Category Archives: Taxes

Crisis of Confidence

I, through my firm, was a customer of PFG, the latest registered broker dealer to steal from its clients’ accounts – first reports indicate $200 million may have been taken.  This pattern is becoming too frequent. Innocent victims have lost money yet again.  How did it come to this?

Broken Markets

Self-regulation by an oligopoly… I don’t think there is any economist or politician who wanted this outcome, but special interests and lobbying have led to this.  This is how the futures industry works today.

Capitalism is broken without fair rule of law and regulation, and today top firms organize and self-regulate with practices that add cost but lack teeth. This discourages competition from smaller companies, but it also gives the largest companies free reign to raid their clients’ accounts and hide their crimes for years. So far it seems there is little or no accountability when they are discovered.

If market participants cannot expect basic protections, then they will leave, prices will fall, volume will shrink, and markets will whither.  Companies will have less access to capital and be exposed to more risk, and the economy and workers will suffer.  We’re already a long way down this path.

The economic ideal and the allure of free markets is only possible when regulation protects innocent market participants, minimizes fraud and cheating, and does not deter innovation. That means expanded domain of the SIPC, the SEC should have unlimited authority to monitor accounts and communication (opt-in would be fine), and companies should only minimally participate in their own oversight. With this structure, investors would be protected, transparency would reduce fraud, and free markets could flourish with competition and innovation.

Sounds obvious, but don’t hold your breath.

Corporate Corruption

There are a lot of types of corporate corruption, but they all start from an imbalance in power and oversight.  There is one tiny change could have a huge impact on this problem: allow shareholders to nominate people for elections of the Board of Directors of public companies.  It’s a small, seemingly obvious shareholder right, but it would have a big impact.

Management should not have the exclusive right to nominate their bosses. In fact, because the Board of Directors is supposed to represent the owners’ interest, it seems crazy that owners can not nominate. When the owners of a company are empowered to nominate Board members, management comes back under control, compensation comes back to reality, performance is scrutinized better, and the interests of investors are better served.

In private equity and smaller firms of every kind, this is always how it has worked.  Major shareholders often join Boards of private companies and nominate other Board members.  How public companies ever achieved the ability to control the Board nominations without rights for shareholders, I’ll never understand.

Too much

There are so many other ways that markets are broken and corruption is bringing us down.  Is it too much to fix?  Are we destined to watch for the rest of our lives as the emerging markets grow right past us and Americans fight amongst ourselves? Is our political and influence machinery too dogmatic or corrupt to embrace new good ideas together?

I’m not confident.

The Independent Globalist: an instruction manual

I drink your milkshake

You drank my milkshake!

Independent globalists optimize after-tax returns, labor, and supply chains into the tax and regulatory regimes that are most favorable.

It’s an optimization exercise and a chess game.  This seems to be the dominant strategy:

1) After-Tax Returns

The equation: taxes + regulation.   Taxes are simple; they reduce your profits by their rate.  Regulation is more complicated because it costs money to comply, but there are also opportunity costs from business activities that are no longer available.

The game: reduce and eliminate taxes and regulation.  Express the stresses of international competition to pressure national politics using one issue at a time in the countries where you do business.

2) Labor

The equation: salary + benefits, including long term commitments.  Retirement, health care, and other benefits have costs, but also may reduce employee turnover.

The game: reduce and eliminate costs within each role.  Divide operational units and move them to locations with optimal rules and costs.  Use the placement of these units to pressure politics to reduce labor’s collective bargaining rights.

3) Supply Chains

The equation: price.  Commodities and other non-labor costs are priced on global markets, and are mostly fungible.

The game: reduce and eliminate regulations that internalize costs of production for your suppliers.

Investors lost $2.5 Trillion on Monday – Policy?

Investors lost $2.5 Trillion on Monday because stock markets were down.  Who still thinks stimulus is a bad idea?  How can anyone argue that it is a bad investment to spend a few hundred billion in the form of infrastructure or other stimulus when the effects are 1000%+ in the form of rising market valuations across the economy.  Stock prices rise in value within minutes when stimulus is announced.  American Freedom does not eliminate our right to make great investments for our economy.

Policy makers – and the rest of us – should pay more attention to ROI.

Reconsider the Stimulus

I am fed up with the structure of the stimulus plan.  Bailing out failed banks is foolish when tax credits for mortgage payments would cut the foreclosure rate and fix the toxic debt.  Why ignore this easy and super-efficient tactic?

If I could recommend a specific plan, it would be to provide tax credits for up to $30k/year in mortgage payments for primary residences for the next 2 years. This relatively cheap solution maintains free market capitalism with all the good incentives, and would dramatically reduce the foreclosure rate — particularly for those paying less than $30k/year for their mortgages. The plan could be extended or expanded if necessary, of course.

The result would be a reduction in mortgage defaults, an increase in the value of mortgage backed securities (MBSs), and a recovery of the financial strength of the lending institutions and pensions that hold MBSs. Essentially, this would repair the cause of the credit crisis rather than throwing money away at the symptoms and rewarding failure.

As soon as it is announced, assumptions about foreclosure rates would fall, raising the value of MBSs the same day.

The Credit Crunch and the Market

[Download the complete article in PDF format, with charts and better formatting]

The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.


The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a “contagion”.

The “Greenspan put” was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the “animal spirits” of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

  • Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
  • A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

Outside-the-box Economics

The US, Japan, and other countries have converging economic policies which are not optimally stimulating growth within their national economies. The following is an attempt to eliminate inefficiencies and improve incentives: a discussion point, not a recommendation.

Eliminate all taxes, and print the money that the government needs to handle it’s budget. Tax would be implied by the inflation of the currency. The US government’s annual budget of $1.864 Trillion in 2001 represents a small portion of the total US assets and capital. I don’t know the total number–I’m not sure if anyone does–however, GDP in the US is $9.8 Trillion. With a total US currency capital base of only twice GDP, the marginal increase in money supply would be about 10%. M3 (The broadest indicator of money supply, including bank deposits and money-market mutual funds) rose by almost 14%, year-on-year, to the end of October, 2001, meaning that the US gov’t annual budget would add another 42% to the increase in M3. Meanwhile inflation is about 3%. If we increase the inflation rate by the same factor, we get 4.25% inflation. And no taxes.

The stimulation of the economy would be furious for a few reasons: 1) Elimination of taxes increases disposable income by 50% (assuming 33% average tax, which is probably low), 2) an increase in inflationary expectations creates an increase in spending, and 3) enormous increases in efficiency.

In terms of efficiency, the entire IRS and tax calculation and collection processes would be unnecessary. In addition, the legal complication surrounding estate taxes, loopholes, alternative minimum taxes (AMT), purchase basis tracking, tax avoidance, foreign tax safe-havens, audits, etc. would become unnecessary.

Sales taxes, including targeted taxes to discourage some goods or behaviors could (and should) still be used.

Currently, there is no tax on wealth. Instead, taxes are paid for income, sales, and other movements of capital. The current mechanism creates an inefficiency in a huge range of transactions. Inflation, on the other hand, is an effective tax on wealth, and in doing so, eliminates the inefficiency on transactions while discouraging hoarding and encouraging investment and spending.

The base of wealth is so much higher than the base of incomes that taxing wealth can bring in the same revenues with a much lower tax rate. Closing all the loopholes and eliminating inefficiencies should also boost tax revenues substantially.

The U.S. Government should implement an Investment Company, Financed by a Federal Corporate Income Tax

Technology has changed market dynamics, and new economies of scale are making it increasingly hard for small businesses to compete.  National and international communications and transportation have increased the global nature of businesses, so scale and international optimization of supply chains make enormous advantage for the largest businesses. Another important example is the nearly infinite ratio of fixed to marginal costs in information businesses that leads to increasing pressure toward consolidation.  Meanwhile, the value of public companies shifting from 40% intangible assets in 1996 to 75% in 2000. These forces push toward anticompetitive oligopolies, and are newly strengthened because of the new communications and transportation infrastructures.

Unfortunately, when you combine the globalizing economy with massive consolidation pressures, the natural equilibrium is a monopoly.  A monopoly can act in its own best interest and harm consumers.  America has a long history of working to ensure consumer markets remain competitive.

If you want to reduce the burden on the Federal Trade Commission lawyers, then we should implement a structural incentive that acts to offset any negative changes in the economic dynamics.   Specifically, we could create a new incentive for competitive markets.

This can be achieved with a progressive federal corporate income tax that finances an investment company and, in turn, finances companies that can improve competitive pricing or innovate.   The progressive tax could begin at a high profit level so that competition would be encouraged. Not a very popular suggestion among stockholders in the largest corporations, I suspect, but the benefit in the long run would be very great.

Necessity is the mother of invention, and monopolists can sustain their position with far less innovation than occurs in competitive markets. We will see advancements in communications, transportation, environmental protections, health care, entertainment, safety, and even life span. These innovations will occur inevitably, but it is our decision as a society how we structure ourselves to best approach this evolution.

Note – The Government-financed investment company should probably be independent in a similar model to the federal reserve.

Note – The competitive application for the funds of the Government-financed investment company avoids the incentive problems associated with socialist policies.

Note – The investment company would consist of many competing portfolios, managed by accountable teams, and with regular culling of underperformers.

Note – This would be a particularly effective economic stimulus mechanism because it supports high velocity of money in productive markets and more directly drives employment.

Note – The enormous potential financial gain from the investment company would be reinvested and used to reduce corporate, individual, and other tax rates.  It has the potential to create a self-financing government.

Note – The investments of the investment company would be direct – new equity or debt capital – not the purchase of existing securities.