My insights, or lack thereof come from working in life insurance financial reporting in a number of different ways for around 15 years.  Only on time in 15 years, in what is arguably one of the most complex industries as accounting goes, did I ever find serious questioning going on.  Should I tell this story?

Yeah, I should, because it involves the “piece of work” that I reported to at AIG who told me, “Dealing with auditors is bloodsport.”  He also said, “Dealing with reinsurers is bloodsport.”  Delicious that this came to bite him in both ways.

A certain life reinsurer who was large then (call them Geta Life), but is out of the business now (unimaginable then, but given what happened here, no surprise), reinsured a large portion of the immediate annuities and structured settlements, including rated structured settlements that the AIG domestic life companies had written.

Did the treaties pass risk?  With a vengeance they did; not only did they pass mortality risk, but all investment risks were passed as well.  For this fine service, Geta Life earned 1% per year on the surplus relief, i.e., the difference between the book value of liabilities and assets reinsured.

It was not so well understood then, but mortality risk for structured settlements did not tend to work out well.  After an injury giving rise to a court case which would structure a settlement for the plaintiff, the defendant would ask insurance companies to bid on the settlement, which was a stream of certain and life contingent payments.  When the injury impaired the life of the plaintiff, bidding would get stiffer, because it is cheaper to fund life-contingent payments to those who aren’t likely to live so long.

Or so you would think… there was one case where a two-year old boy was injured, to the point of being in a coma, and the underwriter who bid the case rated him as having the lifespan of one who was age 73.  But the money transferred to the parents in the judgement was more than enough to care for the boy, and have a lot left over for the parents.  Ding!  The kid would live a lot longer than 15 years as a result of the settlement.

Rated settlements, where one bid on impaired lives, carried the “Winner’s Curse.” If you won, you overpaid.

But this was not on the radar screen of the somewhat oblivious Geta Life, until they found that the treaties were passing large losses to them, and they decided to audit the treaty.  Sadly, the actuaries above me, who had signed the treaties before I was employed by AIG, forgot to inform the investment department that the treaty limited the trading of around 20% of the bonds of the company in ways that would be mimicked 10 years later in CDOs.

• Trades may not lower credit quality
• Trades may not lower yield
• The cashflow profile of the assets can’t be materially changed.
• And a few more things…

This problem got dumped in my lap as a young actuary, as I found we were way out of compliance with the treaty terms, selling had gone on with abandon, on assets the reinsurer relied on, reducing the investment income the reinsurer would receive in a falling interest rate environment.

So, I proposed to the reinsurer that I go back in treaty history, and select assets purchased to replace those sold that would have kept the treaty in compliance, and put those into the segregated portfolio, and inform the investment department of the rules.  Once Geta Life understood that, they agreed to my “solution.”  That solution took me several months to work out, but I got it done.

In the meantime, the reinsurance treaties with Geta Life had become so valuable to AIG’s domestic life subsidiaries that if they came into question, the subsidiaries would fail.  The accountants of the auditors, realizing that there was something big to analyze, but not knowing how to do it, called in one of their best actuarial auditors.  My ever-confident boss knew he could beat him.

I still remember critical parts of the meeting as the actuarial auditor slowly checkmated my boss, and forced him to reduce the reserve credit for GAAP accounting, resulting in a sizable loss.

Closing off the story, Geta Life was satisfied on the changes in the asset portfolios, but was still annoyed at the losses.  The changes in assets did not avail much; bad underwriting was pinching.  They came to us saying that “Reinsurance is a good faith venture. You’re not supposed to take advantage of us.  Refund our losses, or we will take you to court for not having having managed the treaty properly from inception.”

I said, “You wrote the treaty.  You accepted my asset changes.  You are supposed to absorb mortality risk, such as there is.  I am not an officer of the company, so if you aren’t happy with this, talk to my boss.”

Shortly after that, I left AIG; it was not a great place to work.  Geta Life sued AIG for damages and won (far more than they should have).  Should have produced a blip in terms of earnings, and didn’t.

Mmmmm…. back to the original point.  Should auditors be rotated?

In all my years of financial reporting, I got wind of things in other areas of the company that I served that auditors should have questioned.  Auditors have often been “lap dogs.”  Only once did I ever see a significant challenge.  More often, I saw the auditors try to help the company explain an “accounting oddity.”  (AIG had a nonstandard way of reporting deferred annuity reserves that was very liberal, and it was proposed by their auditors.)

If auditors know that they are only going to be on the job for five years, they will realize a few things:

• If this is going to die in a few years, it doesn’t matter as much if it dies next year.  Maybe firm reputation is worth more than two more years of a contract.
• My work will be reviewed by someone unsympathetic to me in a few years.  He will have little incentive not to tear my work up, and call for restatements.
• Having a fresh set of eyes on corporate finances will lead to questioning of assumptions that get ignored because they are boilerplate to the continuing auditor.
• If auditing ceases to be an annuity to auditors, they will be less complacent, and might even act like auditors on occasion.

My experience with auditors was that they spent a lot of time on the data, and rarely asked the tough questions on assumptions and methods.  They were bean-counters, not actuaries, and certainly not businessmen.

If auditors are rotated, the incentives for just letting things slide will diminish.  That’s why auditors should be rotated.

I have an irregular series on penny stocks, largely off of advertisements mailed to me, or things found on the web.  Every promoted penny stock I have run into has done badly.

Now for all of my prior penny stocks that I have been written about, all have done horribly.

• Bonanza Gold
• GTX Corp
• Bioneutral
• Uniontown Energy Inc.
• Obscene Jeans Corp
• AER Energy Resources, Inc

Today’s gem is iTrackr [IRYS], which the advertiser says is the “Groupon Killer,” complete with a cover page that has a dinosaur labeled “Groupon,” being hit by meteors labeled “iTrackr” and “IRYS.”  Now, this time I got a full 16-page shiny brochure, which had quotes on iTrackr from two notable publications, but in 2006 & 2007, long before Groupon was prominent… and iTrackr did not gain in profitability since then, rather, it had larger and larger losses.

In five-point (or so) type, near the back of the brochure, there is the disclaimer.  I scan it with OCR so that you can read it at a normal size:

Disclaimer:

The xxx Newsletter and/or its publisher, Author Inc., dba blablabla.com did not receive any direct compensation (other than future subscription revenues, the amount of which is not known at this time) with respect to the publication of this Advertisement. Author Inc. has received ten thousand dollars in cash compensation to assist in the writing of this advertisement. BHB Marketing paid eight hundred thousand dollars to marketing vendors to pay for all the costs of creating and distributing this report, including printing and postage, in an effort to build investor awareness. BHB Marketing was paid by non- affiliate shareholders who intend to sell their shares.

 This publication does not provide an analysis of a company’s financial position. iTrackr Systems, Inc.’s financial position and all other information regarding iTrackr Systems, Inc. should be verified with the company. Information about many publicly traded companies and other investor resources can be found at the Securities and Exchange Commission’s website at www.sec.gov. Investing in securities is speculative and carries risk. It is recommended that any investment in any security should be made only after consulting with your investment advisor and only after reviewing all publicly available information, including the financial statements of the company. This mailing piece is not intended to be, nor should it be construed as, an offer to sell or a solicitation of an offer to buy securities, nor should it be construed as the provision of any investment-related advice or services tailored to any particular individual’s financial situation or investment objective(s). The xxx Newsletter is a bona fide publication of general and regular circulation offering impersonalized investment-related research to readers and/or prospective readers and is not an investment adviser. As such, it relies upon the “publisher’s exclusion” as provided under Section 202(a) (11) of the Investment Advisers Act of 1940 and corresponding state securities laws. The xxx Newsletter is not a registered broker dealer. Staff members of The xxx Newsletter and its affiliates may hold positions in investments mentioned herein, and may buy or sell their interests on the open market at anytime. The xxx Newsletter presents information in this report believed to be reliable, but its accuracy cannot be guaranteed. Additionally, it includes forward-looking statements and information within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding expected growth of the featured company. Any statements that express or involve discussions with respect to predictions, expectation, beliefs, plans, projections, objectives, goods, assumptions or future events or performance may be forward-looking statements. The forward-looking statements contained herein (which include all statements other than historical information) involve significant uncertainties. Factors that could cause actual results to differ from the results or implied in forward-looking statements include the size and growth of the market for the Company’s products, the Company’s ability to fund its capital requirements in the near term and in the long term, pricing pressures for the Company’s products and services, the Company’s ability to obtain needed resources, and the local, regional and global markets. Forward-looking statements are based on expectations, estimates and projections at the time the statements are made that involve a number of risks and uncertainties that could cause actual results or events to differ materially from those presently anticipated. Past performance does not guarantee future results.

Emphasis mine. I wanted to split and highlight the juicy stuff.

Now, let’s think about the math of the scam: they pay the author $10,000 to sell his limited credibility to pump a penny stock.  They put $800,000 into the production and mailing of the glossy brochure.  But the market cap of the company is only $6.7 million.  They think the advertisement will create a lasting 12%+ rise in the stock that they can sell into.  Pump-and-dump.  Proclaim a biased story in big print; offer retractions in small print.

No surprise to me, this company has negative earnings (which are getting worse) and a growing negative tangible net worth.  For fun let’s look at the risk disclosures from the 10-K:

• Because there is doubt about our ability to continue as a going concern, an investor may lose all of his investment in our company.  [Oh yeah, the auditors don't believe in us.]
• iTrackr has a history of losses and may not be able to generate sufficient net revenue from its business in the future to achieve or sustain profitability.
• iTrackr’s cash on hand and anticipated near term sales may be insufficient to fund operations for the next 12 months.
• If iTrackr is unable to fund its operations and capital expenditures, iTrackr may not be able to continue to develop and market its products and services which would have a material adverse effect on its business.
• iTrackr is dependent upon key personnel whose loss may adversely impact iTrackr’s business.
• iTrackr’s management systems and personnel may not be sufficient to effectively manage its growth.
• If we are not competitive in the market for online sales, marketing and customer service solutions, or online consumer services our business could be harmed.
• We are dependent on technology systems and third-party content that are beyond our control.
• Our services are subject to payment-related risks.
• We may be liable if third parties misappropriate personal information belonging to our clients’ Internet users.
• Our products and services may infringe upon intellectual property rights of third parties and any infringement could require us to incur substantial costs and may distract our management.
• Technological or other defects could disrupt or negatively impact our services, which could harm our business and reputation.
• Our promotion and marketing of our websites may not result in generation of significant revenue which may cause our business to fail.
• Unauthorized disclosure of sensitive or confidential client and customer data, whether through breach of our computer systems or otherwise, could expose us to protracted and costly litigation and cause us to lose clients which may result in our going out of business and for you to lose your investment.
• Competition in the social networking, online marketing and e-commerce industry is intense and our competitors have greater financial resources and development capabilities than we have, and we may not have the resources necessary to successfully compete with them.
• Our services may become obsolete and unmarketable if we are unable to respond adequately to rapidly changing technology and customer demands.
• The loss of our executive officers or directors, could adversely affect our business.
• Our Controls and Procedures may not prevent misstatements.
• Our Financial Statements for the year ended December 31, 2009 and the quarterly periods ended March 31, 2010 and June 30, 2010 were Restated as a Result of a Re-Audit by our New Independent Accountant Which was Necessitated Due to Revocation of our Former Auditor’s Public Company Accounting Oversight Board (“PCAOB”) Registration.
• There will be a substantial number of shares of iTrackr’s common stock available for sale in the future that may be dilutive to its current stockholders and may cause a decrease in the market price of its common stock.
• Our common stock is considered “a penny stock” and may be difficult to sell.
• iTrackr may be unable to receive a listing of its securities on NASDAQ or another national securities exchange, and this may make it more difficult for its stockholders to sell their securities.
• One stockholder owns a majority of our common stock and may act, or prevent certain types of corporate actions, to the detriment of other stockholders.
• If we issue additional shares of common stock in the future this may result in dilution to our existing stockholders.
• There is currently no market for trading our common stock, and when such a market does develop, the trading price of our common stock may be volatile, with the result that an investor may not be able to sell any shares acquired at a price equal to or greater than the price paid by the investor.
• The trading price of iTrackr’s common stock is likely to be volatile, and you might not be able to sell your shares at or above the public offering price.
• The concentration of iTrackr’s capital stock ownership with insiders will likely limit your ability to influence corporate matters.
• The Company does not expect to pay any cash dividends for the foreseeable future.

Not too optimistic, as you can see, and one looking through the financials would note that they are running out of cash.

Do the large holders think that they will dupe enough people to buy their shares from them, and at advantageous prices?  Hmm… maybe any price above zero is an advantageous price.  As with many promoted penny stocks, it usually looks like a future zero.

Even if the scam is legal, I don’t get how the math works.  They really think they will get a sustained 12%+ rise in the stock, adequate to turn over the entire capitalization of the company into the hand of suckers?

Which makes this double-dumb.  When even the scammers don’t make money, it is one really dumb scam.

Main lesson: don’t buy promoted stocks, and particularly not penny stocks.

Recently, he wrote two  articles on financial intermediation.  Now I’d like to try my own thoughts on the topic.

Financial intermediation has two purposes: transactions and safety.  People want to buy and sell, but don’t want to have a currency where its value shifts radically day-to-day, which would complicate their decisions considerably.  They want a stable unit of account, and don’t want the possibility that they lose a lot of money as a result.  (Yes, during conditions of hyperinflation that boundary disappears, but that’s because they are already losing value already each day from holding the formerly “safe” transactional asset.  They get more careless on the intermediary, because of the risks of holding the safe asset.)

The second goal is safety/preservation/growth of purchasing power.  Can I park money or a short to long amount of time and be assured that when the term is up, I will:

• Receive receive back as much or more in purchasing power terms.
• Reduce my risks or the risks of those I care for from death and other calamities.

Financial intermediation leaves money on the table.  It does not seek the best investment outcome, but takes a lesser return, so that goals can be achieved with greater certainty.

Now, that provides an advantage to the financial intermediaries.  It means that they get cheap funding under most conditions.  Now, can they invest it over the likely lifetime of the funding and not lose money?  That’s a lot of what solvency regulation is about in banks and insurers.   Because financial promises made can’t be easily analyzed for quality by those that offer money, there are two responses by the government:

• Capital rules (which vary by liability and investments)
• Insurance, so that users don’t have to worry about loss.

And, for what it is worth, 12 years ago I played a large role in setting the rules for Maryland life insurers in place, both writing the law, and explaining to the legislators how it protected the public interest.  (Hey! Passed unanimously on the first try, and with the d-word! (Derivatives)  My bill allowed risk mitigation but not risk taking with derivatives.)  The then-governor dressed like a mafia don at the bill signing, for what it is worth… My boss and I and our external and internal legal counsels spent a lot of time on this, but I was the prime mover on getting it done.

As an aside, sitting around in hearings in Annapolis, not knowing when your bill will come up is a chore.  If you know me well, you know I brought work to do, and if that wore out, good books to read.  I was never sitting there with nothing, bored. In the process I learned that Johns Hopkins owns Maryland, but declines from making that public, except when they care. When they spoke up, the legislature rolls over and asks for a scratch on the tummy. Arf!

Sorry, got lost in reminiscing.  Can I say that it was weird?  (I will leave out my dealings with the Department of Insurance, which were surreal.)  I’m not political for the most part, but in the end, the Maryland life insurance investment code is one of the best of the 50 states.  Kind of sad that we don’t have more life insurers here.

The last three paragraphs were quite a detour.  Let me take a different tack.  Yes, intermediation is opaque; that is true by necessity.  Depositors and insureds do not know how their money is invested.  I am here to tell you that that is a feature and not a bug, because the regulators know you can’t analyze the safety of your deposited assets.

In most things, I am a libertarian, but in areas where average people can’t ascertain truth or or falsehood, I support some form of regulation.  Financial promises fall under that rubric, because they are hard to discern.

To close this off, my main point is this: people want financial intermediation, particularly during the bear phases of the financial cycle.  They want to be protected, and transact, and save.  It is reasonable that the government regulates this, because the ability to make future promises that people rely on is valuable to society as a whole.

2011 was characterized by using debt to “solve” debt problems.  Avoid default, extend the loan.  Or, let a public entity refinance the loan.

2011 was a year of rebellion — more pointedly in the Arab world, late to Russia and China, and lazy in the US.  Lefter then most leftists, like Marx, they assume that a wimpy “protest” will produce change.  Sorry, you have to organize, produce leaders, and either influence existing parties or create a new one, or, fight (of which I am not in favor).  If “Occupy” can’t do that, it ain’t worth a warm bucket of spit.

And personally, I am disappointed in those that have come out in favor of Occupy, not because their many contradictory causes don’t have merit, but because Occupy is so singularly ineffectual.  “You say you want a revolution, weelll you know, we all would like to change the world.”  Talk is cheap.  Disorganized talk and effort is pollution, not cheap; we would pay to have it eliminated.  Either organize, or be gone.

As far as the stock market went, it was volatile, but went nowhere.  As for me, I had my worst relative performance calendar year in 12+ years being down 1% while the S&P 500 was up 2%, with dividends.

The US politics of 2011 was nothing abnormal — we have had other periods of delay and intransigence, but few where we ran such huge deficits, and for so little good.  (Congress has not declared war, after all.)  Personally, I am for Ron Paul, not because I like everything that he stands for, but because his delegates have the best odd of deadlocking the Republican Convention, and leading to the selection of another candidate far better than the midgets currently out there.  Personally, I think primaries are overrated, and think we might be better off with conventions where parties analyze/fight over who would be the best candidate.

Never have we had a world so indebted, where there are so many fixed claims asking to be paid out at par.  The future has ugly surprises awaiting creditors — you won’t get repaid in full, whether by inflation or compromise.  Overages of debt clamor to become equity, and only such a change will heal the global economy.

If you are a lender, analyze your portfolio and adjust it where you can to the strongest borrowers.

But goodybye 2011, it was not a good year for me, and for many.  May 2012 be far better, and may we see orthodox policies triumph, even if prosperity lags.

PS — and eliminate or curb the Fed, please.   If there is dirty work to be done, let Congress do it so we can vote them out.  Would that Ron Paul is our next President with a a compliant Congress that will rip out and eliminate our third failed central bank.  We would have some hard times for a number of years, but once they end, the growth would be strong.

I have a bias that modernity is more fragile than commonly believed.  One aspect of that is income/wealth distributions.  Inequality was far more pronounced in the past, and was fairly stable in being so.  So why should the last 150 or so years not be viewed as a possible aberration?

Let me give you five or so reasons why the middle class should shrink:

1) Education — middle classes in the developed world were relatively large when the education systems produced a large portion of the educated people of the world.  That is no longer so, and relative education levels have tipped against the US.  Any surprise that we fall behind?

2) Lazy choices for majors/jobs — “follow your bliss” is stupid advice if no one wants to fund your bliss.  All prosperity comes through serving the needs of others.  Follow their bliss, not yours, and you will do well.

3) Technology — some technological advances aid equality, and some aid inequality — we have been getting more of the latter lately.  If a technology aids one person to serve many at low marginal costs, it will aid inequality, unless the technology is broadly shared and used.

4) Global Conditions — Resources are scarce.  Capital is somewhat scarce.  Unskilled labor is not scarce.  Skilled labor is somewhat scarce.  For those that have not prepared themselves to be productive by having needed skills, it is a tough time.  You won’t be carried along by the prosperity of your nation, because there are many others competing against you overseas, which was not true in the 50s, 60s, and 70s.  (Nor even the 80s and 90s, in degree…)

5) Personal Ethics — Societies that tolerate many children conceived out of wedlock, and no-fault divorce create an underclass of poor women with children, and the children are far less able to compete because they have no father figure.

6) Politics won’t change things — this is yet another hard reality.  People may vote, but money/resources “vote” more.  Especially in societies where education has slumped, power gravitates to those that will better the whole, even if it means the elites get more.

Someone please send the memo to the “Occupy” crowd, and tell them that have succeeded at being the “freak show” amid changing times, but utterly irrelevant to the changes happening around the globe.  If they have jobs, get to them, if not, go find one.  You might be relevant then.

But in another sense, they are very much to blame.  Why?  As Buffett has said, he thinks about the things others say “can’t happen.”  Secured lending fits into another aspect of the “net capital rule,” an aspect less noticed.  That can be geared up 50 times, not the 12 times commonly considered.  Who would have thought that secured lending would be so overlent that it would push up asset prices, and that so many would rely on holding assets via short-term loans via repo?

Well, I fingered some of it at the time, but not all of it.  So the argument shifts — the SEC was not wrong for shifting its standards in 2004, which had little impact — it was wrong long before then with the net capital rule 15c3-1 by being too lenient with secured lending.

Secured lending often fails colossally, because lenders think the current value of the asset is a guarantee, when it is really subject to the conditions of the market.  When many lenders rely heavily on collateral, it proves to be less than valuable.  Also, secured lending tends to be done by leveraged entities, who think they can do it because it is safer.  When it fails, it can be like a string of dominoes.

We need to abandon the idea that the SEC made some grand shift in 2004, and rather, take up the idea that the SEC had the net capital rule wrong in the first place — it should have been tighter with respect to secured lending.   Given the short-term nature of the repo markets, and the correlated nature of changes in repo haircuts, maybe the SEC should ban investment banks from using repo financing.  Yes, it will kill profits, but no regulator should care about that.  Regulators should care about solvency under all scenarios.

Short-dated financing of long-term assets is at the root of most financial crises.  Let the regulators move to a strict asset-liability matching framework for regulating the investment and commercial banks, where they look through the financing arrangement to the ultimate asset being financed.  Long assets deserve long financing.

Now for all of my prior penny stocks that I have been written about, all have done horribly.

• Bonanza Gold
• GTX Corp
• Bioneutral
• Uniontown Energy Inc.
• Obscene Jeans Corp

Now we have AER Energy Resources [AERN] which has done horribly, and does not file financial statements, having “gone dark.”  From a research note on the web, this is what they said:

Please be advised that VictoryStocks.com has been paid $1,300,000 by Sanaz Trading Inc. to perform promotional and advertising services for a one month profile of AER Energy Ressources Inc. which services include the issuance of this release and the other opinions that we release concerning AERN   VictoryStocks.com has not investigated the background of Sanaz Trading Inc. the hiring company. Anyone viewing this newsletter should assume the hiring party or , affiliates of the hiring party own shares of AERN of which they plan to liquidate, further understanding that the liquidation of those shares may or may not negatively impact the share price. VictoryStocks.com has received this amount as a production budget for advertising efforts and will retain amounts over and above the cost of production, copywriting services, mailing and other distribution expenses as a fee for our services. As such, our opinion is neither unbiased nor independent, and you should consider that when evaluating our statements regarding AERN. VictoryStocks.com is owned by: FreePennyAlerts, LLC, 40 East Main Street, Suite 572, Newark, Delaware 19711. Questions regarding this release may be sent to Editor @ VictoryStocks.com.

I only ran into that scam because I Googled Lone Star Gold [LSTG], and that popped up.  Lone Star Gold is a negative income negative net worth stock.  A promoter for Lone Star Gold snail mailed me, complete with handwriting and excess staples, but the horrid disclosure in teeny tiny type was this:

IMPORTANT NOTICE AND DISCLAIMER: This paid email advertisement by XXX (hereafter “XXX” does not purport to provide an analysis of any company’s financial position, operations, or prospects and this is not to be construed as a recommendation by XXX, or an offer to sell or solicitation to buy or sell any security. Lone Star Gold Corp. (hereafter “LSTG”), the company featured in this issue, appears as paid advertising. Mermaid Finance Ltd has paid $1,768,000 for the dissemination of this info to enhance public awareness for LSTG. Although the information contained in this advertisement is believed to be reliable, XXX makes no warranties as to the accuracy of any of the content herein and accepts no liability for how readers may choose to utilize it. The information contained herein is based exclusively on information generally available to the public and does not contain any material, non-public information. Readers should perform their own due-diligence before investing in any security including consulting with a qualified investment advisor or analyst. Readers should independently verify all statements made in this advertisement and perform extensive due-diligence on this or any other advertised company. YYY has received twenty thousand dollars for this and related marketing materials. YYY/XXX also expects to receive new subscriber revenue, the amount which is unknown at this time, as a result of this advertising effort. YYY and XXX nor any of their principals, officers, directors, partners, agents, or affiliates are not, nor do we represent ourselves to be, registered investment advisors, brokers, or dealers in securities. XXX is not offering securities for sale. An offer to buy or sell can be made only with accompanying disclosure documents and only in the states and provinces for which they are approved. Research and any due diligence was conducted by an outside researcher for this advertisement. More information can be received from LSTG’s website at www.lonestargold.com. Further, specific financial information, filings and disclosures as well as general investor information about publicly listed companies and other investor resources can be found at the Securities and Exchange Commission website at www.sec.gov and www.nasd.com. Any investment should be made only after consulting with a qualified investment advisor and only after reviewing the financial statements and other pertinent corporate information about the company. Many states have established rules requiring the approval of a security by a state security administrator. Check with www.nasaa.org or call your state security administrator to determine whether a particular security is licensed for sale in your state. This advertisement is not intended for readers in any jurisdiction where not permissible under local regulations and investors in those jurisdictions should disregard it. Investing in securities is highly speculative and carries a great deal of risk, which may result in investors losing all of their invested capital. Past performance does not guarantee future results. The information contained herein contains forward-looking statements and information within the meaning of Section 27A of the Securities Act of 1933 and Section 21 E of the Securities Exchange Act of 1934, including statements regarding expected continual growth of the featured company. Forward-looking statements are based upon expectations, estimates and projections at the time the statements are made and involve risks and uncertainties that could cause actual events to differ materially from those anticipated. Forward-looking statements may be identified through the use of words such as expects, will, anticipates, estimates, believes, or by statements indicating certain actions may, could, should, or might occur. Any statements that express or involve predictions, expectations, beliefs, plans, projections, objectives, goals or future events or performance may be forward-looking statements. In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, the publisher notes that statements contained herein that look forward in time, which include other than historical information, involve risks and uncertainties that may affect the company’s actual results of operations. Factors that could cause actual results to differ include, but are not limited to, the size and growth of the market for the company’s products and services, regulatory approvals, the company’s ability to fund its capital requirements in the near term and the long term, pricing pressures and other risks detailed in the company’s reports filed with the Securities and Exchange Commission. XXX is a trademark of YYY. All other trademarks used in this publication are the property of their respective trademark holders. XXX is not affiliated, connected, or associated with, and are not sponsored, approved, or originated by, the trademark holders unless otherwise stated. No claim is made by XXX to any rights in any third-party trademarks.

Each promoter paid more than a million bucks.  Given the light level of trading in the stocks, and the low share price, the promoters were trying to do a significant pump-and-dump.  Personally, I think it would be really tough to squeeze over $1 million off of these tiny horrible companies, but maybe I don’t know the revenue model so well.

As I frequently say, “Don’t buy what someone want to sell to you.  Buy what you have researched, and what you think has value.”  Ignore penny stocks, with all of the ads that are on the web.  Short them if you dare.  These are horrible companies; any stock that has someone paid to promote it is a sell.  Sell, sell, sell!

This could not be simpler, so ignore the touts that promote penny stocks.  Short them if you dare, “the market can remain insane longer than you can remain solvent,” as Keynes said.

Penny stocks are for losers who dream of great gains.  They get the losses that they deserve.

This book was surprisingly good, and ambitious.  It takes on the short-term nature of our business culture in many areas:

1. The nature of the problem is that the owners no longer work for the corporations, and so managers run companies for shorter term objectives.  Owners would care more about the survival and long run profitability of the firm.
2. Much of the financial crisis stemmed from managing for the short-term, as financial institutions moved from a originate-to-hold to an originate-to-sell model.
3. Corporations focused on meeting quarterly earnings estimates, possibly to the exclusion of longer-term profitability improvements.
4. Investment managers manage for the short run as they try to beat indexes in the short run rather than over the long term.  Investors pulling money in the short term influences that.

The book then takes on these problems, and proposes solutions:

1. Create the proper long-term incentives for all parties: Executives, Line managers, and Employees.  I think he gets it right.  Make them long-term, and relative to a proper market index.  Or do it on a book basis, but make the hurdles reflect the cost of capital.
2. Communicate to the external world that you are no longer going to play the short-term game, like Berkshire Hathaway.  No more earnings guidance, and no more pseudo-earnings guidance where the analysts get enough to publish their estimates.
3. Most boldly: adopt new accounting principles that revolve around free cash flow, not earnings.  Make balance sheets probabilistic.  (even as an actuary, I don’t think we are ready for that, good as it would be)
4. Incent investment managers properly.  This is probably the weakest part of the book, because the problem of incenting investment managers properly is probably impossible.
5. Finally, how to make money.  Concentrate your investments, and if you are a good investor, you will make money over the index.

Now, some of these insights are truisms: sure concentrate your investments, and if you have good insights, you will do well.  Duh.  Most professional managers don’t have good insights, but they aren’t dropping out, and their investors are sticky enough.  That will be hard to change.

But creating longer term incentives for managers and realizable goals for workers are significant ideas.  I have argued for these for some time.  At my fellowship admissions course for the Society of Actuaries, I remember arguing with a consultant over these ideas, where she told me that longer-term incentives were unrealistic.

In a similar vein much of the book argues that you should think like a life actuary (my words, not the author’s).  Discount over the long term, taking into account interest rates and likelihood of the cash flows occurring.  I can heartily back that idea, though I wonder how well the average professional would deal with the concept.  Imagine a new income statement that has a pessimistic, realistic, and optimistic scenarios, and has ranges for accrual items off of that.  I would enjoy that, but the average investor would blanch at the complexity.

Average professionals, much less investors, don’t do well with probability  They want a point estimate and that is human nature.  Are we trying to create the NEW CAPITALIST MAN here?

Maybe, and I actually like the effort, though I think it won’t amount to much. Eliminating self-interest is very difficult; channeling it is another matter.

Quibbles

The book uses the exact same quote from Peter Bernstein on pages 54 & 130… come on, you can do better than that.  Where is the editor?

Beyond that, if you are going to rework the income statement, then differentiate between investment capital expenditures, and maintenance capital expenditures.

I think the proposed excess return versus shortfall ratio is flawed.  Under your definition, a manager who beats once by a lot, and loses often by a little, but loses versus the index overall would look good.  I think it is better to just look at long term returns versus the index, and consider Buffett’s dictum, “I would rather have a noisy 15% than a smooth 12%.”

Who would benefit from this book: Those who want to see a better capitalist economy built could benefit from this book.  If you want to, you can buy it here: Saving Capitalism From Short-Termism: How to Build Long-Term Value and Take Back Our Financial Future.

Full disclosure: The publisher sent me a copy of the book for free.

If you enter Amazon through my site, and you buy anything, I get a small commission.  This is my main source of blog revenue.  I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip.  Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book.  Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website.  Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites.  Whether you buy at Amazon directly or enter via my site, your prices don’t change.

But that doesn’t mean I can’t keep going.  I backed up all of my files on Saturday, and I have my most commonly used files backed up in real time by Microsoft Live Mesh.  It’s inconvenient, but the data is safe, and I can keep working and serving clients.

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Almost everyone argues their interests on tax reform, excluding me, but including Buffett.  Buffett is in favor of increasing taxes that he doesn’t pay.  Estate tax?  Buffett isn’t paying it, he’s giving his fortune away to the Gates foundation, largely.  Income tax?  Relative to the increase in his net worth, Buffett pays almost nothing in taxes because we don’t tax stocks until a dividend is paid, or until some stock is sold.  What’s more, BRK has a $38 billion deferred tax liability, which measures taxes that would have been paid on GAAP income, but weren’t paid because taxable income was lower for reasons that may revert, someday.

Thus, I say Buffett is a hypocrite on taxes.  Let him argue for the following:

• Unrealized gains on assets should be taxed each year, for corporations, partnerships, and individuals.  Losses should receive deductions.
• Eliminate deductions/credits from the personal and corporate tax codes.  We could eliminate the deficit instantly with that one simple change.  Don’t use the tax code for social engineering.  Much as I favor a Balanced Budget Amendment, perhaps a “No Social Engineering” Amendment would be better.  Or an amendment that incorporates my anti-gerrymandering idea.
• Tax corporations on their GAAP income, or better, whatever they represent to investors as the true increase in period-to-period net worth.
• Add in an EBITDA tax on private equity, and everything like it, such that we assume a 15% ROE for tax purposes that trues up when the partnership closes.  Everywhere, make the tax basis equal to GAAP, or modifed GAAP, where it exists.  Where it doesn’t exist, make the taxes punitive enough that adopting GAAP is preferable.

With the present tax rates, implementing all of these would put the budget in a decided surplus, WITHOUT RAISING RATES.  You would even eliminate the estate tax, because estates would finally be taxed year-by-year.  The tax code would then be close to fair, like it was with TRA ’86.

But there is one place where I agree with Buffett entirely:

People invest to make money, and potential taxes have never scared them off. And to those who argue that higher rates hurt job creation, I would note that a net of nearly 40 million jobs were added between 1980 and 2000. You know what’s happened since then: lower tax rates and far lower job creation.

Taxes affect business decisions when the definition of taxable income gets changed or credits get offered.  I’ve seen it working on section 42 housing credits, and in insurance company accounting.  I’ve seen it with private equity; I’ve seen with clever investors that max out debt while growing net worth.

In that sense, the definition of income, and the offering of credits make a huge difference in the behavior of those taxed.  But within reason, tax rates don’t make that much difference.  Yes, up 10%, there will be some effect on economic activity.  The bigger changes come from deductions and credits.

You want a pro-growth tax code?  Eliminate the deductions, credits, and deferrals.  Tax us year-by year on an estimate of our increase in income including unrealized capital gains and losses.

Yes, there will be unemployed accountants, actuaries, attorneys and administrators.  But the system as a whole will be better off, and for once, who will argue in favor of preserving the nation, and ignoring special interests?

What Buffett suggests will get little in the way of results.  A focus on defining income properly will bring in more than sufficient taxes, and especially from Mr. Buffett, one of the least taxed relative to the increase in his net worth.

A Ponzi scheme needs an ever-increasing flow of money to survive.  Same for a market bubble.  When the flow’s growth begins to slow, the bubble will wobble.  When it stops, it will pop.  When it goes negative, it is too late.

Here’s how a Ponzi scheme works for the promoter:

Prior Net Assets + Receipts + True Investment Earnings (if any)  – Withdrawals – Expenses = Net Assets

But this is what it looks like to the investor:

Investor Prior Net Assets + Receipts + Reported Earnings – Withdrawals = Investor Net Assets

The investor’s view of the assets is higher than the actual assets by the cumulative difference between reported and true investment earnings, and cumulative expenses. The promoter wants to keep the good times rolling, and keep the ratio of actual to investor net assets as high as possible.  But to do that requires additional receipts, and a lack of withdrawals, which in turn requires an attractive reported rate of earnings, higher than what could be ordinarily achieved. But the higher the reported rate of earnings goes, the further behind the promoter gets.  Also, at very high levels, the authorities take interest.  At very low levels, the Ponzi dies.  Part of the evil genius of Madoff was striking the balance.  He also did four other things:

• Soft-peddled the marketing so that it was like joining an exclusive club.
• Discouraged withdrawals by saying you would not get back in (for some).
• Deluding regulators into thinking that it was a front-running scam.
• He did not rake off much.

Most Ponzi schemes die rapidly because of the greed and impatience of the promoters.  All Ponzi schemes eventually fail. So how does this relate to market bubbles?  With a market bubble, the increase in market values significantly exceeds the increase in intrinsic values.  This could be due to a number of factors:

• Players see that borrowing to chase a rising asset is a winner.
• Promoters make it easy to do for inexperienced investors.
• An easy monetary policy lowers financing costs, aiding bubble financing.
• Players seek stock gains, and disdain debt claims.
• At the end, investors have to feed the asset to keep it afloat, giving up current income to support the “asset.”

Positive cash flow into the bubble asset class supports valuations for a time, the cash flows driven by momentum, but eventually positive cash flows are overwhelmed by negative cash flow from an overvalued asset class. My advice: avoid speculating on momentum, particularly after it has gone on for a few years.  Put a margin of safety first in your investing, such that you will always be around to invest in the future, no matter how bad the  investment environment is.