Everything You Always Wanted to Know About Roth IRA's *But Were Afraid to Ask

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Note: The following article touches on tax aspects of certain investments. Mr. Szabo is not offering tax advice. The article is not a substitute for the expert tax advice that an accountant or tax lawyer might customize to meet the needs of an individual client.

Q. Why would I want to contribute to a Roth IRA in the first place rather than to traditional retirement plan?
A. It depends whether you expect to do better contributing pre-tax dollars or post-tax dollars. Traditional qualifying retirement plans include the traditional IRA, SEPP IRA, 401(k), 403(b) [for non-profit entities] and 457(b) [for government entities]. You can make contributions to such plans from income without paying any federal or state income tax—subject to restrictions—although you do have to pay Social Security and Medicare withholding tax. In such plans, you must begin mandatory distributions from such plans no later than the age of 70 1/2. Any distributions will be taxed as ordinary income, even if some of those same distributions would otherwise be eligible for preferred tax treatment as long term capital gains. In contrast, with a Roth IRA, you make contributions post income tax, but any distributions in retirement are entirely free of income tax, including those that would otherwise be taxable as interest and dividends or short- or long-term capital gains.

Q. When does it make sense to contribute to a Roth rather than to a traditional retirement plan?
A. Mainly, if you think you will be investing for a long period of time and/or if you think your marginal tax rate will be relatively high at the time you take distributions, then you may want to maximize your Roth contributions relative to retirement plans.

Q. Are there any other advantages to the Roth format?
A. Yes. There are no mandatory distributions, so you can maintain your investments in the account as long as you wish. Also, with traditional IRA's, most early withdrawals face full income tax plus a 10% penalty. With the Roth, you may first withdraw all your regular and conversion contributions free of tax or penalty. You can make further withdrawals without penalty if you have reached age 59 ½ and your Roth has been established at least five years before. Finally, as Roth IRA's contain post-tax dollars, they effectively pack in more in useable assets for retirement.

Q. What has been the main obstacle in the past for investors to build Roth retirement accounts?A. The main obstacle has been highly restrictive income qualifying tests and small annual contribution limits.

Q. What are the current limits for contribution to a Roth IRA?
A. You can contribution as much as $5,000 for the 2009 tax year (or $6,000 if you reach 50 or older by the end of the tax year, a so-called "catch-up contribution"). However, you must have "qualifying income" at least equal to the amount contributed. What's more, to make the maximum allowable contribution, your modified adjusted gross income cannot be greater than $101,000 for single individuals and $159,000 for married couples filing joint returns; above these limits, your contribution limits quickly fade down to zero.

Q. Are there any ways to mitigate the tax bite resulting from a Roth IRA conversion?
A. Generally speaking, there are very few allowable mean of creating deductions to offset the gains from Roth IRA conversion. However, one strategy that could be very potent is to harvest deductions from investment in independent oil and gas drilling partnerships. While such deals can be attractive, they require a serious due diligence effort. I steer clients away from wildcat or highly speculative drilling efforts. Instead, I recommend focusing on so-called "fully blanketed formations," in which drilling will commence adjacent wells that have proved productive. Deductions from such investments for intangible drilling costs typically comprise 70% to 85% of initial investment. The deduction may be taken in year one or spread over a term of years. There is also a 15% exclusion of oil and gas income under the Oil and Gas Depletion Allwance. Moreover, in the case of independent oil and gas drillers, as defined under the IRS Code, Congress has provided significant relief from the danger of being taxed under unfavorable Alternative Minimum Tax (AMT); in many cases, investment will reduce calculated AMT income or even prevent taxation under the AMT regime. I am glad to discuss such matters with your accountant.

Q. I fear that federal and state income taxes will rise significantly in the coming years. Should this affect my decision on whether to convert to a Roth IRA?
A. If you expect to be a taxpayer in the years when you take distributions from a retirement account, and if you expect to be in a high tax bracket at that time, then your fear of higher tax rates is very relevant to your decision. In fact, the bigger the increase you expect in federal and state marginal tax rates, the greater will be your motivation to convert to a Roth IRA at this time. Your decision, of course, may be affected by the tax impact in the current tax year of making the Roth conversion.

Q. Is there any special reason why I should convert in 2010, rather than wait?
A. Yes. For the year 2010 only, Congress has provided an opportunity to defer any income from the conversion. This deferred income can then be spread evenly between tax years 2011 and 2012. After 2010, you will face the full tax bite in the same year as conversion.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/. Securities offered only through Choice Investments, Inc., headquartered in Austin, TX; Member FINRA/SIPC.

Last Lap on Health Care Reform

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The House and Senate have finally passed their different versions of health care reform. The two chambers now must now work out a bill that is acceptable to both sides, a messy process that legislators call "reconciliation."

The final vote in each house was straight party line, with the Democrats forced to make many compromises to keep their own cadres in line. In the Senate discussions, a recalcitrant Senator Lieberman (elected as an independent, after his Democratic primary defeat in 2008, he wields leverage as a swing vote) finally helped kill the last residue of a "public option." The House meanwhile passed a greatly watered down public option that also failed to impress or satisfy many liberals. Do not expect any form of government sponsored and administered health care insurance to make it out of the reconciliation process.

Many commentators are skeptical of the cost estimates offered by the Administration. This skepticism is warranted. The two bills differ significantly on the issue of how to pay for insuring additional citizens. As noted in the most recent issue (December 30th) of the Economist, the Administration seeks to limit marginal budgetary costs related to the reform to about $900 billion over the next ten years. The House version imposes on 5.4% surtax on those earning more than $500,000 per year. The Senate bill instead imposes a 40% tax on highly subsidized health care plans offered by corporate employers. Note that projected tax revenues from the Senate version are partly illusory, as soaking the best health care plans would create an incentive for companies to offer less generous ones (possibly replacing that benefit with others), an unintended but logical result of such ploys.

Opponents of abortion have inserted riders that could cause private insurers to deny health coverage for abortions or face loss of federal health care subsidies. The House bill is the more restrictive on this issue. This issue is so incendiary that some commentators think negotiations over it could scuttle the whole legislation. More likely, some bill will emerge during January for the President to sign before his State of the Union address, but it will not cheer supporters of abortion rights. President Obama has put so much of his political capital in the health care legislative effort that he can ill afford to let it collapse.

One great problem not addressed by either bill is health care for undocumented non-citizens. In our economy (both industrial and agricultural), employers rely heavily on immigrant labor. Many households and small businesses also rely on this pool of low wage, no overhead, hard working laborers, as anyone who drives through Port Chester or Stamford in the morning can attest. Our immigration system badly needs reform. To be competitive in an era of high technology, we are best served to attract the smartest people in the world, regardless of origin, particularly including scientists, engineers and, indeed, doctors. Our system is biased instead toward the doctrine of "reuniting families." Undocumented residents and their families, like many of our poor citizens, fall through the health care net. When uninsured people present themselves for care at emergency rooms, hospitals face a terrible dilemma. We need to address this problem at a national level, not dump it on the local hospitals.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail ASzabo@choiceami.com). For more information, please visit http://greenwichfinancial.com/. Securities offered exclusively through Choice Investments, Inc. of Austin, TX, member FINRA/SIPC.

Oil and Gas Investment Partnerships, 3: Questions and Answers

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Note: To receive sophisticated tax advice suitable to your situation, please consult with your investment advisor, accountant or tax lawyer. This column does not present expert tax advice.

Q. For what sorts of investor might an oil and gas drilling partnership be suitable?
A. These are partnerships designed to bring together sponsors with experience in oil and gas drilling with investors seeking to participate in the risks and rewards of drilling. They are most suitable for accredited individual investors paying US income taxes in a high marginal tax bracket and who have ample financial liquidity set aside.

Q. What is an accredited individual investor?
A. An individual with at least $1 million in net worth (alone or together with spouse) or $200,000 in annual income ($300,000 if filing jointly with spouse). (For greater detail, please visit: Definition of Accredited Investor, at SEC Website).

Q. What kind of drilling risk does such an investor take?
A. There are broadly, three kinds of drilling partnerships, depending on the goal: exploratory, developmental and mature. Exploratory deals take the most drilling risk; mature deals the least. For many investors, development deals offer the best mix of risk, reward and tax benefits.

Q. What kinds of geological risks are faced by investors in a developmental deal?
A. One particularly favorable set of risks involves “fully blanketed formations,” where drilling is adjacent to, just above, just below, or sandwiched between known pockets of oil and gas. In many such efforts, the risk that any single drilling will result in a dry hole is estimated at less than 5%. Geographical diversity of drilling lessens aggregate risk. There is potential environmental cost, including water treatment and land reclamation. Another favorable set of risks involves drilling within a limited region whose perimeters include productive wellheads.

Q. What are the potential tax benefits of such partnerships?
A. The tax benefits include deductions for intangible drilling costs (IDC’s), tangible drilling costs, oil depreciation allowance, and write-offs for abandoned wells (if any, minus salvage value). Most exploratory and developmental deals offer opportunities to take tax deductions of about 80% of total invested amount in the first year of investment. Such investment must be made by December 31st of the tax year to qualify. Partnership income is generally excludable from taxes, in part, under the oil depletion allowance and other provisions of the tax code. Investors must take heed of the Alternative Minimum Tax (AMT) in relation to the intangible drilling costs, if taken all in the first year rather than capitalized over five years; however, there is a 40% safe harbor exclusion.

Q. Why are these tax benefits available?
A. Such benefits, including the Mineral Depreciation Allowance, have a long legislative history. Broadly speaking, Congress intended to encourage extraction of domestic mineral resources. In recent years, this has been reinforced by a desire to reduce our dependence on imported oil and gas. Oil and gas drilling by independent producers (and their investment partners) has been particularly favored in its tax treatment. Such officially sanctioned tax incentives, properly employed, should be distinguished from abusive tax shelters based on gimmicks and supposed “loopholes” in the tax code.

Q. What category of partnership risk does the investor take?
A. If the investor is seeking to offset passive income, such as from rents, the investor may go in as a limited partner from the start; risk is limited to loss of investment. If the investor seeks to offset ordinary income, or portfolio income, then the investor must go in as general partner and face unlimited liability. However, in many deals of this sort, there is provision for conversion from general to limited partner status after an initial interval has passed, such as one year. Most investors go in initially as general partners.

Q. What other partnership risks does the investor take?
A. There are potential conflicts of interest for the sponsor between its role as managing general partner of the partnership and its role as acquirer of leasehold interests, seller of drilling services or supplies, receiver of certain fees and interests upfront, and sponsor of other activities or transactions. There are also issues of partnership governance and the typical problems faced by minority investors in any entity.

Q. Where can I find disclosure of the risks and rewards of an oil and gas partnership?
A. The definitive source of information is contained in the Private Placement Memorandum (PPM). This document will include or be accompanied by a Subscription Agreement, if you should decide to invest. Do not rely on oral representations.

Q. How do I recover my investment?
A. A portion of the recovery may come from tax benefits, including IDC’s received in Year One. Payout from oil and gas drilling is more or less predictable depending on the nature of the risk taken: exploratory, developmental or mature. Most development style deals experience “payback” of initial investment (in nominal terms) within three to five years, but of course this is not guaranteed. Residual payout may continue up to 20 years; the so-called “decline curve” varies from deal to deal and is not entirely predictable.

Q. What characteristics distinguish a high quality sponsor?
A. One of the most important characteristics of a highly qualified sponsor is a track record of successful past deals, with attractive returns shown over time for investment partners. Be wary of the risk of bogus or fraudulent transactions by unknown or unreliable sponsors. Investigation, expert advice and due diligence are essential.

Q. How do I understand the risk presented by fluctuating commodity prices?
A. The price of oil and gas, and the percentage of each produced, will directly affect the dividend payout (usually monthly) to partners from successful production. The Sensitivity Analysis, which should be found in the PPM, shows in tabular form how the investor’s rate of return on investment will likely be affected by such fluctuations.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Oil and Gas Investment Partnernerships: 2. Sensitivity Analysis

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

As we have written recently, oil and gas drilling partnerships, properly structured and managed, offer several layers of tax benefits for high income taxpayers, while also enjoying potentially high investment returns.

As to tax benefits, the Mineral Depreciation Allowance is one of those “orthodox” tax incentives that we have contrasted favorably with abusive tax shelters; it was enacted by Congress to encourage domestic mineral extraction. See Mineral Depreciation Allowance: Oil and Gas Depletion Incentives for Taxpayers. For historical and political reasons, the treatment of oil and gas exploration by independent producers, and for limited partners of such producers, is particularly favorable. The tax benefits may include deductions for Intangible Drilling Costs (IDC’s) in year one, typically equal to 80% to 95% of the invested amount, tangible drillings costs, and percentage depletion allowance (under the Oil Depletion Allowance)or cost depletion allowance. Further, for abandoned wells, there are generous provisions in the Internal Revenue Code allowing the deduction of remaining equipment and leasehold costs, minus salvage value.

If we look at these partnerships as an investment, aside from the tax incentives provided by the government, one important aspect of risk and return to consider is the market price of oil and gas.

Oil and gas partnerships are generally distributed to investors via a private placement offering. The private placement memorandum (PPM) is the legal document describing the offering. There may also be a related selling memorandum, which should be read in conjunction with the PPM. The PPM usually includes—and ought to include—projections of total investment return based on oil and gas price fluctuations. This “sensitivity analysis” or “sensitivity study” gives the investor a framework for understanding risk exposure to fluctuations in the prices of these commodities. We may define a sensitivity analysis as one that examines the effect of some investment variable(s) on the expected investment return. The return will typically be measured as an internal rate of return (IRR), such as 20% per year, as one measures the yield on a bond. Although it’s often placed in the back, as an appendix, and consists of tables of numbers, the sensitivity analysis is one of the most important parts of the PPM for the investor to consider—so don’t let your eyes glaze over!

Frequently, the output from a wellhead includes both oil and gas. Typically, the gas is captured first. Usually, the sensitivity analysis will include some pairing of an oil price and a price for natural gas. Here, for example, is a sensitivity analysis from a current deal that I am studying. It assumes the average of the "high" and "low" cases for wellhead oil and gas flow. I will not cite the deal’s sponsor, however, as my purpose in this article is educational, not promotional. Notably, the returns quoted do not include any of the potential tax savings to a taxpaying investor.

Sensitivity Analysis: For a Texas-based Drilling Program

Price of oil ($ per barrel)	Natural gas ($ per MCF)	Projected Annual Return (%)
$40	$3	14.92%
$70	$5	26.03%
$100	$7	37.13%
$130	$9	48.23%

So, for example, on the low side, the sensitivity analysis suggests that in aggregate, for the drilling projects proposed, a crude oil price of $40.00 per barrel, in tandem with a price of natural gas of $3.00 per thousand cubic feet, predicts an investment return on the partnership (not including tax benefits) of 14.92%. Similarly, a price of oil of $100.00 per barrel, and natural gas of $7.00 per thousand cubic feet, predicts an investment return on the partnership (not including tax benefits) of 37.13%. Compare these prices with current trading levels. NYMEX crude future are currently trading at $70 to $71 per barrel (down from 2008 levels as high as $147.27), and natural gas is trading at about $5.43 per thousand cubic feet (down from 2008 levels as high as $15 per million cubic feet). By contrast, looking ahead only two to three years, I believe that the price of both commodities, owing to the forces of supply and demand, will be substantially above current levels; however, there can be no certainty as to such forecasts.

The sensitivity study, by pairing the price of oil and natural gas, makes a simplifying assumption about the inter-relationship of oil and gas prices that will rarely prove true. Nevertheless, there is obviously some correlation between the price of the two commodities, and they are somewhat substitutable. For example, there are utilities with duel-firing burners, who can switch opportunistically between oil and natural gas.

There are assumptions built into the sensitivity analysis regarding the success rate of drilling (which is in part a geological problem), the timing of success, the degree of success, and operational expenses. Each of these merits further study. We will publish separate articles regarding geological risk and operational expenses.

The bottom line is that (at current market level prices of oil and natural gas) there is a safety margin in the illustrated deal for a very significant decline in prices (of either commodity) before projected IRR’s fall below the teens, let alone make losses. Even the lower end of the range of projected returns--combined with the tax benefit, much of which occurs in year one--is attractive.

Note: To receive sophisticated tax advice suitable to your situation, please consult with your investment advisor, accountant or tax lawyer. This column does not present expert tax advice.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Independent Oil and Gas Partnerships: 1. Tax Incentives

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

There are three types of structured investments that seek to reduce tax burden, of which only one is prudent. The first, call it the “Too Clever” approach, seeks inconsistencies or loopholes in the Internal Revenue Code and accompanying regulations and rulings. The Too Clever game, sometimes played even by major accounting and law firms (they may later regret it), exploits an unanticipated situation. Since the taxes code is complex and changing, such opportunities spring up all the time. The IRS often whips both sponsors and participants in such schemes. The second approach, call it “Orthodox,” works with incentives that Congress explicitly intended to provide to taxpayers. If properly handled, such structures fulfill legislative intentions to accomplish cherished social goals and are virtually unassailable by tax authorities. The third approach, “Too Much of a Good Thing,” works with a sanctioned or orthodox tax incentive, but stretches it too far through aggressive interpretation or leverage, or it combines elements of the Too Clever and the Orthodox approaches.

The Mineral Depreciation Allowance, which encompasses oil and gas depletion allowances, is an example of a well-established tax incentive with a long history. Congress enacted such allowances because it wished to encourage exploration and extraction of various natural resources. Investment banks structure partnership deals that allow individual investors to participate. Not all such deals are legitimate or sound, but there is at least the potential to find mineral depreciation deals in the “Orthodox” category that also pass muster as investments, and which are suitable for high bracket taxpayers (only). Such investments may be particularly worthwhile, if: 1. underlying project economics are sound, 2. the sponsor has a strong track record, 3. upward price pressure continues on extracted minerals, e.g. oil (as is implied by futures markets for crude oil, natural gas, gasoline and heating oil), and 4. the highest marginal federal income tax rates remain the same or climb higher, which is very likely.

Mineral depreciation deals are structured in tax pass-through entities. For example, there is a limited partnership, and you as an investor become a limited partner. Or it may be a limited liability company (LLC), and you will have membership interests therein, and there will be a Managing Member. Unlike a corporation, there is no risk of double taxation; the tax impact passes through pro rata to the individual partners.

Mineral depreciation deals fall into three categories, depending on the degree of geological risk: exploratory, developmental and income. Only the first two types provide significant tax advantages. Exploratory deals entail the highest risk (and potential return). However, in many developmental deals, up to 10% of the proceeds may be used for exploration.

There are several types of risk that you may face in the underlying project. The first, of course, is that the project drills a “dry hole.” The second is that a strike is made, but the well’s performance subsequently lags or is mismanaged. A third risk is environmental, for example, a natural gas site may require dewatering, and the Bureau of Land Management may delay approval of a water treatment plan. A fourth risk is timing: the development may take longer than expected to deliver cash flow. A fifth risk, sometimes tied to the fourth, is that project costs outrun estimates. A sixth risk is that the price of the extracted raw material declines to a level where the project becomes uneconomic.

An important metric to look at is the sponsor’s past success in delivering returns to investors. As with mutual funds, of course, past performance is no guarantee of future results.

There are several stages of potential tax benefits. The first stage offers tax deductions from intangible drilling costs (IDC’s). Second, there will be the opportunity to offset taxable income from the partnership, in part, with tax deductions from “percentage depletion,” a more investor-favorable method than "cost depletion." These depreciation rates for mineral extraction are attractive; for uranium, the rate is 22% per annum, for oil and gas, 15%, and for coal, 10%. For oil and gas properties, percentage depletion may be taken up to 100% of net income; for other resources, the limit is 50% of net income, except for geothermal production, where there is a 65% limit. They may be taken by two methods: cost depletion or percentage depletion. There will also be writeoff of tangible drilling costs (everything with salvage value). Third, for abandoned wells, there are generous provisions in the Internal Revenue Code allowing the deduction of remaining equipment and leasehold costs, minus salvage value.
Keep in mind that the revenues flowing from your investment will be taxable, in the proportion not protected by the oil depletion allowance or other deductions, and there is no exemption according to the notion of return of principal on your investment. However, there are few other investment opportunities that provide such sizable tax deductions upon initiation. The total tax deductions in most cases should significantly exceed the principal invested, and from a present value perspective, the available of the IDC deduction upon commencement of drilling operations has a large present value advantage, particularly if your earnings in the current tax year are unusually high.

The favorable tax treatment of oil gas extraction in particular--as to percentage depletion rules, for example--reflects the clout of the oil and gas lobby as well as the perception in Congress that greater extraction of these minerals is vital to the national interest.

Keep in mind the economic reality--not just the tax rule--that the asset is depreciating (losing remainder value). Your return will depend on the overall recovery over a period of years, versus the ongoing costs. Improvements in technology, or further discoveries, could also extend the life of your asset or increase the rate of extraction.

The IDC’s in year one usually amount to about 80% to 90% of the investment, deductible in the current tax year for projects that actually commence the contemplated drilling the following year. Thus, there is a December 31st deadline for investment in projects that potentially would yield IDC’s for the current tax year. For this reason, there is usually a burst of demand for such projects toward the end of each calendar year; however, there is the danger of lack of availability of desirable projects if one waits too long.
The upfront tax benefit from IDC’s can reduce the overall risk substantially. The value of the deduction depends on your tax bracket. If you are paying a marginal federal tax rate of 35%, and you buy a unit of $100,000, the deduction of $90,000 could create a tax savings of $31,500. Limited partners can only offset the IDC’s against passive income (such as from rentals). If you undertake general partner risk, then generally you can deduct against ordinary income. In some deals, you come in as an investor general partner in year one, but later you convert to limited partner, which reduces risk.
One other issue deserving diligence is the hoary Alternative Minimum Tax (AMT). AMT analysis applies to the IDC’s but not to the percentage depletion, fortunately. A favorable factor for royalty recipients is that IDC's are not generally includable in the AMT calculation unless they exceed 40% of total AMT income. Your accountant can calculate a "safe harbor" investment within the 40% rule or within a margin over 40% but before you become subject to AMT.

There are potential conflicts of interest and tensions in any investment partnership. There are actions that the managing general partner may take that could harm the limited partners. There is a concern that the managing general partner could favor the interests of the deal sponsor over the limited partners, or that the managing general partner could favor one set of limited partners over another. You will find language in the private placement memorandum, and in the underlying operating agreement of the partnership, addressing these concerns.

The total return from investment in the partnership, including tax benefits, is typically projected to be between two and three times the initial investment. Note that this return will be highly sensitive to the price of the mineral extracted. You should look in the private placement memorandum for a “sensitivity analysis” that shows how changes in the price of the raw material could affect your return. You will find (for most recent deals) that if current prices of oil and gas merely are maintained, the potential returns are quite robust.

Note: To receive sophisticated tax advice suitable to your situation, please consult with your investment advisor, accountant or tax lawyer. This column does not present expert tax advice.

Note: To receive sophisticated tax advice suitable to your situation, please consult with your investment advisor, accountant or tax lawyer. This column does not present expert tax advice.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

How to Get Energy-Related Tax Breaks

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Many taxpayers are not fully aware of the range of incentives—some placed into law during 2008 and 2009—related to energy. There are significant incentives both for individual consumers and for businesses. Not all of these programs make good economic sense. Indeed, some of these incentives, by tilting toward Congress' view of the most desirable forms of energy production and conservation, probably represent an unwise meddling with market mechanisms. However, as a taxpayer, you are entitled to claim such benefits as Congress intends and makes available to you.

Please keep in mind this important distinction. A federal tax credit is a direct offset of federal taxes owed. A federal tax deduction is an offset to income earned, whose value will depend on a person's marginal tax rate for federal income tax in the relevant tax year. A tax credit is more valuable than an equivalent deduction because it reduces your tax bill dollar for dollar.

Here are some of the principal tax incentives:

• Home energy efficiency. There is a tax credit for 30% of the cost of materials (only) used to make energy saving improvements in home heating, water heating and cooling. Regarding insulation, these improvements can also include eligible replacement storm windows, storm doors, skylights, window films, the sealing of cracks, and the use of certain asphalt roofing materials with cooling granules. The cap is $1500 for the combined tax years 2009 and 2010, for either new or existing homes. With renewable energy sources—such as photovoltaic, geothermal heat exchange, wind, fuel cell, or solar/hot water systems--the cap does not apply. See The Green Destination.com Website. Concerning tax filing, see Residential Energy Efficient Tax Credit, IRS Form 5695. Though you don't need to submit it, make sure to keep the manufacturer's energy efficient certification in your tax records in case of audit.
  
  
• Incentives for home builders. Home builders whose homes are certified to exceed national model energy codes by 50% or more are eligible to receive special tax credits. EnergyTaxIncentives.Org Website.
  
  
• Fuel efficient vehicles. There are tax credits available for certain hybrid, lean fuel, alternative fuel and plug-in (such as the coming Chevrolet Volt) vehicles, as well as for hybrid electric conversion kits. However, there are phase-outs after a manufacturer has reached certain volume thresholds. See Alternative Motor Vehicle Credit, IRS Form 8910. Thus, Honda and Toyota have already exhausted these phase-out limits for their gasoline-electric hybrid vehicles. There is also a 10% tax credit, up to a $2,500 limit, for certain low speed and two or three wheel electric vehicles. See Department of Energy - Tax Breaks.
  
  
• Appliances. Some manufacturers of energy efficient appliances offer rebates or promotions to customers. These may represent in part special promotions made possible by government tax incentives for the manufacturers. See EnergyStar.Gov Website to find retail offers available in ones zip code area.
  
  
• Incentives for Oil and Gas Exploration. These are the grand-daddies of energy tax incentives. As we will discuss further in the next article, there are very significant tax deductions potentially available for investment in independent oil and gas exploration partnerships in the United States. These include deductions for intangible and tangible drilling costs, the mineral depletion allowance, and write-offs for abandoned wells. These deductions can offset, according to the position one assumes in such partnerships, either ordinary income (such as salary) or passive income (such as rent).

Note: To receive sophisticated tax advice suitable to your situation, please consult with your investment advisor, accountant or tax lawyer. This column does not present expert tax advice.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

The National Debt Snowballs

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The lead article in the November 23rd issue of the New York Times was titled, "Federal Government Faces Balloon in Debt Payments." The article discusses how US Treasury officials are rushing to finance US debt for the long term at today's low rates. The national debt now exceeds $12 trillion. So far, the article noted, the world has been glad to take a heaping portion of our Treasury securities at such rates. But what if that appetite becomes sated? What's more, the Fed's role in containing inflation may come into conflict with the need of the US Treasury to keep interest costs low. In such a dilemma, the US dollar may become an unattractive asset for foreigners to hold.

People often confuse the federal debt with the federal deficit. The deficit is the annual shortfall. The debt is the cumulative amount owed. Another point of confusion is between real numbers (inflation adjusted) and nominal dollars. The most telling way to look at a nation's debt is in relation to its Gross Domestic Product (GDP), the sum of all the final goods and services created within the borders of an economy in a given year.

In September and October of 2004, we published a series of articles in this newspaper about the federal deficit. These are still available on the GreenwichFinancial.com Website. See The National Debt. We commented at the time that the policies of the Bush Administration--which involved cutting taxes, dramatically raising spending, and funding two overseas wars using gimmicky off-balance sheet financing—created fiscal perils for the future.

To see the estimated US debt in real time, here is a link: http://www.usdebtclock.org/. Currently, the debt represents about $40,000 per US citizen or about $110,000 per taxpayer. Currently, our debt amounts to about 95% of GDP. At the time of our September 2004 article, that ratio was a much more manageable 65.3%. The all-time high was hit just after World War II: 121.7%.

More recently, at the tail end of the Bush Administration and into the Obama Administration, we have initiated programs to bail out failing banks, insurance companies and automobile manufacturers. We are also using massive deficit financing to stimulate the economy, following a Keynesian anti-cyclical program. Arguably, it has been successful; we have averted a worldwide depression and are now starting to emerge from a recession.

Some may be familiar with "the national debt clock" that ticks on a billboard nearTimes Square. The clock measures the total estimated national debt, measured moment to moment, and it also estimated each family's share in this debt. When first plugged in 1989, the clock increased at a pace of $13,000 per second, and the right-hand numbers were a blur. In 1999, it began to decrease, after the Clinton Administration announced a reduction in the national debt via a series of buybacks of outstanding Treasury bonds. In its final display before being unplugged on September 7, 2000, the sign read: "Our national debt: $5,676,989,904,887. Your family share: $73,733." The sponsor decided to take down the sign because the backward direction might lead to complacency, the opposite of their aim. But the clock was reconnected on July 11th of 2004, as the national debt started to accelerate under the George W. Bush administration. The clock will soon be refurbished to allow it to display a quadrillion dollars (one thousand trillion!).

Regarding what would happen in the long run if governments use deficit spending to counteract a collapse in demand, economist John Maynard Keynes famously remarked, "In the long run, we are all dead." However, our children and grand-children may not be dead. The part of Keynesianism that is often forgotten is that it makes good sense to reduce national debt during times of prosperity. That was the salutary policy that was beginning to be followed by President Clinton. However, after that came the NASDAQ collapse in 2000, the 9/11 tragedy, and President Bush's allegiance to the doctrines of supply side economics. Ironically, in our quest to strengthen America militarily and economically, we so weakened our Treasury that real danger now lies ahead to our international standing.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Should You Convert to a Roth IRA?

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

With a Roth IRA, contributions are not deductible, but—beginning at age 59 ½--distributions can be taken income tax free. Also, there are no required minimum distributions (RMD's) after retirement. A Roth IRA thus contrasts with a traditional IRA. In the traditional IRA, certain contributions are eligible for tax deduction, but those pre-tax monies and any gains upon them will be taxed as ordinary income upon ultimate distribution. Moreover, in a traditional IRA, RMD's begin at age 70 1/2, and there are stiff penalties for missing an RMD.

The problem with the Roth IRA for many people, though, has been its income limits and (like traditional IRA's) very restricted annual contribution amounts. For this reason, most existing Roth IRA's are dinky.

Starting in tax year 2010, there will no longer be income limits on conversion from traditional IRA's or other qualified plans (such as 401-K's) to Roth IRA's. Certain companies are now also offering Designated Roth Accounts (DRAC's) as a 401-K or 403(b) option; a business proprietor working alone can also establish a solo 401-K or solo DRAC. Such DRAC's allow for much higher annual contributions than do IRA's. For these two reasons, Roth accounts are becoming a potentially attractive retirement planning device for high income people as well as for some of those who meet the traditional restrictions.

Roth conversion accelerates the recognition of ordinary income to the tax year of conversion, with one exception. For tax year 2010 only, the converter will have the right to defer the payment of that income tax and to split it between the following two tax years, that is, 2011 and 2012. This may reduce the marginal tax rate paid by the converter, spreads out the tax pain, and is the preferred way to go from a present value perspective.

As a rule of thumb, if there are ten or more years remaining until you plan to take any distributions from your IRA account, and if you expect your marginal tax rate in retirement to be rather high, then a Roth IRA re-characterization may make sense. Another reason for conversion might be if you wish your retirement savings to be passed on to the next generation.

Member of Congress reportedly hoped, in enacting the Roth conversion reform, to create current tax revenue on monies that would otherwise stay locked in traditional IRA's for many years, until either death (the ultimate tax event) or gradual taxation as RMD's begin. You might argue with the gimmick; younger savers will now have the opportunity over time to make huge profits on their contributions without ever paying any tax on those gains. Maybe Congress is being short-sighted. On the other hand, from a saver's point of view, the conversion under the proper circumstances can be truly compelling.

To analyze rigorously whether a Roth IRA conversion makes sense for you, your investment advisor should provide a spreadsheet future value analysis based on certain assumptions that you help provide. The assumptions would include long-term annual rate of return on your investments, amount of conversion tax, date of retirement, timing of distributions and tax rate at time of distribution. Given these premises, you will be able to see which plan will give you a greater final value after tax. As people become more aware of this opportunity, there will be a flood of Roth conversions, particularly in 2010.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Wisdom on Value Investing

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

There is a pun in the title of the new book, Wisdom on Value Investing (John Wiley, 2009). The author is Gabriel Wisdom, and what he sets out is wisdom concerning the "value investing" style.

Wisdom is a co-founder of American Money Management, LLC and President of the Fallen Angel family of mutual funds. According to the book jacket, he has managed "more than a billion dollars for wealthy investors since 1983." He hosts a daily program on Business Talk Radio Network.

The author favors "fallen angels"—securities offered at prices below their intrinsic value. There are three sources of such situations, he says: the business cycle, excessive pessimism in the market and a one-time "calamity befalling an otherwise sound company" (pp. 18-20). He urges the reader to follow a contrary stance, against prevailing sentiment in the market.

Wisdom suggests as standards of value a number of financial statistics followed by most value investors, including the price to earnings ratio, debt level, return on equity and free cash flow.

One question that many investors puzzle over is when to sell. Wisdom cites three signals: first, if the reason you bought is no longer valid; second, if profits come sooner than expected (in other words, don't succumb to over-optimism); third, if a better opportunity comes along. In practice, those who have an eye for something worth holding a long time are probably best suited for the value style of investing. I'm not sure if Warren Buffett has ever unloaded a company, although a few of his picks (especially early on, such as Dexter Shoe) came out poorly.

At times, the reader may be puzzled by Wisdom's practice of citing investment principles that are in tension with one another, without his resolving or even noting such differences. For example, he cites Shawn Andrew to the effect that the crowd is usually right, except at major turning points (p. 9) but also cites with approval George Soros' statement: "I assume that the markets are always wrong" (p. 131). By the same token, he cites Warren Buffet (p. 1) about how a net saver should buy when prices are sinking, but then he also recommends buying when technical patterns show a rising price trend, albeit close to the bottom.

Although most of this book concerns securities investing, chapter fourteen concern real estate as the "other fallen angel opportunity." He sees evidence for an eighteen year real estate cycle in the United States, following the work of statistician Edward Dewey (1895-1978). The chapter discusses how to watch this recurrent pattern and invest opportunistically. He suggests as examples of fallen angels in this area abandoned properties in working class neighborhoods at the bottom of a business cycle.

Wisdom offers a breakdown (pp. 114-117) of the "twelve most common opportunities for investors": fallen angels; out-of-favor blue chip stocks; spinoffs; overlooked smaller companies; companies run by gifted deal-makers; cyclical companies at the bottom of a cycle; growth at a reasonable price; distressed companies; post-bankruptcies; the part is worth more than the whole; activism in the marketplace; oddballs/innovators.

One section of the books that is highly misleading concerns "book value." The author describes book value as a "bottom-line assessment, by an independent source, of a company's value…arrived at by auditors who seek to determine the actual value of each share of the enterprise, independent of the market price….The process is similar to an appraisal [of] real estate…an estimated fair market value is determined." In fact, if these procedures were actually followed by companies, book value would probably be a much more interesting number. In fact, the book value of a company is an accounting measure, equal to a company's assets minus its liabilities, preferred stock and intangibles. The book value of an asset is based on its original cost minus accumulated depreciation. Notoriously, these numbers can deviate wildly from any reasonable estimate of an asset's "fair value" or "market value." How can a seasoned professional like Wisdom, on such a fundamental matter, fall this far from the mark? Did he skip class that day?

Perhaps the most impressive part of the book is Chapter 15, concerning "Ten Fallen Angels for the Next Five Years." Here are five large capitalization stocks he recommended early this year, the price he recommended them at (on 3/30/2009) and their present price per share (market close, 11/6/2009):

• General Dynamics (GD, $41.59; now $65.58, up 58%);
  
• Google (GOOG, $348.06; now $551.10, up 58%);
  
• Jacobs Engineering (JEC, $38.66; now $43.81, up 13%);
  
• Johnson & Johnson (JNJ, $$52.60; now $60.30, up 15%).
  
• Visa (V, $55.60; now $43.81, up 13%)
  
  Among smaller companies, he recommended:
  
  
• Hansen Natural (HANS, $36; now $34.46, down 4%);
  
• Sketchers (SKX, $6.67; now $22.80, up 242%) (!);
  
• World Fuel Services (INT, $31.63; now 51.36, up 62%);
  
• Move (MOVE, $1.45; now $1.66, up 14%);
  
• Lincare Holdings (LNCR, $21.80; now $33.10, up 52%).

Not bad for a 221 day holding period! One might say, "Oh, almost everything has done much better since March 2009," but that would be to deprive the author unfairly of the courage of his timing of publication. And in fact, this portfolio beat the market handily. The mean gain was 50% for these ten stocks. Over the same interval, the S&P 500 gained 36% and the Russell 2000 40%.

Journalist Joe Tash aided in the writing of the book, which is clear and understandable. The book is aimed at individual investors, and many would profit from the lucid presentation of basic value investing principles. On the whole, despite some flaws and inconsistencies, this book is worth adding to the bookshelf of serious investors.

Among other works deserving a place on the value investor's bookshelf, I would mention Benjamin Graham's classic, The Intelligent Investor (1949), David Dreman's New Contrarian Investment Strategy(1982), Timothy Vick's Wall Street on Sale (1998), and Martin Whitman/Martin Shubik, The Aggressive Conservative Investor (1979). Among more recent works, consider Joel Greenblatt, The Little Book that Beats the Market (2005) and Christopher Browne/Roger Lowenstein, The Little Book of Value Investing (2006).

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

China Scours Planet for Commodities

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

We recently discussed China's nervousness about the safety of US assets, which has been reflected in lesser demand for US Treasuries and Agencies and a shortening of maturities they are willing to buy. While the Chinese have been losing appetite for any more servings at the all-you-can-eat US Treasury banquet, they have been buying raw materials, resources and precious and non-precious metals voraciously. These two trends are organically connected.

Chinese demand has contributed to huge rallies in the markets for precious metals, carbon fuels, industrial minerals and even some agricultural products. "Commodities and shipping executives describe Chinese stockpiling in recent months of a range of other commodities as well, including aluminum, copper, nickel, tin, zinc, canola and soybeans. Starting in April, China began stockpiling significant quantities of crude oil." Source: Some See China’s Buying Spree on Commodities as Short-Lived - NYTimes.com (6/10/2009).

Chinese demand stemmed from more than one source. Some companies bought metals in anticipation of a rise in spot prices as the world economy recovers. The Chinese government, according to the Times article, supported domestic processors by buying heavily in canola oil and aluminum. The Chinese Central Bank has reportedly been a big buyer of precious metals, including gold. To the Central Bank, precious metals represent an alternative store of value that compares favorably with US dollar assets.

There was fear that the Chinese buying would be short-lived, that China would soon suffer a huge glut in raw materials and finished goods. When the inevitable adjustment came, Chinese demand for commodities would plummet, according to this line of reasoning. However, the apparently effective economic stimulus program in China has brightened prospects. Although many Western sources predicted China would not meets its 8% higher GDP growth target in 2009—perhaps growing at about half that rate—more recent forecasts suggest growth will exceed 9%. If anything, there are signs of over-stimulation, inflation and questionable state bank lending practices: a liquidity boom.

Those who buy US Treasury and agency securities take three kinds of risk. The first is that they will not be repaid. This risk has become more salient. For example, holders of Fannie Mae and Freddie Mac preferred shares (including the Chinese government) have seen the value of their securities fall almost to zero, as these agencies suspended their dividends indefinitely. The second risk is inflation and rising interest rates in the US; this risk correlates with the length of the obligation. As rates rise, the value of existing US Treasuries falls, reflecting the ability of investors to receive a higher coupon rate from new issues than from outstanding ones. The third risk is a fall in the value of the US dollar relative to other major currencies, such as the Euro, the Yen, the Swiss Franc, and the Pound.

The Chinese understandably wish to diversity their assets and risks. In addition to purchases in the commodities markets, Chinese industry has been scouring the world to secure resources--in Africa and Latin America as well as the developed countries. These acquisitions stir insecurity among those who are not yet reconciled to China's status as a great power. China faces daunting challenges, including population control, ethnic unrest, environmental degradation and political reform, but its dynamism and the discipline and talent of its people are undeniable. Just as the United States was known as the American Century, the 21st may well be known as the Chinese Century. In coming articles, we will discuss how US investors can diversify their own portfolios to take these trends into account.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Amazon Amazes

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Amazon (stock ticker: "AMZN") released quarterly earnings, which were up a remarkable 62% versus last year's (weak) third quarter. The announcement, made after trading hours on October 22nd, caused shares to surge almost 15% in after-market trading (from $93.45 to $107.07) and to close the following day at $118.49. The lowest trade for this stock in the past year was $34.68 (11/20/2008). If you like to kick yourself in the pants for missing a big one, this stock will suffice. The impressive results give evidence both of resurgence of consumer demand and of Amazon's fundamental strengths as a retailer.

Amazon always had potential to be the super-store to beat. It has the online ordering, warehousing and distribution system down pat. It knows how to stock but not over-stock. Amazon has effectively adapted a system of artificial intelligence (based on Bayesian statistics) to suggest—based on your past browsing and buying activities at the site—other items you may wish to buy. Apple recently introduced an analogous feature at iTunes called "Genius", which gives very apt and striking suggestions in many cases, at least after it has a few weeks of activity to learn of your interests. That one is so good that you may fear that Big Brother is watching you.

One factor driving Amazon's success has been the popularity of its "Prime" program, under which U.S. customers pay $79 per year for unlimited two day shipping of eligible merchandise. The eligible stuff includes almost everything Amazon sells directly. I don't usually give little tidbits of personal financial advice, à la Suze Ormann, but it must be said, this is a very good deal if you frequently buy online.

Amazon's "Kindle" electronic book has a good head start, but it now will face competition from such companies as SONY. The electronic book will eventually meld with the tablet PC, with uncertain opportunities and risks for Amazon.

Another success for Amazon has been its distribution pacts with a wide range of other merchandisers. This may be siphoning some business away from E-Bay, whose offerings are less organized and much harder to find. Moreover, the frequent choice at E-Bay of whether to buy something right away at a guaranteed price or go into an auction leaves me dithering and usually doing nothing.

I have sold some books though Amazon. If you are patient, and you have something desirable, you can fetch a good price. The feature whereby users grade your reputation as a seller (also used at Ebay) often provides valuable clues to the buyer. As to books, I find some of the user book reviews helpful and have contributed myself.

Amazon is now trading at about 80 times earnings for the trailing twelve months and about 50 times analysts' expectations for 2010. However, some of those analyst expectations are still being revised upward. Amazon continues in growth mode. It is one of America's premier merchandisers. However, wait for a major correction (down 20%) to buy this stock, then put it your long-term portfolio.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Investor Perspective: The Threat from Iran

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

History always repeats itself, said Karl Marx, the first time as tragedy, the second as farce. In contemporary Iran, it’s vice versa: the farce is making way for a tragedy.

After a dubious election that he claims he won by a “wide margin,” President Mahmoud Ahmadinejad has elevated the position of the Revolutionary Guard into a vanguard that seeks to control every aspect of politics and society. The Guard has moved in to arrest and threaten all those who question state policies, which apparently includes critics of prison torture and rape.

Today, the New York Times reported that talks aimed at having Iran hand over its nuclear enrichment process to other countries have bogged down. I fear that Iran's intentions in these talks are, as in the past, to buy more time to develop its weapons and to sow discord among Western countries.

President Ahmadinejad is to lying what Michael Phelps is to swimming. In mendacity, only he can top himself. A long-time Holocaust denier, the President now insists that Iran is seeking alternative energy sources at its formerly secret nuclear enrichment facility near Qum. You don’t usually place such peaceful facilities in hardened underground bunkers.

As the legitimacy crisis deepens in Iran, the adventurism of Ahmadinejad’s policies increases. With even Russia criticizing the secret enrichment site, Iran recently tested its longest range missiles as part of exercises its military dubs “The Great Prophet IV.” Like those Hollywood sequels (“Rocky V”), this series is getting stale.

It’s unclear what can be done to protect against this threat. President Obama has moved to shift our regional anti-missile strategy away from a presumed Soviet threat and toward an Iranian shield. See Mobile.POLITICO.com: Missile defense winners and losers. Israel possibly could launch a preemptive strike against Iranian facilities. However, the regional backlash would be great and even short-term success uncertain.

Rousseau said that we have two aspects to our role in society, as “bourgeois” and as “citoyens.” As citizens, we must take whatever positions help preserve peace. As bourgeois, though, let’s consider how to profit.

The notion of the following trades is to get ahead of the news. In the full blossom of a crisis, unwind these for a profit. Prices given are per share as of the close of trading on 10/20/2009.

Long positions:
>Gold, silver and other precious metals, and select precious metal stocks, such as Barrick Gold (“ABX," $37.85).
>Oil reserves and refinery capacity. I like Exxon Mobil (“XOM”) and Valero Energy (“VLO,” $20.11).
>Defense stocks. I particularly like Raytheon (“RTN,” $45.54), maker of the Patriot surface-to-air anti-ballistic missile. See Raytheon MIM-104 Patriot. Lockheed Martin (“LMT,” $71.99) is crucially involved in the Aegis missile defense system and PAC-3 missile interceptor.

Short positions:
>Resorts, cruise lines, casinos.
>Airline stocks. A good short position might be American Airlines (“AMR,” $7.66)

Pair trades:
>Long US high grade corporate bonds, short emerging markets and junk bonds.
>Long large capitalization stocks, short small capitalization.
>Long Dow index; short Russell 3000.

A number of crisis scenarios, or a more general aversion from risk, could make some of the trades above profitable. On the other hand, if everything proceeds peacefully, if “the wolf dwells with the lamb,” then these positions are overly defensive.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Legal Issues in Insider Trading Cases

Following up on the Galleon insider trading story, there is a good article in today's NY Times, "A Thin Line Separates Trading and Legal Research," by Alex Berenson, 10/20/2009, discusses some of the legal challenges in prosecuting these cases.

Some of the challenges relate to fiduciary duty, as articulated in the famous Dirks v. SEC (1983) case. Several tippers in the Galleon-related cases would clearly have a fiduciary duty to their own company not to reveal inside information. This would potentially include, for example, the executives at Intel, McKinsey and IBM. Further, Mr. Rajaratnam under one theory knew or should have known that he was receiving confidential inside information, based on the corporate role played by these executives, and thus could be considered a "temporary insider." See, for example, the landmark case of SEC v. Texas Gulf Sulfur (1965). The government must support the argument that Mr. Rajaratnam knew that he received material inside information misappropriated by a corporate insider, in breach of that insider's fiduciary duty. However, some of the wiretaps, if admitted as evidence, could go toward showing that state of mind in Mr. Rajaratnam's own words. On the other hand, Mr. Rajaratnam's defense attorney will seek to show that he was being a diligent security analyst, putting together information and clues from a variety of sources, under the so-called "mosaic theory."

The Times article lays stress on the lack of many direct cash payments alleged in the Galleon case. However, I believe this emphasis is misplaced, as the government merely has to show some potential benefit for the tipper and tippee, which could include such things as reciprocal tips, career assistance, valuable social introductions, and so forth.

Another Shocker on Wall Street

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

After the Bernie Madoff revelations, one might have feared that we are hopelessly jaded by financial intrigue. Then along comes the Galleon insider trading story. It restores faith in Wall Street's continuing power to shock.

Federal prosecutors on October 16th filed criminal charges of conspiracy and securities fraud against Raj Rajeratnam, billionaire founder of Manhattan-based Galleon Group. Federal marshals arrested him under allegations of insider trading in the stocks of companies including Hilton Hotels, Google, Advanced Micro Devices and Akamai. Also arrested were five alleged co-conspirators: Mark Kurland, President of Newcastle Partners LP, based in White Plains, New York (formerly affiliated with Bear Stearns; no relationship to a similarly named merchant banking firm in Greenwich CT, called NewCastle Partners LLC); Danielle Chiesi, an employee of Newcastle; Rajiv Goel, of Intel, who was involved in their venture capital effort; Anil Kumar, an executive at consulting giant McKinsey & Company; and Robert Moffatt, an IBM executive working at its Armonk headquarters. Source: "Dealbook," NY Times, 10/16/2009 and Forbes.com.

The Galleon allegations differ fundamentally from those against Madoff. Madoff's operation siphoned huge amounts of money from investors under false pretenses. However, Madoff's firm carried out little or no actual trading, and it did not benefit from any privileged information about publicly listed companies. The federal allegations against Mr. Rajeratnam center on another fundamental purpose of federal securities laws (particularly the 1934 Securities Exchange Act, and regulations under it). That goal is to preserve fairness among competing investors as to the availability of highly relevant and timely information affecting publicly listed companies.

Others charged by prosecutors include Mark Kurland, the president of Newcastle Partners LP, a firm based in White Plains that formerly was associated with Bear Stearns (no relationship to NewCastle Partners LLC, of Greenwich, as incorrectly reported); Danielle Chiesi, an executive at Newcastle; Rajiv Goel, an executive at Intel’s treasury department who supported the company’s venture capital arm; Anil Kumar, an executive at McKinsey & Company; and Robert Moffatt, an executive at I.B.M..

A former Galleon employee, not yet named, cooperated with federal authorities in hopes of receiving a reduced sentence. Prosecutors say that they have wiretap evidence implicating the defendants. Although insider trading cases can be hard to prove, the wiretap evidence is potentially damning.

Of course, the SEC has made insider trading allegations quite frequently. What distinguishes this case is the scale of the trading and the scope of the alleged ring and the number of blue firms whose employees or principals allegedly participated in it. I can't remember anything of this magnitude since the Ivan Boesky trading ring of the 1980's. (The character of Gordon Gekko in the movie Wall Street was based in part on Boesky.)

We can expect more cases, both relating to the alleged Galleon trading ring and to unrelated matters, as part of a federal crackdown on insider trading networks. Targets will include hedge funds, Wall Street firms and law firms. The government has identified certain targets for investigation based on a "data mining" project, begun about two years ago, that looked for patterns of suspicious trading. "Once investigators find a cluster of correlated trades, they tap other sources of information to unravel how its members obtain and share tips…. For example, if a group profits on trades before a series of corporate takeovers, the SEC may check...which investment banks or law firms advised the deals. If one firm was involved in all of them, an employee there may be the source of the leak." Source: Joshua Gallu and David Scheer, "U.S. Said to Target Wave of Insider-Trading Cases After Galleon," Bloomberg News Service, 10/19/2009.

The Galleon news suggests that the Securities Exchange Commission and federal authorities, shamed and embarrassed by the Enron, Madoff and other debacles, are increasing the scope effectiveness of their enforcement activities.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

China Rumbles Currency Markets

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

For many years, the US Treasury has taken the position that China artificially maintains its currency (called the Renminbi, or RMB) at a low value in order to give its exporters a competitive edge—making Chinese exports cheap to overseas buyers while keeping imports expensive in China.

Such a "cheap RMB policy" might be impractical to maintain, if the RMB were a free-floating currency, like the US Dollar, the Yen or the Euro. Instead, the Central Bank of China maintains a "crawling peg" regime based on a target valuation.

Obviously, a cheap currency is not China's only advantage. Chinese exporters benefit from a vast pool of cheap labor, a large cadre of skilled and highly educated workers, long pent-up entrepreneurial energy, official export subsidies and tax incentives, and (in the case of state-owned enterprises) favorable access to state-owned bank credit. Moreover, one element of most exports is imported content. Nevertheless, by objective measures, the RMB probably is undervalued, perhaps by as much as 40%. For this reason, it would make a lot of sense for an investor to be long the RMB and short the US dollar, although this trade is not easy to put on for a foreign investor.

China now holds about 2.5 trillion dollars equivalent in central bank reserves, of which about two thirds are in dollar assets. These investments include primarily US sovereign and agency obligations, but also US commercial bank deposits, corporate bonds and stocks.

In early March, Chinese Premier Wen Jiabao stated: "We have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried." (Source: ForexBlog.org, 3/13/2009.) This statement sent shivers through the market for US Treasury debt, as in recent years China has been the foremost central bank buyer at Treasury auctions.

However, a couple of weeks after Wen Jiabao's statement, China's top foreign exchange official, Xu Xiaolian, affirmed that Treasuries are "an important element in China's investment strategy for its foreign-currency reserves." She added, "We will continue this practice." (Bloomberg News Service, 3/23/2009). Of course, there is a very good reason for Xu to state this position, which is that China does not want to devalue its existing stock of dollar investments.

Prospectively, though, we can expect to see China play a less prominent role in US Treasury funding, and also to keep its maturities shorter, with a preference for Treasury Bills over Notes.

More recently, in early July, the People's Bank of China announced on its Website that it would allow companies to use the RMB to settle cross-border trades, while keeping their right to export tax rebates. It will also encourage its commercial banks to offer RMB settlement services. “Companies in China and neighboring countries are facing relatively huge risks of exchange-rate fluctuations because of big swings in the U.S. dollar, the euro and other major settlement currencies,” the Central Bank statement explained. (Source: Bloomberg News Service, 7/2/2009). Some economists view this move as a step toward making the RMB a global currency.

Finally, the Chinese have expressed the aspiration for a new international reserve currency, analogous to International Monetary Fund "Special Drawing Rights" (based on a basket of international currencies). Indeed, I believe we are going to see a major realignment of international currencies. The US is in the process of losing its status as the sole international reserve currency, and this will entail some potentially arduous effects for both our government and our consumers.

Next week: China buys natural resources as a "store of value."

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

From Beautyrest® to Bed of Nails

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Back in early 2007, we featured a six part series on the leveraged buyout boom that then loomed large in corporate finance. While recognizing that leveraged buyouts could bring improvement to some badly run companies, we warned: “Whatever Wall Street advises, it then over-advises. The fierce competition among the proliferating LBO sponsors is leading to signs of excess. Such excesses could negatively affect the performance of the sponsors and their lenders (the banks and junk bond investors), while leaving some shareholders feeling better about having taken quick buyout gains while available.” “Unhappy Shareholders,” 1/29/2007, viewable at http://greenwichfinancial.com/wm139.htm. That conclusion was timely.

A recent front page story in the New York Times chronicled the sad story of Simmons Bedding Company, an illustrious mattress maker brought to tatters by a series of increasingly questionable leveraged buyouts. See At Simmons, Bought, Drained and Sold, Then Sent to Bankruptcy - NYTimes.com, 10/5/2009

Leveraged buyout firms look for stable, easy to understand businesses that generate predictable cash flow. If management has stuffed some cash in the mattress, even better, for that could be used to fund the acquisition or finance large cash dividends afterward.

Thomas E. Lee Partners (THL), original leveraged buyout investor in Simmons, recouped its founding stake and more by a series of dividend payments funded (primarily) by additional debt, so-called "dividend recapitalizations." THL did not invent this practice, which was prevalent during the credit boom. The style might better be called “Leveraged Cash-Outs,” as the sponsor sought to buy the target using the target’s own cash and credit.

Management was doing a bit of featherbedding itself. The Times relates that Charlie Eitel, CEO of Simmons under Lee’s tutelage, hired numerous relatives and wooed clients from an 80 foot company-financed yacht called “Eitel Time.”

A similar disaster befell Ohio Mattress. Ohio Mattress was known for its Sealey and Stearns & Foster brands. LBO firm Gibbons Green van Amerongen took Ohio Mattress private in 1989, paying $1.1 billion. Junk bond traders referred to that deal as “Burning Bed.” The collapse of the junk bond market in late 1989 knocked the stuffing out of its investment banker, First Boston. Unable to extricate itself from $457 million in mezzanine financing extended to the buyout, First Boston sought a rescue from Credit Suisse, with whom it merged. In 1993, First Boston sold its stock in (renamed) Sealey Corp. to the investment firm, Zell Chilmark. In 1997, management together with buyout firm Bain Capital bought out 90% of the stock. In 2004, leveraged buyout kingpins KKR stepped in and bought out most of Bain’s interest. KKR in turn brought the company public with an initial public offering in 2006. Fitful Rest From Sealy. My favorite part of that IPO is the stock ticker they chose: “ZZ.” The stock has been a sleeper. Issued at $17.50, it currently trades for three dollars and small change per share. According to public filings, the current book value of its equity is negative $1.247 per share

There’s a saying on Wall Street that if, after five minutes in a poker game, you haven’t figured out who the chump is, you’re the chump. In the Simmons LBO game, who were the chumps? Well, to start, who amassed chips? The investment banks who underwrote bonds and advised transaction parties made money. Ditto the lawyers. Ditto the consultants writing the “fairness opinions.” The real losers ended up being: 1) the workers, who allowed their traditional pension plan to be transformed into a now worthless Employee Share Ownership Plan (ESOP), whose sole holding was stock in the leveraged-up entity (recalling the Enron ESOP travesty), and 2) those with Simmons debt outstanding (bank loans and bonds). The workers deserve our sympathy; they got colossally bad advice. It’s harder to feel sorry for the lenders now lying on a self-made bed of nails.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

The New Exotica on Wall Street, 3: Re-REMIC's

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Like the legendary snake that swallows its own tail, “Re-REMIC’s draw their collateral from old REMIC’s. In this final installment of our series on financial innovations, we will discuss how Wall Street chefs prepare this exotic new dish for investors.

Before there were re-REMIC’s, there were REMIC’s. The acronym stands for Real Estate Mortgage Investment Conduit. The Tax Reform Act of 1986 provided that such vehicles, if they follow strict rules, are not subject to taxation at the entity level; instead, the government taxes only the distributions to investors. Eligible REMIC collateral includes federally backed securities, such as those backed by Ginnie-Mae, Freddie Mac and Fannie Mae, as well as unguaranteed mortgage “whole loans.” These whole loans might be, for example, subprime or “Alt-A” mortgages, or high quality “jumbo” size mortgage loans.

REMIC’s typically comprise a series of sequential pay “tranches.” Investment banks seek an “arbitrage” (versus the cost of buying the collateral) by matching these tranches carefully to the investment preferences of investors—including maturity, credit rating and bullish or bearish characteristics. REMIC’s typically include a bottom class, the “residual,” with the highest potential for gain (or loss).

In a whole loan collateralized REMIC, the early tranches face less credit risk as well as less duration risk. Issuers and sponsors seek to get these tranches favorably rated. The highest attainable rating is AAA from Standard & Poor’s or Aaa from Moody’s Investors Services (traditionally, the two most prestigious rating agencies). Often, the top tranche of REMIC’s received the coveted AAA, while lower priority tranches might receive lower ratings, but generally all “investment grade” (at least BBB-/Baa). Credit rating agencies based such high scores on complex probabilistic models that contained many assumptions derived from historical experience. One approach, called “Monte Carlo analysis,” tested investment results against a very large series of possible scenarios. A prevailing assumption, whether modeled directly or implicity, was that US residential housing values would not experience sharp losses.

Some investors have a special reason to seek highly rated securities. If they are banks or insurance companies, they will need less regulatory capital to hold them. If the investors are fixed income mutual funds, their trust indenture may restrict them to a certain minimum bond rating. But if securities plummet in rating, such investors may feel compelled to sell suddenly at a severe loss.

Neither the Wall Street firms nor the credit rating agencies expected the extreme increase in mortgage delinquency and default ratios that struck the US residential market first, starting in 2008, but is now reaching the commercial market. The potential losses far outdistanced anything in their models. As a result of earlier faulty assumptions, plus, in come cases, sloppiness and even venality at the rating agencies, risk evaluations frequently turned out to be unrealistic. Numerous formerly investment-grade tranches have fallen deeply into “junk bond” status.

The “re” in “re-REMIC” stands for “re-securitization.” One use of the re-REMIC’s has been to slice and dice the downgraded first tranche into a further sub-set of sequential pay tranches, of which at least the first one or two have high investment grade ratings. FT Alphaville » Blog Archive » The Re-Remic gimmick? The “residual” can encompass formerly rated tranches. (For the cognoscenti, a re-REMIC is a form of Collateralized Debt Obligation (CDO), more specifically a Collateralized Bond Obligation (CBO), in that its assets are themselves fixed income securities. A CDO of a CDO is called CDO², and we have even seen CDO³. Each new generation raises the complexity of modeling performance.)

Strictly speaking, re-REMIC’s are not a new thing. First Boston and Salomon Brothers first introduced these structures some fifteen years ago. Toxic CDOs Given Up for Dead Coming to Life With Pension Funds - Bloomberg.com. But investment banks have revived them under current conditions to extract value and liquidity from existing REMIC’s stagnating in the inventories of investment dealers and their clients.

Investment banks bringing re-REMIC’s include Goldman Sachs, JP Morgan Chase, Morgan Stanley and Banc of America (“round up the usual suspects,” some jaded observers of this financial panic may say). Investors in re-REMIC’s include traditional investors in mortgage-backed securities, plus (for the riskier tranches) some of the bold new players formed to seek opportunity amid the distress. Whether these Re-REMIC’s will pan out for particular investors depends on a number of variables, but particularly on default rates and credit loss ratios and the priority status of the selected tranche.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

The New Exotica on Wall Street, 2: Synthetic Life Insurance

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Wall Street firms have recently begun to package insurance policies into securities, as we discussed last week. This development has been proceeding for a number of years in the property and casualty insurance business, including so-called “catastrophe” risk. There are also ongoing efforts to create “synthetic” (artificial) securities based on mortality (death) statistics. Investment banks can structure synthetic mortality securities in various forms, including mortality “swaps,” options, swaptions and futures. Such securities must track some credible “index” of mortality that tracks a sample group of lives into the future.

Some major players on Wall Street in the expanding world of life insurance securitization include Deutsche Bank, Credit Suisse and Goldman Sachs. Goldman Sachs has developed a tradable index of mortality that tracks the lives (and deaths) of about 50,000 individuals. The index, dubbed “QxX,” derives from data obtained from American Viatical Services (AVS), a consulting firm that estimates the mortality of individuals (chiefly for the purpose of serving life insurance policy owners and investors). Source: National Underwriter Magazine. To my knowledge, this index has not yet gone into widespread use.

Such mortality indices could track individual insurance policies or, instead,mere reference lives (as with Goldman's index). One issue is ascertaining whether and when the persons referenced have died. The investor may have to rely on the dealer and its administrator to carry out this important function competetently and professionally.

In a swap geared to a mortality index, two counter-parties would agree to make a “difference payment” on some “notional amount” of life insurance policies (i.e. the aggregate death benefit). If mortality is above a certain threshold, the first counterparty will make a cash payment to the second counterparty; if mortality falls below that threshold, it will be vice versa. The counter-parties can save significant transaction costs versus traditional life insurance underwriting. Such savings include the amount that would otherwise be spent marketing policies to individuals through commission agents, processing paperwork, collecting medical records, paying lawyers and viatical estimators, and complying with federal privacy regulations. The swap could create implicit leverage—depending on the amount of posted capital required by the swap dealer.

Investors can expect liquidity in over-the-counter traded mortality swaps or other derivatives to be very limited. If an investor decides to unwind such an investment, the only available bid is likely to be from the original dealer of that position. However, as the secondary life insurance market evolves, we may see the development of a mortality index that trades on one of the major exchanges, such as the Chicago Board of Trade or the Chicago Mercantile Exchange. Large life insurance or reinsurance companies could potentially lay off risk on pools of life insurance policies using such public contracts, much as pig farmers can hedge their price risk by selling pork belly futures. The clearing house would then net offsetting and expiring transactions.

In this brave new world, the possibility will soon exist to create a synthetic insurance company or investment fund that does not insure any “clients.” Investors could conceivably form a company that would take synthetic life insurance risk only. The company might also enter into annuity swaps to hedge its risks. Such ventures would raise many questions, some of which overlap with the securitization of actual policies and some of which are completely novel.

One issue is taxation. Historically, Congress has favored life insurance policies with many tax benefits. Which of these benefits might also apply to synthetic life insurance investment?

Another issue is regulation. If the synthetic life insurance entity is domiciled onshore, who would regulate it? At present, the individual states regulate life insurance; the McCarron-Ferguson Act (1945) codified this jurisdiction. However, such a synthetic insurance company might resemble more of an Investment Company under federal law, subjecting it to federal regulation. If there are no insured clients to protect, the government regulatory efforts would probably focus on the needs of investors under federal and state securities laws. Investor concerns would include fair disclosure, fraud, dealings by related entities, insider trading and transparency of valuation.

A third issue involves the risk rating process. Are the traditional bond rating agencies, such as Moody’s and S&P, well-suited to evaluate the ability of synthetic life investment vehicles to pay their investors back? The ongoing debacle involving the ratings of subprime investment securities suggests skepticism.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

The New Exotica on Wall Street, 1: Collateralized Life Insurance Trusts

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

A recent article in the New York Times noted that Wall Street is back in the business of creating complex bonds that slice and dice pools of underlying hard to value assets. One area that is heating up is securitization of life insurance policies. See esp. Back to Business - Wall Street Pursues Profit in Bundles of Life Insurance - Series - NYTimes.com (9/5/2009). Obviously, after the recent subprime lending and commercial real estate securities fiascos, government regulators will be more alert to the potential risks.

We have discussed in past articles the development of a secondary market in life insurance policies. This market started to bloom during the onset of the AIDS crisis, in the late 1980s, as victims began to seek to sell their policies to investors while still alive. What’s more, spurred by various commercial sponsors, some persons began to seek financing to take out life insurance policies, with the idea possibly to sell these policies after two years, when the so-called “contestability period” ends in most states. The life insurance industry vociferously opposes such “speculative” uses of life insurance. One reason cited by industry spokesmen is that “gaming” of the life insurance market by such speculative uses will tend to increase the cost of life insurance for bona fide uses.

There are now billions of dollars of life insurance policies, many of them originated using leverage, which are looking for a home. The credit crunch has inhibited resale of the policies. For the lenders, many of whom are hedge funds, this is an urgent matter, as the burden of financing further premiums is great. If premiums are not paid, the policies may lapse, the collateral backing the loans will lose its value and the lenders could face a financial crisis.

It is likely that large amounts of such marooned life insurance policies will come to market this year in the form of collateralized life insurance trusts. These securities will seek to match investor preferences for different maturities--short, intermediate and long—by offering a series of tranches of securities, prioritized by the timing of their cash flows.

There are many novel and difficult questions posed by such life insurance securities. First, who will provide the capital needed to keep policies in force? This call on capital is different from most fixed income securities and is perhaps most similar to the risk in private equity funds. Investment banks are batting about different solutions, including reinsurance, contingent claims, letters of credit, sinking funds, zero coupon tranches and other devices. A second problem is estimating mortality risk. The longevity of Americans has increased in every decade since the US life insurance industry began collecting such data in the second half of the nineteenth century. This long-term one-way trend is again different from mortgage prepayment risk, which rises and falls with interest rates. A third problem is the law of “insurable interest,” which can create a doubt about the enforceability of some life insurance assets originated for or re-sold to investors, depending on state statutes and case law. A fourth problem is the bond rating process. Will these new structures be able to receive high investment grade rankings from top rating agencies such as Moody's and S&P? It may be that bankers will need to seek the services of lesser known rating agencies, as the most prestigious agencies are still bandaging their wounds from the subprime catastrophe. Alterantively, Wall Street may need to sell some of these securities unrated, as private placements. A fifth issue for public bonds is what level of risk disclosure the Securities and Exchange Commission will deem adequate. Finally, there is an issue of what underwriting risk the investment banks will deem acceptable, or instead whether instead they will insist on bringing such issues on a "best efforts" basis.

One thing is certain: as long as short-term interst rates remain near zero, investors will be hunting for exotic alternatives that promise higher returns. This is part of the risk environment that the Federal Reserve Board is now creating, which could plant seeds from which future systemic credit problems to grow.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Energy Follies (continued)

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

We’ve written in this column before about the folly of having government select certain alternative energy technologies over others for favorable treatment. In the case of ethanol, government mandates, tax incentives and tax credits at various levels from the farm to the gas pump have created an environmental fiasco. Moreover, economists have shown that these expensive efforts have not so far actually led to reduction in the use of fossil fuels, when all inputs (including fertilizer, planting and harvesting fuel usage, refining and transportation of the refined product) are considered.

Incentives for wind power are also leading to distortions. One such incentive is the federal tax credit of 2.1 cents per kilowatt hour for production of wind energy. An article in the Forbes Magazine (“Take My Juice,” 9/7/2009, p. 29) gives a striking example of the unanticipated consequences of such policies. In many areas where large scale wind farms are being developed, the wholesale price of energy is falling to zero for a portion of the daily energy cycle.

Energy usage is generally heaviest in the daytime. But prevailing winds typically are higher at night. Therefore, wind farms tend to produce peak power when grid demand is low. This would be fine if other forms of energy production could be stepped down when wind power is peaking. With natural gas powered generators, this is feasible. However, with coal fired generators, and with nuclear power, this is not practical. Moreover, as it is expensive to store energy (in batteries, capacitors, reservoirs of water, or otherwise), some utilities have an incentive to dump wind energy at night.

In West Texas, according to Forbes, electricity prices dropped to zero 11% of the time in the year beginning May 2008. What’s wrong with free power? In the short-run, this is dandy for consumers. In the long wrong, though, it undercuts private market incentives for energy investment. It can also deprive utilities of a reasonable rate of return on existing investments.

Over time, such inefficiencies might resolve themselves. For example, more factories could operate at night. Solar power during the day could be used to balance wind power that is generated more at night.

However, we would be better off letting markets make such allocation decisions, setting broad government policies that markets can respond to. For example, there is a growing consensus that we must reduce use of fossil fuels in order to combat global warming. There is also a widespread feeling that we should seek to reduce our dependence on imported oil. A tax on carbon based fuels would help to accomplish this. To keep a level playing field among carbon based fuels, the tax could be geared to energy content, as measured by BTU’s.

If reduction of air pollution is another key policy objective, there could be a second tax on pollution emissions. Such a pollution tax could be justified based on the problem of “externalities”; individual polluters can reap a higher rate of return by using cheap fuels, while imposing the costs of air pollution on everyone. The so-called “cap and trade” system for carbon emissions much more cumbersome and less effective than these tax measures.

However, taxes on carbon-based fuels are politically unpopular. Instead, we grasp around, favoring one energy technology and then another, based on fallible hunches made in Congress or the Executive branch. In such legislation, there lots of pork to go around. In this way, we deal with some of the most important problems of our time by old fashioned log-rolling, wasting precious resources and time.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Playing the Retail Sector

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

On August 13th, the Department of Commerce released a dismal report on retail sales. Those seeking “green shoots” in economic statistics will have to look elsewhere.

The “cash for clunkers” program, a one time shot in the arm for the auto industry, proved less stimulative than anecdotes from dealer showrooms suggested. Motor vehicle and parts sales rose only 2.4% and auto sales alone were up 2.8%. (All economic comparisons here will be month to month, in this case from the end of June to the end of July).

Outside of the automotive sector, sales fell 0.6%, versus a Wall Street consensus forecast of +0.8%, a 1.4% difference. According to the Wall Street Journal, about 1/3 of the decline was the result of falling gasoline prices and therefore sales at the pump. However, the weakness in retailing, with the exception of restaurants and apparel, was marked. Consumers represent 89% of private sector Gross Domestic Product (GDP), and seem to be taking a vacation from their free-spending ways of the past. See Economists React: ‘Back to the Drawing Board’ on Retail Sales - - Wall Street Journal Blog--August 13, 2009.

The weakness in retailing reflects several factors. First, there has been a fall in disposable income among many consumers. Second, the availability of equity lines of credits as a sort of consumer piggy bank for purchases, has lessened, to say the least. Third, high levels of unemployment and partial employment, and even more importantly, fear of future unemployment, are depressing demand. Finally, there is evidence of change among US consumers toward higher rates of saving (off a base of very low saving or even dis-saving). These four factors each have the ability to persist for some time after we have emerged from “recession” as it is usually defined (two successive quarters of decline in Gross Domestic Product).

The retailers who have performed the best during this recession have been the value leaders: McDonalds ("MCD"), Wal-Mart ("WMT"), Dollar Tree ("DLTR"). I went with my daughter to Kohl’s on Sunday to shop for her going away to college, and there were a good deal of people shopping. However, I believe the next leg of the market will bring less obvious names to the forefront.

I ran a quantitative screen looking for retail companies and restaurants with strong balance sheets, good operating momentum, good value, and outperformance of analyst expectations. From that list, I selected several using qualitative criteria such as brand strength and management quality. Here are my recommendations, giving stock ticker, present price per share (as of market close, 8/16/2009).
Aeropostale (“ARO,” NYSE, $35.67/share)—clearer skies ahead for this well managed chain
Chipotle Mexican Grill (“CMG,” NYSE, $86.26)—put a little spice in your portfolio; still room for growth.
True Religion Apparel (“TRLG,” $21.65)—apparel—if you don’t have True Religion, get it.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Master Limited Partnerships (MLP's), 2: Top Picks

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

In last week’s article, we introduced master limited partnerships (MLP’s) as a potentially good investment for those seeking fixed income opportunities that may also create capital gains. In particular, we recommend focusing on the oil and gas pipelines. Indeed, some of the stronger and more growth-oriented pipeline partnerships could readily double their distributable cash flow over the next decade. Let us consider which of these publicly traded stocks is most appealing at this time.

Since the recent market bottom in MLP’s (approximately December 2008), there have been two stages of recovery. In the first stage, investors poured into the larger, better capitalized and more liquid MLP’s, such as Plains All American LP (“PAA,” $47.36) (all quotes as of market close 8/12/2009) and Enterprise Products Partners LP (EPD). In the second stage, somewhat riskier MLP’s (have greater commodity price sensitivity, lesser size, or weaker balance sheets) have led the charge. These included Markwest Energy Partners (“MWE,” $21.99), Regency Energy Partners (“RGNC,” $16.64) and NGLS.

Some of the top-performing MLP’s have more than doubled in price per share since the market bottom. The biggest standouts were in natural gas gathering and processing. Generally, the trading opportunity has passed for many of these assets, though many still have merit for long term investment. Our recommendations are based on an investment horizon of five to ten years and would be most suitable for those looking for a quasi-fixed income investment with capital gain potential.

Among oil and refined products pipelines, Sunoco Logistics Partners LP (stock ticker: SXL, $56.41 per share) deserves attention. Besides pipelining, SXL also terminals, stores, and markets crude oil and refined products, primarily in the Eastern United States. Some of its facilities are linked with refineries of Sunoco Inc. (“SUN”), the giant integrated oil company. Sunoco Logistics’ market capitalization is about $1.82 billion, which is large, though not so much so as competitors such as Boardwalk Pipeline LP (“BWP,” $23.00), with $4.41 billion of market capitalization. The distribution yield of Sunoco Logistics is 7.40% currently (distribution yield equals annual dividend per share divided by price per share). Sunoco Logistics’ balance sheet and cash flow generation can readily sustain its current distributions and, in the future, increase them.

Among the more stable plays in natural gas gathering and processing, I like Williams Partners (“WPZ,” $20.31), which has a market capitalization of $1.3 billion. WPZ also fractionates and stores natural gas liquid (NGL). Its balance sheet is strong and it does not face a problem with rollover of short-term debt. Its distribution yield is currently a stout 11.90%. Second quarter earnings will be negatively affected by a one-time adverse event: the nationalization of its Venezuelan natural gas facilities by the Hugo Chavez regime. The partnership was founded in 2005 and its headquarters is in Tulsa, Oklahoma. Similarly, I like El Paso Pipeline Partners (“EPB” $18.85), which also benefits from a strong balance sheet. El Paso’s assets include pipeline and storage facilities in Wyoming, Colorado and Utah. El Paso shows strong momentum in cash flow growth and has a market capitalization of $2.2 billion. To exemplify our investment thesis—that cash is king in this market—El Paso is currently purchasing an additional 18% interest in Colorado Interstate Gas Company from El Paso Corporation for about $215 million. Jim Yardley, CEO and President of the general partner of El Paso Pipeline Partners LP, says that the acquisition will be immediately accretive to cash flow available for distribution. The dividend yield is currently 6.90%.

It is comforting when an MLP is presided over by a potent and well capitalized parent company with midstream assets. This is true of El Paso Pipeline (parent: El Paso Corp, “EP”), Williams Partners (parent: Williams Companies, “WMB.”) and Sunoco Logistics Partners (Sunoco Inc.). Generally, the parent company will be the general partner of the MLP, will own 2% of its shares and may float some midstream assets down to the MLP, taking back additional stock. The parent will also have an inherent interest in keeping the MLP solvent, as a failure at that level would raise questions about the creditworthiness of the parent.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Master Limited Partnerships (MLP's), 1: Introduction

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

If your investment requirements include current income, but you also seek capital gain potential, one promising vehicle to consider is Master Limited Partnerships (MLP’s).

MLP’s have a treatment under the US tax code that is analogous to (the more familiar) Real Estate Investment Trusts (REIT’s). This treatment is intended to prevent double taxation at the corporate and the individual level, so long as entity restrictions are rigorously followed. In fact, the compound rate of return on MLP’s as a class has surpassed that of REIT’s since 1990. However, as with REIT’s, there are tremendous differences in operating models and investment objectives within the MLP group.

MLP’s are publicly traded; there are currently about 70. They are bought and sold on US stock exchanges. Such MLP’s must make public filings with the SEC and comply with federal securities laws. The stock price, depending on investor sentiment, can be more or less than the book value of assets per share. MLP’s are not yet widely followed on Wall Street, which allows inefficiencies in valuation to occur more readily.

An MLP is a tax pass-through entity. If an MLP follows the restrictions embodied in the Tax Reform Act of 1986 (and subsequent implementing regulations), there is no federal tax due at the MLP level. Instead, each partner receives an allocated share of the partnership’s taxable income (if any). One of the restrictions is that 90% of the entity’s income must be obtained through the transportation or storage of natural resources, including oil, gas, oil distillates, coal, fertilizer, timber and paper.

The general partners in an MLP manage its business and receive “incentive distribution rights” (IDR’s). These provide motivation for the general partner to manage the business well and grow its dividends. The public shareholders of an MLP are limited partners and have limited liability. The incentive splits vary and deserve close attention.

MLP’s have diverse business models. Some explore for oil and gas. Some gather and process natural gas. I particularly favor MLP’s whose major assets are oil and/or gas pipelines. These are long life assets.[1] They are straightforward to understand. These pipeline partnerships bear a resemblance to regulated utilities in certain ways, but MLP’s generally offer more upside.

One advantage of pipeline MLP’s is economies of scale, also called “operating leverage.” The business profit margin tends to increase as their business grows in size. This provides a significant barrier to entry by competitors. A second advantage is that their revenue is not keyed directly to the price of oil and gas, but rather to the supply and demand for these products. A third advantage in many cases is inflation protection; with federally regulated interstate pipelines, revenues generally are inflation-protected through linkage with the federal Producer Price Index (PPI).

Next week: analysis and recommendation of specific MLP’s.

[1] A caution to investors: in the case of some MLP’s, particularly including oil and natural gas production, the distributions may represent in part a depletion of a fixed asset. The economic depletion of most pipeline assets is so slow that that economic depletion per year is relatively insignificant. As a different consideration, those distributions attributed to return of principal as to tax accounting are not subject to U.S. income tax.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

The Health Care Monster, 2: Investment Opportunities

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

With the entire Obama health care agenda up for grabs in Congress at this time, it may seem reckless to invest in the health care industry. President Obama has been jawboning and making deals to contain costs, and Congress is anxious to clamp down on runaway budget expenses in medicine. However, some very good values are showing up in this sector, and there are at least fourth good reasons to take a more sanguine view. First, the overall effect of reform will probably be to increase federal spending on health care, and this probably will translate into greater total health care spending—that is to say, demand for medical care, services, medicine and equipment. Second, any reform that comes out of Congress will look more like what we already have than many—particularly on the Right—fear. Third, there is a wide dispersion in quality and value across this sector, and therefore good room for intelligent stock-picking. Fourth, if reform fails in Congress, there is also upside, similar to the scenario that brought up many health care stocks in the wake of the Clinton’s Administrations failed effort.

In medical equipment, Texas-based Kinetic Concepts Inc. (“KCI,” $33.16) is attractive. (all prices quoted as of market close 8/11/2009; data source is Yahoo Finance). KCI is involved broadly speaking in tissue care, including wound healing, cardio-vascular complications, regenerative medicine (soft tissue repair and replacement) and bariatric (obesity prevention and treatment). Its market capitalization is about $2.35 billion. Its price to earnings ratio for the trailing twelve months is 11.27 times and its expected price to expected earnings ratio for 2010 is a mere 7.76 times. Its operational performance shows good momentum. Its PEG ratio (ratio of price per share to 5 year expected earnings growth, as measured by Wall Street analysts; a measure of long-term value in relation to growth) is only 0.84, where a number below 1.0. Return on equity, a measure that reflects partly on management quality, is a healthy 23.24%.

Industry giant Humana (“HUM,” NYSE, $34.40) offers supplemental health and accident insurance benefit plans to various classes of customers, including government, corporations and individuals. The so-called government segment includes a large Medicare Plus gap insurance program. HUM appears to be quite attractive from a value perspective. The company is potentially vulnerable to adverse affects from health care reform from several angles, which could possibly reduce revenues or operating margins in some of these segments. However, Humana has been on trend of beating analyst expectations and is a well-managed company.

In the biotech sector, a promising candidate is Biogen Idec (“BIIB,” $47.93). BIIB has a number of products in the market currently, including Avonex and Tysabri (for treatment of multiple sclerosis), Rixutan (for certain forms of non-Hodgkins Lymphoma) and Fumaderm (for psoriasis). It also has a rather full pipeline of drugs under development, a number of which are in advanced stages (II or III) of the approval process with the Food and Drug Administration (FDA). It is trading currently at about 17 times trailing earnings and 11 times forward earnings for 2010.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

The Health Care Monster, 1: Issues for Reformers

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The big debate over health care reform continues to mount. Let’s consider some of the basic political, social and economic issues at stake.

On the macro-economic level, Americans spend a high and increasing portion of our Gross National Product on medical care, medicine and medical supplies. For the year 2008, we Americans spent 17 percent of our gross domestic product (GDP) on health care. Economists project that the percentage will rise to 20% by the year 2017. Heath care expenses during 2008 rose 6.9%, about double the rate of inflation. In fact, although about 50 million Americans lack health insurance, our medical expenditures in relation to health care are significantly higher than several nations that offer universal health insurance: “Health care spending accounted for 10.9 percent of the GDP in Switzerland, 10.7 percent in Germany, 9.7 percent in Canada and 9.5 percent in France [according to OECD statistics].” Source: NCHC Facts About Healthcare.

For medical care, our uninsured typically resort to the hospital emergency room, which is often the most expensive, frustrating and least appropriate place to receive it. At Greenwich Hospital, to give a local example, I have the impression these pressures have worsened in recent years, particularly since the closing of United Hospital in Port Chester—itself partly hastened by care for uninsured residents.

President Obama has sought to avoid the political land mines tripped by President and Mrs. Clinton in their health care reform debacle. Obama has held town meetings to build up support, he has in part shifted responsibility to Congress to develop legislation, and he has tried (mostly without a success) to gain some Republican allies.

The President is a consensus builder. However, I am afraid that out of the usual pluralist hopscotch in Congress, we will get a costly mishmash that will not resolve the real issues, especially:
§ How can we change the incentives that govern behavior by physicians?
§ How can we improve incentives for preventive medicine?
§ How can we reduce incentives for ineffective or marginally effective medicines, tests and procedures?
§ How can we reduce the overhead that now falls on doctors and hospitals regarding the insurance claim process?
§ How can we reduce incentives for private insurers to cherry pick the best risks while declining cases believed to be riskier?
§ How can we allocate scarce health resources to make sure all citizens receive at least a minimum level of care?
§ What are we willing and able to do for non-citizens, including undocumented residents (which ties in with our pressing need for immigration reform)?
§ How can we create such favorable incentives for the public weal while continuing to attract health professionals to practice medicine?

In the end, what we get will probably not meet our best hopes or worst fears. It will kluge together existing pieces, such as employer health plans, Medicare, Medicaid and insurance savings plans, with miscellaneous new federal initiatives and experiments.

Next week: likely outcomes and investment implications.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Update on CIT Group

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

CIT Group has been able to stave off bankruptcy, at least provisionally, through a $2 billion secured facility it has arranged with existing bondholders; the bondholders are seeking to arrange an additional $1 billion by the end of this month. CIT apparently rejected an alternative offer from GE Capital, of at least $2 billion, secured by aircraft. See Bloomberg.com article I would continue to avoid CIT Group stock, which will be diluted to homeopathic concentrations whether in bankrupcy or out of it.

The Mess at CIT Group

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The latest financial house to catch fire is US-based CIT Group, which lends to medium and large sized businesses. CIT faces several related problems: a large portion of its loan portfolio is impaired; it has absorbed heavy losses, with more to come; and its liabilities include many debts that mature soon and must be refinanced.

CIT has stated that it faces a $10 billion shortfall of funding over the next nine months. CIT has lost approximately $3.3 billion since the beginning of 2008. In December of 2008, CIT changed to a bank holding company in order to apply for assistance under the federal Troubled Asset Relief Program; it obtained $2.33 billion. CIT also attempted some large asset sales, including its railcar leasing unit, but without results. (Source: Reuters). It is now seeking FDIC assistance to guarantee its bond issues under the Temporary Liquidity Guarantee Program. (Source: StreetInsider.com). CIT has lost all of its investment grade ratings on debt; it is currently rated B3 (Moody's), CCC+ (S&P) and BB (low) (Dunn & Bradstreet). See
CIT Group--Investor Relations. On July 10th, CIT's 5.60% notes due 2011 were quoted at 72 cents midpoint, while its 5.125% paper due 2014 were quoted 54 cents midpoint.

CIT’s assets at the end of the first quarter of 2009 totaled about $75 billion and shareholders’ equity over $7 billion (book values). (Source: federal filing, Form 10-Q). However, the market value of its battered public stock outstanding is only about $500 million (ticker “CIT,” NYSE traded, $1.35 closing price 7/13/2009). (Source: Yahoo Finance) CIT has retained Skadden Arps for counsel regarding a possible imminent bankruptcy filing. (Source: MarketWatch.com)

On March 10, Federal Reserve Chairman stated in a speech to the Council on Foreign relations that current Fed policy in this “fragile environment” is not to allow any “major financial institution” to fail. Investors buy Citi and bank on Bernanke - MarketWatch. This unwise pledge leads to big questions. What is “major”? What is a “financial institution”? What does “fail” mean? How long is this pledge good for? What if a rescue attempt itself “fails”? Does the pledge imply that the government will let small banks fail (aside from honoring FDIC obligations)?

There has long been implicit government support for the “too big to fail” doctrine. The Fed strong armed banks during 1998 to save Long Term Capital Management from insolvency. The Fed argued that the systemic risk from such a failure was not tolerable. Such implicit support has enough negative consequences without making it an explicit promise (to the public, to employees, to shareholders, to creditors). Then the government backs itself into a corner.

Consider the institutions that have received government emergency funding to stave off insolvency. These include giants such as AIG, Citigroup, Merrill Lynch, General Electric/GE Capital and Goldman Sachs. Then look at the cases of Bear Stearns (forced to merge with JP Morgan at a distressed price) and Lehman Brothers (allowed to fall into bankruptcy). Bear and Lehman were both significant Wall Street players but of the second tier. Having said that, Lehman’s bankruptcy shocked and disrupted international markets extraordinarily. If we ask, what is the principled reason (if any) why the Fed allowed Lehman to fail, but not others, size provides a partial if not totally consistent rationale.

The government allowed Lehman, which had about $640 billion of assets, to founder. CIT's are a little more than 1/10 those of Lehman. In the view of Mark Calabria, who studies financial regulation for the Cato Institute, "People need to actually fail at some point. We need to be able to draw a line." (Source: Bloomberg News Service.)

The government has indicated that a CIT bankruptcy does not present “systemic risk,” an indirect way of suggesting that the government might allow it to fail. Federal officials believe that large commercial banks such as JP Morgan can step in to replace CIT in its business lending role. If CIT goes into bankruptcy, the result would most likely be rapid liquidation of its assets and a winding down of its business. The death of CIT could further crimp lending to small business as we seek to emerge from the current recession. At present, though, CIT is too hobbled to be an active lender anyway.

I believe the outstanding CIT stock will likely be extinguished (rendered worthless) in bankruptcy. Therefore, the stock should be sold, even at the present apparently low price. Any intelligent investment in CIT would have to focus on its debt, which would require a careful analysis of the likely outcomes of a bankruptcy for the holders of CIT bank loans and unsecured notes. Its 5.60% notes due 2011 are quoted around 70% of face amount, while its longer 5.125% notes due 2014 are quoted around 50% (with wide bid-offer spreads). I believe the debt ratings will fall further, as will the value of the debt. An arbitrage approach would be to go long the debt and short the stock, using dynamic hedging.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

The Current Economic Cycle: U, V, W or Zigzag?

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Are we coming out of the recession, slowly but surely, and ascending to sustainable economic growth? Martin Feldstein, a senior professor of economics at Harvard, says no: "I think we’re going to see a temporary substantial improvement," Feldstein stated, adding. "I emphasize the words temporary and substantial." Feldstein was formerly head of the National Bureau of Economic Research, a private research group that analyzes economic growth, including the timing of recessions and recoveries. Feldstein predicts that the domestic economy will contract sharply again in 2010. He foresees not a V-shape--into recession and then out--or even a “beautiful, symmetrical W,” but more of a seesaw pattern. Source: Bloomberg Radio; see Feldstein's Remarks.

Feldstein’s “seesaw” metaphor is particularly striking because the consensus calls for a gradual U-shaped recession to recovery cycle. As the consensus of blue chip economists and forecasters is often dead wrong, it is prudent to consider alternatives. One factor that might support Feldstein’s remarks: money supply, as influenced by federal spending.

The fiscal stimulus package so far consists of three parts: immediate, intermediate and long-term. Immediate stimuli included the $400 individual tax credit, which has passed through the system already. The package also included improvements in unemployment benefits. Stimuli of a more intermediate nature included support for state Medicaid plans, a tax credit for first time home buyers, tax incentives for new car purchases and trade-in of “clunkers,” tax incentives for modest income families to weatherize their homes, and temporary extension of COBRA health coverage benefits beyond statutory limits.

Long-term stimuli include: over $100 billion for education and job training; $27.5 billion for highways and bridges; $11 billion to improve the nation’s electricity grid; and $7 billion for broadband development in rural areas. Source: The Stimulus Plan: How to Spend $787 Billion - The New York Times. These projects will take many years to design, approve and build or implement. However laudable some of these purposes are, most of the money may not enter the economy until after the recession has ended, and the spending may fuel future inflationary pressures. Such are the pitfalls of quasi-Keynesian economics as proposed by the Executive Branch and massaged in Congress.

In the meantime, cutbacks in aid to states and cities by the federal government—enacted as part of a political compromise with moderate Republicans—are starting to counteract the federal stimulus.

An unknown factor is the willingness of commercial banks to increase now depressed levels of commercial and consumer lending. Commercial banks and financial institutions so far have used most of their TARP funds to improve their balance sheets rather than to re-circulate the money to borrowers.

Consider also credit creation outside of the commercial bank balance sheets. As economist and independent trader Gary Evans has often reminded me, the overall shrinkage of this “shadow banking system” is severely contractionary. The shadow financial system includes all sorts of institutions and processes that put investors and borrowers together, other than by bank lending. It includes: investment banks; the corporate bond and commercial paper markets; conduits for mortgages and corporate bonds; off balance sheet structured investment vehicles (SIV’s); securitizations of assets [including mortgage-backed passthrough securties (MBS), collateralized debt obligations (CDO's), collateralized loan obligations (CLO's); collateralized mortgage obligations(CMO's); and asset-backed securities (ABS) such as credit cards and utility billings]; monoline insurance companies; over the counter swaps and options; bank loan funds; insurance company funding schemes, including fixed and variable annuities and guaranteed investment contracts; and non-bank finance companies.

Another unknown factor is international trade. We are embedded in an increasingly global economy, and our fortunes are tied to the problems and opportunities of other economies, many of whom are still mired in recession.

Yet another unknown factor is the ability and willingness of the Fed to maintain an unprecedented accommodative stance, with nominal rates for Federal Funds targeted between 0% and ¼%. Four factors that could tilt the Fed toward tightening would be sharp rises in the consumer price index, labor market scarcities, severe weakness in the US dollar or a marked steepening of the yield curve (implying rising long-term inflationary expectations among bond investors).

An implication of Professor Feldstein’s forecast is that the current round of economic stimulus may not be enough to lead to sustained growth. Setbacks would lead to pressure for further fiscal stimulus, lower tax receipts and even greater federal deficit spending. Such conditions could in turn raise the cost of cost of raising capital privately, which would retard corporate recovery.

Shakespeare wrote that the “course of love never did run smooth”, and the same is probably true for the current economic cycle. In this recovery, we may zig and zag more than we zoom.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions: e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Aftermath of the Madoff Scandal

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

On June 29th, federal Judge Denny Chin sentenced Bernard Madoff to 150 years in prison. The fallen financier pled guilty to an eleven count criminal complaint. He made a contrite statement in court, turning to face spectators who included some of his defrauded investors. However, the US trustee overseeing the bankruptcy proceedings of Madoff’s securities firm reported that Madoff did not provide “meaningful cooperation or assistance.” The judge characterized the Ponzi scheme as “evil”, “staggering” and “off the charts.”

Madoff claimed that his scheme began 19 years ago, but government officials believe it started at least ten years earlier. Judge Chin will probably order Madoff to make restitution of $170 billion, approximately equal to the total amount deposited in his business checking account at Chase Manhattan Bank (of which only a small fraction will be collectible).

How could this scheme have gone on for so long and grown so big? One answer is the modesty of the returns promised. The infamous Charles Ponzi promised 50% return in 45 days or 100% in 90 days. Such a scheme will obviously fall apart fast. See Financial Illusions--Greenwich Financial Website. Madoff’s malign genius was to promise steady but not stellar returns—perhaps 10% a year, give or take. He appealed to the craving of many people for a good yielding investment with little risk. Ironically, the longer the scheme went on, the more impressive the track record appeared to be. Second, Madoff claimed to practice a known and legitimate investment style called “split strike conversion.” This is true even though no firm could practice that style—which entails owning stocks and writing call options against them—in such massive size or low volatility. Third, Madoff perfected a masterful marketing scheme in which his reluctant posture was offset by a merry-go-round of aggressive “feeder funds.” Many investors in the feeders never heard of the Madoff sub-investment. The largest of these feeders included various funds of Fairfield Greenwich Partners (about $7.5 billion in affected assets) and Ezra Merkin (about $2.4 billion in affected assets). Finally, Madoff cruelly exploited a circle of trust within the Jewish community, including individuals (both wealthy and not), college endowments and charities.

What will follow? A few points:

• Although Madoff did not cooperate meaningfully, prosecutors may have enough information to prosecute up to ten others. Source: Newsweek.com


• There will be a tremendous incentive for hedge funds (even including startups) to use blue chip, name brand law firms, accountants, administrators, prime brokers and pricing sources. Madoff’s firm lacked each of these. This will further extend the power of these entrenched firms.


• Changes will certainly occur in the federal regulatory system. The scandal calls into question the system of internal enforcement by industry players. It also raises doubts about the ability of the SEC to police financial fraud and even in some cases to understand it.


• Investor trust will remain depressed for many years, and properly so. Enlightened skepticism is a good attitude for all investors to take regarding the management of their money.

A Mushy Recovery

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The economy may start to show some growth toward the end of 2009. However, the recovery is likely to be anemic.

One factor holding back industrial recovery: very low levels of usage of our industrial capacity. When our industrial capacity utilization is low, expansion does not call for much new investment in capital goods equipment. (Capital goods equipment includes plant and machines to make new goods.) At the same time, inventories are high in many industries.

To take a striking and important example, before General Motors makes a lot more cars in the U.S., it needs to find a way to clear out the overstuffed parking lots of its franchised dealers, including the ones it will be closing down. GM feels pressure too from the glutted inventories of its competitors, even including industry technology leaders like Toyota. If GM does need to produce more cars, it can open up one of its idle plants rather than build a new one (leaving aside retooling for new models.) GM can draw steel and many parts from its own overstocked inventory. Let’s say GM does need to order new steel sheet. US Steel and others can deliver it from their own inventories, or they can restart idle capacity rather than building new capacity. On it goes. This glut of capacity is typical of recessions but is especially severe in this downturn.

Economist John Mauldin, in a recent issue of his newsletter (“This Time It’s Different, 6/19/2009), drew attention to the following data compiled by the St. Louis Fed:

As the graph indicates, US capacity utilization has fallen to about 68%, where any level below 80% normally reflects a business recession. As Mauldin aptly asks, “Does anyone really think that businesses (in general) are going to invest more money in expanding capacity, in the face of the lowest level of production relative to potential since the 1930s?”

If demand does not come much from the capital goods sector, then maybe it could come from consumer goods. But here too, there is a major problem: the dramatic restriction in credit to consumers--both as to equity lines of credit on real estate and credit cards—and the reduced sense of wealth and well-being that many feel. What’s more, consumers are tending to save more and spend less: the U.S. savings rate has increased from just below 0% to about 6% since the beginning of the crisis, and it may go higher (Mauldin says 9% is plausible).

Finally, increased exports could spur economic growth. However, this outlet is limited by the continued competitive problems of US industry, but even more importantly, by the worldwide nature of the recession. Demand is slack almost everywhere.

For these reasons, the recently ebullient US stock market, so relieved that we have come out of utter panic, that this is not the end of the world, is likely to stumble. The sky doesn’t have to fall for us to face some harsh weather.

Obama to Propose Regulatory Reform

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The Obama Administration is about to propose an overhaul of our system of oversight and regulation of financial markets. Treasury Secretary Timothy Geithner and Director of the National Economic Council Lawrence Summers have laid out what seems to be a blueprint for the proposed reforms, in an Op-Ed piece published in the Washington Post. The Case for Financial Regulatory Reform - washingtonpost.com (6/15/09)

Geithner and Summers indict the existing system: “Over the past two years, we have faced the most severe financial crisis since the Great Depression. The financial system failed to perform its function as a reducer and distributor of risk. Instead, it magnified risks, precipitating an economic contraction that has hurt families and businesses around the world.” They add that this “crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation.”

Geithner and Summers make these proposals:

• An increase in the capital and liquidity requirements of all financial institutions. The largest and most “interconnected” institutions would face more stringent requirements and would be subject to the consolidated supervision of the Federal Reserve Board.


• Establishment of a “council of regulators” with broad supervisory power over the whole financial system.


• Concerning asset-backed securities: more robust reporting requirements; reduced reliance on credit rating agencies (how?); a requirement that originators, sponsors or brokers of a securitization retain a financial interest in each securitization (how much?).


• Enhanced regulation of derivative securities, especially of over-the-counter (customized) derivatives. More robust safeguards for payment and settlement of over the counter derivatives. [No mention here of a centralized clearing house for such derivatives, which is sorely needed, as we have argued before in this column.]


• Greater consumer protection against fraud and deception in financial marketing.
  Procedures for the orderly resolution of any potential failure of a bank holding company, without inappropriate reliance on the Fed’s lending authority, to “help insure that the government is no longer forced to choose between bailout and [systemic] financial collapse.”


• New efforts at international coordination of financial regulation.

Institutionally, here is what I foresee:

• There will be no master regulator.


• The Fed will come out stronger.


• The Office of Thrift Supervision (OTS), an agency of the US Treasury, has been extremely ineffective and will probably be faded out of existence. OTS supervises a number of holding companies with respect to non-bank financial subsidiaries, which includes such major firms as AIG, General Electric, American Express and Morgan Stanley; this power will devolve to the Fed, the Comptroller of the Currency, and perhaps FDIC.


• Finally, the Commodities and Futures Trading Commission, which ought to be merged into the SEC to avoid overlapping jurisdiction, will unfortunately maintain its independence.

Thus, the so-called “alphabet soup” of federal entities overseeing financial markets will by and large continue, but some of the rules will be tightened up. Given President Obama’s pattern of compromise (and, perhaps, political shrewdness), expect incremental change, not revolutionary—particularly after Congress and the interest groups have their say.

The Compensation Controversy

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

In the wake of massive bailouts in the financial services industry, Congress and the Administration feel increasing pressure to do something about executive compensation on Wall Street.

It is not hard to understand feelings of outrage. Take Citigroup. “If you’ve never worked on Wall Street, it is hard to wrap your head around the idea that a company that lost nearly $19 billion in a single year, as Citigroup did in 2008, could still pay its employees [almost $4 billion] in bonuses.” Getting Theirs Cuts Both Ways on Wall Street - NYTimes.com

Note that Wall Street is nothing if not ingenious (part of what got us into this mess). As the Administration was making a commotion about bonuses, some of the remaining investment banks—including Morgan Stanley, Crédit Suisse and UBS—stepped up many executives’ salaries handsomely. See UBS Raises Top Bankers’ Salaries as Bonuses Fall - DealBook Blog - NYTimes.com and Bonuses abandoned for higher salaries. To some extent, the high proportion of bonus to salary of many executives on Wall Street harked back to the partnership era, and this new regime will further corporatize the financial environment.

I heard talk on the radio that traders may be exempted from new federal compensation guidelines—I don’t why. I was a trader on Wall Street for some time, and we definitely had the power to make as much mischief as the investment bankers, and probably more.
If this exemption goes through, everyone on the Street will want to get reclassified as a trader!

Of course, as to Congress, and both major political parties, there is some hypocrisy. In Congressional hearings during the Bush Administration, Alan Greenspan had clearly expressed alarm at the size of the balance sheets of Fannie Mae and Freddie Mac, and he questioned their need to hold massive amounts of mortgage-backed securities in portfolio. Congress nevertheless abetted the misuse of implicit federal guarantees by these two agencies.

Executives at many financial institutions that accepted TARP assistance—including Goldman Sachs, for example-- are racing to return the government loans. The government recently offered a bailout to a number of insurance companies, and only the most desperate are inclined to accept it. See Investment Value Digest: TARP for Insurance Companies.

There are really four issues: 1> Is Wall Street compensation too high, and if so, relative to what? 2> Is Wall Street compensation too much geared to short-term gains, without regard to long-term profitability and sound practices? 3> If the first or second question are answered yes, does government need to intervene? 4> If proper, should this regulation apply to all financial institutions, only to banks, only to investment banks, only to TARP recipients, or only to repeating TARP recipients?

My judgment is that public financial institutions are right that they may lose top talent if they suppress compensation excessively. Although there is currently a surplus of Wall Street professionals out looking for jobs, there is never a surplus of the most profitable employees, and these are the ones who can cut loose most easily. However, it is probably a good thing that the government seeks to restrict compensation for TARP recipients. It gives the recipients a strong incentive to pay the government back, assuming they meet tests of balance sheet adequacy. In this way, the funds can be recycled to new emergency cases.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions: e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

GM Files for Bankruptcy

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

On June 1st, General Motors filed for protection under Chapter 11 of the federal bankruptcy code. The United States government, which has already provided $20 billion in funding to GM and its financing subsidiary, will now also provide (together with the Canadian government) $39.5 billion in preferred “debtor in possession” funding under bankruptcy. The Obama Administration hopes that a pared down and competitive GM can emerge quickly from bankruptcy after shedding a great deal of liabilities.

In the article, “Panic in Detroit, I: Sell GM” (Greenwich Post, 2/10/2006), http://greenwichfinancial.com/wm94.htm we had recommended “shorting General Motors stock at current levels (closed February 9th at $22.14 per share), with the goal to cover the short at $7 to $10 per share within the next two years. If General Motors were actually to enter bankruptcy, expect the equity (stock) to be extinguished or diluted to near zero value.” We also recommended a risk-controlled trade: to buy the General Motors 7.40% debentures of 91/1/2025 at about 63.875% of face amount and sell short GM stock. Both of these trades would have succeeded brilliantly if held, but both would have been about twice again as profitable if timed at the recent high point of GM stock, which was $42.64 on October 8, 2007. As it is, the stock of proud General Motors is now trading in the “pink sheets,” as a penny stock, and it will indeed be extinguished or diluted close to zero value.

However, it wasn’t short-sellers or arbitrage traders who brought GM to this brink: it was instead poor executive decisions stretching all the way back to the 1960s, ferocious foreign competition, and the lavish benefits granted to unionized autoworkers by management, in what amounted to a joint suicide pact.

One benefit of the bankruptcy process, assuming GM emerges as a going concern, rather than being liquidated, is a dramatic reduction in its liabilities to existing and former workers. The United Auto Workers Union has agreed to receive stock in the new GM equal to about half of GM’s liabilities to the unionized members.

It is easy to understand what the Bush Administration and now the Obama Administration wished to avoid: first, the potential crippling of the auto industry, its suppliers and distributors, in the midst of a recession; second, the potential cost of not bailing out GM, including federally guaranteed pension obligations. I have great reservations. GM didn’t compete very well against companies like Toyota, Honda, BMW and Mercedes. Now it faces potentially crushing competition from China. GM’s existing product line is not particularly promising, though it has bright spots. Further, plans for dealer and plant closings will no doubt generate powerful political interference from Congress, and these objections will be difficult for the Administration to resist.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.
Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Anticipation (the song, the market)

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.
In the song “Anticipation,” Carly Simon sings “We can never know about the days to come/but we think about them anyway, yay.” As with Ms. Simon’s lyrics, U.S. stock investors have likewise been “chasing some finer day.” At a level of 888 on the S&P 500 Index (closing price, 5/21), we are now about 33% above the lows of 667 from March 9th of this year. We had gotten as high as 929 on May 8th (up 39%), before the market experienced some retreat.

Economists consider the stock market a leading indicator (predictor) of economic trends. However, Nobel Prize winner Paul Samuelson has written: “To prove that Wall Street is an early omen of movements still to come in GNP, commentators quote economic studies alleging that market downturns predicted four out of the last five recessions. That is an understatement. Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.” (Newsweek column, 19 September 1966)

Even so, the stock market probably has a better prediction record in this regard than, say, the average opinion of top economists, called the “blue chip consensus.” Investors and traders have been focusing on these positive factors, among others:

• The shrinking “TED spread,” which reflects confidence in banking institutions by other banks.


• The beginning of recovery in certain hard hit residential housing markets.


• The rally in investment grade and high yield bonds, reflecting greater confidence in the ability of issuers to pay on their obligations.


• The decisiveness of the Fed, the Treasury Department and the White House in moving to stimulate the economy.

The reversal of shrinkage in the supply of money, as measured by M1.

Investors, however, may not be giving enough weight to these negative factors:

• The uncertain course of many economies on which we rely for international trade.


• The continued sluggishness of bank lending.


• The likelihood of further increases in the rate of unemployment.


• The likelihood of a continued decline in some other residential housing markets, and in commercial real estate, which were less hard hit initially.


• The danger of inflation or even stagflation (stagnation plus inflation) emerging as a negative investment theme in the near future.


• Our national debt and budget deficit dilemma.


• Weakness in consumer demand.


• The possibility of a bottomless pit in efforts to bail out domestic carmakers.


• The rather high price to earnings ratio of the stock market as a whole, as measured for example by a ratio of about twenty times 2009 expected earnings for the S&P 500 Index. (See "No Pig Heaven," by Alan Abelson, Barons, 5/18/2009).

My view is that we are indeed in the process of climbing out of a bear market. This has not been a false rally in that sense. Volatility (fluctuation of prices) has fallen from late last year (having reached an astronomical 80 on the VIX index then and about 32 now). I see the recent forceful rally already losing some steam, and I anticipate we will spend several months fluctuating within a band of about 30% to 40%above the recent lows.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

TARP for Insurance Companies

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Following through on our recent series considering the credit quality of your life insurance policies, we should note the announcement of federal assistance in this sector. As expected, the Troubled Asset Relief Program (TARP) bailout program will be extended to a group of US insurance companies. The Treasury Department required that any insurance company applicants have a regulated banking subsidiary; most large carriers have such an entity, but this connection with banking is arguably just a fig leaf to cover further mission creep for TARP.

The government has tentatively approved six carriers for potential TARP assistance:

• Ameriprise Financial (ticker: “AMP,” formerly known as American Express Financial Advisors),


• Prudential Financial (“PRU”)


• Allstate (“ALL”) (primarily a property and casualty insurer)


• Hartford Financial (“HIG”)


• Lincoln Financial (“LNC”)


• Principal Financial Group (“PFG”)

Accepting TARP funding has its disadvantages. First, as with the banks, the act of applying for and accepting TARP funds, especially if sizable, highlights the very financial distress it is meant to alleviate. Second, attendant federal oversight can preoccupy management at the expense of other pressing priorities. Third, although insurance companies are not known particularly for sky-high compensation packages, the government would certainly frown on what it considers excessive management pay. In some cases, TARP oversight might lessen the ability of a company to attract or retain top talent. (This is a main reason why financial institutions like Goldman Sachs have been racing to repay their TARP funds. From a taxpayer viewpoint, this is just fine.) Finally, the government may not be willing to accept the future repayment of TARP funds without the recipient first raising substantial capital in the stock market, which would create percentage dilution of existing shareholders (although recapitalization with fresh stock may be both necessary and inevitable regardless).

Some of the insurers are hesitant to accept government help. Ameriprise said it won’t, while Prudential said it is considering its options. On the other hand, Lincoln Financial’s CEO, Dennis Glass, said that they “appreciate…preliminary approval for inclusion” and Allstate’s CEO, Thomas Wilson called the Treasury announcement “a positive and proactive step [that] recognizes the integral role that insurance companies play in our economy.” Source: Fortune Magazine, article by Colin Barr- May. 15, 2009.

Some of the financial problems facing insurance companies are directly related to the current financial crisis. The absence of liquidity impedes the routine refinancing of corporate bonds and even short-term obligations like commercial paper. The purchase of new or additional insurance coverage is also a discretionary expenditure that many strapped consumers will defer. Then too, as part of this vicious circle, the declining credit ratings of many insurance companies on their long-term debt raise the costs of borrowing and decrease access. Other problems preceded the current crisis. One is over-capacity: there are too many insurance companies. Another is the practice of issuing or investing in complex derivative instruments that are difficult to value or hedge, a la AIG. A third is the burdensome patchwork of regulation, which makes introduction of new products and revision of existing products an expensive 50 state process. As fallout from the current crisis, I expect a shakedown in the insurance industry, with many mergers and acquisitions. I also expect increased pressure to move away from state and toward federal regulation, possibly by the SEC.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Joblessness

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.
The most recent payroll employment numbers released by the federal government show that the unemployment rate has climbed to 8.9%--the highest rate in twenty-five years. Total jobs went down by 539,000 in April. These numbers were actually less than the 699,000 loss in March. Source: U.S. Department of Labor. Although government hiring explained most of the improvement, investors took cheer from the report, and US stocks rallied.

The unemployment rate understates the extent of suffering in the United States. This is because, in economies entering a recession, many workers are forced to accept part-time or reduced hours, or substitute less desired work, or even give up looking. Indeed, the combination of unemployed plus marginal or discouraged workers is now approaching 16%, wages are standing still and average work hours are falling. (Source: Financial Times, “Private Sector Leads Job Gloom,” May 9, 2009, based on Department of Labor and Thomson Reuters data.)

President Obama called the lesser loss of jobs compared to the previous month “somewhat encouraging” but still “sobering,” saying “It underscores the point that we are in the midst of a recession that was years in the making and will be months or even years in the unmaking.”

Economists consider payroll employment a “lagging indicator”—that is, it reflects economic trends with a time lag, as opposed to “leading indicators”—which are thought to anticipate or predict economic trends. Therefore, even though the worst of the financial crisis may have passed, unemployment in the United States will probably continue to rise for the rest of this year and maybe into next year.

One (sometimes) fallible leading indicator is the stock market. The S&P 500 Index, at a recent closing level of 929, is about 40% above its low point of 667. I had expected until recently that we would retest the low point. However, although I still expect a correction, the palpable easing of the sense of financial crisis leads me to think that 667 will indeed prove to be the bottom of the current cycle. Moreover, some of the residential housing markets worst hit by the economic crisis shows signs of bottoming out, and speculative real estate interest is budding in selected markets in both the Southeast and Southwest.

A bullish indicator is the sorts of early cycle stocks that have been doing well. These include some of the sectors worst hit in the bear market: energy (including exploration as well as production), raw materials and capital goods. The stock market has been called a “prediction machine,” and although these predictions may fail, investors are acting as if they believe economic growth will resume. Rather than waiting for economic growth or even the ending of decline, investors are focusing on the de-acceleration of the rate of decline.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Chrysler's Fate

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Readers of this column know the dim view we have taken of Chrysler’s prospects (see “Panic in Detroit,” March 9, 2006). We doubted the wisdom of Cerberus in acquiring Chrysler from DaimlerChrysler (now DaimlerBenz) (see “Chrysler on the Block, February 2, 2007), saying we had “trepidation” for the financial health of their limited partners. Then, more recently, we predicted, “Among major financial disasters in the making is Chrysler…Cerberus named Robert Nardelli, who virtually destroyed Home Depot, as CEO. Chrysler was already somewhat poorly positioned in product line, but look for this management to bring the firm to its knees” (“Wall of Worry,” 3/14/2008).

The federal government has provided $5.5 billion in TARP money to Chrysler and Chrysler Finance. Nardelli did some necessary cost cutting and reorganizing, while leaving the product lineup not much changed. Chrysler continues to bleed cash, and its sales in April were down 48% versus April one year ago, a worse drop than that of any other major carmaker. The incoming Obama Administration officials sought a settlement with parties out of bankruptcy, or, alternatively, a “pre-packaged” bankruptcy. Chrysler had been in talks with Fiat, led by the expansive CEO Sergio Marchionne, and the government insisted that any further government financing would depend on a definitive Fiat alliance. The government obtained major concessions from the United Autoworkers and the major creditors, but it would not accept the position of a group of “holdout” secured creditors, including some traditional money managers and hedge funds, who asserted that the offer was too generous to workers and unfair to lenders. Chrysler filed for bankruptcy under Chapter 11 on April 30th, a decision announced by the White House rather than management.

Fiat is not an obvious white knight for Chrysler. Like Chrysler, it has a reputation for unreliability; also like Chrysler, it has only begun to focus seriously on these issues in the last few years. It was not for nothing that automotive enthusiasts used to say that Fiat stood for “Fix It Again, Tony.” Moreover, Fiat is not offering to bring any cash to the table. Finally, it’s not clear that a Euro-American enterprise will be able to survive the coming ferocious competition with China. Warren Buffett’s Berkshire Hathaway has been investing with Chinese conglomerate BYD, which may well beat Detroit off the blocks with an inexpensive electric plug-in vehicle. (See “Warren Buffett Takes Charge,” by Marc Gunther, Fortune, 4/13/2009).

A positive factor is that Chrysler is known for large engine vehicles, whereas Fiat is associated with a line of smaller, fuel-sipping Euro-cars such as the new Fiat 500. Quattroroute, an Italian periodical, has reported that Fiat is developing a hybrid gas/electric system for small cars that it would also offer through Chrysler. A second positive factor is that Chrysler would be combined into a larger and more economic enterprise, possibly also to include GM’s European operations. Source: Autobloggreen.com.

Under the proposed reorganization plan, secured creditors would receive 33 cents on the dollar, while unsecured creditors would receive 9.2 cents per dollar of investment. Likely ownership, if reorganized: 55 percent of the company to the UAW (which it plans to sell to fund its new Voluntary Employee Benefits Association, or VEBA, which will assume responsibilities for health care), 20 percent to Fiat, 8 percent to the U.S. government, and 2 percent to the Canadian and Ontario governments. Car News Blog at Motor Trend. The remaining 15 percent goes to creditors. Fiat’s 20% could rise five percent at a time up to 35% if it meets certain benchmarks. Cerberus would retain zero equity (on an investment of $7.4 billion in 2007), as would DaimlerChrysler (of its remaining 19.9% stake).

Chrysler has shuttered its factories pending emergence from bankruptcy. Whether Chrysler emerges as a going concern, or goes into liquidation under Chapter 7, depends largely on the speed of that process. The Administration optimistically hopes for a “surgical” 60 day proceeding. However, the process could easily drag on much longer, which would be fatal.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Stress Over Stress Tests

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The nineteen largest U.S. banks received the results on April 24th of regulatory “stress tests.” The tests forecast the likely impact on major banks of unfavorable economic scenarios. Analysts are busy speculating on the results. The stress tests have themselves become stressful.

Banks face a temptation to post rosy quarterly earnings reports as a posture going into the stress tests. Indeed, quarterly earnings reports from recipients of TARP aid—including Citigroup, Bank of America, Wells Fargo and Goldman Sachs--look astonishingly strong.

It is now easier for banks to camouflage deteriorating assets, as a group of financial institutions sought and received some relief from the Financial Accounting Standards Board (FASB) as to mark-to-market pricing of long-term assets (especially under Statement No.157, promulgated in late 2007). The American Bankers Association and the US Chamber of Commerce aggressively lobbied for relief. Former SEC Chairman Arthur Levitt opposed the change, as did the CFA Institute. Presumably, many banks will now seek to value loan assets at amortized cost minus impairment rather than market value. Result: at the very time when investors need more transparency, they will get less. Analysts must now prepare a shadow balance sheet using estimated mark-to-market asset pricing for each bank in question.

Another artifice of banks is to take gains on the falling market value of their own liabilities. Here, the realization of the supposed discount is fictional unless the banks in question renegotiate or default upon their obligations. Lehman Brothers followed this valuation practice before its fall, but so have many others. Audacious banks might now mark questionable assets at cost, while discounting their liabilities, an artificial situation on both sides.

U.S. regulators are considering not just traditional capital adequacy ratios, as they relate to lending, but also “counterparty risk” on derivative contracts. One example of such risk is where a bank lent money to a client company and also bought a “credit default swap” to hedge its risk. If the client company defaults on the loan, and the counter-party (probably another commercial or investment bank) itself fails to make good on the credit default swap contract, then there is a risk exposure not captured by traditional measures.

Such regulatory considerations make bankers fret. One brokerage firm (Keefe, Bruyette and Woods) has suggested that the banking industry will need to raise capital of one trillion dollars to reach adequate levels of balance sheet strength. Some analysts believe that number is much too high, but I give it credence. Source: (Financial Times, “Stress
tests likely to force banks into equity boost,” by Krishna Guha, 4/24/2009 issue, pg. 3).

The Obama Administration is considering the release of some stress test information, but it faces a huge potential pitfall. Any bank known to fail the tests would face an immense challenge in raising the needed capital. Panicky counterparties might exit, leading to the need for another costly federal rescue or FDIC deposit exposure.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Chinese Economy Strengthening

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.
Measures of industrial production have begun to increase in China in the first quarter of 2009. The index of manufacturing has shown strength. Demand for oil and raw materials such as iron ore is picking up. Stocks have also rallied broadly. The Shanghai Stock Exchange Composite Index, which fell to about 1700 in mid-November, is currently around 2500, almost a 50% gain—though far below its high of over 6,000 in October of 2007.

However, exports remain weak, which could imply that inventories will build up. To improve domestic demand and reduce reliance on exports, the government is promoting rural purchase of appliances such as televisions and refrigerators. It is also extending the rudimentary social safety net, including expansion of medical insurance.

According to Xeng Xinli, deputy policy research head of the Communist Party, Chinese exports may fall by 10% this year, endangering the official growth target of 8%. China has embarked on a massive 4 million RMB (approximately $585 billion) stimulus package. The package emphasizes infrastructure development and education. China is now considering additional fiscal and tax stimulus measures. China Mulls New Stimulus to Boost Consumption, Bolster Recovery - Bloomberg.com

To be sure, China is not adding to its international reserves at the massive rate it has been experiencing in the last few years. According to the Central Bank of China, reserves increased by only $7.7 billion in the first quarter of 2009 versus $153.9 billion in the same period of 2008. A shift in the balance of trade was one factor, but capital flight by foreign investors in China probably played a larger role. However, there are signs that capital is flowing back toward China, as the sense of crisis eases. The trend is favorable, as “Chinese reserves fell a record $32.6 billion in January and $1.4 billion more in February before rising $41.7 billion in March.” China Slows Purchases of U.S. and Other Bonds - NYTimes.com.

Premier Wen Jiabao made remarks several weeks ago indicating China was worried about the “safety” of its huge investment in US obligations; since that time, there has been heightened concern by US Treasury investors and traders about Chinese intentions. The numbers suggest that even without any prejudice against dollar assets, China’s need to buy foreign obligations will be much less this year.

One way to get invested in China is through the Matthews China Fund (ticker: MCHFX), which has almost $900 million in assets and a long-term track record. It is lead managed by Richard Gao. On April 13th, it closed with a net asset value of $16.34 per share.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Obtaining Small Business Loans from the SBA

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Many readers responded to my posting last week concerning Obama Administration initiatives to aid small business. The questions especially focused on the process for obtaining a loan from the Small Business Administration (SBA).

The main lending program that small businesses access through the SBA is called “7(A).” Providers of SBA-backed loans are called “participants.” These participants include many banks and some non-banks.

A bank seeking an SBA guarantee (or “wrap”) must certify that the loan does not meet all internal loan criteria but does meet SBA guidelines. The bank underwriting an SBA loan retains risk. This is because the SBA does not fully guarantee the loan. Further, the guarantee does not cover “imprudent decisions” by the lender or fraud by the borrower.

According to the official SBA Website, “Repayment ability from the cash flow of the business is a primary consideration in the SBA loan decision process,” but “good character, management capability, collateral, and owner's equity contribution are also important considerations.” See http://www.sba.gov/. The SBA takes into account equity investment by the owners, earnings history, balance sheet factors and the credit history of the business and its proprietors. Further, all owners of a 20 percent or greater interest in the borrower must guarantee the loan personally.

To be eligible for a loan, the business applicant needs to meet SBA maximum size standards, be for-profit, and show that neither the business nor its owners have other resources that could provide the funds. The SBA also considers the cogency of the business plan and the use of funds.

The maximum size for an SBA 7(A) loan is $2 million, of which the SBA will guarantee a maximum of 75%, or $1.5 million. Under the SBAExpress program, the SBA’s maximum guarantee is 50%.

Lending rates are either fixed or variable. Fixed rate loans of more than $50,000 are set at a maximum of Prime plus 2.25%. The Prime Rate is currently 3.25%, so this would indicate a maximum fixed rate of 5.50%, which would be highly attractive for many small businesses.

Under its business lending program, the SBA also provides micro-loans of up to $35,000 for start-up or growing small business concerns, through certified community Lending Intermediaries. Under Section 504, the SBA provides fixed rate financing on land and buildings fixed through non-profit Community Development Companies.

Besides its business lending program, the SBA lends to Small Business Investment Companies, who in turn make equity or debt investments in small business. SBA also provides guarantees under its Surety Bond Program—as to bid, performance and/or payment--which is meant to encourage small and minority contractors.

SBA loan maturities depend on the use of funds, cash flow projections and the useful life of assets. However, there is a maximum term of seven years for working capital and 25 years for real estate and fixed equipment.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Obama Proposes Aid to Small Business

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Until recently, the emergency national measures to stabilize the economy have focused on large institutions: Citigroup, AIG, Bank of America, GMAC, GE Capital, and so forth. Scant attention has been paid, or assistance given, to small business. Yet small business has felt the grip of the credit crunch as much or more than large business. And small business is dynamic; government economists estimate that small businesses generate approximately 70% of net new jobs in this country. (To see if your own business counts as a small business under the rules of U.S. Small Business Administration (SBA), consult the SBA Size Table).

President Obama and Treasury Secretary Geithner recently announced several initiatives aimed specifically at small business. Many of these are implementations of the American Recovery and Reinvestment Act of 2009 (ARRA):

1> The Small Business Administration will temporarily increase the guarantee level of Section 7(a) loans (the most basic and common type) of $150,000 or less up to 90%, from a previous maximum of 85%. SBA will also temporarily reduce fees for many loans. Such loans, by the way, are either fixed or variable and are pegged to the Prime Rate.
2> The Treasury will purchase up to $15 billion in SBA loans in the secondary market, in order to restore liquidity and reassure banks that there will be a ready buyer for SBA loan pools.
3> The Treasury will issue guidance under the ARRA regarding five year loss carry-backs, allowing businesses in some cases to get refunds on past taxes paid. (Normally losses can be carried forward but not backward.)
4> The Treasury will issue guidance under the ARRA concerning a write-off for small business investment of up to $250,000 in new plant and equipment.
5> There will be a temporary reduction of payment in estimated taxes by small businesses from 110% of the past year’s taxes to 90%.
6> The government will issue guidance on a 75% exclusion from capital gains for investment in small business (holding period at least five years). In his latest budget, President Obama has proposed an even more attractive 100% exclusion.

Source: U.S. Treasury (see Unlocking Credit for Small Businesses Fact Sheet).

I wish to note parallel efforts here in the state of Connecticut to complement federal initiatives and ease the credit crunch for our small businesses. My friend Chris Duffy-Acevedo of Keystone Mortgage has championed proposed legislation dubbed the State Assisted Fund and Exchange (SAFE) Act. The idea is to jump start lending in our State with a $5 billion revolving credit facility, overseen by state agencies. Our Community Banks would process loan applications under existing SBA guidelines, with individual loans to be pooled and exchanged for cash under the federal TARP program. I understand that Senators Dodd and Lieberman have sent a joint letter to Secretary Geithner highlighting this Act and supporting its integration with federal programs. Obviously, the future exchange of securitized loans for federal cash would require support from Washington.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Fed to Add $1 Trillion Plus in Liquidity

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The Federal Reserve Board took another bold step on March 18th by announcing a program to prime the economy with an extra $1 trillion plus in purchases of Treasury bonds and US Agency wrapped mortgage-backed securities.

Under the program, the Fed during the next six months will purchase of up to $300 billion in long maturity Treasury bonds (an unusual step). The Fed will also buy up to $750 billion of government-guaranteed mortgage-backed securities, on top of the $500 billion the Fed has already committed to purchase. The effect of these actions should be to reduce long-term interest rates, which could lower the cost of taking out fixed rate mortgages. This is clearly one main purpose of the program.

The Fed, in its regularly scheduled March meeting, kept the Fed Funds target range unchanged between zero and one-quarter percent.

Both domestic bond and stock markets rose in the aftermath of the announcement, as investors received further signals of the Fed’s willingness to take bold steps in the face of pronounced economic weakness. The Dow Jones Industrial Average, which had been down about fifty points, ended the day up about 90 points.

Fed Chairman Bernanke has predicted that the recession will begin easing toward to the end of this year, if the banking crisis resolves. But this is a big if.

There are signs that the domestic equity market is attempting to form a bottom, and this could set the stage for a major long-term bull market. The bull market in stocks would precede economic recovery and anticipate it. That is, unemployment may still be rising, retail sales may be weak and industrial production anemic, but these are lagging indicators. Investors will be watching for a change of direction in certain key leading indicators. I happen to think that signals from the residential housing market, including the inventory of unsold homes, will be very significant, as residential real estate problems brought us to where we are. A confounding factor which I have written about recently is international shocks, including those coming from emerging markets such as China, Brazil and some Eastern European economies, as they reverberate through the world economy.

It’s useful to look ahead to what unintended consequences could flow from the present regime of economic stimulus, however necessary it may be. These could be the mirror image of the problems we face now: excess liquidity instead of a credit crunch; inflation instead of deflation; and a weak dollar instead of a strong one. The bullish trend in gold reflects such forward looking concerns. By the same token, looking backward, we can see the present crisis as being engendered by the long bull market in stocks and bonds and incredible expansion of credit. That expansion of credit was in turn in part a response to the collapse of the technology bubble and the events of 9/11.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

China Voices Doubt on US Treasury Obligations

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

When Chinese Premier Wen Jiabao voiced doubts about the safety of its enormous investments in US Treasury and agency securities, the Obama Administration responded immediately and vociferously.

Mr. Wen said, “We have lent a huge amount to the U.S., so of course we are concerned about the quality of our assets….Frankly speaking, I do have some worries.” (Source: Wall Street Journal, 3/14/2009, p. 1).

The US relies heavily on China’s investment in US obligations; China holds almost $700 billion in US debt, primarily at its central bank. The Obama Administration swung into action immediately to rebut the Chinese remarks. “There’s no safer investment in the world than in the United States,” said White House spokesman Robert Gibbs. Treasury Secretary Lawrence Summers weighed in to defend the large deficit associated with the U.S. stimulus package, arguing that it is a temporary measure to prime the pump of economic growth, after which fiscal discipline will resume.

Why did China amass such holdings of US Treasuries? There are three main reasons. First, China had a massive surplus in its current account, and it need to deploy the capital; the US is the largest economy and largest debt issuer in the world. Second, China sought to neutralize the effects of an influx of dollars to China, which otherwise might have put added revaluation pressure on its currency (called the Yuan or Renminbi), thereby hurting exports. Third, Chinese officials, like other investors worldwide, bought into the idea that US official obligations are close to risk-free.

China is said to have lost heavily on some of its US holdings, including Fannie and Freddie Mac issues. Further, China’s sovereign investment fund took a $10 billion plus stake in U.S. private equity giant Blackstone, and this has lost over half its market value.

China has assailed United States policy, blaming our profligacy and lack of regulation for bringing about the financial crisis. While Western countries are suffering economic contraction, Chinese officials so far admit only that the recent growth rate of 8% a year may dip a bit. However, Alan Abelson writes in Barron’s (3/16/2009) that Chinese exports—its engine of growth—dipped 25.7% last month compared to a year earlier. He notes that the Chinese stimulus package of $585 billion is targeted at infrastructure and will not provide immediate relief.

Meanwhile, unemployment has increased rapidly in China, as factories are curtailing production, and there are reportedly several million workers seeking to return home to agricultural areas. China faces the prospect of great social upheaval, which the police and armed forces would certainly suppress ruthlessly.

We in the United State enjoyed what economists called a virtuous circle, a process which Abelson well describes. The Chinese invested in our debt, which helped fuel a spree by US consumers, who bought cost-competitive Chinese products; this competition helped keep inflation (and the demands of domestic labor unions) in check, while further expanding China’s trade surplus. We now face the danger of a vicious circle, in which declining Chinese purchases of our debt push interest rates and thus inflation higher, and our declining purchases of Chinese products decrease China’s ongoing capital surplus.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

International Contagion

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Although the credit bust in the United States—particularly the bursting of the housing and mortgage finance bubble—started the current economic crisis, the international ramifications have become alarming and unpredictable. The best analogy to make may be convulsions in emerging markets. These include the Latin debt crisis of the 1980s and the Asian debt crisis of 1997-1998. The present situation departed from those by encompassing the whole world.

A lead article in the New York Times on March 8th points to the irony that the US Dollar is strong despite the role of US subprime lending in precipitating the crisis. Why is this so? One factor is the reversal of capital flows, as many investors are withdrawing funds from emerging markets and reinvesting them in dollar assets. Second, China continues to buy US Treasuries in huge amounts, partly to neutralize its own currency, the RMB, from strengthening too much and further crippling exports. Third is the “flight to safety;” investors generally perceive short-term US Treasury obligations to be money good.

The fundamentals of the United States economy are weak. One key measure: our current account deficit (the excess of our imports of goods and services over our exports) is approaching $800 billion, or about 7% of GDP, which is simply not sustainable. Our balance of payments deficit would be that much worse, except that the trade account is being offset in part by large capital inflows. But for how long will foreigners massively buy our Treasury issues at very low interest rates?

The Euro has weakened from a recent low of about 0.63 to purchase one dollar to about 0.79 now. The economic crisis is putting tremendous strain on the European Union, and it potentially could pit some of the neediest members, especially in Eastern Europe, against the richer countries such as Germany. The Yen, having reached a recent high of about 88 ¾ to the dollar in January, has weakened to about 98.75. A stronger dollar is hurting our domestic manufacturers who sell overseas while encouraging imports. This is bad for our balance of trade; however, a strengthening dollar does encourage overseas investment in US Treasuries, and we need to issue a lot of debt.

The collapse in commodity prices, including fossil fuels, is sharply reversing the fortunes of many countries, including Russia and many emerging markets such as Venezuela (led by strongman Hugo Chavez, who has banked on high fossil fuel prices to support his social programs). Gold traditionally performs well when fear prevails in the market. Gold spiked recently over $1000 per ounce but has retreated to about $922.30.

The US economy needs to make a large and painful structural adjustment. It is likely that we will see further de-industrialization. We will certainly see greater government regulation of the financial sector. Tax rates will increase, with a redistributive tilt toward higher income people. But we are more integrated than ever with other economies: through foreign trade, dependence on foreign investors for capital flows and the international market in labor and services. It has become impossible to project US trends without understanding the international economy and its segments. Conditions in many countries—and especially in emerging markets--are now becoming so wild and chaotic that their trajectories and outcomes are anyone’s guess.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Is Your Life Insurance Money Good? Part 3: The State Funds

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

In our previous two articles, we discussed the credit quality of life insurance companies and life insurance policies.

The insurance industry is regulated by the different states, a situation that was legislatively confirmed by the McCarron-Ferguson Act (1945). The patchwork of state laws and regulation creates many inefficiencies and impracticalities in the insurance business. However, federalists might argue that state oversight is preferable to maintain some offset against the increasingly mighty federal government. There is talk now to allow individual insurance companies to opt into federal oversight, but it hasn’t yet been legislated, and this move would provoke a vigorous lobbying battle.

What actually happens to a US insurance company when it falls onto financial hard times and is found by the state insurance department to be insolvent? The state insurance department (or its commissioner) will seize control of the insolvent insurer, for the purpose of either rehabilitation or liquidation. If rehabilitation fails, or is impossible, and liquidation is ordered, then the state guarantee funds provide coverage within the limits defined by law. If the state guarantee fund has a shortfall in covering policies of an insolvent entity, it will assess a charge against in-state insurers. (A different scheme, and a parallel set of state funds, covers the event of insolvency of a property and casualty insurance company, such as one that protects your home or auto against damages.)

An authoritative source of information on the state guarantee funds, and information on the fund in your own state, can be found at the Website of The National Organization of Life and Health Insurance Guaranty Associations: HOLHGA. Its members include representatives of all fifty states. Among other purposes, this organization seeks to coordinate things when an insurance insolvency affects more than one state, as frequently happens.

There are limits to the state guarantee. In most states, the limits are $300,000 for life insurance death benefit, $100,000 for cash or surrender value, $100,000 in withdrawal and cash value for annuities (and $100,000 for health insurance policy benefits). In most states, but not all, there is a $300,000 overall limit to recovery. Connecticut [Code Section §38a-860(g)] has a more generous coverage scheme: up to $500,000 in life insurance death benefit, $500,000 in cash surrender value, $500,000 in present value of annuity benefits--with an aggregate benefit limit of $500,000 per individual. If you have multiple policies from the same carrier, such as life insurance and annuities, keep in mind the aggregate limit per individual.

An individual might seek to diversify coverage by insurers in order to keep each policy within state guarantee limits. However, with larger policy sizes, such as we investment advisors often see in estate planning, this is not practical. Moreover, in many states, the individual carrier limit is also the overall recovery limit. Then too, I would not neglect the credit quality of the insurance company out of reliance on state guarantee coverage.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Is Your Life Insurance Policy Money Good? Part 2: About Protection of the Cash Value

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

This week we continue our review of the credit quality implications of life insurance policies by considering the safety of the component called “cash value.”

If you have taken out “term” life insurance, your policy by definition will never develop cash value. Term life is a stripped down form of life insurance that provides a defined death benefit on the life of the insured for a defined term. There is no investment or cash value aspect to such policies.

Permanent life insurance, however, can develop cash value, and it is usually intended to do so. Cash value is like a savings account inside the policy. In many cases, both as illustrated at inception and as it works out in practice, the cash value becomes a higher and higher percentage of the death benefit over time.

Within the category of permanent life insurance, there are two types: whole life and universal life. Whole life is the older of the two types. Typically, a whole life policy lays out a set of level payments for the lifetime of the insured (or up to some very high age such as 100). To support such an illustration, a (fairly low) minimum investment return is guaranteed by the insurer, such as 2% per annum. The insurance company in turn manages the investment of the cash value, often putting a large portion into long-term bonds.

Universal life is a more flexible form of permanent life insurance. There is freedom of the insured person to put in greater or lesser amounts of premiums when due (within limits). Universal life may be either non-guaranteed (the insured person takes the risk that mortality or administrative expenses may rise in the future) or guaranteed (meaning that the policy will be kept in force for the stipulated death benefit, so long as the illustrated minimum premiums are paid, regardless of whether there is cash value in the policy).

Finally, there is within universal life a distinction between “fixed” and “variable.” In the fixed form, the insurer guarantees some minimum return on cash value and manages the investments. In variable life, the insured person chooses from a range of investment options—which often track public mutual funds—by sector and type, such as large cap U.S. stocks, real estate, Asian stocks, and so forth. Variable life investors thus select the type of market risk they face from the menu of choices and have opportunities to change their selections. Under federal law, variable life policies are considered “securities” and can only be offered by insurance agents affiliated with an authorized “broker-dealer.”

The rules of insolvency priority are established under each state’s insurance statute. This matter gets complicated because insurers operate in many states simultaneously. Further, some insurance companies are mutually held and others are stock companies. Then too, individuals also often move from the state where they originally took out an insurance policy.

Concerning the credit status of the cash surrender value, a special advantage of variable life policies is that the assets are held in segregated sub-accounts for the benefit of the account holder. To the extent that the market value of assets in these segregated sub-accounts grows over time as a proportion of the promised death benefit, exposure to the insurance company’s general credit risk diminishes. In the current brutal credit environment, some sophisticated policy holders may see this feature of variable life policies as advantageous.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Is Your Life Insurance Policy Money Good? Part 1: Assessing the Credit Quality of Insurers

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

In the present harsh credit environment, I have received inquiries about the claims paying ability of life insurance companies.

To understand insurance policy credit risk, we need to look at three basic questions. First, what is the credit quality of my life insurer? Second, what is the nature of ownership of any assets held in the policy as “cash value”? Third, what backstop protection do I have from my state insurance fund? We will start this week with the first issue.

The longer an insurance policy is likely to stay in force, the longer a view the policyholder must take of an insurer's credit quality. In a permanent life policy insuring a woman now 30 years old, the event insured against, death, may not happen for 50 or more years. It's hard to predict how a company will be doing in five years, let alone fifty. Nevertheless, default by life insurance companies on the claims of policyholders is relatively rare, and there are numerous published measures of insurance company credit quality available.

There are several ways of measuring the credit quality of insurance companies. The least sophisticated way is by looking at their so-called “regulatory capital”—essentially a book value measure of the excess of stated book assets minus stated liabilities. This measure is important because insurers must maintain certain regulatory capital limits to stay in business. Each state has a statute regulating insurance companies domiciled there; the State Insurance Department and its Commissioner oversees insurance company capital adequacy.

A more sophisticated measure is called “economic capital.” If a company has adequate economic capital, security analysts believe it holds adequate reserves to meet probable real world challenges; this requires evaluation of the probable market value of both its assets and liabilities under various stress scenarios.

Third party credit agency evaluations of long-term debt obligations provide another important perspective. Insurance companies, like other large borrowers, pay fees to have their obligations rated by private agencies. Unfortunately, each agency has its own rating scale. With Standard & Poor's (S&P)( www.standardandpoors.com ), AAA is the highest rating for long-term obligations, then AA, A, BBB, BB, B, CCC, CC, C, and D (default); there are plus and minus gradations. Any rating of BBB- or above is called "investment grade" for bond investors. I recommend you consider companies with long-term ratings no lower than A equivalent for term life and AA equivalent for permanent life. Moody's (www.moodys.com ; requires registration) three highest ratings are Aaa, Aa, and A, with descending gradations of 1,2,3. The four highest ratings of insurance company "financial strength" at A.M. Best ( www.ambest.com ), which specializes in insurance, are A++, A+ ,A and A-. Finally, Fitch ( www.fitchratings.com ) has an Insurer Financial Strength rating scaled like S&P. See "What You and Your Family Need to Know About Personal Insurance," from GreenwichFinancial.com Website.

Generally, you pay more premium to be insured by a higher rated company. When you purchase insurance, your agent ought to apprise you of the credit ratings of your prospective insurer; you should stay informed of significant changes. Caveat: the ongoing subprime lending fiasco has highlighted the foibles and conflicts of interest endemic to such rating agencies; critics say they are often the last to recognize serious financial difficulty.

When an insurance company fails, and it goes into receivership, whether for rehabilitation or liquidation, the claims of insurance policyholders (aside from reinsurance) rank higher in priority than those of general creditors or shareholders, and usually are not impaired. In egregious cases, though, such as that of Executive Life Insurance and its aggressive junk bond strategy, some policyholders have had their claims at least partially impaired.

For a variety of reasons, a company may show a significant regulatory surplus even though its solvency is questionable. A very good resource for state regulation of insurance companies is the Website of the National Association of Insurance Commissioners, www.NAIC.org; with their Consumer Information Service, you can check on the licenses, consumer complaints and financial status of each insurance company operating in your state. The NAIC's Insurance Regulatory Information System (IRIS) provides analysis that assists the state commissioners in detecting insurance companies that may face financial problems.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Toward a Better Bailout: Bringing the Market Back In

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

The government has spent hundreds of billions to bail out banks, but the financial system is still sinking, and so is the broader economy.

Under the Troubled Asset Relief Program (TARP), Congress authorized the Treasury Department to purchase up to $700 billion in “troubled assets,” defined as “residential or commercial mortgages.” The Bush Treasury Department, under the leadership of Secretary Henry Paulson, used elastic program provisions to veer far from this mandate. An initial allocation of $250 billion was spent buying preferred stock and warrants in commercial and investment banks, including Citigroup ($50 billion, two injections), Bank of America ($50 billion, two injections), AIG ($40 billion, and still bleeding), JP Morgan ($25 billion), Goldman Sachs ($10 billion), Morgan Stanley ($10 billion), and others. The Treasury advanced another portion to General Motors ($10 billion), General Motors Acceptance Corporation ($3.4 billion) and Chrysler ($4 billion) as an emergency short-term fix to the auto industry; Ford abstained. It is not easy to value the notes, private issue preferred stock (non-voting) and warrants that Treasury has received in exchange for its cash, but the government faces the probability of large losses. Unfortunately, the program has not stimulated lending, though it did head off the panic that would have followed more large scale financial institution collapses such as that suffered by Lehman Brothers. By and large, though, many of the troubled assets still remain on the books of the bailed-out institutions, a toxic molasses.

It is beneficial to the country that our major financial institutions continue to operate and particular that they resume and expand lending. However, the best way to do so is to help lenders clean up their bad balance sheets by removing distressed assets, including non-performing residential and commercial mortgages.

There is talk that the Obama Administration is considering changes to the bailout program. Various alternatives have been discussed in the press, by economists and by advisors to the new Administration. The following set changes and enhancements, fitted together as a coherent market-oriented program, make sense to me:

• Assets should be received from financial institutions on consignment rather than purchased outright. These assets should be sold off to private investors in an expeditious but well-organized fashion. The government should go into the moving business, not storage.
  
• Any FDIC guaranteed institutions could be required to participate in the facility, under the guidance of FDIC examiners, until such time as overall asset quality is deemed acceptable in relation to capitalization.
  
• The government should organize pools of each institution’s assets and carry out an orderly Dutch auction process, similar to the way US Treasuries are sold, with plenty of lead time for investor due diligence.
  
• The government should leverage its allocated funding by offering a floor or guarantee for a percentage of the purchase price, and the buyers should seek any needed financing privately. I would suggest a government-provided floor of 50% of the purchase price as a last loss. That is, if a bidder successfully buys an asset for one million dollars, he has a “put” back to the government lasting for an agreed term for one half of that amount, or $500,000. The government should look to the market to take a substantial first loss position, but at an asset value that is competitively established.
  
• When the government provides a floor guarantee, it should receive in return warrants on the common stock of the seller. These should be granted on terms equivalent to the assessed economic value of the guarantee.
  
• Proceeds of asset auctions would flow back to the selling institutions, if solvent, or to FDIC if in receivership. Banks as going concerns will need to raise fresh equity capital privately, which should be facilitated by having cleaned up balance sheets. Some banks, if they cannot raise adequate capital, may fail. The priority then should be orderly liquidation.
  
• Some TARP funds, rather than being spent, should be sequestered as a reserve against possible losses under the program from potential exercise of the put by disappointed buyers. Where possible, the government should seek to lay off its risk through insurance policies purchased privately from international reinsurance syndicates or through public syndications offered by the investment banks.
  
• Further government funds that would have been invested in banks can be released through changes in taxation and payroll deduction, for a more immediate stimulating effect.
  

Under these rules, the government would get the private sector involved in valuing, investing in, and lending against troubled assets. There would be less total government borrowing need, meaning less crowding out of private borrowers. The US government’s creditors—those who buy our Treasury Notes and Bills—would have less to fear. The capital needed to make such investments or loans would form in the private sector—probably in part through private investment vehicles such as hedge funds and private equity. Skeptics might question whether that capital would really be forthcoming, but I maintain that part of the genius of our capital markets is that the opportunity will be seized by many enterprising investors. Some of these investors will indeed make great fortunes taking such risk, and the prospect of riches is the fuel that makes markets work.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Exxon Mobil Weathers the Storm

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

We had recommended recently (“Opportunity: Oil and Gas,” Jan. 22nd) to consider investment in large integrated oil companies with strong balance sheets. Of these, we had mentioned Exxon Mobil as “one of the best run.” Subsequently, on January 30th, Exxon released its earnings for 2008, and its performance validates its reputation for running a tight operation.

Exxon earned $45.2 billion for fiscal/calendar year 2008, better even than its 2007 results of $40.6 billion, which set a record for corporate earnings by a U.S.-based company.
Earnings for the fourth quarter of the year were $7.82 billion, down about one third from the $11.66 billion earned a year earlier; in per share terms, earnings fell from $2.13 to $1.55. The result moderately bettered median Wall Street expectations of $1.45 per share. Earnings in the fourth quarter were hurt not only by the decline in fossil fuel prices at all levels but also by the effects of Hurricanes Gustav and Ike.

During a conference call with investors, Exxon’s investor relations spokesman said, “These results reflect the strength of our business model.” As noted in a report in the New York Times (1/31/2009, p. B3), “More than any other oil company, managers at Exxon emphasize a strict attention to containing costs and are disciplined about their investments,” a discipline that has served the company well in the harsh cycles of the energy market.

Exxon has over $36 billion of cash or cash equivalents on its balance sheet. Short term assets overall of about $96 billion compares with short term liabilities of about $68 billion. The debt to equity ratio is a modest 8.2%. Three notable expressions of Exxon’s balance sheet strength: First, Exxon is increasing capital spending by 20% for 2009. Second, it is maintaining its buyback program for common shares, albeit with a slight cutback to $7 billion for Q1 2009 vs. $8 billion for Q4 2008. The buybacks, of course, increase demand for shares; they should (and do) reflect a view by management that shares are overall undervalued. Third, Exxon does not feel the pressure to lay off workers or shutter facilities, moves that that some of its competitors are making. Moreover, the financial strength creates at least the capacity for possible value additive acquisitions in at atmosphere where cash is king.

Here are some frequently used value measures as they apply to Exxon. The stock is trading at about 10.65 times the median Wall Street estimate for 2009 earnings and at 8.26 times trailing earnings. Its price to book value ratio is 3.11. Exxon shines in measures of management effectiveness; looking back at the last twelve months, return on assets measured 19.46% and return on equity, 40.23%.

Exxon Mobil (ticker: XOM, traded on NYSE, closing price 1/30/2009 of $76.24 per share) remains a buy.

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Roth IRAs--What, Why, Who, When, How

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

President Obama said in his inaugural address that “the time for putting off unpleasant decisions…has surely passed.” One such unpleasant decision that we will face in the intermediate term is whether to raise income taxes. If you believe that income taxes will have to rise, and you wish to lessen your potential tax burden in retirement, then you might want to study up on Roth IRA’s.

Qualified retirement plans such as 401(k)’s and traditional IRA’s allow individuals to contribute a limited amount each year on a pre-income tax basis (keep in mind that your contribution is still subject to Social security and Medicare withholding). Thus, the contributor benefits over the years from starting with a higher base amount and from deferring tax on any interest, dividends and realized gains. Further, you may expect to be in a lower tax bracket upon retirement, when the distributions are received (this being uncertain, however, if overall rates rise significantly). The downside of such plans is that upon distribution (usually in retirement), all the proceeds (both contributions and accumulated growth) are subject to taxation at ordinary income tax rates. The highest marginal rate on ordinary income is currently only 35%. In the past, this rate has gone as high as 90% and for a long period in the 1950’s and from 1954 to 1963, it was capped at 87%. Source: http://www.truthandpolitics.org/top-rates.php. A second downside of qualified plans is that there is a 10% penalty on premature withdrawals (with certain exceptions), on top of the income tax bill one faces upon any withdrawal. Many people who are taking borrowings now on an emergency basis could face the potential need to repay in full, or face a penalty, if employment is terminated.

A Roth IRA is the reverse of a 401-K, 457(b), 403(c) or traditional IRA. In a Roth, you contribute money post-income tax. In return, no part of the distribution is subject to income tax. Further, you can withdraw funds from a Roth at any without penalty or income tax. Quite a good deal, for those are eligible!

A Roth IRA could be an especially good idea if you are relatively young, far from retirement, will possibly need to make an early withdrawal, or expect high rates of gain on your account.

There are also certain options to pay taxes on a traditional IRA and convert it to a Roth IRA. There are income limits on such conversions. The Tax Increase Prevention and Reconciliation Act, enacted in May 2006, strips away this limitation beginning in 2010, setting the stage for a massive movement in which almost all affluent people with retirement accounts would consider conversion. Look for Congress to reconsider this revision, which was not well thought out and may be viewed as potentially too costly to the Treasury. I expect that some compromise will be arrived at by Congress that expands eligibility and contribution limits permanently, as part of a rational policy for increasing our national savings rate.

As with all IRA’s, the annual deadline for contribution is April 15th of the following tax year.

The main problem for higher income people is limits on eligibility and size of contributions to Roth plans. For the 2008 tax year, you cannot make the maximum contribution unless you have modified adjusted gross income of less than $156,000 (married, filing jointly; some contribution up to $166,000), $10,000 (married, filing separately), or $99,000 (single filer or head of household, or married filing separately, but not living with spouse at any time during taxable year; some contribution up to $114,000). For 2008 annual contribution limits--whether for traditional or Roth IRA's--are only $5,000 per account holder (a higher $6,000 "catch-up" contribution if you are fifty or older). Further, certain forms of income, such as rents or dividends, are not eligible for contribution; the idea is to contribute from salary, wages or business income.

The way in which some higher income employees are making major contributions to Roth’s is through an option offered at work to use the company 401(k) or 403(b) plan as a Roth. Annual contributions to such plans for 2008 are $15,500 ($20,500 if age 50 or higher). In this way, much more material contributions can be made. If you don’t have such an option at work, consider lobbying for it (a plan amendment is needed).

Note: Please consult your accountant or tax advisor to receive expert tax advice customized to your situation.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

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Opportunity: Oil and Gas Sector

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

We have discussed in this column on many occasions the doctrine of contrarianism. The really big money in investment is generally made going against the crowd. Recently, in the last six months, we have seen a collapse in the prices of many commodities, as world markets have recoiled from over-inflated expectations and the prospect of prolonged recession. The collapse in fossil fuel prices has been dramatic. Light sweet crude oil is currently trading at $34.63 (NYMEX futures contract “CL”) for February delivery versus a high about $100 higher last July. Natural gas is trading around $4.71 per thousand cubic feet (NYMEX Henry Hub pricing) versus a high of about $13.50 last July.

My thesis is that: 1> Numerous projects that could produce more oil and natural gas are in the process of being shut down, thereby limiting supply. 2> Demand will reassert itself, both from developed and emerging markets, as the recession eases. 3> It will not be easy or simple to conserve enough, or substitute other fuels enough, to meet future excess demand. 4> As a result, the value of oil and gas reserves will once again increase.

I was driving in Central New Jersey and I noticed that Lukoil is offering regular gasoline for $1.60 per gallon. Pretty good price! So, if you disagree with my thesis that such prices are bottoming out and heading higher, go crazy, get yourself a Hummer.

Probably the most conservative way to play this investment hypothesis it to invest in one of the great integrated oil companies that have large proven reserves. Among such companies, the following selections are based on a blend of criteria, but including particularly balance sheet strength and operating momentum. The firms with strong balance sheets will not only survive but will also have the chance, in this harsh environment, to make attractive acquisitions of properties and companies. The recommended investment horizon is two to five years; these are not short-term recommendations.

Of the large integrated oil companies, I recommend particularly at this time Occidental Petroleum (ticker: OXY, $55.54 per share as of 1/23/2009 close of trading), Imperial Oil Company (based in Canada) (IMO, $31.50), Royal Dutch Shell Oil (RDS-A, $48.30) and Petroleo Brasileira (“Petrobras”) (based in Brazil)(PBR, $24.58). For a broader diversification, I would also add exposure to Exxon Mobil (XOM, $78.04) (one of the best run among the integrated companies), Chevron (CVX, $70.82) and Hess (HES, $57.54).

Note: Clients advised by Greenwich Financial Management Inc. may hold long or short positions in securities mentioned in this article or in derivatives of those securities. The author of this report has no personal holdings or interest in the referenced investments and has received no compensation for providing the above research from any of the listed companies. The information is not sufficient by itself to make an investment decision. The suitability of such investments for particular individuals has not been assessed.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Obama Stimulus Package

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

Last week, we discussed the clouded economic policy legacy of the Bush Administration. Looking forward to the new administration, the outlines of what we can expect are becoming clear.

Despite fears that Obama would make radical or far-out appointments, his economic policy team appointments have been mainstream. His appointee for Secretary of the Treasury is Timothy Geithner, presently head of the New York Federal Reserve Bank. In that role, Geithner has been working closely with Fed Chairman Bernanke and the present Secretary of the Treasury, Henry Paulson. He has been in the trenches trying to keep the banking system from going bust.

Obama’s appointee for chief economic advisor is Larry Summers, who served as Chief Economist of the World Bank and as Treasury Secretary in the later years of the Clinton Administration, presiding over the federal response to the Asian financial crisis. He served as President of Harvard University from 2001 until 2006, when he stepped down owing partly to fury over remarks he made concerning women in science.

Understandably, President-Elect Obama has focused on a plan to stimulate the economy. As the Target Fed Funds rate has approached zero, while key gauges of economic activity and payroll employment continue to fall, it has become apparent that low interest rates alone will not be enough to revive the economy, particularly while banks continue to shun lending. We are potentially falling into what economist John Maynard Keynes called the Paradox of Savings. According to Keynes, if consumers respond to a threat of recession by saving more, they reduce aggregate demand and worsen economic conditions. Under such conditions, Keynes advocated government deficit spending to reflate the economy.

Deficits we will have. According to Obama Administration officials, trillion dollar plus deficits are likely for the next several years. These will dwarf recent federal deficits, which were $162 billion in 2007 and an estimated $455 billion in 2008. Areas targeted for stimulus including tax cuts for individuals and enterprises, plus spending on
infrastructure, education, medical care, extension of unemployment insurance, and (apparently) rescue of the US auto industry. As I have argued in recent columns, in our planning, we should strenuously avoid having the government choose winners and losers in business competition, whether that business is energy, autos, green technology, or anything else. We also need to guard against the notion that government will not allow massive companies to fail.

There are several real dangers stemming from the massive stimulus package. The first is that the stimulus will be mis-timed. That is, spending will come in too late and continue too long, or even indefinitely. Once government starts new programs, or expands existing ones, it’s difficult to rein them in. Second, there will likely be great waste, especially if funds are put out in a hurry. If you need a case study of such losses, consider the government contracting process in Iraq. Third, there is the danger that the stimulus, if carried on too long, could fuel inflation, balloon the federal deficit, damage the dollar and create an undue burden of repayment for future generations.

However, sometimes a lack of boldness is as much of a risk as audacity. To head off a deflationary spiral, President-Elect Obama has elected to take drastic measures, of which we will probably learn more through his inaugural address. For now, sentiment favors President-Elect Obama’s bold thinking.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

RIP Bush Economic Policy

Copyright © 2009, Greenwich Financial Management Inc., a registered investment advisor.

As the Obama Administration arrives in Washington, how shall we judge the economic record of the outgoing President?

We are of course ending poorly, at least from the standpoint of economic performance. Presidents don’t control the business cycle, though we vote for presidents as if they do. Secular trends in technology, external shocks, the money policy of the Federal Reserve Board, fashions on Wall Street—all these can play a bigger role than the President.

However, there is some accountability of President Bush for our current economic malaise. This relates to an excessive deregulation in the banking and investment banking sectors.

It turns out that almost complete deregulation of most basic industries was unambiguously pro-consumer. The government did not need to oversee rail rates, as it once did, or micro-manage airlines, or enforce a monopoly in telephones. De-regulation in these areas may have discomfited some industries, hurt some shareholders, even cost many people their current jobs. But the consumer won out through lower costs and increased competition.

However, with finance, we are re-learning lessons from the savings and loan fiasco during the Reagan Administration. Economist Hyman Minsky (1919-1996)-- whose work is enjoying a renaissance—taught that Wall Street, with its unbridled profit motive and innovation machine, can unintentionally subvert the economy. The innovations made by mortgage bankers, banks and Wall Street firms, which now go under the name of “subprime lending,” were both radical and ungoverned; in retrospect, the government should have taken caution and clamped down.

What’s worse, since the time of the New Deal, our country’s commercial bank deposits have enjoyed a limited FDIC public guarantee, thus intertwining risk in the public and banking spheres. Moreover, in the current environment, almost any large financial institution can argue that it is “too big to fail.”

Four factors helped contribute to the current malaise: 1. A laissez faire policy toward regulation of financial institutions, both at the SEC and at the Treasury Department. 2. An excessive frothiness in financial liquidity, which in turn was in part a response to the 9/11 emergency, and in part the result of massive tax cuts. 3. A lack of timely response to warning signs, starting in 2007, that things were going amuck. 4. A failure to rein in federal mortgage lending institutions, particularly Fannie Mae and Freddie Mac. Of these factors, the Federal Reserve Board shares crucial responsibility for the second and third, and Democratic presidents and Congress share responsibility for the fourth.

These weren’t the only disappointments. Partly owing to the preoccupation and massive cost of the wars in Afghanistan and Iraq, other opportunities were missed. Social security, Medicare and Medicaid reform went nowhere. Only modest progress was made in tort reform. Charter school programs were not advanced, nor were school vouchers. National educational testing made little progress. Our national science policy, in such areas as population control, stem cell research and global warming, was politicized and misguided. Overall, the economic policies of the Bush Administration did not pass muster, and in the wave of reaction against Bush’s policies, the pendulum will now shift toward excessive regulation and government intervention.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Credit Crunch Year-End Follies

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

As we approach year-end, the credit crunch continues to widen, and the Federal government’s activist role continues to expand and extend wildly. Here are some recent developments:

• The US Treasury will grant credit card giant American Express access to $3.39 billion in capital. It will also grant loans of $2.33 billion to finance company CIT. They thus follow other large financial institutions—including investment banks Morgan Stanley and Goldman Sachs—by becoming bank holding companies regulated by the Federal Reserve Bank and the Comptroller of the Currency (US Treasury Department).


• The Treasury is reportedly warming up a $200 billion asset stewpot, with credit cards, car debt and student loans to be thrown in.

President Bush announced an emergency package of $17. 4 billion in financing for General Motors and Chrysler (owned by private equity investor Cerberus). No one expects this package to be more than a raft to keep these companies afloat until President-elect Obama is inaugurated. In making this gesture, the federal government makes a critical departure. To date, the rescue efforts have involved financial institutions and perhaps could be justified by the need to keep financial liquidity from collapsing. But if we are now to rescue ordinary brick and mortar companies (albeit huge ones?), where does this stop? Won’t every troubled company in America come begging to the Feds? How will the government separate the interests of all Americans from those of autoworkers, an important Democratic Party constituency? With talk of a new Car Czar and federal oversight of new clean energy initiatives in Detroit, are we now to embrace Industrial Policy just as Europe and Japan were weaning themselves off of such illusory policies?

• As if to confirm ones worst fears about the increasing government involvement with private companies, a group of real estate companies has proposed a purchase program for commercial mortgages, of which $160 billion will reportedly come due in 2009, and $530 billion in the next three years. According to the Wall Street Journal, Developers Ask U.S. for Bailout as Massive Debt Looms - WSJ.com, major real estate interests lobbying for a support package include William Rudin (who family owns Manhattan office towers), Stephen Ross (Related Companies) and Steven Roth (Vornado Realty Trust).

As remedies proliferate to remedy what is diagnosed as “market failure,” are we failing to understand the role government itself played in instigating the current financial malaise? I would cite three factors especially: the role of federal agencies such as Fannie Mae and Freddie Mac in unwisely extending credit; excesses in money supply creation by the Federal Reserve Board; and the favoring of mortgage finance for first and second homes by our tax code.

Moreover, Treasury Secretary Paulson keeps changing direction. The government’s policy has come full circle: first, purchase distressed assets; then, skip the assets, rescue the financial institutions with capital injections; now it’s coming back to buying distressed assets. What the hell, try anything, the government seems to say. Can anyone discern a coherent strategy?

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

End of Year Tax Deadlines for Investors

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

If there is a time for every purpose under heaven, this is a good season to give thought to financial and tax planning for the New Year. The right approach is to consider investments and income tax in a unified fashion. If you have a tax accountant who prepares your tax returns each year (as I highly recommend), it’s particularly timely to have your investment advisor do a quick end of year phone consultation. It’s a necessity to have the accountant and the investment advisor working as a team.

With a deadline date of December 31st, here is a (partial) list of things to consider:

1. Realization of gains or losses on capital assets. Under our tax system, most capital assets only create a gain or loss upon realization, that is, purchase or sale. If you are a typical investor, this was a truly terrible year for your stock portfolio, for REIT’s and even for many bonds, and you have disproportionately more losses than gains this year. Consider harvesting some of those losses. Keep in mind that only $3,000 of capital losses ($1,500 if you are married and filing separately) can be deducted per year against ordinary income (such as salary or wages) in each tax year; however, capital losses realized in tax year 2008 but not fully used can be carried forward into later years until used up.


2. Taking of any expenses or giving of any charitable donations eligible for inclusion in the 2008 tax year.


3. The making of any gifts under the annual exclusion from gift tax. The exclusion for calendar year 2008 is $12,000 to each donee ($24,000 with spouse). It goes up to $13,000 in 2009 ($26,000 with spouse).


4. Tax incentives relating to energy investments. Congress over the years has enacted significant tax incentives for independent domestic mineral extraction, especially for independent oil and gas exploration. Well-structured investments can offer tax advantages for accredited investors. Tax deductions for intangible drilling costs (IDC’s) generally run from about 80% to 90% of initial investment for projects that commence drilling in the following year. Project economics and sponsor quality should always be carefully considered, not just tax benefits. Your investment advisor should consult with your accountant considering the safe harbor from Alternative Minimum Tax (AMT).


5. Required Minimum Distributions (RMD). If you have reached age 70 ½ in the current calendar year, and you have qualified retirement plans, consider taking a distribution in the current tax year to avoid income bunching in the following one.


6. Stretch IRA’s. If some one has died, leaving you as a beneficiary of an IRA, you may have opportunities under the plan document to stretch out the distribution period to include a possible second generation beneficiary, creating a so-called “stretch IRA.”

Wishing you a happy, healthy and prosperous New Year!

Note: Please consult your accountant or tax advisor to receive expert tax advice customized to your situation.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Investment Fraud Invites Further Regulation

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

Wall Street was shocked at the revelation that Bernard Madoff’s investment operation (Bernard L. Madoff Investment Securities LLC) was an absolute fraud. Madoff was arrested and led away in handcuffs and his firm has gone into receivership. According to his own account, his firm dissipated some $50 billion in investor money, making this one of the biggest financial frauds on record. Recent securities filings suggest the firm only owned about $1 billion in stocks. Where did the rest go? See "Who Madoff With the Money?" by Robert Cyran and Richard Beales, 12/12/2008, BreakingViews.com.

Madoff had claimed to be making remarkably consistent profits over a very long period though an equity and option strategy known as “split strike” trading. He operated in the “black box” style, explaining to no one exactly what he was doing. His senior staff consisted of family members.

According to the complaint filed by the US attorney, Madoff confessed to his employees that it was “it’s all just one big lie” and was “basically, a giant Ponzi scheme.” He admitted to FBI agents that “There is no innocent explanation” and that he “paid investors with money that wasn’t there.”

Bernie Madoff’s firm was structured in an unorthodox way that is not comparable to typical hedge funds; investors had accounts at Madoff’s broker-dealer operation, and there was no third party custody or administration of assets or third party valuation. Skeptics, including Barron’s, had questioned Madoff’s results before. See“Multiple Red Flags in Madoff Case,” by Gregory Zuckerman, 12/12/2998, WSJ.com

The Madoff blowup follows other recent frauds emanating from the private investment community. In September, investors learned of trouble at the Minneapolis based Petters Group Worldwide. Other investment firms, including Lancelot Investment Management, had lent Petters affiliates perhaps three billion dollars, allegedly secured by fraudulent receivables. Let us not forget either Bayou Hedge Fund Group, based here in Greenwich. At his sentencing, founder Samuel Israel III said to his investors, "I lied to you and I cheated you and I cannot put into words how sorry I am.” "Bayou's Israel Gets 20-Year Terms for Hedge-Fund Fraud," 12/14/2007, from Bloomberg.com. Israel was taken into custody to serve his prison sentence on July 2nd, having been in hiding after his pretended suicide at Bear Mountain.

Bernie Madoff’s scheme was similar to classic Ponzi schemes in that investors seeking redemption or dividends were replaced by new investors. He enhanced his reputation by service as head of NASDAQ Stock Market (1991-92) and by charitable good works. Madoff’s approach differed from traditional Ponzi schemes in that he did not promise a pie-in-the-sky return. Instead, he offered just 10-12%, but steady, in the form of a never-ending 1% or so accretion per month to wealth. This appealed to those craving safety over the highest possible return.

These profoundly disturbing revelations promise to accelerate the trend toward greater regulation of hedge fund activities. At the same time, the news promises to change the competitive landscape. Public mutual funds, regulated under the 1940 Investment Advisor Act, will benefit in investors’ eyes from the much greater transparency of their operations. At the same time, investors may gravitate more toward individually managed accounts. In such accounts, investors can see all transactions in real time, securities are held for them in separate custody and ownership, and they receive a complete monthly trade summary, statement of gain or loss, and balance sheet. Instead of black box models, investors will seek a glass box, and secrecy will give way to disclosure.

I feel profoundly sorry for those investors who trusted Mr. Madoff with their wealth. As a service to readers, I will seek to answer questions without fee from any investors who fear they have been a victim of this fraud; there are some important income tax considerations that could mitigate part of your loss that you should also be investigating with your accountant. [Greenwich Financial Management is licensed as registered investment advisor in the states of Connecticut, New Jersey and New York.]

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Understanding Annuities with Upside Potential

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

If you would like to participate in upside in the present depressed stock market, but you would like to guard against loss of principal, there are several options available to you. One that might be worth considering in a specialized kind of annuity that offers opportunities linked to a stock market index. These are called “equity linked annuities.” I thought it might be a good service to readers, and timely, to discuss how these instruments could fit into your own financial plan.

Let’s start with some basics. An annuity is a financial instrument, usually issued by an insurance company, into which an investor makes one or more contributions and out of which the investor then takes periodic distributions (either beginning immediately or after a period of deferral). The period during which value builds up in the annuity account is called the Accumulation Phase; the time during which the annuity issuer returns money to the investor is called the Distribution Phase. In the United States, annuities are regulated by the different states and their insurance commissioners.

In general, annuities share the characteristic of income tax deferral, both for state and federal purposes. That is, value will build up during the Accumulation Phase without interim taxation. For fixed income investors, putting your money to work to grow for a term (typically 5-15 years) without any interim taxation can permit a significantly higher final value (post-tax) than subjecting it to interim taxation every year. All of the accumulated value from an annuity, regardless of whether it is invested in a fixed account or not, is treated during the later distribution phase as interest income and is subject to ordinary income tax. How much the deferral feature is worth to you depends upon your marginal tax rate during the distribution phase, the length of deferral, the performance of your investment and tax rates in force during distribution.

If you were considering investment in so-called zero coupon bonds, in which the investor makes an investment now, receives no income for a term, and receives a final payment that reflects a locked in rate of interest, annuities in general offer a powerful advantage: lack of interim income taxation. This is because zero coupon bonds are subject to tax each year on so-called original issue discount (OID) income. Annuities don’t put you in the position of paying tax on money you haven’t yet seen come in!

On the other hand, if you put annuity money in an account that is already tax deferred, such as a 401-K or IRA, you are gilding the lily. Without setting a hard and fast rule, it is right to say that annuities are usually most suitable for taxable accounts, not retirement plans.

Equity linked annuities have many differentiated features, depending on the issuer. But they share the characteristics that there is some minimum final account value guaranteed by the issuer and there is an option to participate in a portion of the growth of the stock market as measured by an index. We will discuss in subsequent articles the value of the option on stock market growth, the framework of state regulation and consumer protection, option riders, surrender costs and the credit quality of annuity issuers.

Note: This article does not present the kind of specialized tax advice, customized to your situation, which could be provided by a qualified accountant or tax attorney.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Recession

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

What everyone has expected is now official: the United States economy has entered a recession. The National Bureau of Economic Research announced that according to its metrics, the recession began last December. The Bureau's measure takes into account declines in gross domestic product, personal consumption, employment and housing prices. See NBER release.

The Dow fell by 680 points (7.70%) on the day of the Bureau's pronouncement (Dec. 1st), although it’s hard to say how such unsurprising news could move investors. Perhaps it was time to end the winning streak which had brought us five consecutive positive days in US stock markets, taking us up from 8121 to 8840.

By any reckoning, the problems facing the U.S. and world economy are grave. Although central banks--notably including the US Federal Reserve--have been acting aggressively to add liquidity, the private banking sector is pulling liquidity back out.

The decline of commodity prices reflects and anticipates the magnitude of the contraction. I was recently driving in central Pennsylvania and saw regular gasoline offered at $1.68 per gallon. For consumers, this is an isolated bright spot. For parts of our country such as Texas that are energy producers, it’s scary. As discussed in last week’s column, fear of deflation is growing, and with it, further concern for the solvency of borrowers large and small.

John Maynard Keynes described a dilemma he called the “paradox of saving.” As an economy contracts, people tighten their purse strings, seeking to save more; as a result, total demand goes down, and as a whole, everyone makes (and saves) less. We must avoid a potential collapse in demand for goods and services and in the money multiplier. (Thus, although it was not exactly inspiring when President Bush urged us after 9/11 to keep shopping, there was a rational basis for it.)

There are a number of key economic decisions facing the incoming Obama Administration. One has already been made: the Bush era tax cuts will be extended. This decision helps head off a divisive fight in Congress and is also stimulative, or at least it is not contractionary. A second major decision involves the big three US automakers. All three, but particularly GM and Chrysler, face imminent financial collapse. Bankruptcy may be unavoidable, but the government may have to play a role in providing debtor in possession (DIP) financing. A third decision involves government spending stimulus; President-Elect Obama is expected to propose to Congress huge initiatives in infrastructure, which could also be helpful, though there is a lag in putting such projects in motion.

The Fed has acted with extraordinary aggressiveness and innovation. Economist Peter Fisher has described their efforts as “appropriately hyperactive.” (Source: Bloomberg News Service.) He added that similar consistent efforts after the stock market crash of 1929 might have shortened or forestalled the Great Depression. There will of course come a time when the Fed will need to mop up some of the liquidity it is now creating, perhaps in a year or two, or face the danger of runaway inflation.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Seeking Principal Protection Plus Upside

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

Many investors I talk to are trying to reconcile two objectives:

 Not to lose further principal.
 Not to sell at the bottom or forfeit the chance to make up losses.

As to the potential for long-term gains, legendary investor Warren Buffett recently wrote that he is buying U.S. stocks. He says he doesn’t know when the market will recover, but he finds many good values at current prices. Warren Buffett, “Buy American. I Am.” (October 16, 2008) NYTimes.com. However, few have Buffett’s ability to lose tens of billions of dollars of net worth and remain among the richest individuals in the world. Hence, the desire to place a floor under what you can lose.

As to the risk of loss, I would note the following numbers, which represent the current level of a stock index (or exchange-traded fund based on an index) (as of market close November 20th) compared to its one year high closing level:
 Dow Jones Industrial Average: 7552.37 (down 45.47%).
 S&P 500 Index: 752.44 (down 50.61%).
 NASDAQ Index: 1316.12 (down 51.88%).
Emerging markets have been hit severely. “EEM,” which denominates an exchange traded fund (IShares MSCI Emerging Markets Index) is at 19.39 (down 64.13%). “EFA,” representing IShares MSCI Europe and Far East Index), is trading at 36.90 (down 56.4%). As to stocks, this year, you could run, but you could not hide. Moreover, we appear to heading into a prolonged worldwide recession.

In the next several articles, I will discuss several methods to protect principal (not necessarily including inflation adjustment) while preserving upside in stocks. Notably, none of these methods provide either perfect protection (such as could be provided by US Treasury Bills) nor maximum profit potential (such as could be obtained by purchasing naked out-of-the-money call options on US stocks).

Among the products we will discuss are the following:

1. Equity-linked CD’s. In this product, a bank promises you a minimum rate of return, or alternatively, a return geared to formula including a component of stock market performance, whichever is higher. Gains on such products are subject to current income taxation.
2. Equity linked annuities. In this form of annuity, you contract to receive a minimum guaranteed rate of return, or a return linked to the stock market, whichever is higher, with many possible variations and options. Annuities offer the additional feature, potentially, of deferred income taxation. The credit quality of the guarantor is a key consideration.
3. Hedge funds. Many hedge funds offer strategies designed to mitigate downside market risk, pursuing strategies of either partial or full market neutrality. These strategies may be more or less successful. Hedge funds are generally offered as private partnerships offered exclusively to “accredited investors.” The tax efficiency of hedge funds differs depending on the strategy and its execution.
4. Home-made strategies. These may involve purchase of UST zero coupon bonds or instruments expressing a bearish stock market view, in conjunction with other securities expressing a bullish view. The zero coupon bonds potentially create current taxable income (called “Original Issue Discount” income), even though the return is deferred.

Note: The author of this article is not a tax expert. This article does not purport to give the kind of specialized advice, customized to your situation, which could be offered by a qualified CPA or tax attorney.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Deflation Fear Haunts Market

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

The main U.S. consumer inflation index registered a sharp drop in October. The Consumer Price Index-Urban Area (CPI-U) fell 1%, the largest single month decline in the 61 years the survey has been taken. The CPI-U survey depicts the cost of a representative basket of goods and services in a variety of U.S. urban markets.

The CPI decline fanned fears of deflation and led to a further rout in the main stock indexes. Although most central banks view their main mission as fighting excessive inflation, it is accepted that a moderate rate of inflation, such as 1%-3%, is ideal. Deflation, a falling in absolute price levels for a broad variety of goods and services, is much feared by economists and central bankers as a corrosive and insidious problem.

The greatest percentage price decreases occurred in the volatile food and energy components of the CPI-U, particularly energy. The core index, excluding food and energy, fell only 0.1%. Thus, the market may have over-reacted to the CPI news, since the recent fall in energy prices was already well-known. Nevertheless, the easing of price levels has been accompanied by further indicators of weakness in the problematic real estate sector, including a drop in new housing starts of 4.5% in October, high inventories of unsold homes, rising rates of mortgage delinquency, and signs of trouble in commercial leasing. Weak demand conditions have started to afflict other sectors as well, including retail, transportation and technology.

Why is deflation so feared? One reason is that when prices fall, traditional methods of stimulating economies by lowering interest rates may not work, even when nominal interest rates approach or reach 0%. An example may illustrate how this works. Suppose you are a purchasing agent who will need goods in one year, and suppose you can borrow for one year at 0% but you expect the price of what you can purchase in one year to fall by 10%. You would save 10% by waiting to buy, instead of purchasing now with borrowed funds and stockpiling the item.

An often cited recent example of a prolonged deflationary spiral is Japan after the collapse of the so-called “bubble economy,” beginning in late 1989. Japan found that low interest rate medicine alone was not simulative enough. Indeed, our own Fed is running out of room to drop rates. The Target Fed Funds Rate is currently just 1%, having already by dropped by a full ½% on October 29th. Still, expect the Fed to announce a further cut at its December meeting, or perhaps earlier.

Suppose deflation becomes a stubborn problem for the national and international economy. What are the investment implications? First, borrowers will have a harder time repaying loans, as the real rate of interest (after considering inflation) is increasing. Thus, banks in theory benefit, if they have not hedged out their rate risks. However, depending on the magnitude and persistence of deflation, the banks would face a rising tide of delinquencies and defaults in an already dicey environment. Second, portfolios of bonds should do better, as deflation implies low interest rates. Third, stocks may not do well, but among sectors, consumer staples should do better than discretionary purchases. People still need to buy groceries and go the drug store, but they may well skip purchasing the 50 inch flat screen display. Fourth, commodities and precious metals in general will perform poorly. Fifth, real estate investments of all kinds would suffer.

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Estate Planning Under Obama

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

David Letterman quipped that Barack Obama is now President, and he thinks he speaks for most Americans in saying that it’s alright if he starts the job a little early.

One economic item that President-Elect Obama will take up soon is the “sunset provisions” of President Bush’s tax cuts. Under this gimmick, the Administration created large tax cuts but did not need to budget them as permanent deficit items, as they disappeared unless re-enacted by Congress. So, for example, the legislation ended the federal estate tax in 2010 only to bring it back in its prior form in 2011.

Here are the specifics under current law: For tax year 2008, under the federal Unified Estate and Gift Tax, up to $2 million is excluded from a person’s estate (minus amounts used up during that person’s lifetime, for example, by gifts); this excluded amount is scheduled to increase in future years up to $3,500,000 in 2009. The maximum marginal estate tax is 45%. The estate (but not gift) tax is slated to cease in 2010, then returns to a $1,000,000 exclusion and maximum 55% rate in 2011. Some quipped that it had become part of sound tax planning to die in 2010.

The idea of an estate tax is based on ideas going back to the founding of our country. Thomas Jefferson among others believed that the development of great hereditary fortunes would threaten our republican form of government. The first estate tax, imposed in 1797, supported naval construction during the Revolutionary War; it was repealed in 1802.

In modern U.S. politics, Republicans often portray the estate tax as confiscatory. Democrats are apt to see the estate tax as equitable and providing a tax incentive for charitable giving. The political parties thus express certain elements of the conflict between social classes. However, billionaires Bill Gates and Warren Buffett—perhaps practicing noblesse oblige--have opposed elimination of the estate tax.

The Democrats have won the national election. As to the estate tax regime, we will probably take a middle route. Most likely, Congress will enact legislation to raise the “lifetime exclusion” on estate tax to $3.5 million, the stipulated 2009 level, on a permanent basis. (A useful but unlikely change would be to index this amount to future changes in inflation.) Congress may also vote to raise the annual gift exclusion, perhaps to $15,000. These changes will make it possible for most moderately well to do families to avoid the need for serious estate planning, while cementing that need for decedents likely to have a net worth at death substantially greater than $3.5 million. Such wealthy individuals and families will need to make traditional estate planning decisions, including the potential use of trusts, family limited partnerships, private foundations and life insurance.

[This article is not written by a tax expert and does not present the kind of customized tax advice available from a qualified tax attorney or accountant; however, the author is glad to discuss PPLI as an investment product with your tax advisor.]

Andrew Szabo CFA is managing director of Greenwich Financial Management Inc., a registered investment advisor. Questions call 917-796-8500 or e-mail Szabo@GreenwichFinancial.com). For more information, please visit http://greenwichfinancial.com/.

Private Placement Life Insurance and Annuities

Introduction

Many individual investors seek the advantages of diversification into hedge funds.[1] The advantages sought (depending on the funds selected) include: hedging market risk; diversification as to asset class; alignment of interest with the portfolio manager; specialized asset class knowledge; leverage; and, ultimately, superior risk-adjusted returns.[2]

However, many investors fail to inquire into the tax characteristics of favored hedge funds. The tax efficiency[3] of a hedge fund is closely related to its level of trading activity and portfolio turnover. There may well be merit in a very actively traded portfolio. Some of the funds of SAC Capital (Steven Cohen) and Tudor Investments (Paul Tudor Jones II) come to mind, for example. But these same funds can generate copious amounts of taxable income.

In the current environment, having taxable income from hedge fund may be considered a “high class problem,” given the many hedge funds that are suffering sharp losses. However, some hedge funds are indeed creating gains in the current environment. Others will no doubt soon return to that position.

Gains in a hedge fund portfolio can be divided into three types. First, there are gains that have not been realized (by the sale of a purchased security, for example). Under our tax system, unrealized gains (as a general principle, with exceptions) are not taxed. Second, there are short-term capital gains. Short-term capital gains, not offset by capital losses, will typically be taxed at the same high marginal rates as “ordinary income,” such as salary. Third, there are long-term capital gains, which apply only to assets held at least one year and a day. Long term capital gains are taxed at a preferred rate. A highly tax efficient fund maximizes deferred gains first, and long-term capital gains, second, while minimizing short-term capital gains; it may also generate or carry forward capital losses (short-term or long-term) that provide offsets allocable to the limited partners.

Suppose you wish to invest in hedge funds but would like to mitigate significant potential tax burden? Are there any solutions? In fact, there are workable approaches to this problem—through insurance vehicles. The first is “private placement life insurance.” The second is “private placement deferred variable annuities.” [4] Both vehicles offer the additional benefit that they do not lead, as investment partnerships do, to receipt of Form K-1 (stating allocable share of partnership income), which would in turn require an individual to file a Form 1065 (Partnership) tax return.

Private Placement Life Insurance

Private placement life insurance is a form of variable universal life insurance. This means that it is permanent life insurance (the policy illustration generally runs to age 100, or beyond), that it is “universal” in having flexibility as to contributions and withdrawals, and that it is “variable” in having the investor elect investment options whose minimum rate of return is not guaranteed. See Overview of Personal Insurance. In private placement life insurance, the investment options can (and generally do) include hedge funds. More specifically, the menu of investment options made available to such accredited investors may include hedge fund surrogates, usually in the form of insurance sub-accounts run in parallel to a hedge fund, and replicating or at least simulating its trades.[5] See Alfred Winslow Jones and the Idea of a Hedge Fund--Greenwich Alternative Advisors.

Private placement life insurance offers the three main tax advantages offered by all permanent life insurance. First, the death benefit on a life insurance policy, received by the named beneficiaries, is not subject to income tax. Second, accretions of gain in the investment account of a life insurance policy are not taxed. Third, there is the opportunity under most life insurance contracts to borrow against ones prior principal contributions at a low interest rate without creating taxable income.

It is also true that the death benefit on a life insurance policy for an insured person, owned by a properly structured irrevocable life insurance trust, will be outside the estate of the insured person, and therefore not subject to the probate process or the federal estate tax; this is true of any asset so owned. A life insurance policy, including private placement life insurance, may thus become part of a broader plan for transmitting wealth to a younger generation. Part of your consultation with specialized trusts and estate counsel in this regard would be structuring things to mitigate the impact of gift tax.

With private placement life insurance, the insurance agent accepts a much different commission setup from conventional life insurance. Instead of receiving most commission upfront (called “target commission”), the agent generally a much smaller percentage distributed as a level commission paid steadily over the years the policies is in force and remains agent of record. Consequently, private placement life insurance will usually show surrender values immediately upon being put in force (assuming adequate funding to create cash value in the policy). Of course, the overall burden of commissions and administrative expenses, and the cost of insurance itself, must still be assessed. Any commissions and administrative costs chargeable to the life insurance policy must be fully disclosed in the official illustration created by the carrier.

Permanent life insurance (whether private or conventional) offers various options, called “riders.” These must be registered with the states where the policy is being offered. The riders are usually included at the end of the policy description. Most carry an annual cost, so a tradeoff must be considered versus the potential advantage offered. Universal life policies generally offer a “guarantee” option, which locks in a fixed cost of insurance (COI) against possible future increases in mortality experience; this option often costs an additional 1/2 % per year or so in premium costs. As overall mortality experience (and hence, COI) is going down, not up, this option is of questionable value versus its cost. An option that is worth considering, with current longevity trends, allows extension of the policy beyond age 100 (sometimes without paying any additional premiums from that point onward). Another rider offers cash benefits for disability; this option is usually not priced competitively with the best pure disability policies.

As the owner of a life insurance policy depends on the paying ability of the insurance carrier in the future, life insurance policies should only be purchased from carriers with sound finances and a strong investment grade rating on long-term debt. See Analyzing the Credit Quality of Life Insurance Companies. With PPLI, the credit quality issue pertains to death benefit not covered by cash value in the (segregated) insurance sub-accounts. In the current credit crunch underway, this issue has been highlighted. Carrier credit quality is a point you should discuss carefully with your insurance agent or investment advisor.

Not everyone can take advantage of private placement life insurance. First, not everyone is an accredited investor. Second, it is not a suitable risk for all individuals. Third, not everyone is insurable, either because of poor health or advanced age (usually, over 90 years old). Fourth, not everyone has excess insurance capacity.[6] Fortunately, there is an alternative, private placement deferred variable annuities, for which there are no capacity limits.

Private Placement Variable Annuities

A private placement variable annuity is, as is indicated by its name, a variable annuity available exclusively to accredited investors through private placement. An annuity offers a potential stream of distributions in the future in exchange for an upfront payment by the investor. As with private placement life insurance, the menu of investment options made available to such accredited investors may include hedge fund surrogates, usually in the form of insurance sub-accounts run in parallel to a hedge fund, as with private placement life insurance.

Annuities include various options that need to be understood. With “variable” annuities, the investor chooses from a list of investment options, whose performance will vary; with “fixed” annuities, the carrier guarantees a rate of return. The kind of annuity that offers deferral of income is called a “deferred annuity”; those that that begin payout right away are called “immediate annuities.”

A similarity between private placement life insurance and private placement variable annuities is that commissions are generally not weighted upfront, but rather spread out evenly over the years. For example, conventional variable annuities may include upfront sales charges of up to 8% or so, and these commissions create a surrender charge issue in the early years of such an annuity. Any commissions and administrative costs chargeable to the annuity must be fully disclosed in the official illustration created by the carrier.

Deferred annuities (properly structured) lead to deferral of taxation. Eventually, though, the piper must be paid, and any future distributions are subject to tax at the full marginal rate for ordinary income. Note, however, that future distributions (when the instrument is ultimately “annuitized” or cashed out) are treated as ordinary income under federal and state law.

The deferral of tax is nevertheless an important advantage, and the longer the deferral, the greater the potential advantage. First, deferral allows the accumulation of wealth in the insurance account without taxation, thereby augmenting its potential growth and end value. Second, some investors may anticipate being in a lower tax bracket in the future (for example, upon retirement) than now, thus providing a double advantage. (Of course, no investor can know what federal marginal rates may prevail on income at that time, as those rates are subject to the will of Congress and the vicissitudes of the federal budget process; a similar stipulation applies to state and local income taxes, where these are imposed.)

The purchase of a private placement deferred variable annuity does not entail health examination, medical tests, or disclosure of ones medical records. Thus, for some investors, there is a significant privacy advantage versus the purchase of life insurance. Another reason some accredited investors buy private placement variable annuities is that sizable purchase of life insurance is not an option. This may be because of lack of insurability (owing to health problems or advanced age) or because one has maxed out on insurance capacity in relation to ones net worth.

Conclusion

An accredited investor may find some hedge funds attractive on a pre-tax basis but of equivocal benefit post-tax. This is particularly true of many hedge funds that engage in active trading. Such hedge funds can generate sizable percentages of short-term capital gains, and these are taxable to the limited partners at each partner’s marginal rate for ordinary income.

Two insurance vehicles offer a way to obtain the benefits of some actively traded hedge funds, while mitigating income tax burden: private placement life insurance and private placement deferred variable annuities. In the case of both vehicles, investment options often include insurance sub-accounts run in parallel to those of private hedge funds.

Private placement life insurance offers a more comprehensive tax mitigation scheme. Indeed, the death benefit of a life insurance policy, paid to the original beneficiaries, is generally not subject to any income tax. Further, the accretion of cash value in a life insurance policy, during the lifetime of the insured, is also not subject to income tax. Finally, one may generally borrow against the cash value of a life insurance policy at a preferred rate, and borrowings up to the amount of prior contributions are not includable in “income” for income tax reporting purposes.

Private placement deferred va riable annuities offer a deferral of income tax. Ultimately, though, the piper must be paid, and proceeds of future distributions will be taxable as ordinary income. However, the deferral of income tax burden can be very valuable; the longer the deferral, the greater the potential benefit. Private placement annuities can also be an attractive alternative for those high bracket U.S. taxpayers who do not wish to purchase, or cannot purchase, private placement life insurance.

The purchase of either private placement life insurance or private placement variable deferred annuities requires due diligence as to suitability, cost, availability, and ultimate economic advantage on a post-tax basis. There is also important investigation needed regarding the claims paying ability of the chosen carrier(s). The author would be glad to review such issues with investors and their advisors.

[1] Hedge funds distributed by private placement can only be invested in by individuals who are “accredited investors.” The same is true of private placement life insurance and private placement annuities. See Accredited Investors--SEC Definition. An accredited individual investor must have a net worth of at least $1 million or recurring annual income of at least $200,000 ($300,000 if married and filing jointly).
[2] As a preamble, we wish to state that investment in financial markets—including investment of the sort discussed in this article--involves risk and returns cannot be guaranteed.
[3] This article does not present expert tax advice and is not written by a tax expert. For tax advice properly customized to your particular situation, please consult your accountant or tax attorney.
[4] Private placement life insurance and private placement variable annuities are considered “securities” under federal and state securities laws; they can be offered only by properly licensed agents of licensed broker-dealers. The licensing status or registered representatives and broker-dealers can be checked at the following Website: http://www.finra.org/.
[5] Where a sub-account does not accurately parallel the performance of a corresponding hedge fund, there may be “tracking” error, which can be either favorable or unfavorable depending upon circumstances.
[6] No one, no matter how rich, is eligible to purchase infinite life insurance coverage. As a rule of thumb in the insurance business, “insurable capacity” equals approximately 80% of ones net worth, minus life insurance already in force, plus an amount equal to five times ones recurring non-investment income (such as income from salary or social security benefits). One is economically eligible to take out additional life insurance equal to insurable capacity. Of course, some individuals are not insurable for health reasons, even though they may have “capacity” in this economic sense. As a practical matter, individuals have difficulty assembling more than about $100 million to $150 million in life insurance coverage, even when a “syndicate” of carriers is arranged to spread the liability. The life insurance carriers do not want to risk breaking the bank through coverage of a single life.



Copyright © 2008; all rights reserved. The author, Andrew Szabo CFA, is Managing Director of Greenwich Financial Management Inc., a registered investment advisor. Questions, contact Szabo@GreenwichFinancial.com or call 917-796-8500.

Market Update on Life Insurance, Life Settlements and Premium Financing: Questions and Answers

Copyright © 2008, Greenwich Financial Management Inc., a registered investment advisor.

The following discussion is meant to help persons considering life insurance policies on their own lives or that of loved ones. It is intended to aid understanding of: what life insurance is; the different kinds of life insurance; how to analyze life insurance as an investment; financing options available to pay life insurance premiums; and current market trends. The discussion covers many topics in a summary way and is definitely no substitute for customized advice from an investment advisor or insurance agent based on analysis of individual needs.


Question: What is life insurance and what are the major types of life insurance policies?

Answer: There are two periods of life insurance: term and permanent. Term insurance contracts afford the policyholder life insurance coverage on an insured person for a defined period. Of all types of insurance policies, term life offers the least expensive coverage per year in the short term. The contracts are typically renewable without further underwriting until the insured reaches a certain maximum age, such as 75. Many policyholders abandon term life as they grow older and premiums skyrocket. “One year term” means that the rate resets upward every year. “Ten year term” means that the rate is locked for the first ten years, jumps in price at that time, then increases incrementally in each year thereafter (and similarly for “twenty year term,” etc.). Some term life policies are convertible into permanent policies, usually whole life, at the rates prevailing when converted.

With permanent insurance, in contrast to term life, the policyholder can maintain coverage until the death of the insured,[1] assuming premiums are paid as required; the premium payments are exactly level or relatively level. In effect, you pay much more in early years than you would with term life, in exchange for the benefit that your premium doesn’t keep going up (exponentially) as it does with term life, and for the equity you develop in your policy, called “cash value.” Whole life and universal life policies can develop this cash value, but term life by definition never will. In the event that a permanent life insurance policy is “lapsed,” or allowed to expire (usually after exhausting any cash value available to keep it in force), the insurance company issuer receives a windfall, as there will never be a death claim to pay. A certain rate of lapse is assumed in most insurance company underwriters, allowing them to price policies more aggressively; such assumptions are a sensitive matter to insurance companies and aren’t bandied about.

There are in turn two kinds of permanent insurance, depending upon who takes the risk concerning overall rates of mortality and administrative expenses. In “whole life,” the insurance company takes the risk that death rates or administrative costs may exceed actuarial expectations, and obliges itself contractually to accept a level (or “constant”) periodic premium payment from the policyholder in return for providing a certain death benefit. In “universal life,” the policyholder takes the risk that mortality rates or administrative expenses may go up, and in the case of at least one reputable insurance company, the policyholder also has enjoyed a benefit if mortality or administrative expenses go down (mortality rates have been declining historically, owing to better sanitation and nutrition and advances in medicine and pharmaceuticals). Universal life contracts are much more flexible than whole life, allowing many variations in contributions over time. Because the premiums on universal life are typically arranged to be low in the early years and to increase rapidly in later years, the lapse rates on universal life are extraordinarily high. [2]

Finally, there are two kinds of universal life: standard and variable. In standard universal life, the cash value of the policy is guaranteed to advance at a certain minimum rate, assuming the expenses stay the same; the insurance company makes the investments itself (primarily in bonds and bond-like instruments) for the group of policyholders. In variable universal life, the policyholder decides on investments from a menu of mutual funds or variable annuity sub-accounts (held in segregated custody for the benefit of the policyholder) and can make periodic changes; here, the policyholder takes the mortality risk and all of the investment risk, with the goal of superior performance.

The bottom line: a permanent life insurance policy contains implicitly an important option relevant to an investor. This option is the right to keep the policy in force indefinitely at a pre-agreed premium ledger, regardless of changes in health status. When the health status of the insured person falls below what an insurance underwriter anticipated in setting the policy premium ledger, such that life expectancy is significantly shortened, then the potential desirability of the policy from an investment perspective increases. This option is the very foundation for the life settlement market, to be discussed below.


Question: What are the potential tax benefits of permanent life insurance?[3]

Answer: There are significant tax benefits related to life insurance for high net worth persons. Virtually every serious exercise in tax and estate planning considers life insurance as a component. We will discuss here four potential tax benefits you can obtain through life insurance policies. Each is considered uncontroversial and well-accepted by law.

The first large tax break regards the “death benefit,” which is the money payable to the beneficiary of a life insurance policy in force when the insured person dies. The death benefit, paid in a lump sum, is entirely exempt from income tax. The benefit can be very helpful when there is estate tax to pay and assets are tied up in illiquid investments, especially where the family desires to hold onto those assets or sell them at the best time and price. If the beneficiary decides to annuitize the death benefit, then the future interest portion but not the principal will be taxable.

The second tax benefit is growth of the cash value of the policy without income tax (since a Tax Court decision in 1963). The cash value is the equity in a whole life or universal life policy. The growth of the cash value is untaxed, and no federal tax report goes out to the policyholder or the IRS, even though the investments made by or on behalf of the policyholder might otherwise lead to realization of ordinary income or capital gains. This benefit does not apply, however, to term life, which does not develop cash value. So-called “dividends” normally represent premiums paid earlier on a whole life policy; these are not subject to income tax either.

A third advantage is that the policyholder may also borrow against the cash value of a life insurance policy, to the extent of any premiums paid to date, without tax effect. [Limits: where borrowing exceeds premiums paid, or when the policy is deemed a “modified endowment contract” (MEC). Advisors usually structure tax shelter oriented policies to include periodic premiums equal to the maximum non-MEC amounts.] Typically, interest paid is credited back to the policy’s cash value, so the borrowing is effectively free or of minimal cost.

A fourth benefit is exemption from estate tax on the estate of the insured, when the future proceeds to a beneficiary (or beneficiaries) are transferred to an irrevocable life insurance trust (ILIT). (Alternatively, your intended beneficiary could apply for and purchase insurance on your life, assuming that person has an “insurable interest.”) A properly structured trust places the property outside probate and the estate tax system. Exception: if you transfer property to an ILIT, but die within three years, the transfer may be subject to estate tax as made “in contemplation of death.” Your trust and estates attorney may establish “Crummey powers” within the ILIT to allow your contributions to qualify for the $12,000 per person ($24,000 for a married couple) annual exclusion from gift tax. However, the cash value of an existing policy transferred to an ILIT could still be subject to gift tax or reduce your lifetime exclusion. Frequently, ILIT’s provide a tax-efficient way to transmit wealth upon death to the next generation.

Background on estate taxes: For tax year 2008, under the federal Unified Estate and Gift Tax, up to $2 million is excluded from a person’s estate (minus amounts used up during that person’s lifetime, for example, by gifts); this excluded amount is scheduled to increase in future years up to $3,500,000 in 2009. The maximum marginal estate tax is 45%. The estate (but not gift) tax is slated to cease in 2010, then returns back to a $1,000,000 exclusion and maximum 55% rate in 2011, under a crazy-quilt “sunset” provision that Congress enacted. Unless you expect to die exactly in 2010, not planning for estate taxes could be costly. Elimination of the Estate Tax has been a stated priority of the Bush Administration, but the Democrats have opposed it, and this is a presidential election year. A likely political compromise would be to preserve the $3,500,000 exclusion (or slightly greater amount) after 2009 rather than to allow the sunset provision to take effect. The current financial and fiscal crisis obviously reduces greatly the possibility of imminent elimination of the Estate Tax in the near future.


Question: Can an insurance policy ever be worth more than its surrender value?

Answer: Traditionally, the money value of a permanent life insurance policy equaled its cash value minus surrender charges (if any). However, more recently, an alternative valuation of a permanent life policy—sometimes higher—is available through the secondary market for viatical settlements and life settlements.


Question: What is a viatical settlement? What is a life settlement?

According to industry nomenclature, a “life settlement” is the sale of a policy by the policy owner to a third party, except for “viatical settlements.” Viatical settlements entail the sale of a policy to a third party, where the life expectancy of the insured person, as certified by a physician, is two years or less.[4]

The secondary market for viatical settlements first attained significant size in the wake of the first wave of the AIDS crisis, in the late 1980s. Numerous ill men sought to sell permanent life insurance policies in order to raise money for medical treatment while still alive. The possibility of selling the policy for more than its cash value became tangible because at that time the life expectancy of AIDs victims was considered very short and the disease invariably terminal. The later development of a cocktail of medications that could inhibit the HIV virus for long periods led to a vast change in expected mortality for AIDS infected persons. As a result, many investors in pools of such policies were disappointed, and the sponsors of such investments were often sued. As an unsavory residue from this era, other sponsors were later accused of creating insurance mills in which known AIDS infected persons obtained new life insurance policies by providing fraudulent medical information. The subject of “viatical settlements” retains an unsavory reputation in some quarters. However, both life settlements and viatical settlements have legitimates uses; trust fiduciaries increasingly feel a responsibility to consider the life settlement market as an alternative to surrender of a life insurance policy, where discontinuance is being considered.

Out of the market for viatical settlements, a different market arose for life settlements, particularly for those with chronic illness and highly reduced life expectancy (but greater than two years), and to seniors aged about seventy or greater. Even for such seniors, there is the possibility but not the certainty that any given policy on an insured person might find a market bid from some investor greater than the policy’s surrender value.


Question: Who are the major players in the life settlement market?

Answer: The life settlement industry, although relatively young, is stratified (both by practice and to some extent by regulation) into distinct categories of activity, although occasionally these overlap.[5]

Those who arrange or facilitate the sale of a life policy to a life settlement provider, or another life settlement broker, are known as life settlement brokers. Such brokers are not the contractual buyer of seller of policies; they are arrangers. In life settlements, the brokers act as agents of the life settlement provider, not the consumer, a fact that is not always clearly understood. There are several hundred licensed life settlement brokers in the different states.

Those who act as the contractual purchaser of life settlements are considered life settlement providers under the laws of many states. In the majority of cases, life settlement providers are not principals either, though they can be; they typically act as agent of behalf of end investors. There are approximately twenty rather active life settlement providers.

Life insurance agents, generally speaking, act on behalf of the insurance carriers they are appointed with; this is a murky area, however, and the agents also have specific responsibilities to consumers under state laws. Agents may be either “independent”—associated with multiple carriers—or “captive.” Captive agents include the majority of those associated with Northwestern Mutual Life and Metropolitan Life. Independent agents, especially smaller ones, are not allowed to deal directly with insurance carriers, but instead must deal through a wholesaler called a “general agency.”

End investors in life settlements buy life settlements to hold, not to resell Among the most aggressive investors in recent years have been German mutual funds dedicated to life settlements.[6] Europe lacks a developed market in universal life insurance policies, so fixed income investors seeking life settlement opportunities must look to the US.

Clients sometimes ask: why not deal with the end investors, cutting out the middleman? However, for the most part, the end investors wish to deal exclusively with wholesalers, namely, the life settlement providers. The brokers add value by providing access to numerous life settlement providers. However, the client’s best interests are served when life settlement commissions are reasonable and fully disclosed. In the end, receiving the highest possible net price is the goal, and the intermediaries are a means.


Question: What is the tax treatment of life settlements?

Answer: There are several questions regarding the tax treatment of life settlements that have not been clearly resolved.

The proceeds of a life insurance policy, payable in a lump sum at death, are generally exempt from income tax to the beneficiary.[7] However, if the “transfer for value” rule is violated, this income tax-free treatment is lost.[8] The transfer for value rules are complex, but the market consensus is that a life settlement investor is not entitled to income tax free treatment of the death benefit.

If income tax might be payable on receipt of life insurance proceeds by an investor, there is then the problem of calculating gain, which turns in part on establishing a cost basis. The IRS has held in several situations that premiums paid to keep a policy in force may be included in basis, but against such payments a deduction should be made for the value of the insurance benefit received. [9] As a practical matter, the IRS guideline appears to be that basis is increased (or decreased) by augmentation (diminution) in the cash value of a policy, not by the mere payment of premiums.

If a life settlement is a capital asset in the hands of the life settlement investor, and it is held for at least one year and a day, it might be eligible for favorable long-term capital gains treatment. This appears to be a cogent position, but it is not explicitly supported by the Code, regulations, or private letter rulings, nor is it clearly presented and resolved by case law.


Question: If I look at my policy as an investment, how should I value it?

Answer: The valuation of an insurance policy is different in some key ways from other financial assets. One key variable is the timing of the death of the policy holder, which is uncertain, but about which one can make an estimate, especially with the help of complete medical records from the insured. Such records are in practice submitted to a third party life expectancy estimator, of which about seven are established in the market. A second key variable is the schedule of premium payments laid out in the original life insurance contract, as updated by an in-force policy illustration. Unless such premiums are paid on schedule or at least within the allotted grace period, the policy will lapse and become void.

The market standard for analytical software to calculate the value of life settlements is Milliman [see www.Milliman.com]. The Milliman software takes the key financial variables, as inputted by the user—that is, the illustrated premiums to keep the policy in the force and the life expectancy of the insured—and from these, calculates a present value and a predicted internal rate of return.


Question: How is life expectancy calculated?

Answer: The underwriting department of each insurance company calculates life expectancy of a proposed insured, based on the submitted health questionnaire, complete medical records, and a fresh medical exam and tests supervised under the auspices of the carrier. Investors do not have access to this information gathered by the carrier. Instead, investors seek life expectancy reports from independent, third party life expectancy consultancies. Of the life expectancy estimators, probably the foremost are American Viatical Services, or AVS, and 21st Services. AVS estimates of life expectancy, are generally regarded as among the most conservative by investors; “conservative” in this context means that their bias is toward longer life expectancies, allowing investors to pay a lower price for each policy given some stated internal rate of return. 21st has been moving toward longer life expectancies recently, partly in response to newly released insurance industry mortality data. Other life expectancy estimators in include Fasano Associates, which is also considered conservative. Among estimators considered more aggressive by some investors are EMSI and Midwest. End investors differ to some degree in the credence given to particular estimators. A typical approach of investors, though, is to request three estimates, of which two must be from AVS and 21st Services.


Question: Suppose I intend to hold my policy for a short time and then sell it at a profit, thereby repaying the loan. Is this permitted?

Answer: The answer has two parts. First, it is well established under American law that a valid insurance policy is a form of property, like a stock or bond, which can be sold by the insured or policy owner. Justice Oliver Wendell Holmes wrote a famous opinion in a Supreme Court case enunciating this principle. [10]Second, however, an insurance policy can only be initiated by someone who has an “insurable interest,” which can be thought of in crude terms as the interest of someone who would rather see the insured person alive than dead. This could be a close relative, a spouse or a business partner, for example. The law seeks to discourage “speculative” or “gaming” interests in life insurance policies. If you take out a policy only with the intention to resell the policy at a later time, an insurance company may be able to argue that you lacked an insurable interest in the life of the insured person. This is a ground for voiding a policy in all fifty states during the contestability period (the first two years of the policy, as defined under state law), and in a few states the lack of insurable interest may arguably be a ground for rescission indefinitely.


Question: What is life insurance arbitrage?

Answer: Life insurance arbitrage consists of the analysis of a life insurance policy to an insured person, where the decision of whether to initiate or continue the policy is determined by a hard-headed analysis of whether the likely economic benefits exceed the pre-determined cost of carrying the policy and paying the premiums (and also interest payments, if borrowing is involved) until either the death of the insured or sale of the policy into the secondary market.

Classical financial arbitrage entails the exploitation of a risk-free profit by the simultaneous buying and selling of securities into two markets. Such risk-free profit is not available in the life insurance policy market. More loosely, though, the purchaser of a policy may make sound comparisons of policies, properly equilibrated in terms of illustrated cash flows, as to cost.


Question: What steps have insurance carriers taken to prevent arbitrage of their insurance policies?

Answer: The insurance carriers and their advocates label any life insurance policy that is initiated with the intention to resell that policy at a profit to investors as Investor Owned Life Insurance (IOLI) or, more pejoratively, as Stranger Owned Life Insurance (STOLI). The insurance carriers have taken several steps to inhibit writing of IOLI/STOLI policies. First, they have reduced the assumption on the percentage of life insurance policies that will lapse, which has had the effect of raising the cost of insurance, especially for those persons over 65 to 70 years old. Second, they have alerted their insurance agents that they will discipline those who promote life insurance arbitrage schemes, including termination of appointment. Third, they have pursued in selected cases actions in state courts to rescind existing life insurance policies, where they believe there have been abuses in the nature of STOLI.


Question: When does it make sense to borrow money to fund a life insurance policy?

Answer: It can make sense to leverage a life insurance policy under several scenarios:

1. where there is a need for life insurance, but temporary conditions require borrowed funds to do so.

2. as part of a long-term plan to invest in life insurance, where the projected rate of return on the investment is hig