Monday, November 21, 2011

The Supercommittee: Designed to Fail

On August 2, 2011, in response to congressional deadlock over a debt-ceiling limitation, the United States enacted the Budget Control Act of 2011, establishing, among other things, the Joint Select Committee on Deficit Reduction, commonly referred to as the Supercommittee.  This committee is charged with issuing recommendations by November 23, 2011, to reduce the nation’s deficit by no less than $1.5 trillion over a ten-year period.

The Supercommittee consists of twelve members, all appointed by the leaders of the two major political parties.  To ensure perfect partisan balance, there are three members each of Republican and Democratic senators, and a like number each of Republican and Democratic members of the House of Representatives.

As of this writing, three days before the recommendations deadline, nothing but partisan dogma and illusive accusations have emanated from its members.   There is no sign mutually agreeable suggestions will appear, and I suspect this was intended by its founders from the start.  It’s my belief the Supercommittee does not exist to develop a sensible debt-reduction plan, but rather to act as a public distraction while the members of congress contrive among themselves quietly to further rig the system to favor their natural constituency groups.

I suppose the futility of the Supercommittee should have been obvious from the start, considering who became its members.  How could Congressman Christopher Van Hollen, (D, MD), who as a Maryland State Senator led efforts to raise taxes, prohibit oil drilling, and increase education and healthcare funding, find common ground with Senator Rob Portman (R, OH), who championed the elimination of capital gains taxes on homes and regards as his proudest moments the passage of a balanced budget amendment and welfare reform bill?

Another matter, relating to the assigned task of the Supercommittee, deserves consideration: Reduction of the national deficit by “no less than $1.5 trillion over a ten-year period,” or an average of $150 billion per year.  Is this meaningful, considering the most recent estimate by the Congressional Budget Office of a $1.3 trillion deficit for 2011 fiscal year?  Thus, a yearly $150 billion savings represents only 11.5% of the total deficit.  This doesn’t deserve the hyperbole it receives.

I’ll conclude with an analogy.  The Supercommittee, which will soon be but a memory, brings to mind a tale from the 1960’s.  It too involved a proposal to form a committee to resolve various social problems gripping America at the time.  In keeping with attitudes then prevalent, composition of the committee mandated diversity.  A specious suggestion called for eight members to be selected, consisting of one person each from the following groups: a religious fanatic, a hardcore atheist, a grand wizard of the Ku Klux Klan, a member of the Black Panthers, a bomb-throwing anarchist, a representative of the Daughters of the American Revolution, a card-carrying member of MENSA, and an inmate from a nearby insane asylum.  The instructions under which this committee would function: “Come and let us reason together.”

Friday, October 21, 2011

Occupy Wall Street: The Morning After

    On September 17, 2011, about two hundred protestors set up camp in Zuccotti Park in New York City.  In the past weeks the effort, now known as “Occupy Wall Street,” has morphed into a massive crusade with encampments in many cities throughout the nation.  Its impetus was the Canadian-based Adbuster Media Foundation which earlier in the year proposed a peaceful occupation of Wall Street to redress corporate abuses.  Their proposals included some sensible suggestions such as reinstatement of the 1933 Glass-Steagall Act, abandoned in 1999, as well as use of congressional and executive oversight to more effectively investigate and prosecute Wall Street crime.

The goals that spawned the encampments seem lost on most of the participants, as they have yet to convey a coherent message.  Although they appear to harbor a general hostility toward the business community that Wall Street represents, the only thing the various constituent groups appear to have in common is a deep-seated anger at inequality in this country.   Many want to redistribute wealth; others want to enlarge government social programs; some are protesting against the wars in Iraq and Afghanistan.

I acknowledge that the protestors have a legitimate grievance against Wall Street.  Corporate investment in America is mostly a “shell game” by which the investor is consistently lured to part with money through a variety of deceptive schemes.  It’s the rare stockbroker or securities adviser who has any knowledge of the market.  Following any hectic day, where stock prices have either soared or plummeted, hundreds of market analysts will describe in detail what happened— and why.  However, the day before none of them will have harbored a clue. 

As for mutual funds, which are now the investment by default for most Americans, it’s an industry in which the astute placing of investors’ money is not a consideration.  By and large they are little more than skimming machines.  Their rapid growth in both numbers and varieties will ultimately wreak financial ruin on an unsophisticated public.  It is the workings of these funds and their threat to many citizens’ livelihoods that deserve to be exposed by the Occupy Wall Street movement.  Thus far there’s not a word to be heard.

My prediction is that the protests will amount to nothing of consequence.  The sort of movement needed to eradicate the abuses in the investment world requires a far more concerted action.  Only a systematic effort that is well organized, adequately funded, and politically directed can hope to force the changes necessary to correct the abuses currently built into the system.  The ragtag gang of exhibitionists who specialize merely in chanting slogans will not bring about any improvements.

Sunday, October 16, 2011

Herman Cain: Flat Tax Advocate

Ever since casting my very first vote— for Dwight Eisenhower in 1952—presidential campaigns have fascinated me.  This year’s GOP contest for the nomination is proving to be confusing, with the pollsters proclaiming a new frontrunner as rapidly as the news media can anoint a favorite.  The latest flavor of the week is Herman Cain, who seems to have struck a chord with a segment of the voting public.  Mr. Cain’s claim to temporary immortality appears to be his 9-9-9 Plan.

The Plan is simply explained.  First, it replaces the personal income tax, immersed in its complexities, with a flat 9% tax on all income, with capital gains taxes excluded completely.  The only allowable deductions will be charitable contributions and a credit for living in an “entitlement zone,” translated to mean an approved slum.  Secondly, it establishes a 9% national sales tax.  This, of course, is in addition to the sales taxes currently in effect in states and communities throughout the country.  And lastly, it provides for a 9% federal corporate tax, a levy which currently extracts rates exceeding 30% on all annual corporate income over $75,000.

I’ll not attempt to dissect Mr. Cain’s handiwork, other than relate a comment from a friend.  His sole livelihood is from a 28-unit apartment building he managed to acquire a few years ago.  He told me he generates about $580,000 in annual gross rentals, but after property taxes, maintenance expenses and mortgage interest, he nets only $35,000.  His current income tax bite is modest, so he manages to get by, though not extravagantly.  He expressed dismay that Cain’s plan, described as taxing gross income, would strip him of $52,200.

The flat tax, which at its simplest is the taxing of all income from whatever source, with no exemptions or exclusions, at a single rate, is not new.  The concept is propounded from time to time by various political candidates in the hope its simplistic approach will somehow capture the hearts and imaginations of the beleaguered tax-paying voters.  Its supporters include representatives of both major parties, where variations on the specific details are introduced in order to satisfy one or another special interest group.  Though popularized by Republican Stephen Forbes in both his 1996 and 2000 presidential bids, a decade earlier current California Governor Edmund G. (Jerry) Brown, Jr. championed it with an equal lack of success.  Over the years the flat tax contrivance has remained a durable issue for those candidates utilizing the Christopher Columbus approach to electioneering: just discover an issue and land on it.

Whether we like it or not, taxation is an intricate and convoluted process.  It must be, because it involves taking the possessions of some persons and giving them to others.  I’ll conclude with a final thought by a most profound philosopher, H. L. Mencken: “For every complex problem there is an answer that is clear, simple, and wrong.”

Wednesday, October 12, 2011

The 7 Fundamentals of Sound Investment

Reprinted from the newsletter by Al Jacobs, author of Nobody's Fool: A Skeptic's Guide to Prosperity June 2011

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Over the past four decades of involvement in investments, both participating in and observing, I’ve witnessed about every variation imaginable.  During this period I’ve also surveyed endless advice and recommendations on the subject.  Yet, despite the overwhelming amount of information available, the actual principles of investment are few in number and basic in their application.  Generally, if you can cut through the maze that surrounds a proposal or offering, the elements upon which its probable success or failure relies becomes easily observed.  To this end, I’d like to discuss the seven fundamental factors that govern investment.

1.  Consider your Comfort Level.  Whatever your selected endeavor, take into consideration your personal abilities and limitations.  If, for example, you function well with people in a down-to-earth business setting and enjoy the challenge of making repairs and improvements to real property, you might be a natural in owning and managing apartment units.  However, if you consider the prospect of tenant interaction repugnant, and regard property maintenance as a drag, you’ll do yourself no favor by entering that field.  Similarly, if you find a corporation’s annual report intriguing, and eagerly scrutinize analysts’ reviews in the evaluation of public companies (there really are such people), you could find success in building and maintaining an active and profitable securities portfolio.  But for those of you who regard corporate securities a bore, or for whom ownership of a share of stock that declines in value causes mental anguish, you’re probably better off staying clear of the market.

2.  Beware of Needless Complexity.  Mounted in a frame on my wall is one of the many versions of Murphy’s Law.  It reads: “Nothing is as easy as it looks.  Everything takes longer than you expect.  And if anything can go wrong—it will, at the worst possible moment.”  That pretty well spells it out; as matters become increasingly complex, there are more things to go wrong.  Therefore, if you choose to purchase subordinated debentures issued by a firm that manufactures and markets highly specialized golf clubs, the safety of your investment will be subject to successful management of the company, competition by other firms, the popularity of golf, and many other variables I can’t even imagine.  By contrast, when loaning money to a homeowner with good credit and substantial home equity, secured by a mortgage on that property, there is far less uncertainty.  As the prevailing theory goes, reward increases with risk, so that you’d expect interest paid on that debenture to be far greater than on the mortgage loan.  But in real life it doesn’t always work that way.  It’s for this reason that in every case, it’s your job to consider the complexities, analyze the risk, and decide whether the return is adequate.

3.  Be Certain the Numbers Make Sense.  When presented with an investment proposal, together with a set of figures that purports to show how advantageous it will be, the first thing to consider is whether the numbers are reasonable.  Do they seem to make sense?  I’ll give you an actual example.  I recently analyzed the purchase of an annual 1-week interval at a timeshareproject for a friend, the specific property being a 750 sq ft, 2-bedroom condominium in an outlying resort area in Southern California.  The terms: $14,500 price, 20% down payment, monthly mortgage installments $97.90 for 15 years, and $47.50 monthly toward taxes, insurance, maintenance, and supervision.  Although my friend could easily afford the $2,900 down and $1,745 a year carrying cost, I pointed out that an identical unit at the resort rented at a daily rate of $125.  Why purchase if the cost of a week’s stay is only $903, with no initial investment or mortgage burden?  To conclude my argument I quickly calculated that, with buyers for each of the year’s 52 weeks obtained under the same terms, thetimeshare association receives $754,000 in sales revenue plus $29,640 in annual payments for that single unit.  Adding insult to injury, similarly sized condominiums a few miles away garnered a market price of only $195,000.  As you might guess, my friend expressed no further interest in the project.

4.  Identify the Source of Profitability.  If anything constitutes the heart of an investment, it’s the reasonable assurance that it will generate a benefit of some sort over a defined period of time.  In the case of corporate stock, this is the systematic payment of a dividend and/or appreciation in share value.  For the ownership of commercial real estate, it means an expectation the property will generate a net cash flow as well as experience some value enhancement.  Note that the basis for value is not the benefit generated, but rather the “reasonable assurance” of this benefit.  This may seem illogical, but it’s significant.  In each case, value is determined by careful analysis of the underlying operations.  To make the point, even though it may pay its holder a fortune, a lottery ticket possesses no definable value.  There can be no reasonable assurance that it will deliver anything.  And yet it is this gambling mentality that often takes charge in establishing whole industries.  As a striking example, consider America’s technology firms in the years leading up to their 2000 collapse.  Many of those companies experienced phenomenal increases in common stock price despite the fact they neither generated income, produced viable products, nor offered future promise.  No reasonably anticipated benefits existed; any value relied on pure speculation.  By contrast, as I began purchasing previously foreclosed-upon condominiums in 1995 from banks and government agencies in then-bankrupt Orange County, California, the rental market assured an annual 16% return on the less-than-replacement-cost purchase prices.  Whether or not the properties might one day appreciate in value seemed almost unimportant.  The predictable cash return justified any long term risk.  It worked nicely and the six-fold increase in market value over the following ten years, almost an afterthought, proved to be massive frosting on the cake.

5.  Verify the Information.  Though you obviously realize it’s unwise to make an investment without verifying all the pertinent details, this is more easily said than done.  One case in point is the selecting of corporate securities.  You’re familiar with the information that firms such as Value Line and Standard & Poor’s provide when advising on the soundness of a company.  However, you can’t ignore the fact that shortly before Enron Corporation filed in Chapter 11 Bankruptcy, all the rating services gave the company’s stock a high grade.  Similarly, the mutual-fund monitoring service, Morningstar, evaluates funds on the basis of risk and performance.  Nonetheless, when in the autumn of 2003, many of the funds experienced a melt-down amidst revelations of fraud, Morningstar provided no advance warnings.  If these professional evaluators found themselves so easily fooled, what are your chances?  Of course, there’s no pat answer to that question.  Each of us must recognize our own limitations.  One response is to hedge our bet with diversity.  Thus, instead of heavy investment in each of only a few stocks, we’ll spread our choices to minimize the risk if one or two of them go sour.  One prominent radio advisor urges no more than four percent of a person’s portfolio be placed in any one security.  A second technique, and one I favor, is to avoid the sort of investments that require reliance on either company reports or rating services.  It means that in examining an operation, sufficient details that can be understood and relied upon must be available from independent sources.  Above all, each element of the information must be clear enough that it can be corroborated by common sense.  This is the approach of one very successful investor, Warren Buffet, Chairman of Berkshire Hathaway, who escaped the collapse of technology stocks in 2000.  He explained that he abstained from investing in that sector because he did not understand it.

6.  Arrange for Adequate Security.  I’ll repeat the admonition of Murphy’s Law, “If anything can go wrong—it will,” following it with the Boy Scout motto: “Be prepared.”  It’s always advisable if you can cover downside risk with some sort of security.  There’s no better example of this principle than in the lending business.  The difference between unsecured debt, such as a signature loan, and an obligation that’s secured by a mortgage—a document that permits the lender to seize a parcel of property by foreclosure—can mean the difference between wipeout and full recompense.  To hew the line even more cautiously, we might further distinguish between mortgage loans secured by owner-occupied single family homes versus those secured by apartment houses.  In the event of loan default in the former instance, the owners may avail themselves of various delaying tactics including prolonged bankruptcy action.  If the home equity securing the loan is inadequate, the lender may suffer.  But with an apartment loan in many judicial districts, the courts will often award receivership, permitting the lender to commandeer the building and collect the rents during the foreclosure period.  It is this option that can make the difference between loss and gain.  It goes without saying, of course, that the more clearly you understand the details of an endeavor, the better you are able to prepare for what might go wrong.

7.  Search Carefully for any Overriding Defect.  The last thing to do before making a financial commitment is to step back and view it for any element that seriously detracts from its viability.  Is there some specific defect that might nullify an otherwise inviting opportunity?  As an example, I’ll offer a testimonial.  In 1993, at the depth of a Southern California real estate recession—admittedly far less disastrous than the depression we are suffering here in 2011—I encountered an opportunity to purchase a 38-unit apartment building in Riverside County.  The owner, a bank that acquired it in a prior foreclosure, wanted to unload.  From my perspective, almost everything seemed ideal.  With only six units occupied, and those by evictable deadbeats, I intended to secure tenancy of my choice.  Despite its abysmal physical condition, other buildings in that locale looked pretty good.  And best of all, the bank offered to make a 95% loan-to-facilitate at a purchase price of only three times the building’s annual potential rent schedule—virtually a “steal.”  As I said, everything seemed ideal—almost.  There was, however, one fly in the ointment: A partner came with the property.  For reasons I never fully understood, the bank seemed bound to a commitment that a former holder of interest retain an undivided fifty percent beneficial ownership interest with whoever should purchase the property.  Thus, I would be only half-owner, with all the limitations that might entail.  To make a long and traumatic story very short, I met the prospective partner, ordered a credit check, and ran a five-county judicial search on him.  His record proved to be as bad as I perceived him.  For that reason, although the property offered the potential of quadrupling in value over a four year period, I reluctantly passed up the purchase.  I’ve never regretted my decision, though I do shudder somewhat when I think back at the lost opportunity.

Let me sum things up.  Successful investment can be challenging, but need not be overwhelming.  Apply these seven fundamentals to each investment opportunity you encounter and you’ll quickly eliminate those with fatal flaws.  But keep in mind that you’ll not be popular with whoever is advocating your participation.  It’s unhappily true that most investments are promoted by interested parties who exaggerate benefits and minimize risks.  My advice: Ignore the pitch and rely on your own analysis.  And remember always that if it doesn’t make sense to you, it doesn’t make sense.

A Reaction to Bill Clinton’s Views on the Economy by Al Jacobs

In a kickoff of his soon-to-be-released book, Back to Work, former President Bill Clinton was recently interviewed by Fortune managing editor Andy Serwer.  Mr. Clinton said much about how to fix our moribund economy.  Many of his comments seemed to be conventional palliatives, the sort to which you smile and nod without delving too deeply into the details.  However, I’d like to peek a little closer into two of his recommendations to see how they square with reality.

Mr. Clinton seems intrigued with the “Buffet Rule” when he suggests it’s only fair the rich pay more in taxes.  There’s no concept more engrained in government than that all problems can be solved by soaking the wealthy.  The reason it’s so popular with rank and file citizens is basic: a willingness to spend other peoples’ money.  In this he agrees with President Obama who equally recognizes the impact of a good campaign slogan: Tax the Rich!  However, Great Britain’s former Prime Minister Margaret Thatcher assessed the fallacy in this approach when she remarked: “Eventually we run out of other peoples’ money.”

When we advocate taxing the rich, we encounter a couple of problems.  The first: As the rules are enacted and enforced, the tax is on income, not wealth, arranged normally by increasing the marginal rates on higher income individuals.  In this way the Michael Moores and Warren Buffets remain untouched.   Add to this the ability of the truly wealthy to arrange their affairs to minimize taxable income, and it’s obvious who is taxed: not the wealthy, but rather those with far less personal worth, who merely aspire to be wealthy.

The other problem is that money garnered from the incomes of the wealthy won’t stretch very far.  If the government confiscates 100% of the taxable income of every taxpayer earning $500,000 or more, the take will be $1.03 trillion.  But the Obama administration is spending $3.6 trillion annually.  Most of it must come from the middle-income taxpayer.

A second utterance of Mr. Clinton related to the housing market: Rather than continuing to dump houses on a depressed market, they should be converted into rental property in an “aggressive and comprehensive way,” where the renters would simply pay the utilities, taxes and maintenance.  In short, the owners of the property receive nothing until “the economy picks up.”

I can visualize how this will work.  Government boards will be set up in every community in the nation to oversee and coordinate the program.  It will then evolve as did rent control in New York City, which began in 1943 under federal jurisdiction and continues to this day as a state function.  Over the decades a combination of systematic corruption and political patronage stripped apartment owners of their properties, making the local government the City’s foremost landlord.  There’s no reason to doubt history will repeat itself.

A final thought: Mr. Clinton is an affable gent with proven political credentials.  When he ventures into economics he’s out of his depth.