The Danger of Too Much Capital

Some women have been told they can be never too rich or too thin. In the financial regulatory world some say “you can never have too much capital.” After most market crashes, regulators call for more capital. In regulators' analyses, the firms that failed were under-capitalized. A careful examination of the failed firms showed that most had assets in excess of liabilities. They had merely made a misallocation of capital, often in relatively new areas that proved to be more illiquid than thought. Both Lehman Brothers and Bear Stearns had more assets than liabilities if their mortgages and real estate were properly marked.

What is of more concern to me is that often after a new surge in capital, firms, governments, and individuals make large new investments in areas “beyond their circle of competence,” to use Warren Buffett's phrase. As Wall Street firms moved from partnerships to corporations, regulators expressed a desire for permanent capital. This led to some firms going public, being acquired, or obtaining large strategic investors. Both Goldman Sachs and Morgan Stanley followed this route and built up capital businesses beyond their historical bases. Lehman and Bear Stearns were less successful in generating excess capital and were prone to using leverage. All of these firms were among the leaders in the arbitrage business which allowed them to take momentary advantage of unequal prices within markets. These skills were critical in the development of other proprietary trading activities using leverage. Because part of these trades involved being short certain securities, a culture of concern about counter parties evolved.

One of the lessons from both the arbitrage and the proprietary trading desks is when traders have too large a line of capital they take on more risk to earn a return on the enlarged capital base. This has often led to large losses. Governments also generate augmented capital. In ancient times this capital was from defeated countries. In modern days the augmented capital comes from the captive taxpayers. The results are the same, to allow the rulers to undertake new adventures or programs. In a similar way, when a family becomes rich beyond its legitimate needs it also takes on new initiatives. Understandably, this is one of the problems we deal with advising ultra high net worth families. However, it is more difficult with average net worth families, smaller companies and governments. More capital without more discipline is dangerous.

Applying this lesson to the selection of stocks, I would suggest that one should be wary of companies that have a great deal of excess capital. Disciplined investors should invest in disciplined companies.

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To Members of Mike Lipper's Blog Community:

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Will the Dodd-Frank (Obama) Legislation Lead to Higher Cost Financial Failures?

One of the advantages that arm-chair generals have over commanders is that they are not burdened with a great deal of facts. Of the many frightening items about this bill, one is how opaque it is. JP Morgan Chase, who lobbied against many elements of the bill, is reported to have assigned 100 teams to understand all the implications of this 2300 page piece of legislation, requiring at least 243 unwritten regulations to be promulgated. My guess is that by the time all of the regulations and administrative orders are published we could be dealing with 10,000 pages of texts to fight over.

My Initial Thoughts

Citizens, business people, and investors can not wait until clarity is established, if that ever happens. To provide some guidance in the aftermath of the new law the following are my initial thoughts:

1. I agree with Henry Paulson and Harvey Pitt that the law will not prevent another large financial crisis. The former Treasury Secretary and former chairman of Goldman Sachs guesses that a crisis will happen within the next six to ten years. For a Washington-based politician, the time frame is instructive. As the one Marine officer serving on board an attack troop transport, I heard various officers of the day (in command of the ship until the Captain retook command), say that what was critical was that nothing happened that was bad “on my watch.” Today the common expression is to “kick the can down the road.” In both cases the approach is to avoid having to deal with a problem and to let the next officer deal with the problem, not try to solve the problem from occurring. Harvey Pitt a brilliant lawyer and former chairman and staff member of the SEC believes the new law does not address a badly broken regulatory system. Further, he sees a brain drain from our large sophisticated financial institutions that will take the creative business to new organizations or to overseas providers.
   
   
2. My concern is that Tim Geithner, as the President of the New York Federal Reserve Bank, saw the collapse of Bear Stearns and Lehman happening in real time and was very much aware that Merrill Lynch could also have disappeared that weekend. The markets in the US and perhaps more significantly in London had already made their judgments that the firms assets were mispriced, and would not provide the crucial liquidity needed. Because these were publicly traded vehicles, the “bear raids” were a critical alarm. The new Council of Regulators will be made up of people who should have known from their own review of the firms’ books, or heard the loud rumors of the firms’ troubles. If under the new legislation they anticipate the problem to avoid the “not on my watch” syndrome, the firm and their employees could be destroyed. If they move too late we are no better off than our recent history. What comes out of the bill is that the Secretary of Treasury is the dominant force in the future. (Think about past persons in that post and do you want to give them the keys to the kingdom?) By putting an unwinding mechanism in place are we creating a moral hazard that will let big players gamble with the public’s money in a provision that is not afforded to the smaller players?
   
   
3. The claim that “It won’t be the public's money” would fail a beginning economics course. Yes, the surviving banks would have to refund the bailout to the public purse. As we live in a closed economic cycle, what do you think the banks will do on this further demand on their capital? We are already seeing the early results of the Card Act of 2009. In this case banks and credit card companies are restricted from various charges. What we are beginning to see instead is that the banks are just charging for other services, some of which were formerly free or required little or no balances. What may be worse, because it is more difficult to quantify, is a decline in the level of service. On an overall basis if the market wants a particular service it will be paid for either directly or indirectly.
   
   
4. In some ways the most insidious element of the Administration-sponsored bill is the creation of the Office of Minority and Women Inclusion which is to be established in 29 government agencies. This office will require all those who are government contractors and subcontractors to file reports as to their employee rosters. This requirement goes all the way down to office cleaning services. The answers to these questions undoubtedly will push vendors into hiring and promoting various minorities and women. Assuming that businesses are already hiring the best people they can, they will be forced to hire less qualified people which will in turn raise their costs or worse, reduce the level of service provided.
   
   
5. There are other far ranging provisions in the law and probably more in the required regulation. I suspect that the implications for our society are much larger than what we expected. Just like the so called health care reform which is a classic case of "not on my watch" syndrome of first the change and then the pain.

Portfolio Implications

How do we translate the legislative analysis into our portfolios? I would suggest the following are worthy of your consideration;

1. When others play a short term focused game such as “not on my watch” or one year performance, I play for the long term. My focus for my family and managed accounts is the likely lifetime, therefore I am looking to future generations, including in one account, the future generations of professional football players.
   
   
2. I assume that history will repeat itself so we will see financial crises and frauds. Thus some level of reserves could be good as a cushion regardless of the interest income earned.
   
   
3. Minor league games can be more enjoyable to watch than the majors. Translation: a significant portion of one’s equity account should be small companies and those who have graduated to mid size. (In general, I would resist “fallen angels” whose market capitalization has dropped back into the mid and small cap range.)
   
   
4. One of the major lessons from the financial crisis is that it was brought on by the regulators finally waking up to the changes in technology that caused the markets to operate differently. My response is to invest in change or even disruptive elements. This means not only technological innovators, but also early lead adaptors change.
   
   
5. Since the US government is increasingly unfriendly to capital on both a corporate and on an individual basis, an increase in investing overseas is perhaps warranted. You may already be doing so with your investment in US traded securities. Some estimate that roughly half the revenues of the S&P 500 come from overseas. I believe that earnings growth for these companies will be predominately earned outside the US. At some point you may wish to invest roughly the same portion of the world’s GDP as the US does, or roughly one-third.

Thank you for sending in your comments on our survey. Any others would be appreciated.


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To Members of Mike Lipper's Blog Community:

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IS THIS BLOG USEFUL?

As I approach the 100th posting to my blog, I would like to hear from you whether this is useful to your needs, if so, how?

Please take a moment to answer these three questions:

• Is this blog useful to your needs?
  
• Was any specific blog post particularly useful?
  
• What investment advice/counsel are you NOT receiving?
  

Please take a moment and Email me



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My goal has been to present thoughts on topics relevant to my family, to our clients, to the beneficiaries of our clients as well as to high net worth and ultra high net worth investors.

My previous 96 blog titles are listed below. Though each post is still viewable, the older pages may be difficult to navigate. If you would prefer, let me know in your reply Email, and I will send you a copy of any previous blog post(s) you would like to read.

• #96--The Declaration of Independence and Your Investments
  
  
• #95--Is Breaking Even Equal to Breaking Up?
  
  
• #94--Unpredictability and My Grandfather
  
  
• #93--Too Much Focus on Short Term Imponderables, Not Enough on Long Term Challenges and Opportunities
  
  
• #92--The Buyers’ Strike May Continue; Was Friday a Clue?
  
  
• #91--On Memorial Day, and the Future Leaders of the Investment Community
  
  
• #90--Unintended Consequences: Investors Again Lose to the Politicians
  
  
• #89--The Fork in the Road to Your Investment Policies
  
  
• #88--Why Didn’t We Buy? Did the Game Change?
  
  
• #87--Answers from Warren and Charlie - Omaha Highlights
  
  
• #86--Why Some Individual Investors Produce Better Results than Investment Committees
  
  
• #85--Too Much Reliance on FICC Can Be Dangerous
  
  
• #84--“The People” vs. the Economies and the Markets
  
  
• #83--Leadership Companies Are Not Always Leadership Stocks
  
  
• #82--Are We at a Turning Point or at a Vantage Point?
  
  
• #81--Twenty, Forty, Sixty: We are Going Global
  
  
• #80--A Rainy Weekend or a Prerequisite to a Future Bloom?
  
  
• #79--“End Game” Training for You and Your Heirs
  
  
• #78--When Warren Buffett Speaks About Investing, the Wealthy Should Listen
  
  
• #77--Connecting the Dots and Fears Are they Already in The Price?
  
  
• #76--Valentine’s Day Challenges for Ultra High Net Worth Investors
  
  
• #75--“Stop the World, I Want to Get Off,” I Don’t Want to be Global
  
  
• #74--The Price of Lack of Clarity on Your Investments
  
  
• #73--The Super Bowl and Fund Selection II
  
  
• #72--Enjoy a Laugh on My 10 Year Investment Plan
  
  
• #71--Investment Policies for Investment Personalities
  
  
• #70--The “Fifth Season” for Investors
  
  
• #69--Boxing Day and Bond Funds
  
  
• #68--More Positives than Negatives Ahead
  
  
• #67--Will it be Safer to Go Back Into the Water After the Financial Services Legislation?
  
  
• #66--W
  
  
• #65--The Good and the Bad about “Black Friday”
  
  
• #64--Changes to Risk Compensation and “Best Practices” Are They Barn Door Closers?
  
  
• #63--Post Mortem 2007-8 and Pre Mortem 201X
  
  
• #62--Winning Calls
  
  
• #61--Random Thoughts on November 1st
  
  
• #60--When Experience is not the Best Teacher
  
  
• #59--Are We Selling the US Too Short?
  
  
• #58--On Building Effective Investment Committees
  
  
• #57--Old Money vs. New Money Mistakes
  
  
• #56--Seven Steps For Giving to Charities
  
  
• #55--Wrong-Headline Risk
  
  
• #54--Who are Better Equipped to Make Decisions?
  
  
• #53--Searching for Innovations
  
  
• #52--Are We Gambling Too Much and Speculating Too Little?
  
  
• #51--Possible Implications of Statistical Traps
  
  
• #50--Setting Investment Goals Properly Through the Use of Science and Art
  
  
• #49--The Art Form of Selection for a Portfolio of Funds
  
  
• #48--I have met the enemy which has trained us.
  
  
• #47--Learn from London and Paris But Invest Creatively Elsewhere
  
  
• #46--Modified Behavior = Intervention vs. Newton
  
  
• #45--Can We be Independent?
  
  
• #44--The Temptation to Go Short
  
  
• #43--The Aging of the Uncertainty Principle
  
  
• #42--The Scots May Understand the Current Rally
  
  
• #41--Investment Lessons from the Belmont Stakes
  
  
• #40--Is the Tipping Point Cyclical, Secular or Both?
  How does this Influence the place of Real Estate in the Wealth Portfolio?
  
  
• #39--Anticipating Unintended Consequences or The Impact of MPG Efficiency on Inflation and Taxation
  
  
• #38--Supply and Demand for Homes is Different from Securities
  
  
• #37--Does Wealth Equal Freedom or Independence?
  
  
• #36--Could the “Stress Test” be a Big Trap?
  
  
• #35--Schooling vs. Education Charity Auctions vs. TARP and PPIP
  
  
• #34--Should We Appreciate Bonds? Part II
  
  
• #33--Relations and Correlations
  
  
• #32--Shrinking Discipline and Its Consequences
  
  
• #31--Should We Appreciate Bonds?
  
  
• #30--The Land of Re, Revisited
  
  
• #29--In the Land of Re
  
  
• #28--What We Can Learn from Mutual Funds
  
  
• #27--Lessons to all Investors from Warren Buffett’s Letter
  
  
• #26--Washington & the Necessary, But Insufficient, Signs of a Market Bottom
  
  
• #25--For the Greater Good: Frugality vs. Stimulus, T.A.R.P. and Foreclosure Relief
  
  
• #24--Financial Community Restructures
  
  
• #23--The Next Big One - FX
  
  
• #22--Searching for the Comfort of Cycles
  
  
• #21--Are There Big Traps in the Credits and Foreign Exchange Markets?
  
  
• #20--Did Fixed Income Confusion Create Madoff Victims?
  
  
• #19--Similarities in Picking the SUPER BOWL Winner and Fund Selection
  
  
• #18--General Misperceptions of “The Madoff Affair”
  
  
• #17--Correlations: Useful, Labels: Misleading.
  
  
• #16--Round Peg in Square Hole Produces Splinters
  
  
• #15--Four Aspects of a Four-Letter Word
  
  
• #14--An Attitude of Gratitude
  
  
• #13--Will 401(k) Miracle Help All Investors?
  
  
• #12--Reserve the Reserves
  
  
• #11--Augmented Unemployment Report Leads to Augmented Balance Sheets
  
  
• #10--Ultra High Net Worth Grantors & Charities: Plans “B”, “C” and “D”
  
  
• #9--Joe the Plumber and his Personal Financials
  
  
• #8--Turning Points Provide Hope for Everyone's Wealth
  
  
• #7--Fear is a Four Letter Word
  
  
• #6--Brilliance, Guilty and Bounce Back
  
  
• #5--Expect Unintended Consequences From This Weekend
  
  
• #4--Keep Your View Long Term
  
  
• #3--The Need for Speculators
  
  
• #2--Thursdays Down, Fridays Up
  
  
• #1--The Alphabet Bottom

____________________________________________
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at www.MikeLipper.blogspot.com.

The Declaration of Independence and Your Investments

Introspection is not one of the listed activities for usual July 4th celebrations though perhaps it should be, at least this year, in terms of your investments. Let’s start with the Declaration itself. The assertion of independence, among other elements, was to sever dependence on Great Britain with its laws and its world dominating Navy and Army. In the future these United States would be governed by our own laws and natural, perhaps God given, principles. In a much less dramatic way, the recent reactions to the global financial problems are similar to the yearning for freedom which was sweeping the world in the 18th century.

Changes going forward

There is a good chance that going forward the investment world will be as different as were the changes in the political world as a result of the first successful revolution to create a new country. In a small way the enactments of the “Dodd-Frank Wall Street Reform and Consumer Protection Act,” “Obamacare,” and the European and the Chinese austerity programs plus the investor reactions to these moves will change the investment world going forward in a similar way as did the American Revolution.

Two important aspects of the Declaration

There are two aspects of the Declaration of Independence which do not get enough attention. The first is the framers belief in “natural law.” They recognized the limitations of appropriate government authority. They looked primarily to our citizens to follow the recognized natural law of seeking the pursuit of happiness among other rights. Putting this natural law into perspective today, we need to recognize how people operate within markets not only for securities but also for a full array of goods and services. There will always be more and less popular items. The congregation of popularity can be handled in most markets. When popularity becomes extreme, the market structure will force a higher or lower price. As prices gyrate so does the temptation to take advantage of driven transactors. There are other natural laws, e.g. nine women can’t have a baby in one month.

The second aspect the Declaration I would like to emphasize is the 56 signers. They were all risk takers, not just 11 merchants but also the 24 lawyers or judges. They paid for taking the risk of rebelling against the most powerful nation in the world. Five of the signers were captured, tortured and killed as traitors. Twelve had their homes ransacked and burned. A number died destitute or bankrupt.

The important things to remember from our founding are that from the beginning we were risk takers and we would look to new laws. As a group we are used to unimaginable changes. (I believe this attitude should be incorporated in our portfolio thinking.)

Entitlements

However, the saga of the Declaration shows we are only willing to move ahead so far until proverbially, we kick the can down the road. In today’s terms, the issue that our Founders could not settle was an entitlement. We properly recognize it as slavery. For many it was a moral issue and for others an economic entitlement. With the coming austerity programs, I believe we are on a collision course with entitlements. Just as the issue of slavery in the US was settled with much loss of life in the Civil War (unlike the UK, where the issue was settled bloodlessly), I fear there will be high social costs to a cutback in entitlements. Some of these costs will be borne by investors.

Portfolio implications

With all of this as background, what should we do to prepare our portfolios for the post revolutionary phase? I would suggest the following as a general outline that needs to be adjusted for each investment account:

1. A large liquid tactical reserve.
   
2. Equities of companies that can adapt to change.
   
3. Investments in countries of savers who also have rising productivity.
   
4. I would avoid those “go anywhere” funds, not that the concept is faulty. The practice unfortunately is that these portfolio managers go back to the securities they are accustomed to. Very few of them learn new things.
   

Please share with me how you are preparing for the post regulatory revolution.

__________________________________________
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at www.MikeLipper.blogspot.com.