About 4.5 years ago, I wrote a short piece called The Good ETF.  I’ll quote the summary:

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a “roll” or some replication strategy.
  • Not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.  There are many ETFs that are Closed-end funds in disguise.  An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Though I said ETFs, I really meant ETPs, which included Exchange Traded Notes, and other structures.  I remain concerned that people get deluded by the idea that if it trades as a stock, it will behave like a stock, or a spot commodity, or an index.

What triggered this article was reading the following article: How a 56-Year-Old Engineer’s $45,000 Loss Spurred SEC Probe.  Quoting from the beginning of the article:

Jeff Steckbeck didn’t read the prospectus. He didn’t realize the price was inflated. He didn’t even know the security he read about online was something other than an exchange-traded fund.

The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a volatility bet, or about 80 percent of his investment, after a Credit Suisse Group AG (CSGN) note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he’d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.

“In theory, everybody’s supposed to read everything right to the bottom line and you take all the risks associated with it if you don’t,” he said this month by phone from Lebanon, Pennsylvania. “But in reality, you gotta trust that these people are operating within what they generally say, you know?”

No, you don’t have to trust people blindly.  Reagan said, “Trust, but verify.”  Anytime you enter into a contract, you need to know the major features of the contract, or have trusted expert advisers who do know, and assure you that things are fine.

After all, these are financial markets.  In any business deal, you may run into someone who offers you something that sounds attractive until you read the fine print.  You need to read the fine print.  Now, fraud can be alleged to those who actively dissuade people from reading the fine print, but not to those who offer the prospectus where all of the risks are disclosed.  Again, quoting from the article:

Some fail to adequately explain that banks can bet against the very notes they’re selling or suspend new offerings or take other actions that can affect their value, according to the letter.


“My experience with ETN prospectuses is that they’re very clear about the fees and the risks and the transparency,” Styrcula said. “Any investor who invests without reading the prospectus does so at his or her own peril, and that’s the way it should be.”


The offering documents for the VelocityShares Daily 2x VIX (VIX) Short Term ETN, the TVIX, says on the first page that the security is intended for “sophisticated investors.” The note “is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,” according to the prospectus.

While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name, didn’t say that the price had become unmoored from the index it was supposed to track.

David Campbell, president of Clermont Wealth Strategies, declined to comment.

Steckbeck, who found the TVIX on the Yahoo Finance website, doesn’t have time to comb through dozens of pages every time he makes an investment, he said.

“Engineers — we’re not dumb,” said Steckbeck, who founded his own consulting company in 1990. “We’re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can’t sit there and read prospectuses all day.”

If you are investing, you need to read prospectuses.  No ifs, ands, or buts.  I’m sorry, Mr. Steckbeck, you’re not dumb, but you are foolish.  Being bright with math and science is not enough for investing if you can’t be bothered to read the legal documents for the complex contract/security that you bought.  I read every prospectus for every security that I buy if it is unusual.  I read prospectuses and 10-Ks for many simple securities like stocks — the managements must “spill the beans” in the “risk factors” because if they don’t, and something bad happens that they didn’t talk about, they will be sued.

In general I am not a fan of a “liberal arts” education.  I am a fan of math and science.  But truly, I want both.  We homeschool, and our eight kids are “all arounds.”  They aren’t all smart, but they tend to be equal with verbal and quantitative reasoning.  Truly bright people are good with both math and language.  Final quotation from the article:

“The whole point of making these things exchange-traded was to make them accessible to retail investors,” said Colbrin Wright, assistant professor at Brigham Young University in Provo, Utah, who has written academic articles on the indicative values of ETNs. “The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.”

So, I contacted Colby Wright, and we had a short e-mail exchange, where he pointed me to the paper that he co-wrote.  Interesting paper, and it makes me want to do more research to see how great ETN prices can be versus their net asset values [NAVs].  That said, end of the paper errs when it concludes:

We assert that the frequent and persistent negative WDFDs [DM: NAV premiums] that appear to be driven by uninformed return chasing investors would not exist to the conspicuous degree that we observe if ETNs offered a more investor-driven and fluid system for share creation. We believe the system for share creation is ineffective in mitigating the asymmetric mispricing investigated in our study. Hence, we recommend that ETN issuers reformulate the share creation system related to their securities. Specifically, we recommend the ETN share creation process be structured to mirror that of ETFs. At a minimum, the share creation process should be initiated by investors, rather than by the ETN issuers themselves, as we believe profit-motivated investors will be more diligent and responsive in creating ETN shares when severe mispricing arises.

Here’s the problem: ETNs are debt, not equity.  To have the same share creation system means that the debtor must be willing to take on what could be an unlimited amount of debt.  In most cases, that doesn’t work.

So I come back to where I started.  Be skeptical of complexity in exchange traded products.  Avoid complexity.  Complexity works in favor of the one offering the deal, not the one accepting the deal.  I have only bought one structured note in my life, and that was one that I was allowed to structure.  As Buffett once said (something like this), “My terms, your price.”

To close, here are four valuable articles on this topic:

So avoid complexity in investing.  Do due diligence in all investing, and more when the investments are complex.  I am astounded at how much money has been lost in exchange traded investments that are designed to lose money over the long term.  You might be able to avoid it, but someone has to hold every “asset,” so losses will come to those who hold investments long term that were designed to last for a day.

When I was a kid, my life was mathematics.  When I was little, my mom would hand me sheets of addition and subtraction problems that did not involve carrying or borrowing, and I would fill them out for her, and she would give me more.  That’s my earliest memory.  Second earliest is the procession for President Kennedy after his death.  Third earliest might be my Dad changing my brother’s diaper.  My mother once said, “You must have remembered it because of uniqueness.”

Anyway, when I was a kid, before I went into first grade, my mom taught me multiplication and division.  My Dad taught me some heuristic rules around percentages.

So when I came into first grade at age six, I was shocked that no one else could do math.  I was good enough with math and reading that the special education teacher took note of me, and helped give me my unusual education 1967-1969.  Though I was in a normal classroom, I was a “group of one.”  I had my own special reading and math books.  The teachers pushed a variety of enrichment materials to me, but it was like subpar homeschooling.  I was on my own, and no one would correct my work.  For a little kid, I was pretty motivated, but it would have helped a lot to have more adult interaction.

SRA helped on the reading side, and there were later SRA attempts at math though I don’t think that did much.

In third grade, they gave me a programmed instruction curriculum in math, in addition to the ordinary class.  At some points, I acted as a tutor to other students.  The programmed instruction was modeled after the “new math” fad.  I could get it, but at the time, I realized that I was so different from my peers, that I knew that if I could get it, that did not mean that others my age could get it.

Then in fourth grade, they mainstreamed me.  I spent time playing around with how to do square and cube roots by hand.  Tedious, but not that hard to do.

In fifth grade, my Father brought me an algebra book that used programmed instruction.  I puzzled over it, and didn’t get it until I talked to an older friend about it who told that “x’ is a number that we do not know, but are trying to calculate.

There’s more to this story, but I will drop it, lest I bore you…

What I experienced as a child affected me.  I could see the abstraction of math while young, and it amazed me.  But now look through my eyes as I find out that I am unusual.  There is a normal track for math, and a normal way to teach it.  As I tried to tutor my classmates, I realized math was not intuitive for almost everyone else as it was for me.

I became a good math tutor.  Parents would hire me , and ask me what my rates were.  I don’t know how I thought of this, but I said, “Five dollars per sitting.  A sitting could be five minutes or two hours. If I lose their attention span the sitting ends.”  That motivated the parents to motivate the kid.  After one short sitting, future sittings got longer.

As an adult, I married a math teacher.  She admits that I am the better with math, and that I often come up with creative ways to teach concepts that she could not.  She is still quite good with teaching math such that all of our biological and adopted children made progress in their percentile scores in math and other topics as they grew.

I think that I know math, and how to teach math.  I have done it while young, and older with my older children.  I have never taken a course in education, and thus my views of pedagogy have never been sabotaged by what is taught in most colleges regarding teaching children.

Some may think this assessment too harsh, but remember, we had the “New Math” in the Sixties.  It was a disaster.  For me, a math prodigy, thinking about math through the lens of set theory, it was challenging and interesting.  To most students, it was deadening.

So now we have the evil “Common Core Math Standards.” [CCMS] When I was a kid we joked about Communist plots to destroy America.  Well, I think the Communists are pretty weak in general — they don’t understand the nature of man.  But here we are trying to make kids try to make adult judgments regarding math.  That’s just plain stupid, because it doesn’t get the way children develop.

The Holy Grail of Critical Thinking

I don’t think critical thinking can be taught.  If you are smart enough, you will think critically. If not, no.

I say this as one where my wife and I have homeschooled our eight children for 18 years, and as my children get older they disagree with us to varying degrees.  We taught them well.  Sadly, some disagree with our premises.  But, they are all smart and the seven that have gone through standardized testing have all shown significant progress, moving 25% or more in the percentile rankings from elementary school to high school.  My wife teaches very well, and I support her. Please also note that five of the children were adopted, and the same effects happened with them.

But the CCMS flips things on its head.  Children need to learn facts.  They can absorb facts because they are easy for the young  to absorb.  Drill on math facts is a very good thing because it eliminates a hurdle to learning more in math.  Once you know the basics, the mind is capable of absorbing more abstract reasoning.

It is the opposite of what the experts say.  Math should focus on the concrete with young children, and as they get wiser, on to things that are more abstract.  They should not begin with abstraction, and try to move to the concrete.

Think about it for a moment: would you rather hire a guy who understood the basics of your business, or hire a guy who had a theory about your business, but did not understand the basics?  You would hire the former if you were smart.

Understanding the basics is important, and sadly, we have gotten away from it in the last 60+ years in math.  We did much better in the past, and we paid teachers less in real terms back then.  The colleges that teach teachers should be dismantled, and teacher accreditation should be eliminated, because there is no clear value created by accreditation.

We need education to be more like home schools, where teachers train students for many years in elementary grades K-8, where tutoring plays a large role. Understanding the student, and consistent mentoring makes a far brighter student.  Eliminating credentialing would being in brighter, more motivated teachers that ignore the idiocy to the teaching colleges.

Now maybe there is a home and private-schooling cabal, pushing CCMS in an  effort to destroy the public schools, or at minimum, assure that those who go to public schools will be peons to those who don’t go there.  I really doubt that, because those who don’t send their kids to public schools are more upright than those that don’t.  They are putting forth extra effort for their kids, versus people who don’t care.

Practical Advice

I live in Howard County, one of the richest counties in America.  Unique to Maryland, the counties are the school districts.  We homeschool in a county that is one of the best around.  We are evangelical Christians, but most homeschoolers here are secular. Why?

The school districts adopt a variety of dumb ideas like CCMS that hinder reading and math.  If I could vote to eliminate the public schools I would do so not out of ideology, but raw incompetence.

Most parents that we interact with are either hiring a tutor in math, or doing it themselves.  If that is the case, why not homeschool? It’s a lot easier than it looks, and it doesn’t take a lot of effort to outperform the public schools.

The main reason is the two-earner household.  Most could tighten their belts, and have one parent stay at home to teach the kids.  The second trouble is child control/discipline — my comment is if you are firm with them as parents were prior to 1950, you should have no problem, but consult your local statutes to figure what you have to hide from.

With CCMS many families will have to do one of the following:

  1. Tutor their children in math
  2. Pay someone to tutor their children in math
  3. Homeschool
  4. Start a war against those that set the public educational standards


Children are not capable of absorbing abstraction.  Every real parent knows that.  Fight the educated idiots who are trying to ruin math education with their misbegotten theories that do not understand math or kids.

My wife was a high school teacher in math and science in West Sacramento when we married.  (West Sacramento is in Yolo, not Sacramento County, and is considerably poorer than Sacramento.)  She is forever grateful that I took her away from “all that,” and allowed her to have a life where she homeschools our three biological and five adopted children.  She does a great job, and I assist her where she requests, usually where it involves advanced math.  Having public school teaching experience is an impediment to schooling at home, but my wife has adjusted well.  (In general, what you learn about teaching at college makes you less capable to teach.  My oldest daughter just went through that, and didn’t believe us when we told her that in advance, but agrees with us now after going through the courses.)  Our educational system would be better if we eliminated teacher credentialing, and just hired motivated people who know the subject areas, who love to work with kids of the appropriate ages, and have grit — a determination to succeed.  The present system favors those who are capable at dealing with the paperwork that state and federal governments demand.

For the first two years we were married, I was quiet or sympathetic to my wife’s fellow teachers.  There is a pathology of sorts where because you have gone to school, and have seen a lot of teachers, therefore you understand teaching.  Teachers often do not like amateurs offering their opinions.  I did not volunteer my opinions to them, in deference to my wife.

That said, I would like to offer my opinion on testing students and using those scores to set teacher pay, or district transfer payments.  Remember, this doesn’t affect me because we homeschool; we pay our state/county taxes though we get less from it than most.

(Before I continue, I would like to note that our dealings with the Howard County school system have been unfailingly pleasant; they are a model for how the public schools and homeschoolers should interact.)

Dedicated teachers will say, “We don’t want to teach to the standardized test.  We want to impart real knowledge, rather than the ability to grind out answers to multiple choice questions.”  That’s a good goal.

In my life, I have taken many exams.  I have passed handily with almost everything, but the toughest exams were essay exams where you had to show your reasoning.  This is true in Math, Science, English, Social Science, etc.  This applied to the second half of my actuarial exams, and also roughly half of my CFA exams.  It was true for virtually all of the exams I had in college and graduate school. (As an aside, the actuarial exam multiple choice problems are much, much harder than normal multiple choice problems… schools should adopt their techniques if they do multiple choice because the methods really test people.)

But for the actuarial and CFA exams, those were my experience with broadly administered exams that were mostly essay.  To grade such exams, the test writers create a grading outline and assign points for each point made.  If someone makes a valid point that the grading outline did not account for the grading outline expands to accommodate it.  Typically two people grade each paper, and the average is the grade, unless they differ by too much, in which case a third grader comes in, and the average of the closest two grades is the final grade.

This is real testing and real grading, and guess what?  It is expensive to do, but generates real results.

With both the actuarial and CFA exams, you could not study to the test.  You could only study.  You could not tell year-to-year what would be on the test.  It varied considerably.

The Payoff

That is the way the public school examinations should be.  The tests should be essay-based (after a certain age, like 10), randomized (not everyone gets the same test), unpredictable, but relevant to what should be taught to students at a given age.  Where warranted, the ability to write should be a factor in scoring, because that is a large predictor of how well you have learned your verbal skills.  Partial credit would come to those that show reasoning capability, even if they didn’t get the right answer.

This would be an expensive way to administer exams, but hey, maybe more college graduates without jobs could get some part-time work as a result.  Or, college students could grade them over a summer, lessening the economic cost of college.  But it would be an effective way of encouraging real learning, and measuring it.

Best of all, the essay exams would be a lot like the life they are going to face.  It’s not predictable.  You don’t know what you are going to face.  Face it bravely, or you have no chance.  Prepare now, study hard, or your odds of success diminish.

The same applies to the teachers.  Teach the most important stuff.  Stress reasoning.  Try to create thinkers, not mere memorizers.  Motivate the material in the best way that you can to inspire students to think.  Teach them to write well, and encourage them to read widely.  I may be conservative in my views, but I have read widely, including many things that I disagree with a lot.  Teach them to look at both sides of a question (when they are old enough), and understand the arguments of those that disagree.

And then, let the teachers live with a system where the test is unpredictable, and they cannot affect its outcome directly.  Will they like that?  I don’t know.  What I do know is that if America is serious about reforming its schools, it will adopt an approach like this, and pay the money necessary to have standardized essay tests graded.

But once teachers can’t affect the results of the testing directly, they will teach their students the best that they can, because if they don’t and the scores of their students sag, they may be gone after some time.  This would empower real accountability, and eliminate the deadwood among teachers that can’t do the job.  Remember, aside from the best, most teachers peak in their effectiveness after year six.  As a result, tenure for public school teachers is really a bad idea.

Education improves by removing unmotivated and untalented teachers.  The best teachers love their subject, their students, and love what they do.  They have grit, and are determined to make a difference.  With 35-45 years behind my public school education, I can still name my teachers who were motivated, against those that went through the motions.

PS — to my regular readers, I know this was an unusual post.  I’m not planning on doing more of these.

This is a little different.  Those who have read me for a long time know that I have a large family — eight children, with five adopted African-American children.  We also homeschool in the great State of Maryland, which, for all of its liberalism (so blue that it is indistinguishable from indigo) is actually quite free and permissive relative to many other states with respect to homeschooling.

Taking it a step further, we live in Howard County, which arguably has the best school district in the State.  Most of our homeschooling friends are not evangelical Christians like us (homeschooling grew among evangelicals, after it being a province of the diplomatic corps, child actors, and the loony left); they are as secular as can be, and have left Howard County public schools for reasons of perceived quality.  Our estimate is that homeschooling in Maryland is predominantly secular.

But, we have nothing but praise for our interactions with the local school district.  They are unfailingly friendly and helpful with the standardized tests, etc.  Our oldest still at home may run on the Track team.

So, when my wife asked me where one of our kids could submit his poem, I said, “We could look into a bunch of kids magazines.  But I could post it at my blog, and it would probably be read by more people.”

So she asked me to post it.  The following was written by my son Matthew, who is a native tinkerer and experimenter.  One more thing to commend homeschooling: boys who learn slowly initially get labeled “learning disabled” in the public schools.  Matthew would have been one of those, but in seventh grade at age 13, he is at grade level on average for all subjects.  Tutoring (homeschooling) has overcome a native disadvantage, and he presses on.

So, it is with pleasure that I present his poem about the 54th Massachusetts Volunteer Infantry.  Recently my wife read a book aloud to the children about them, and Matthew found it inspiring.  With no further ado or comment, here it is:

The 54th

Charge, ye men, charge!
Blood and death all around.
Everything fell, but not the 54th.

Honor and bravery
Gun and cannons roared.
All fell.
But not the 54th.

Into the halls of Fort Sumter.
Into the halls of Fort Wagner.
Many fall.
But not the 54th.

Who is so brave?
Why do they fight?
They fight for freedom.
Who does?
The 54th.

-Matthew C. Merkel

This is a post about economics, but it will probably sound more political than most.  Part of being mature is learning to live within boundaries.  No, not everything is possible.  Immature people like Bush II, Obama, JFK, and FDR tell us that we can have our cake and eat it too.  It is not an uncommon positions for assume, particularly when they can use a particularly large cohort of workers as a tool to sap revenue from, while not retaining the funds for retirement benefits.

That said, I can look at the past and be a critic.  That’s easy, there have been real jerks that have milked our society, and retained a good name, though they robbed the future to pay the past.  It is criminal what municipal politicians have done, hiding behind high assumed investment assumptions, supported by brain-dead consultants who assumed markets are magic, and always provide high returns.

But there are enough targets in the present.  The evil party, the Democrats, ignore the long run effects of their deficits, and ignore the entitlements crisis that will engulf the nation.  The stupid party, the Republicans, rolled over for the idiocies of Bush II, and ignored the long term effects of debts and entitlements.

But there is a new force of anger, the t-party.  And that is about all they have, is anger.  They want their taxes reduced, but don’t want large entitlement programs reduced, or defense.  They represent small-minded libertarianism.  I am an economic libertarian, but I recognize that my views mean real pain for many in the short run, though I think those policies will be best for all in the long run.

There was a real loss in our nation when we abandoned the idea that national budgets needed to be balanced.  It brings out the worst in politicians when they think money is free, and they can engage in the basest demagoguery with no cost.  As it is today, we would probably be better off electing our politicians via random selection.

I have no sympathy for the t-party.  If you only have economic interests, and aren’t willing to take stands on broader ethical questions, you do not deserve to be our rulers.  Government is ethical as a rule, and the most important questions are what behaviors we encourage and discourage in our society.

I have a further concerns.  Leaders should not be merely facile rhetoricians, but should be genuinely mature.  I cringe listening to the t-party endorsed politicians, because they aren’t mature enough to rule.  If you can’t control what you say, and how you say it, you don’t have enough control over yourself to be one who promotes order in society.


I wrote the above three weeks ago and sat on it.  After writing it, I said to myself, “This is not one of your better works, are you going to say that?”  After review, I am saying this with full conviction.  Most t-party candidates are not ready for prime time.

Take Sarah Palin as an example. Sarah Palin is a bad joke.  If she is such a good Evangelical Christian woman, why is she not at home taking care of her young children, particularly the one with Down Syndrome.  Or, why was she occupied with Alaska politics at a time when she should have been there for her daughter Bristol, who was about to make some very bad decisions.

Feminism has no place in Christianity.  Men are to lead, not women.  Go home, Sarah.  Homeschool your children, if you can. I would not say this to a woman outside the Church, but since you claim to be one of the disciples of Christ, I say it to you.

I say this as a leader in the Church, ordained by the elders of my presbytery, in a Bible-believing church.  There is no good that comes from neglecting your own home to address the problems of the nation.  Sarah Palin is no Deborah.  Deborah was wise, and Sarah Palin is not.

I fear God more than I care about the political direction of this country.  As the Apostle Paul said, “Shall we do evil, that good may come?”  Paul spoke rhetorically, saying that we should do what is right, regardless of the results.  There is no good that comes from trying to save society, when our own house is not in order.


I could talk about the other t-party candidates and their idiocies.  Time would fail me.  I am in favor of a brainy libertarianism and Biblical morality, rather than a brain-dead libertarianism, and appeals to general morality.

The most pressing and immediate economic problem is this: we are facing a funding crisis for all of the promises made by governments and corporations regarding retiree employee benefits.  Every day I see more articles about the pain municipalities are going through over funding pensions, with occasional pension strengthening from corporations.

The sins of past governments, making promises that could not easily be fulfilled, or, at least fairly funded in the short run, are coming home to roost.  Funding issues for all levels of government are rising.  It doesn’t matter if you have met the budget this year, however you have done it.  Next year will be worse, because the assets will not throw off enough income to satisfy the liabilities over the intermediate-term, across the whole nation.


We go to the polls in the US today, but no one dares talk about the funding crisis.  They talk of tax cuts or protecting benefits, while at the same time the economic decay continues, where debt grows, and ability to repay it declines.

It is a sad state of affairs, and indeed, I despair over it.  I love my nation, though I do not support its wars or its economic foolishness.  Unlike what Reagan said, America is not the last best hope of man on Earth, rather it is the God-man Jesus Christ, to whom we must all eventually answer.


If I have a fault economically, it is that I look to the long-term.  For me, it is Heaven, though on Earth it is what will happen to my great-grandchildren and beyond.  Our policies are slanted to the present, and will force those who are younger to pay far more than they ought to pay, because they will be carrying the profligacy of the Baby Boomers.

No party is seriously looking at the future funding crisis.  There are little hints among the municipalities that are the worst running into problems now.  Those problems will only grow, and spread.  The problems in the unfunded Federal plans will be a plague in their time.


This is an unusual post for me, prompted partly by the elections, because I don’t think anyone from an economic standpoint is addressing the real problems that we are facing.  Mere politics prevails for now, with fine-sounding but empty words telling the electorate that they will be restored to prosperity.

There are bigger forces in play here.  Consider my old piece, Rethinking Comparable Worth; as it stands, less skilled labor in the US should see wage declines as the rest of the world becomes more competitive.  Unskilled labor is not scarce. Skilled labor is somewhat scarce. Good ideas are scarce.  Real capital is scarce, but financial capital is not scarce.  Commodities vary in scarcity.


I see this as a time for the US to “grow up,” and see that there are no easy solutions, but that it will take shared sacrifice to preserve our nation.  Taxes will have to rise while benefits are cut.  Keynesians will scream, but the average person in the US will see it as fair, because they know that everything must be paid for; there is no free lunch.

Dear David,

Quick question in case you find yourself with time to spare on your blog (ha!! ) :
You have a large family. What do you teach your children?  How do you prepare them using the economic back drop? What are the hopes, the fears that a parent has for their youngsters ?

It is the real-life application that so often is skipped over in financial blogs.  Maybe that’s as it should be – not every reader might find it of interest.  But isn’t that where the rubber meets the road?

So, I’ll send this off and maybe one of these days, the question ties in with something you were going to write.

Thanks a lot for your insights.




As the snow starts to fall, and Baltimore is in the eye of the storm (18-24 inches of snow predicted), I think it is a good time to sit back and think about the bigger things of life.  I’ll be spending all day tomorrow with my family.  Now, that’s normally true.  I work from home, and my wife and I homeschool.  We have two graduates, one drop-out (a sad tale, and what made me start working from home to protect my family until we told him he had to leave), an eleventh grader, ninth grader, two sixth graders, and a second grader.  Five of the eight are adopted, and are African-American to varying degrees.  All of them have very different ability levels, and different levels of being willing to work hard.  The one that left was bright, but lazy, and that was part of his undoing.

I’m not a natural parent, but I have learned to control my temper better as the years have gone by.  I never realized how much I like things quiet until I had a lot of kids. 😉  My wife and I work as a team.  She does most of the teaching, and I do most of the discipline, but each of us does both.  My wife is bright, but I can still do Algebra 2 through Calculus.  I pick up the slack there.

My kids do get some economic training from me in a variety of ways:

1) Informally at dinner, I explain what is going on in the world.  The eleventh grader gets a lot of it, while the college students can’t be bothered.  The ninth grader and sixth graders get a decent amount of it.  But it is precious when one of the kids comes and says “Dad, can you explain to me what happened during the Great Depression?”  That said, it was even more precious when I tried to explain what I did as a corporate bond manager to my kids seven years ago (100 phone call per day), and the then eight-year-old said, “It’s like ordering pizza all day, right?”

2) There is the “Bank of Dad.”  This is not original to me, but I tell the children that they can deposit their money with me, and I will pay them 5% interest (annual equivalent yield).  Oh, and to get started, they must amass $100.  That is psychologically important, because it is a barrier to getting into an exclusive club.  The rate has been 5% for the last 10 years — the rate is subsidized to encourage children to save.

My children are not all natural savers.  Half are and half aren’t.  The ability to earn interest makes them all more inclined to save.  What we try to put forth to those that are not natural savers is to spend less than all that they earn, and save the rest.  If all Americans did that our economy would be much better off.

3) Work hard.  That applies to schoolwork and chores.  Basic chores get no pay but there is an allowance if those normal chores are done.    Then there are other tasks that are available for pay, and those have varied over the years:

  • Cutting the yard.
  • Yard work.
  • Analyzing documents, and shredding the useless ones.
  • Sorting financial documents.
  • Shredding documents.
  • Checking derivative confirms.
  • Entering ABS cashflows for delivery to Bloomberg.
  • Entering industry rank data into spreadsheets.
  • Washing/waxing the cars.
  • Fixing the cheap Ikea furniture around the home.
  • Killing crickets and other vermin in the home.
  • Teaching math, or other subjects to younger children.
  • And more… if their schooling is done, neighbors often employ them for tasks, because the children are very reliable.

4) I spend time regularly explaining to my children what careers are in demand, and which are not.  I also explain the basic ideas of how companies make money, or not.  Then they follow what is happening in my career, with the media appearances, talks and other things that go on with me.  In any case, I try to explain to them to be practical, which is not generally taught in the schools.  Yes, do what you love, but don’t be dumb… no one will pay for useless bits of knowledge, and there are few teachers needed in such areas.

5) I do drop in on the homeschooling to provide greater background on history, economics, theology, and science.  I see my wife smile as I give greater depth to topics as I motivate them.

6) We have dinner together every night, and the discussion helps the children grasp on to what is going on in the world, as does subscribing to The Economist, and The Wall Street Journal.  I have subscribed to both for the last 20+ years.

7) Hopes and fears?  Ugh.  My third child made my life a mess.  I loved him so, but he gained a bunch of evil friends and turned against us.  But that is just one child.  My goal is not to create clones of me, but to create people who can be productive in the world, and faithful to Jesus Christ.

I have fears that the future won’t be as good for my children as it was for me, but I also know that my children are better prepared than most.  I can’t control the external macroeconomy; even my predictions are only a vague help.  My goal is to turn out children that are better prepared than most, and willing to work.  Beyond that, I pray to Jesus, but that is the best that anyone can do.

In the end I know that my efforts are valuable but not determinative.  I can’t make anything happen.  I can only teach my children, and trust in God for the rest.

If you have time, there are two long articles that are worth a read.  The first is from the Washington Post, and deals with the demise of AIG, highlighting the role of AIG Financial Products.  It was written in three parts — one, two, and three, corresponding to three phases:

  • Growth of a clever enterprise, AIGFP.
  • Expansion into default swaps.
  • Death of AIG as it gets downgraded and has to post collateral, leading to insolvency.

What fascinated me the most was the willingness of managers at AIGFP to think that writing default protection was “free money.”  There is no free money, but the lure of “free money” brings out the worst in mankind.  This is not just true of businessmen, but of politicians, as I will point out later.

My own take on the topic involved my dealings with some guys at AIGFP while I was at AIG.  Boy, were they arrogant!  It’s one thing to look down on competitors; it’s another thing to look down on another division of your own company that is not competing with you, though doing something similar.

As I sold GICs for Provident Mutual, when I went to conferences, AIGFP people were far more numerous than AIG people selling GICs.  The AIG GIC sellers may have been competitors of mine, but they were honest, and I cooperated with them on industry projects.  Again, the AIGFP people were arrogant — but what was I to say?  They were more successful, seemingly.

The last era, as AIG got downgraded, was while I wrote for RealMoney.  After AIG was added to the Dow, I was consistently negative on the stock.  I had several worries:

  • Was AIGFP properly hedged?
  • Were reserves for the long-tail commercial lines conservative?
  • Why had leverage quadrupled over the last 15 years?  ROA had fallen as ROE stayed the same.  The AIG religion of 15% after-tax ROE had been maintained, but at a cost of increasing leverage.
  • Was AIG such a bespoke behemoth that even Greenberg could not manage it?
  • My own experiences inside AIG, upon more mature reflection, made me wonder whether there might not be significant accounting chicanery.  (I was privy to a number of significant reserving errors 1989-1992).

In general, opaqueness, and high debt (even if it’s rated AAA), is usually a recipe for disaster.  AIG fit that mold well.

Now AIG recently sold one of their core P&C subsidiaries for what looks like a bargain price.  This is only an opinion, but I think AIG stock is an eventual zero.  Granted, all insurance valuations are crunched now, but even with that, if selling the relatively transparent operations such as Hartford Steam Boiler brings so little, then unless the whole sector turns, AIG has no chance.  Along the same lines, I don’t expect the “rescue” to be over soon, and I expect the US govenment to take a significant loss on this one.

The second article is from Bethany McLean of Vanity Fair.  I remember reading her writings during the accounting scandals at Fannie Mae.  She was sharp then, and sharp now.  There were a loose group of analysts that went under the moniker “Fannie Fraud Patrol.”:  I still have a t-shirt from that endeavor, from my writings at RealMoney, and my proving that the fair value balance sheets of Fannie were unlikely to be right back in 2002.

Again, there is a growing bubble, as with AIG.  The need to grow income leads Fannie and Freddie to buy in mortgages that they have guaranteed, to earn spread income.  It also leads them to buy the loans made by their competitors.  It leads them to lever up even more.  It leads them to dilute underwriting standards.  Franklin Raines’ goals lead to accounting fraud as his earning targets can’t be reached fairly.

One lack in the article is that the guarantees that Fannie had written would render Fannie insolvent at the time the Treasury took them over.  On a cash flow basis, that might not happen for a long time, but it would happen.  Defaults would be well above what was their worst case scenario, and too much for their thin capital base.

The last article is another three part series from the Washington Post that is about the failure of our financial markets.  (Here are the parts — one, two, three.)  What are the main points of the article?

  • Bailing out LTCM gave regulators a false sense of confidence.  They relished the micro-level success, but did not consider the macro implications of how speculation would affect the investment banks.
  • Because of turf and philosophy conflicts, derivatives were left unregulated.  (My view is that anything the goverment guarantees must be regulated.  Other financial institutions can be unregulated, but they can have no ties to the government, or regulated financial entities.
  • The banking regulators failed to fulfill their proper roles regarding loan underwriting, consumer protection and bank leverage.  The Office of Thrift Supervision was particularly egregious in not doing their duty, and also the the SEC who loosened investment bank capital requirements in 2004.
  • Proper risk-based capital became impossible to enforce for Investment banks, because regulators could not understand what was going on; perhaps that is one reason why they gave up.
  • The regulators, relying on the rating agencies, could not account for credit risk in any proper manner, because the products were too new.  Corporate bonds are one thing — ABS is another, and we don’t know the risk properties of any asset class that has not been through a failure cycle.  Regulators should problably not let regulated entities use any financial instrument that has not been through systemic failure to any high degree.
  • Standards fell everywhere as the party went on, and the bad debts built up.  It was a “Devil take the hindmost” situation.  But as the music played, and party went on, more chairs would be removed, leaving a scramble when the music stopped.  Cash, cash, who’s got cash?!
  • In the aftermath, regulation will rise.  Some will be smart, some will be irrelevant, some will be dumb.  But it will rise, simply because the American people demand action from their legislators, who will push oin the Executive and regulators.

A few final notes:

  • Accounting rules and regulatory rules were in my opinion flawed, because they allowed for gain on sale in securitizations, rather than off of release from risk, which means much more capital would need to be held, and profits deferred till deals near their completion.
  • This could never happened as badly without the misapplication of monetary policy.  Greenspan enver let the recessions do their work and clear away bad debts.
  • Also, the neomercantilistic nations facilitated the US taking on all this debt as they overbuilt their export industries, and bought our debt in exchange.
  • The investment banks relied too heavily on risk models that assumed continuous markets.  Oddly, their poorer cousin, the life insurers don’t rely on that to the same degree (Leaving aside various option-like products… and no, the regulators don’t know what is going on there in my opinion.)
  • The insurance parts of AIG are seemingly fine; what did the company in was their unregulated entities, and an overleveraged holding company, aided by a management that pushed for returns and accounting results that could not be safely achieved.
  • The GSEs were a part of the crisis, but they weren’t the core of the crisis — conservative ideologues pushing that theory aren’t right.  But the liberals (including Bush Jr) pushing the view that there was no need for reform were wrong too.  We did not need to push housing so hard on people that were ill-equipped to survive a small- much less a moderate-to-large downturn.
  • With the GSEs, it is difficult to please too many masters: Congress, regulators, stockholders, the executive — all of which had different agendas, and all of which enoyed the ease that a boom in real estate prices provided.  Now that the leverage is coming down, the fights are there, but with new venom — arguing over scarcity is usually less pleasant than arguing over plenty.
  • As in my blame game series — there is a lot of blame to go around here, and personally, it would be good if there were a little bit more humility and willingness to say “Yes, I have a bit of blame here too.”  And here is part of my blame-taking: I should have warned louder, and made it clearer to people reading me that my stock investing is required because of the business that I was building.  I played at the edge of the crisis in my investing, and anyone investing alongside me got whacked with me.  For that, I apologize.  It is what I hate most about investment writing — people losing because they listened to me.

(graphic obtained here, by enrevanche)

I’ve subscribed to The Economist for 22 years.  IN my opinion, it is the best English language newsweekly in the world.  Every now and then they toss a game into the magazine.  This time, the Internet aids the game, in that you can download cards, money, pieces, and rules.

This evening, three of my eight children said they wanted to play the game with me.  How it happened: I had printed out the money, cards, pieces and rules, and I had The Economist open to its centerfold, and the one who recently scored well on the National FInancial Literacy challenge saw it and asked what it was.  I told him it was a game from The Economist, and that if he made the effort to cut the pieces of paper and get the pieces together, we would play the game.  Two other children joined in, and we started the game.

Now, ay my house, you learn about the markets atmospherically.  As one of my kids said, who is not markets-oriented, “Yeah, in school neither the teacher nor the students understood what was going on in the economy, but I was able to explain it.”  (That floored me.)  As for the children that played with me this evening, it was filled with “Dad, what does it mean by…?” and laughter over the concept of naked short selling, especially given the graphic on the board.  There were a lot of “teachable moments” from a home schooler’s point of view.

The board and cards are filled with the clever humor of KAL, The Economist’s main cartoonist.  The kids picked up the copious easy humor, while I smiled at the nuances that they missed.  We have not finished the game yet, and two of my other children have said they want to play the next game.  One more aspect of the game: it starts in an intensifying boom cycle, and moves to an intensifying bust cycle.  The business cycle concept is definitely taught.

The length of the game seems to be an hour at minimum, and I’m not sure what the maximum could be.  Already the children are learning aspects of negotiation.  After one child went bankrupt for the second time, she received a buyout offer, a contingent debt offer in exchange for a “Get out of Chapter 11 free” card, and a free offer of money with the condition that if she went bankrupt again, she would sell out for a price fixed now.  She chose the contingent debt offer, and we all said she made the right move.

It may not be Monopoly, but it’s a fun game, and it is free.  Give The Economist and KAL credit for a clever game that sheds some light on the current crisis in a fun way.

Ordinarily, when I sit down top blog, I know what I want to write.  That’s not true now.  Yes, I could do a few book reviews.  I have six books read, and ready to go, but given the volatility of the markets, I feel I have to say something about the current activity.

I am a strong believer that there are few free lunches.  If there are simple policies that will easily produce prosperity, they would likely have been done by now.

As I have commented before, what we are seeing now is a shift in debt from the banks to the government.  Banks get capital, the government gets debt, and the money for the debt comes from three places: taxpayers, foreign lenders (central banks, probably) and perhaps at some point, the Federal Reserve could buy it (whether they monetize it or not is another question).  As jck noted yesterday, this has led to a selloff in Treasuries.  (Interesting that it happened on a day when the cash markets were closed, but the futures markets were open.  The reaction of cash bond market today is similar to that which the futures market exprerienced yesterday.)

Which brings me to my first point.  Today, when the rally in the fixed income markets gets reported (the markets again, were closed yesterday, you will likely hear that spreads rallied sharply.  But watch for the discussion of yields and prices (if there is any).  It’s quite possible that yields rise from Friday to the close of business today.

Second point, today $250 billion of the $700 billion got used on nine big/critical banks.  Now, this may have been somewhat coercive to some of the nine banks; as was said at Bloomberg:

None of banks getting government money was given a choice about it, said one of the people familiar with the plans. All of the banks involved will have to submit to compensation restrictions, said the person.

The government will also guarantee the banks’ newly issued senior unsecured debt, making it easier for them to refinance their liabilities, the person said.

Possibly the following message was delivered, “Be a good boy and get in line.  This is good for the nation, and we won’t be around for a decade.  You want to be a survivor, right?  You want friendly regulators when we review the levels at which you are marking your illiquid assets?  We thought so.  Sign here.”  (No surprise that Goldman then applies for a NY State, rather than Federal bank charter.  State regulation, particularly when you are a local champion, is much more flexible.  Just ask AIG. 😉 )

Though this leads to a short-term bounce in bank share prices, the long term effects are less clear, which brings me to my third point.  It’s one thing to bolster their balance sheets.  It is another to get them to lend, particularly in the bear phase of the credit cycle.  Also, as leverage comes down, and it will come down, so will profitability at the investment banks, and probably other banks as well.  Securitization will be less common, eliminating hidden leverage that allowed for less capital.

The same thing is going on in Europe, though they actually think about how they might pay for the bailouts.  In the UK, it pushes the national debt to GDP ratio to 100%.  As it gets closer to 150%, the international debt markets usually start to choke.  We have traded bank credit risk for national solvency risk at the margin.  Maybe that will be different here, if only government creditworthiness is perceived to be safe.  It is a “new era,” right? 🙁

I find it interesting that Barclays is refusing help.  Either the UK regulators aren’t so coercive as those in the US, or Barclays is not as levered as I thought.  Or, it could be hubris on the part of Barclays’ management team.

Even Japan is getting into the act, though these measures seem so weak that I wonder why they would bother.  The government and Bank of Japan stop selling bank shares, and allow companies to buy shares back more aggressively.  That may push share prices up in the short run, but it substitutes debt for equity, which shouldn’t have much of a long-term impact.

On the Central Banking Front

Now, with the seemingly limitless amount of US liquidity being to the short end of the US money markets, you would think that we would get a bigger move than we have gotten so far. This will take time, but watch the yield as well as the spread.  Also remember that LIBOR has become somewhat of a fiction at present.  There many quotes, but not so many loans to validate the quotes.

What is being done that is new?

  • TAF expanded to $900 billion.
  • New commerical paper program where the Fed backstops the A-1/P-1/F1 CP market, including ABCP.  Terms hereFAQ here.  This is big, and it is much easier to start such a program than to end it.  It is difficult to end any program where credit is granted on less than commercial terms.  My guess is that it will be extended past its April 30th, 2009 planned expiry date.
  • Swap agreements allowing unlimited dollar liquidity to foreign entities through agreements with their central banks.
  • The Fed can now pay interest on reserve balances held at the Fed, which allows them to increase their balance sheet significantly.  In one sense, they become the Fed funds market.

What is not new is the idea that all we have to do is restore confidence, and everything will be fine.  No, we have to delever, and the US Gowernment is included in the list of those that need to delever.  There is no national reform going on here, but merely a shifting of obligations from private to public hands.

For investors:

For those that are investors, the biggest bounces tend to occur during depressionary conditions.  I would not get overly excited about the rally yesterday.  As John Authers at the FT points out, given the extreme changes being made, there should have been a bounce.  The question is whether it will persist.  I was a net seller into the rally toward the end of the day.  I think we have more troubles ahead.  Two things to watch:

  • LIBOR, CP yields and the TED spread. (The short end)
  • Overall yields of medium-to-long Treasuries and other long-dated debt.  (The long end.)

I expect yields to rise, even if some spread relationships fall.  The added financing needed by the US government is large.  Let us see where Treasury buyers have interest.

There are elements of this that remind me of my The US Dollar and the Five Stages of Grieving piece. This is for two reasons: first, we are asking foreign entities to hold more dollar claims at a time when they are stuffed full of them.  Second, this phase of the credit crisis reminds me of the “bargaining” phase of the five stages of grieving.  We are past a long denial phase, and the anger continues, but now we bargain that these proposals will allow us to escape the pain that comes from delevering.

I’m skeptical, but I hope that I am wrong, lest we get to the fourth stage “depression,” before we finally reach “acceptance.”  As it is, I am looking for companies with blaance sheets strong enough to survive the worst.  That is my task for the next few days.

Uh, this is an off-topic piece. One of the benefits of working from home is that I can listen to my wife teaching our children, and every now and then, I drop in and explain some aspect of the topic further. Out of the corner of my ear, I heard my wife Ruth explaining Greatest Common Factors and Least Common Multiples to our fifth child, Jonathan.

When I was a kid, I was kind of a prodigy with math (I am not so now), and when we went through it in school, I remember tutoring my classmates on the two topics. I always thought the two concepts were related, but I never understood how, until it struck me last week.

Consider the numbers 60 and 144. What are their Greatest Common Factors and Least Common Multiples? To start, let’s factor the two numbers:

Then, let’s place the common factors in the intersection set.

The greatest common factor is the product in the intersection set, in this case, 3x2x2 = 12. The product of the union set (just multiply across) is the least common multiple — 5x3x2x2x3x2x2 = 720.

When I realized this, I drew it out for Ruth and Jonathan, and told them “Look at the ravings of a madman.” But later that evening, Ruth came to me and thanked me for it, because it worked with Jon, and clarified it to her.

As a mathematician, I am nothing great, but my intuition has been a great help to me at many points. This was one of them.

Update Saturday Afternoon

As F comments, “Which has the consequence that LCM*GCM = number1*number2.”

I should have written that myself, but didn’t.  Thanks for pointing that out.  It is an application of the rule that:

set A + set B = union of A&B + intersection of A&B