did. The setup was totally simple and flawless.

Then my Air said, “Would you like your picture taken?” I looked up at the screen and there…was me. NOOOOO! I’d never seen my face on a computer screen. I nearly dropped the darned laptop again. Seeing myself up-close and personal was unreal. I tilted the laptop and my head, and sure enough my face tilted. It was a mirror image of me. I decided to be brave. I said, “yes” A light and a timer went on. One. I smiled, big teeth showing. Two. Three. It flashed. And there was a photo. Of me on the screen.

So here’s the thing. The new app on the dock along the bottom of the screen that looks like a Photo Booth takes pictures just like a camera. You drag photos from the Booth to IPhoto, the app with a camera icon. IPhoto asks if you want to name the photo. You click “Name” and an outline of a square and a cartoon caption appear on the screen. You drag the square over the face and type in the name in the caption. That’s the new face recognition feature. You can also input places. It takes IPhoto awhile, especially with baby faces, but eventually it recognizes faces, and it suggests a name. You click the “agree” checkmark or you type in the correct name. Names remain hidden until you want to scan through all your photos of the same person.

But here’s the cool thing! There is an Address Book app with a little @ sign on the tan cover. Along with automatically typing an address (or even bunch of addresses from a group folder) into your emails that you write with Mac Mail (the app that looks like a postage stamp with a flying eagle), your Address Book will also suggest names of people for your photos when you begin typing a name onto a caption in your IPhoto app!

Are you following? NOT ONLY DO MAC APPS  (or “accessories” to you PC users) ACTUALLY WORK—THEY WORK TOGETHER. If your jaw is dropping. I repeat. THE APPS ACTUALLY WORK and THEY WORK TOGETHER.

You wouldn’t believe how much time this saves and how many new things you can do with a MAC that you couldn’t with a Windows PC. In addition, my Air is so smart I feel like it is my Personal Assistant. From the get-go it automatically filled in blanks in forms on the Internet with any information that I gave it about me in the setup and any of its apps. Even the design makes it mine. Click on one of the many app icons down on the dock, and they jump up and down like they’re saying “How high?” Even the teeny printer bounces. The first time an app icon did this, I waved back. I couldn’t help it. I felt immediately it was my little friend.

Yes, MAC apps are friends: not enemies like Windows “accessories” to its monopolistic crimes against users!

Sister and brother Windows sufferers, how much money have you shelled out for expensive software to do what Windows wouldn’t on your PC. Apple has worked with app developers to provide all kinds of things you need, most of them free or low-cost.

For example, a free program called Skitch lets you cut and paste any picture from an email or from the Web. Drop the image you want onto your desktop, and it will automatically turn into a .jpg file. Skitch has a snapshot button that inserts a perpendicular line extending downwards and a horizontal line extending towards the right from wherever you put your cursor. You then drag your cursor diagonally down to resize the photo into any shape you want. Release the cursor to take the picture. Click another button at the bottom of the Skitch box, and you can drag the .jpg anywhere–into an email or your iPhoto albums, or you can just leave it on your desktop or put it in a folder. Using my Air and Skitch, I made a .pdf presentation file with 24 photos and text documents in less than hour!

If you just want to grab a photo “as is,” just click and drag it off the Internet or other source onto to your desktop or an app like Word or an email. The photo turns into a .jpg automatically. Need to find photos (or music)? Try the LimeWire app (the one with the tiny round green cut-open-lime icon). Oh, I could go on and on!

But to return to the very beginning of my relationship with my new Air, here’s also what I liked:  the intelligent design of the whole interface. The desktop wallpaper is a night sky. When you hook up Time Capsule, the automatic backup machine for Macs, the screen shows a series of index cards (each with a dated backup). The cards stretch out through a 3-D universe and then finally vanish into a black hole. A slider lets you navigate back through time.

Another surprising trick is the way when you hit the yellow button to minimize a program; an invisible hand whisks programs away like a magician drawing a handkerchief over his top hat. The minimized program icon sits on the right side of the dock until you click it again. The whole experience is like an entertaining magic show. I don’t dread going to work anymore now that I’m on Air.

Dell just put out a “luxury” laptop, a pricey ultra thin laptop to compete with the Air. The Dell “Adamo” costs more than an Air. It’s ugly, with a stripe down the cover that makes it look like an old two-tone “sixties” family car. And you can bet: it doesn’t have Apps That Work, let alone Apps That Are Fun And Work Together!

Well, yes, a couple of email drafts did vanish when I made an instinctive Windows keyboard command, and we had to use Time Capsule to find them. Apple’s backup system is so easy even I could use it to find and restore a single file in seconds. The hardest thing about switching, if you’ve used a Windows PC, is to learn the different keys and keyboard commands used for the MAC.

So save yourself the heartache, my friends. Check out Apple’s video on switching at http://sn.im/pc2mac.  Then get yourselves a mentor who knows the good stuff to download and all the tricks to transition to using a MAC, and switch today.

[Many thanks to Susan Pomeroy, my MAC mentor, Internet guru, and the friend who kept telling me to try a Mac all these years! My gratitude forever!]

Copyright © 2009 Nancy K. Humphreys

[NOTE: Today's news:  bondholders with derivatives force GM towards bankruptcy. How many more companies might this happen to?]

According to Ira Glass’ “This American Life” program on NPR, the scope of the financial problem is as big as that huge 100 foot wave in the movie, “The Perfect Storm.” The title of the NPR show is “Another Frightening Show about the Economy.”  Included is a terrific section on derivatives, specifically the type of derivatives called credit default swaps (CDSs). [minutes 20-40 of Oct. 3-5 episode 365 on http://www.NPR.org]

Credit default swap derivatives (CDSs) were bought and sold by AIG, the five giant investment banks, other big banks, hedge funds, pension funds, mutual funds, and corporations. Just about every large financial institution had a “derivatives desk.” If you wanted to buy one of these “insurance policies,” you had to have at least $5 million in your accounts.

What is a derivative? For a derivative to exist there first has to be a financial transaction. A financial transaction is an exchange between two people or “parties.” The exchange usually involves one party buying and one party selling something, For example, a company or municipality sells its bonds to a buyer (called a bond shareholder.) A derivative sits on top of that underlying financial transaction. Supposedly it “derives” from the underlying transaction. In the case of many CDSs, that connection was exceedingly remote.

CDSs are legal, but unlike ETFs, they are not sold on the stock exchanges. They are private deals and completely unregulated—because Congress voted not to regulate them. When the SEC head finally asked them to regulate CDSs, Congress essentially said “These rich guys are sophisticated investors and smart. They wouldn’t screw up.”

Amazing as this seems given that CDS derivatives are essentially based on nothing more than the reputation of the company buying or selling them, even some regulators at the SEC and financial reporters didn’t seem to understand the dangers. Whenever credit swaps were discussed in the newspapers they were called “insurance” or a “hedge” against risk.

CDSs did start out as a form of insurance. You went to an insurance company like AIG or a big bank and you bought  “insurance” against one of your investments going bad, say an investment in a company’s bonds. If the bonds went bad, your insurance paid you.

But then people began hedging with CDSs. They went so far as to buy CDS “insurance” on investments they didn’t own! If the investment became shaky, you could sell your “insurance policy” to another buyer for a higher price than you paid for it. If the investment completely defaulted, your “insurance policy” paid you. But if the investment stayed OK, you could still sell your “insurance policy” on it and lose no money. This is how CDS “hedges” were used for speculating.

The problem with CDSs is, that unlike regulated insurance policies, companies that sell CDSs don’t have to have “capital reserves” on hand to cover them. As companies started having credit problems from the mortgage mess, they also started having headaches from the CDSs they sold. With no short term credit available to borrow, AIG just couldn’t pay off the billions it owed on its CDSs.

Financial institutions panicked. When the economy started going badly, banks stopped trusting each other because no one bank knew how many CDSs (and other speculative investments) any other bank was in hock for. So, in reality, derivatives like CDSs didn’t protect against risk. They increased it!

The horror isn’t just that an estimated five trillion dollars worth of CDSs were issued. The horror is that there was “leveraging” (buying and selling investments without having all the money on hand if called on to fulfill their contractual promises to pay). Leveraging caused the total amount of money tied up in CDSs to eventually become $60 trillion! But that’s just part of what the bailout has to deal with.

Add in tens of trillions more for failing “whole” mortgages. Then add hedging done with another kind of derivative, CDOs (collateralized debt obligations). CDOs are mortgages mixed up together and then cut up into up investment pieces called tranches. The result of using CDSs and CDOs? You get the perfect financial storm.  The ensuing gigantic financial wave coming at us could run as high as 100s of trillions of dollars.

Do we think a little more than just one-half of one trillion dollars for the bail-out can go very far towards de-leveraging or “unwinding” that huge of a “toxic” debt? Not unless Hank Paulson of the Treasury and Ben Bernanke of the Federal Reserve are wizards worthy of a position at Harry Potter’s school! That’s what’s truly scary.

Copyright © 2008 by Nancy K. Humphreys

“What’s this?” I yelled, scattering receipts every whichway off my desk. It was April 15th of my first year in business. I looked at the screen again. I owed a HUGE amount to the IRS. At first I was sure it was a glitch in the new tax software I’d bought. But it wasn’t. I’d just been KO’d by a one-two punch by the IRS—the self-employment tax and the quarterly estimated tax payments.

I went in search of information. Why was the SE tax so high? What was a SE tax? And why did I have to pay estimated taxes up front if I was self-employed?

The quarterly estimated tax question was pretty easy. As an employee I’d had to pay withholding because the IRS wanted to be sure I had the money to pay my tax when it came due. I figured the quarterly estimated tax, which is paid in advance just like withholding tax, was based on the same principle, only for businesses.

But what was that expensive SE tax? I’d ascertained that it had nothing to do with my income tax calculated on Form 1040. In fact, I had to pay the SE tax in addition to my income tax. I finally discovered SE referred to my Self-Employment Social Security and Medicare tax. But why was it so much? I knew employees only paid about 7.5% for Social Security tax. Why did I have to pay nearly twice that?

The answer I found down at a nearby bookstore was mindboggling. The SE tax was so high because now that I was self-employed, I had to pay both the employer and employee portions of Social Security/ Medicare tax of about 15% for me.

This split by IRS accountants of an individual into two parts, employee and employer, seemed “crazy” to me back then. I wasn’t two people. I was just Nancy Humphreys.

I resented the tax. Why should I have to pay twice as much as an employee pays?

This, of course, tells you my mindset. I thought of myself simply as an employee rather than as business owner. The distinction between being self-employed versus being a business owner is something I read about when I came across Robert Kiyosaki’s Rich Dad, Poor Dad 2: The Cash Flow Quadrant. His comments in that book about self-employed people shocked me, and hit a nerve at the same time.

As I read more about owning a business, I came to realize how useful a tool the IRS’ “two-people-in-one” method of looking at self-employment was. I began to use that idea to examine my business in terms of costs and benefits. The IRS’ principle of two hats (employer and employee) helped me examine two problems that I had when I first went into business for myself.

Problem # 1 When calculating how much it would take to go into business for myself, I wore only an “employee hat.” I thought of all the benefits that not going to work would bring. No more lattes and lunches out, no more gasoline or time wasted in commuting, no more closet full of professional clothes, etc. I never even thought of the “employer hat” costs of running a business. As a result I underestimated the true costs of a home business.

Problem # 2 I didn’t have a model for estimating my real business costs. This led me to overestimate my salary as an indexer.  That too led to frustration. I kept feeling I wasn’t really earning enough, and I didn’t know why.

Both of these problems began to seem manageable as soon as I began using the IRS “employee/employer in one person” tool to look at my business.

I was amazed to find out how many costs my employers had borne on my behalf while I was earning a paycheck. Seeing how many “hats” my employers wore was key to seeing my costs, necessary costs apart from doing indexing, that you should think about in relation to your work.

A model for determining how many hats  you wear

As I’ve said, those in business for themselves, even if it’s a solo practice, wear two hats: employee and employer. Employees, whether self-employed or working for others, rarely see the whole extent of the employer benefits we receive.

Employers wear many other hats. Here’s my simple model for how to see yourself as an employer if you’re self-employed OR how to understand the total employer benefits you receive if you’re a salaried employee.

As an example of my model, I’m going to walk you through my last place of employment, a small two-story non-profit that employed about 25 people. You’ll need to follow me through this example, then make up your own way of walking through your memories of a workplace you know well.

In this model, “hats” refers to job titles of employees. I’ve given these job titles an initial capital. You’ll also see the various duties belonging to each job. I’ve underlined and numbered the duties that you need to take care of in order to support your indexing work.

The public face of the organization

At the front door was the Receptionist. We didn’t get a lot of walk-in traffic, so the Receptionist mainly (1) fielded the phones. The Receptionist also (2) ordered supplies for everyone in the building and kept the supply cabinet stocked.

Across from the Receptionist’s desk was the Director (or CEO). The Director was responsible for (3) setting the mission and goals for the organization, (4) the budget, and 5) being the “public face” of the organization to the outside world. The Director also led weekly staff meetings. The Director had four Associate Directors and an administrative staff. The Associates had other functions, but also served as sounding boards when the Director needed feedback.

The rest of the administrative division

Down the front hall and turning to the right was the rest of the administrative division.

The Administrator of this division was mainly concerned with (6) employee benefits. These included disability, health insurance, life insurance, worker’s compensation, and retirement benefits. About thirty percent of our salaries were paid in benefits. The Administrator also supervised the other employees, including the Receptionist, and handled large purchases for the division.

The Accountant and Bookkeeper managed the financial paperwork and worked yearly with an outside CPA to review the books. They handled (7) invoicing and payroll, withholding and other (8) tax forms, and ((9) kept track of the income and expenses along with assets and liabilities of the organization.

The Administrative Assistant supported the rest of the division, and (10) maintained the phone system used by the receptionist and all the employees. This AA also assisted me in (11) maintaining the network of computers, printers, faxes, and other equipment. (Later the Accountant took over that job!)

The information services division

Down the front hall and to the left on the first floor was me, the Library Director. Along with managing the computer network, I also served as an Associate Director who assisted the Director.

I had four employees who worked under my direction: a Librarian; an Administrative Assistant; a Library Aide, and an Indexer.
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In the library, our job was to (12) locate information the other employees needed to do their jobs. We also served groups of people our employees worked with in the outside world. For example, we created a thesaurus and put out an annotated bulletin each month that summarized articles from all the magazines we subscribed to. 13) Besides ordering books and magazines, the library was also the place where supply catalogs and professional reading materials were ordered and organized for all staff.

The line staff of the organization

In the back hallway on the left and on the second floor were all the “line” employees of three main primary divisions of the organization. The line employees performed the primary functions of the organization.

The three main divisions of line staff were: a) local community organizing, b) national media relations [and they also handled (14) marketing for the organization itself], and c) an international pilot project.

Work contracted out

Maintenance was performed weekly by an outside (15) cleaning company.

This model as a model

Now, please don’t misunderstand. I’m not saying the above model is an ideal organizational model. As you might have noticed, several people held positions in two different divisions, an ambiguity that often causes problems in organizations.

In addition, the usual position of  COO (chief operating officer) was left empty. No one had responsibility for (16) coordinating all the support and line functions for the organization, a lack that led to the closure and reorganization of the organization a few years after I’d left it.

Where do indexers fit into this model?

If you are a self-employed indexer, you are a line employee. You produce the product of your organization. If you work as an indexer within an organization, you may be a line employee, a support staff member, or your position may be a hybrid one similar to the indexer who worked  for my library. That indexer produced an annotated magazine database and newsletter which were used both by line employees within and clients outside of the organization.

If you’re a self-employed indexer, you can use this model to see what your employer expenses are and begin to track the amount of time you spend while wearing employer hats. If you’re employed at an organization, you might do this walk-through in your own workplace to uncover all the support staff you benefit from or to find where you need more support to get your work done.

Ok Nancy, I see your point about all the “hats,” but exactly what does this mean for my business?

Using the above model and tracking your time, you can easily calculate your” employer costs” of being self-employed or being an employee.

If you look above, you’ll see that I’ve underlined 16 chief support functions at the place where I used to work. These are your “employer costs” of indexing. That’s true whether you work alone, or you operate a business which hires other employees to index with you, or you work in a large organization as an indexer.

If you work at an organization like the one in my example, consider what the numbers of underlined duties above mean. Over half of the organizational staff in my model were support staff. If you work in an organization, you are actually receiving support from the majority of the support staff at your workplace. You get way more benefits than insurance and retirement from your employer!

On the other hand, if you are a self-employed indexer, or you’re an indexer who employs other indexers, you probably don’t have any support staff. Instead, you’ve got at least 16 employer-hat-duties to take care of by yourself. The duties performed while wearing these hats are ones that do not directly concern your main business of indexing. But these things must be done so you keep on indexing or keep owning your indexing business.

And if you are self-employed, the numbers of employer duties under the hats in the model described above suggest this: at least half of your working time will be spent in support staff functions rather than on indexing itself. Each of these 16 employer duties entails costs! Most importantly, these costs include the amount of time you spend while wearing employer hats.

How many of us actually track all of those “employer costs” when we estimate our worth? If we do track these costs as labor time, how do we price our labor? Do we price it at what we earn as indexers? Do we price it at what we’d pay if we hired someone else to do those tasks? Or…do we price our time spent on employer tasks at zero?

NOTE: This article was published in advance of my workshop talk titled “How Much Are You Really Worth” for the American Society for Indexing conference in Portland, Oregon, April 24, 2009.

Copyright © 2009 by Nancy K. Humphreys