Just a quick note on how my equity investing is doing — in April I was slightly ahead of the S&P 500, and year-to-date, things are quite good. This is not to say that I haven’t had my share of failures… Deerfield Capital, YRC Worldwide, Jones Apparel, National Atlantic, and Vishay Intertechnology have hurt. But in a portfolio of 35 stocks, even large percentage whacks get evened out if the stock picking on the remainder has been good enough. And, for me it has, though the successes are not as notable as the failures.

As an investor, I am a singles hitter, but my average is high, and strikeouts low. I have my failures, but the eight rules, which are my risk controllers and return generators, protect me. At least it seems that way for the last 7.7 years, but I know enough that even if the principles are right, they are no guarantee for the next day, year, or decade. “The markets always find a new way to make a fool out of you,” and so I encourage caution in investing. Risk control wins the game in the long run, not bold moves.

So, I keep plugging on, adapting to what I think the market will reward in the future, and ignoring the past for the most part.

Full disclosure: long VSH YRCW NAHC JNY

1) I think Ambac is dreaming if they think they will maintain their AAA ratings. Aside from the real deterioration in their capital position, they now face stronger competition. Buffett got the AAA without the usual five-year delay because he has one of the few remaining natural AAAs behind him at Berky. (Political pressure doesn’t hurt either… many municipalities want credit enhancement that they believe is worth something.)

2) I read through the documents from the Senate hearings on the rating agencies, and my quick conclusion is that there won’t be a lot of change, particularly on such a technical topic in an election year. And, in my opinion, it would be difficult to change the system from its current configuration, and still have securitization go on. Now, maybe securitization should be banned; after all, it offers an illusion of liquidity liquidity in good times, but not in bad times, for underlying assets that are fungible, but not liquid.

3) I am not a fan of Fair Value Accounting. But if we’re going to do it, let’s do it right, as I suggested to an IASB commissioner several years ago. Have two balance sheets and two income statements. One set would be fair value, and the other amortized cost. It would not be any more work than we are doing now.

4) Now, some bankers are up in arms over fair value, and I’m afraid I can’t sympathize. If you’re going to invest in or borrow using complex instruments that amortized cost accounting can’t deal with, you should expect the accounting regulations to change.

5) Just because you can classify assets or liabilities as level 3 doesn’t mean the market will give full credibility to your model. Accounting uncertainty always receives lower valuations. It as if the market says, :These assets will have to prove themselves through their cash flows, we can’t capitalize earnings here. The same applies to the temporary gains from revaluing corporate liabilities down because of credit stress. If the creditworthiness recovers, though gains will be reversed, and good analysts should lower their future earnings estimates when bond spreads widen, to the degree that present gains are taken.

6) The student loan market is interesting, with so many lenders dropping out. This is one area where the auction-rate securities market initially hurt matters when it blew up, but there was a feature that said that the auction rate bonds could not receive more than the student lenders were receiving. So, after rates blew out for a little while, now some the auction rate bonds are receiving zero (for a while).

7) After yesterday’s post, I mused about how much the high yield market has come back, and with few defaults, aside from those that should have been dead anyway. With liquidiity low at some firms, there will be more to come. Personally, I expect spreads to eclipse their recent wides as things get worse, but enjoy the bear market rally for now.

Many munis are still cheap, but the “stupid cheap” money has been made. Lighten up a little if you went to maximum overweight.

9) What’s the Big Money smoking? They certainly are optimistic in this Barron’s piece. One thing that I can find to support them is insider buying, which is high relative to selling at present. And, even ahead of the recent run, hedge funds (and many mutual funds) had been getting more conservative. Guess they had to buy the rally. On the other side, there is a sort of leakage from DB plans, as many of them allocate more to hedge funds and private equity.

10) Does large private equity fund size lead to bad decision making? I would think so. Larger deals are more scarce, and so added urgency comes when they are available. Negotiating for such deals is more intense, and the winner often suffers the winner’s curse of having overbid.

11) I am not a believer in the shorts being able to manipulate the markets as much as some would say. It’s easier to manipulate on the long side. Here is a good post at Ultimi Barbarorum on the topic.

12) Financials are the largest sector in the S&P 500.  Perhaps not for long… they may shrink below the size of the Tech sector at current rates, or, Energy could grow to be the largest.  Nothing would make me more skittish about my energy longs.  The largest sector always seems to get hit the hardest, whether Financials today, or Tech in 2000, or Energy in the mid-90s.

As I sit here, my taxes are done, all except for one K-1 that is very late, to put it mildly.  My taxes are complex, but my rule is that I do my own taxes.  If I can’t figure out the code, then I am probably doing something that I don’t understand the full economics behind it, and I should avoid it as a result.  Besides, it keeps me up with trends in the tax code that I might not truly grasp.  Surprises this year included the form for HSAs, and a credit  for promoting domestic production.  I also learned some of the intricacies in accounting for the sale of S corporation stock.  Not fun, but I learned something, and that is good.

It does motivate me to write a piece on tax reform, though.  I don’t fit neatly on the political spectrum: I’m a libertarian on economics, and a conservative on social policy (though conservative really isn’t the right word). Tax reform means different things to different people; let’s consider what it means to conservatives and liberals.

What does tax reform mean to conservatives?

• Eliminate the estate tax
• Eliminate the double taxation of dividends
• Eliminate the marriage penalty (actually should be a goal of liberals, and not conservatives, but hey…)
• Flatten the tax rate structure
• Preferentially tax income classes that aid in capital formation
• More taxation at the state level, less at the federal level
• Carve out exceptions for political allies that support your broad agenda

What does tax reform mean to liberals?

• Roll back the Bush tax cuts
• Keep the estate tax
• Increase the progressivity of tax rates
• More taxation at the federal level, less at the state level
• Preferentially tax wage income at lower rates
• Carve out exceptions for political allies that support your broad agenda

To me, both of them miss a dimension of the problem.  The main problem is how we define income, not the rate at which we tax income.  Both liberals and conservatives support areas in the tax code that allow for deferral of taxation.  To me, that is a core problem in the tax code.  Taxation should be roughly proportionate to the good that a taxpayer is deriving from society.  As a proxy for that, it should be proportional to his increase in net worth, whether the increase in net worth is liquid or not.

I will use Warren Buffett as my example.  Because he rarely sells stock, his taxes are deferred both personally, and at Berkshire Hathaway.  His net worth keeps going up, and the Treasury doesn’t get a piece of it.  Then he has the nerve to show up on Capitol Hill in favor of the estate tax, a tax of which his estate will pay little, because he has given most of it away.

My view is that people should be taxed like traders, on the increase in their net worth, at the same rate, regardless of where the income comes from.  Taxes would be paid on a mark-to-market basis.  There would be no more tax deferral IRAs or 401(k)s, and even pension earnings would get taxed inside DB plans.  Life insurance and annuities would lose their tax breaks.  Even charitable endowments would be taxed.  Private equity would get taxed off of “phantom income” at a 15% compounded rate, i.e., a private equity fund with $100 million in equity would have to pay taxes on $15 million of phantom income, at the fund if 15% distributions are not made to shareholders.  Truing up would occur at the dissolution of the fund.

Another key component here would be that there would be no separate tax accounting basis — the IRS would use GAAP.  What you report, is what you get taxed on, with the exception that firms that are heavily indebted to avoid paying taxes would get taxed on phantom income, the same as private equity.  Also, all like-kind exchanges would be taxed.  Even real estate would follow the property assessor, and income taxation would occur on the increase.

Then eliminate all deductions, conservative and liberal ones, and you have a tax code that can operate at a low rate because the entire increase of wealth in the economy is being taxed, without exceptions.  Oh, and since the income has been taxed all of the way up, the estate tax is no longer needed.  It was needed when wealthy people could shelter their increasing net worth from taxation.

Objections to this Outlandish Proposal

• Would you really allow investment losses to reduce someone’s income to zero, or below?  Yes, though there would have to be some safeguards against people who disguise their hobbies to be businesses.
• This will kill investment; the economy won’t grow without tax deferral!  Nonsense.  Most tax deferral incentives don’t change the amount of investment, but just the forms that the investments go into.
• Without tax deferral, people won’t buy life insurance, annuities, and corporations won’t provide pensions.  To some degree, yes, but after the shock wears off people will invest for maximum advantage again, and with an eye toward what is best, not what is tax-favored.  With my proposal, I don’t care if people have pensions or savings.  It’s all the same.  Life insurance and annuities will be bought for risk reduction reasons, not tax reasons.
• This will kill private equity!  It won’t.  It may shrink it a little, but there are many advantage to private equity aside from deferral of taxation.
• But phantom income will require illiquid investments to retain liquidity for taxes, or require equity holders to fund taxes.  Guilty as  charged.  It changes the business model to that degree.
• This discriminates against the poor in favor of the rich.  No, it discriminates against the clever rich, who shield the increase in their net worth from taxation.  Taxes delayed often become taxes avoided in entire.  Poor people should pay some taxes.  They benefit from society a little, and taxes would give them greater interest in voting.
• If there’s no deduction/credit for JKL, then JKL will disappear.  Good, or, maybe I should say, yes, there will be a decrease, but if it is valuable, it will find its own level.
• This proposal is incomplete!  You haven’t considered a lot of other areas.  No doubt; there would be a lot to do here, should it ever see the light of day.  Let John McCain be a real straight-talking maverick, and adopt a proposal like this.  He could be a real conservative, while offending all of the “conservatives.”

I harbor no illusions here.  We have the tax code that we deserve.  Don’t blame the IRS.  Don’t blame the President or Congress.  Blame those who elected them, and those who failed to vote.  The politicians offer us favors from our own money, and we thank them for it, by re-electing them.  I know that my views of tax reform will never be enacted because it steps on too many feet.  Can you imagine how many accountants, attorneys and actuaries would be unemployed by this?  If they fought hard against TRA ‘86, just imagine how they would fight against this.  The politicians like fostering the illusion that they create our prosperity, when in reality, they take a share of it.  A proposal like this, that makes taxation more immediate, and more transparent, would make people more concerned about where their taxes go, because they would feel it more acutely.

And then, after all of this, we should move election day to April 15th.  Let the voters feel acutely what the politicians have decided for raising revenue, and they will render a better verdict.

When I was younger, twenty years younger, I subscribed to the WSJ, Forbes and Barrons.  Though I am retaining my subscription to the WSJ (my wife wants it for one of my older sons), I am letting my subscriptions to Forbes and Barrons lapse.  What good that they do, I can get online.  (I will probably keep my Barrons Online, but dump WSJ Online.)

I just don’t get enough from Forbes to justify reading it anymore.  Their lists are a convenient way to fill space, and the advertising to articles ratio is high.  I like Barron’s, but I can read it online.  As for the Wall Street Journal Online, it may already be free.

I learned a lot from all of these publications when I was younger, but time is shorter now, and I get more information from online sources at present.

One of my Finacorp colleagues pointed me to some Fed funds data yesterday, and it made me want to write an article. He pointed out something that looked anomalous about the way Fed funds is trading, namely, that on many days in the last month, that some trades are going on where some banks out there are accepting almost zero for the rate on investing excess reserves.

Let me back up. We talk about Fed funds all the time, but we don’t often stop to talk about what it means. Banks and thrifts have to keep non-interest bearing reserve funds at the Fed. Those funds can be deposited by the depositary institution at the Fed, or, they can borrow the funds from another institution that has excess funds deposited at the Fed. Thus there is an active lending market between banks for reserves deposited at the Fed. The weighted average rate at which these overnight loans get done is called the effective federal funds rate.

The Fed influences where Fed funds trades through open market operations, where they lower the Fed funds rate by increasing the supply of reserves to the system through temporary repurchase transactions, and outright purchases of securities through the creation of new credit, thus expanding its balance sheet (a permanent injection of liquidity). The Fed raises the Fed funds rate by decreasing the supply of reserves to the system through temporary reverse repurchase transactions, and outright purchases of securities which reduces credit, and shrinks the balance sheet of the Fed (a permanent reduction of liquidity — rare).

All the guessing games that go on around FOMC meetings today, revolve around the Fed funds target rate. That’s the rate the the Fed in the short run says that it will try to keep the effective Fed funds rate at, primarily through temporary measures using repurchase and reverse repurchase transactions.

Back to the Present

Since August 1993, the high and low transaction yields for Fed funds each day have been recorded. The following graph shows the high, low, and effective Fed funds rate from then until the present.

As you can see, the difference between the high and low for Fed funds on a given day can be substantial.  Most commonly the big ranges happen near the end of accounting periods, or at minor financial panics, whether for legitimate reasons (LTCM, 9/11), or dubious reasons (Y2K).  In any case, there can be a scramble for overnight fed funds, leading to a very large high rate for the day.  Conversely, there can be a very small low rate for the day when enough institutions have significant excess funds to lend at Fed funds, and few takers at some point during the day.

That range between high and low Fed funds can be quite large, as you can see in the following graph.  In order to show the persistence of the range, to flatten out the influence of disasters, and quarter- and year-ends, I threw in a 22-day moving average, which is meant to approximate the rolling monthly average.

In this present environment, I am most concerned with how low Fed funds trades on a daily basis.  Since that is a noisy figure as well, I applied a 22-day moving average there.

The range for Fed funds trading is high on a monthly average basis, butnot as high as it was at points back in the mid-90s. Short-term interest rates were higher then, so there was more room on the downside for the range to expand, which is not possible today.  What is unusual now is that the low trade for Fed funds is averaging near the levels achieved during the wondrous 1%-1.25% Fed funds rate policy that the Greenspan Fed instituted from late 2002 to mid-2004.

In the midst of a period where liquidity is so scarce, we have a situation where some banks are having a hard time getting a good yield from Fed funds.  To summarize the situation, look at my final graph:

This is a scatterplot to show how the moving averages for low Fed funds varies against the range for Fed funds.  The diagonal line is there for convenience to show where the moving averages for the range and the low would be equal.  Back during the 2002-2004 era, though rates were low, Fed funds traded in a tight band.  In the mid-90s, rates were higher, but we had occasional periods where the range would explode for accounting or crisis reasons.

Now we are in a period where we have a volatile range for Fed funds amid low rates.  This is unusual.  I’m open to new ideas here, but it seems that the liquidity situation in Fed funds is volatile enough that some banks end up snapping at low yields at some point each day.  Just another piece in a difficult policy period for the banks and the Fed.  If I have to speculate, it indicates that some banks are already awash in liquidity, and aren’t sure what to do with it.

I ended up doing more in the first quarter reshaping than I had originally intended. Here are the trades:

New Buys

• Avnet
• Ensco International
• Alliance Data Systems

New Sales

• Bronco Drilling

Rebalancing Sales

• Valero Energy (that was fast)

The trades left me with 5% available in cash, and my normal 35 positions, with one being a double-weight (NAHC), and one being a 1.5x weight (JOF).

I didn’t want to go a lot heavier into financials, and particularly not insurance. Ensco ends up replacing Bronco; it’s time to move from the land to the sea in drilling, at these oil price levels. In addition, much as I admire Third Avenue and Curtis Jensen, I reckon their efforts to renegotiate the merger might end up with no merger, as likely as a better deal.

In technology, I tend to buy cheap simple building block companies rather than companies that face possible obsolescence from technological change. Avnet fits that bill.

As for Alliance Data Systems, they are cheaper than before the attempted acquisition, and still have decent growth prospects. This is not usually my style, but the free cash flow can support the current valuation. Yes, it is a financial, but very different from the other companies that I hold.

That’s all. Oh, what a snapback in Valero. When I bought more, I could feel the panic in the market. I bought it anyway; don’t give in to feelings of panic when you are dealing with well-capitalized companies that are leaders in their industries.

Full disclosure: long JOF NAHC AVT ADS ESV

In the center of the picture to the left are my friends Bill and Margie Wright. They have been dear friends of our family for eight years. Their kids have played with ours; they have ten, we have eight.

They’re special people. Margie has homeschooled all of their children (so far), and Bill has built a thriving enterprise, Wright Manufacturing, which makes the best commercial lawn mowers in the world. (Full disclosure: I own a little less than one percent of his private firm.)

Wright Manufacturing is unusual because it is a very innovative firm. They manage the business well with a series of principles borrowed from some of the best Japanese manufacturers, but then marry that to the exceptional innovative engineering talent of Bill Wright and his staff. Many of his competitors license his patented technologies.

Oh, the person on the far right of the picture is, yes, President Bush. He came to visit Bill’s factory today, and gave a brief talk on the economy, and the proposed stimulus package. Here’s what he said:

1:55 P.M. EST

THE PRESIDENT: Let me tell you why I’m here. This man started his own business. He’s a manufacturer, he employs over a hundred people, and he represents the backbone of the American economy. And today I talked about our economy, and the fundamentals are strong, but there’s uncertainty. And there’s an opportunity to work with Congress to pass a pro-growth package that will deal with the uncertainty.

Any package has got to remember that jobs are created by small businesses. A good package will have incentives for investment. The package we passed early in my administration helped him. He bought some equipment and made his firm more productive, kept him in business. And that’s the same spirit that needs to be in this next growth package.

The other thing is, is that we got to make sure that we benefit consumers. We want our consumers out there spending, and the best way to do that is broad-based tax relief. Now, this plan ought to be broad-based, it ought to be simple, and it ought to be temporary.

I had a conversation, Congressman, with the leadership on both sides of the aisle yesterday, and I was encouraged by what I heard. And I believe we can come together on a growth package very quickly. We need to. We need to get this deal done and get it out and get money in the hands of our consumers and our small business owners to help this economy.

I’m optimistic, I truly am. One reason I’m optimistic is because I understand we got all kinds of Americans just like this man here, working hard to provide a living for folks and to make a product people want.

And so, while there’s some uncertainty right now, if we act quickly and in a smart way that helps growth, we’re going to be just fine.

Anyway, thanks for letting me come by. I’m proud to be — I love the entrepreneurial class in — I love people who have a dream and work hard to achieve the dream.

And so — a fine-looking machine you got here.

MR. WRIGHT: Thank you. It’s a team effort. We thank you, thank you for all your work, too.

THE PRESIDENT: Do you wonder where they got the name “Wright?” That’s his name. And his wife is the co-founder of the company. And this is — it’s really great to be with you.

And, Congressman [DM -- Roscoe Bartlett, another good guy with a big family], thank you for being here. I’m proud to be with your workers. You’ve got some fine workers.

MR. WRIGHT: We’ve got a great team here, don’t we?

THE PRESIDENT: Yes, you do. And if they get a little more money in their pocket as a result of the growth package, it will help make sure this economy continues to grow.

Anyway, thank you all very much.

END 1:59 P.M. EST

Bill, for all of his accomplishments, is a humble guy. He and Margie went through many lean times during the early years, and they bore with it well. The business began as a lawn mowing business, and then broadened out to software for managing lawn mowing businesses, together with grass catching attachments. That started the manufacturing. Bill developed a wide number of innovations, from zero-turning radius mowers, to sulkies, and more.

In my opinion, President Bush could not have picked a better place to visit. It is an example of American manufacturing at its best, and Bill Wright is a great example of American entrepreneurship. I am proud to be a part owner of the firm, and to have been able to help Bill at times on financial issues.

Now, for further coverage of the visit of President Bush:

Bush Wants Fast Tax Aid to Boost Economy

Frederick Residents Voice Concerns About Economy

Frederick Officials Hope They Are Recession-Proof (Video)

As far as I am concerned, the stimulus package is hooey; what stimulus occurs now will be funded by debt and a cheaper dollar later. There is nothing wonderful there. There is something wonderful about the Wrights though, and I am happy to be a small part of that.

Yesterday I called my auto dealership for regular service on my van, and they said, “When can you come in?”  I said that I could come in any time over the next seven days.  “How about tomorrow?” was the reply.  I agreed, and then I thought about how I normally have to schedule a week or so in advance to get service, which made me wonder whether things have slowed up that much in the economy.

Almost makes me want to test the waters, and call a contractor to do some deferred maintenance on our humble hovel.

I’ll put it to the rest of you.  How much do you think business conditions have slowed down?  How anxious are sellers to get your business?

Every now and then, you get a reader response that deserves to be published.  Such was this response to my piece, “If Hedge Funds, Then Investment Banks.”  I have redacted it to hide his identity.

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I read your latest blog entry with interest because I have worked in the derivatives business and as a part of that helped to set up General Re’s financial subsidiary in 19XX - General Re Financial Products (GRFP). I was one of XX people that started that business from the ground up. I left shortly XXX Buffett arrived on the scene but I still knew a large number of people that remained and I have very good information about what happened there. I may be a bit biased so you should consider where I am coming from as you continue to read.

Just thought I would add my two cents (looks more like 25 cents now).
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For the record, both he and I are admirers of Buffett, but not uncritical admirers.  The initiator of a trade usually has to offer a concession to the party facilitating the trade.  Forced sellers or impatient buyers typically don’t get the best execution.  What my correspondent suggests here is at least part of the total picture in the liquidation of GRFP.  All that said, I still think there are deadweight losses hiding inside that swap books of the major investment banks.

With all of my family and guests gone or asleep after a big Thanksgiving Day at my house (17 people), I reflect on what I am thankful for.

• My relationship with my God, Jesus Christ.
• My wife of 21 years (today).  What a good woman, and what a help she has been to me.  Among many other things, she helps me focus on what is truly important in our short mortal lives.  At the church that I met her at, she was regarded as the “prize” of all the young women there.  I can tell you that their opinions were right.
• My eight children.  Some do better, some do worse, but in aggregate, they are all doing well.
• My congregation; good friends all, and they are a real support.
• My friends, including the readers of my blog.  We all need friends.

Now for the broader stuff:

• Though our civil liberties have been degraded by the misguided “War on Terror,” we still have significant liberties in the personal, political, religious and economic spheres.
• Our economy still prospers, even amid bad monetary and fiscal policy.
• Development in the developing world is screaming ahead.  As (classical) liberal economic economic policies are embraced across the globe, poverty is being reduced globally, which is something dear to me.
• I haven’t made a lot on investments this year, but I’m still doing adequately.
• I have several possibilities for how I will work as I labor to support my family.  (Perhaps an announcement coming soon…)
• I’m grateful that my views of the Fed, residential real estate, and the debt markets have largely proven correct.
• I’m even grateful for my losses; they keep me humble, and teach me a lot about investing.

That’s what I am thankful for; I hope you have it as good, or better, than me.